Slide 28.1 Chapter 28 Review of Financial Ratio Analysis

Slide 28.1

Chapter 28

Review of Financial Ratio Analysis

Slide 28.2

By the end of the chapter, you should be able to:calculate operating, liquidity and activity ratios

from an annual report;discuss the implication of the ratios;describe and draft a report using inter-firm and

industry comparative ratios;critically discuss the strengths and weaknesses

of ratio analysis;calculate EBITDA and EBITDA margins for

management control purposes.

Objectives

Slide 28.3

Initial impressions

Impact of economic conditions Is liquidity likely to be under pressure? Are debt covenants likely to be broken? Will assets need to be sold to reduce debt?

Slide 28.4

Initial impression of the sector

• Possible risk of:– A significant fall in revenue– Plant closures– Redundancy costs

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Initial impressions – misrepresentation?

What are the pressures on management to:– Understate liabilities – Overstate inventories – Overstate trade receivables– Overstate bank balances – Understate impairment losses.

Slide 28.6

Initial look as prelude to moresystematic look

Need for an extremely inquisitive and enquiring frame of mind

Some issues will be quickly evident, e.g. A company has made losses in the past 2 years or It has a declining sales turnover or A large overdraft or A greatly increased accounts payable figure.

Slide 28.7

Ratio analysis – main strength

Ratios: Direct the user’s focus of attention Identify and highlight areas of good and bad

performance Identify areas of significant change.

For a ratio to be useful, there must be a significant relationship between the two items being compared. A ratio focuses attention on the relationship.

Ratios require additional investigation of the underlying data being used.

Slide 28.8

Caveat

Beware creative accountingView that:

Every company in the country is fiddling its profits It is a myth that the financial statements are an accurate

reflection of the company’s trading performance for the year

Accounts are little more than an indication of the broad trend.

Slide 28.9

Compare like with like

Comparing current financial ratios with:Financial ratios for a preceding periodBudgeted financial ratios for the current periodFinancial ratios for other profit centres within

the companyFinancial ratios for other companies within the

same sector (industry).

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Importance of uniformity

Comparison is possible only if there is: • Uniformity in the preparation of accounts

– IFRS helping to achieve this • An awareness of any differences in international

accounting policies

– US SEC still has not adopted IFRSs.

Slide 28.11

Need to understand how ratios are defined

Implications of any given ratio requires a clear definition of its constituent parts Which profit is being used? EBIT? EBITDA? NOPAT?

Definitions of ratios may vary from source to source, e.g. concepts and terminology are not universally defined How is capital employed defined?

Slide 28.12

Awareness of underlying trends How to interpret a constant ROCE? ROCE remains a constant 10% over the years 20X7–20X9 Net profit and capital employed increased by 50% in both 20X2 and 20X3 This trend is not ascertainable in the ROCE ratio.

Return on

Net profit Capital employed capital employed

£ £

20X1 100,000 1,000,000 10%

20X2 150,000 1,500,000 10%

20X3 225,000 2,250,000 10%

Slide 28.13

Review ratio analysis

• Three primary ratios:

– Investment ratios

– Operating ratios

– Liquidity ratios.

Slide 28.14

Primary investment level ratios

Return on equity:

Earnings before interest and tax

Shareholders’ funds

Measures the return available to the shareholders.The objective of management is to generate the

maximum return on shareholders’ investment. This ratio serves as an indicator of management

performance, but should be used in conjunction with other indicators.

Slide 28.15

Return on equity

A high return, normally associated with effective management, could indicate an under-capitalised company.

A low return, usually an indicator of poor management performance, could reflect a highly capitalised, conservatively operated business.

Net profit after taxes and preference dividend is used because this is the amount available for distribution to the ordinary shareholders.

Slide 28.16

ROE driven by

• Financial leverage multiplier

Capital employed

Shareholders’ funds• Return on capital employed • where capital employed = total assets

Slide 28.17

Primary operating level ratios

Return on capital employed

Earnings before interest and tax Capital employed

• No single definition of capital employed• Often used for strategic planning.• Also known as:

• Return on total assets, or• Return on investment

Slide 28.18


Measures the return to shareholders and lenders on the total investment they have in the business. It is a measure of the overall effectiveness of management in employing the resources available to the business.

Heavily depreciated plant and equipment, large amounts of intangible assets, or unusual revenue or expense items can cause distortions to the ratio.

Is also known as return on investment.

Slide 28.19

Use of ROCE as a target

The Royal Mint’s financial performance improved for the second consecutive year in 2007–08, with a pre-exceptional operating profit of £9.6m

The return on capital employed of 11.5% was substantially above the financial ministerial target of 7.2%.

Slide 28.20

Calculation of ROCE

2003 2002


9.19% 8.95%

Financial leverage multiplier

2.56 2.53

Return on equity

23.5 22.6

Slide 28.21

Calculation of ROCE (Continued)

ROCE is calculated as the product of: the % return on sales and the asset turnover.

Slide 28.22

Asset turnover

The asset turnover ratio measures the number of times that ₤1 of assets results in a ₤1 of revenue

If asset turnover increases, then either the total value of revenue is increasing or the capital asset base is decreasing, or both

Has increased sales been achieved at the expense of the profit margin?

Has a reduction in the capital asset base adversely affected productive capacity?

Slide 28.23

Primary operating level ratios

Primary utilisation ratio (asset turnover) Sales

Capital employed

Improved by:

Sales increasing

Assets decreasing

• Fixed asset replaced?

• Inventory falling?

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Sales/capital employed increasing

Sales increasing Volume increase

Price increase

Possible Effect on profits

Price reductions

Sales promotions.

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Sales/capital employed increasing (Continued)

Assets decreasing

• Non-current assets

– Disposal?

– Impairment?

• Inventory

– Run down of inventory?

– Possible stock outs?

Slide 28.26

Current ratio

a short-term measure of a company’s liquidity position comparing current assets with current liabilities.

no rule of thumb measure, such as 2:1, that can be applied.

appropriate ratio depends on the industry sector and each individual company’s experience.

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Current ratio – what if it increases?

– Good reasons Growth: Inventory buildup expecting sales growth Expansion: Permanent increase in scale.

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Current ratio – what if it increases? (Continued)

Poor reasons: Decline: Inventory buildup result of falling sales Inefficiency: Poor control over working capital.

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Subsidiary ratios

Gearing ratios

Liquidity ratios

Asset utilisation ratios

Investment ratios

Profitability ratios.

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Subsidiary ratios – gearing (leverage)

Analysing long-term financial stability – to indicate a company’s capacity to meet long-term obligations (solvency)

Slide 28.31

There are a number of different formulae used to express the gearing ratios

(a) Long-term debt to Capital employed ratio

(b) The debt ratio – (total debt / total assets)

(c) The debt-to-equity ratio

– (total debt / total equity)

(d) The equity ratio

– (equity / assets).

Slide 28.32

Definition of gearing for text

For the purposes of illustrations in this chapter we are defining gearing as long-term debt to Capital employed.

A number of companies report the debt/equity ratio as their preferred choice and include total debt rather than long-term debt if a company relies heavily on overdraft facilities.

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Leverage (debt) ratios Leverage ratios measure the extent to which:

borrowed funds are used to finance the business, and earnings can decline before the business is unable to

meet its fixed charges. Leverage ratios measure the business’s long-

term solvency – the ability of the business to meet all of its liabilities

Leverage ratios are calculated by comparing fixed charges and earnings from the Income Statement, or by relating debt and equity items in the Balance Sheet

Slide 28.34


Creditors use them to see whether the business’s profit can support interest and other fixed charges and whether there are enough assets available to pay off debt if the business fails. Shareholders are interested because the higher the debt, the higher the interest expense and, therefore, the less profit available to them. If borrowing and interest are excessive, the business may become insolvent.

The various types of leverage ratios are: • debt to total assets ratio • debt to equity ratio • times interest earned • cash flow to debt ratios.

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Debt to total assets ratio Measures the percentage of funds provided by creditors,

and shows the protection provided by the shareholders for the creditors. It is calculated as follows:

The higher the ratio, the greater the risk being assumed by the creditors. A lower ratio suggests long-term financial stability. A company with a low ratio also has greater flexibility to borrow in the future.

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Creditors prefer low-to-moderate ratios because these indicate greater safety for their claims on the company.

Shareholders may seek higher leverage because this increases the return on their investment.

A highly leveraged company can also affect the shareholders’ returns unfavourably. If profits are not enough to cover interest expenses, shareholders will not receive any dividends and the company could become insolvent and be liquidated.

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Debt to equity ratio The debt to equity ratio is calculated as follows:

Debt may be defined as either total debt or long-term debt. Most analysts tend to use long-term rather than total debt for this ratio.

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Long-term creditors prefer to see a low-to-moderate debt to equity ratio. Why?

This means that there is greater protection for them and more at stake for the shareholders. There is, therefore, greater motivation for the owners to ensure the business operates profitably.

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Times interest earned (Interest cover) A measure of the degree of protection creditors have from default on

interest payments. It shows the business’s ability to meet its interest payments. The ratio is calculated as follows:

Net operating profi t is earnings before interest and taxes (EBIT). EBIT is used because the ability of the business to pay interest is not affected by the company’s tax liability.

What does a low times interest earned ratio suggest? The business may have difficulty in raising additional finance if the

need arises.

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If debt is bad, why have any? Despite its riskiness, debt is a flexible means of financing

certain business operations. Because it has a fixed interest charge, it limits the cost of

financing and presents a situation where leverage can be used to advantage.

Eg, if the business can earn more than the interest cost, it will make an overall profit. In times of inflation, debt (which is a fixed dollar amount) is repaid with ‘cheaper’ dollars than the ones originally borrowed. The dollars used to repay the debt are worth less in buying power than the ones originally borrowed. But, if the business does not earn a return on its assets equal to the cost of interest, it operates at a loss.

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Cash flow to debt ratios A measure of the ability of a business to service its debt is

the relationship of annual cash flows to the amount of debt outstanding. The ratio is calculated as follows:

Cash flow is defined as the cash generated from the operations of the business that is shown in the Cash Flow Statement

The cash flow to long-term debt ratio can also be used for evaluating the long-term solvency of a company

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Subsidiary ratios – liquidity

analysing stability – to indicate a company’s capacity to meet short-term obligations

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Liquidity ratios Liquidity ratios look at the relationships between

the components of working capital. The most commonly used ratios are: 1 working capital

Working capital = Current assets – Current liabilities 2 current ratio

a measure of immediate ability to pay debts. 3 liquidity (quick or acid test) ratio.

the ratio of liquid assets to current liabilities.

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Working capital Working capital = Current assets – Current liabilities

used as a measure of a business’s ability to meet its short-term commitments.

Which company has the better working capital?

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The current ratio is the ratio of current assets to current liabilities.

The make-up and quality of the current assets is a crucial factor in using this ratio as an indicator of the business’s liquidity.

Consider the following two companies.

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Company B is more able to meet its current obligations. It does not have to convert inventories to cash. It must still collect its receivables, but this is easier than converting inventories into sales to create receivables that must then be collected as cash.

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What can cause the current ratio to increase? Decrease?

Increases could indicate poor inventory management, poor credit control, unfavourable prices for purchases, poor production planning and increases in sales due to high

discounting leading to increased accounts receivables. Decreases could indicate

improved inventory control, Increases in cash sales, and improved production planning.

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Liquidity (quick or acid test) ratio Liquid (or quick) assets are cash, marketable

securities, and accounts receivable – the assets that can be turned into cash quickly

It shows a business’s ability to meet its current obligations promptly.

When the ratio is less than 1, it implies dependency on inventories and other current assets that have been excluded from the formula to liquidate short-term debt

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The formula is:

Should all current liabilities be included, or just those that could be termed ‘quick’ liabilities (i.e. those liabilities that require to be met immediately)?

Bank overdraft, Taxes payable, Dividends payable? When must these be paid?

Slide 28.50


Current and liquidity ratios of seven New Zealand companies (2006 figures)

Company Current ratio Liquidity ratio Cavalier Corporation Ltd 2.97 1.42 Michael Hill International Ltd1 3.80 0.43 Nuplex Industries Ltd 1.99 1.21 Provenco Group Ltd 1.64 0.98 Steel and Tube Holdings Ltd 2.29 1.14 Trustpower Ltd2 1.02 1.02 The Warehouse Group Ltd1 1.93 0.46 1 These companies purchase their inventories on credit, but the majority of

their sales are cash sales. Consequently, they are able to operate satisfactorily with a low liquidity ratio

2 Because of the nature of this company’s’ business, it does not hold any inventories, hence the current and liquid ratios are identical.

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What is an acceptable current ratio or liquidity ratio? Factors that need to be considered when evaluating

short-term solvency include: the size of operating costs – the financial statements

do not usually show how much cash is needed for operating expenses such as salaries, rent and expenses other than those required to be disclosed. If these expenses are large and the liquid assets are few, the business could have problems meeting them.

bank credit – if the business has an excellent credit record and facility with its banker, lower current and liquidity ratios can be carried. The Warehouse Group would fall into this category – hence its ability to operate with a liquidity ratio of 0.45 : 1.

Slide 28.52


seasonal trade patterns –ratios can be distorted through the seasonal build-up, or run-down, of inventories and accounts receivable to meet sales demands when they peak. As retailers, The Warehouse and Briscoe Groups will carry much larger inventories over the Christmas shopping period than at other times of the year. However, these companies also increase certain types of inventories for other times during the year – such as Mother’s Day.

the type of business – for manufacturers and wholesalers, a larger ratio is needed because most of these firms’ sales are on credit, and it will be up to 51 days from the date of sale before cash payment is due to be received. Retailers, however, have a considerable volume of cash sales to supplement the credit sales and so will have a greater ability to meet cash liabilities as they fall due. Therefore, they can operate with a lower liquidity ratio.

Slide 28.53

Quick ratio – identify the company norm

The following is an extract from the 2008 Annual Report of Barloworld:

2004 2003 2002 2001 2000 1999

Quick ratio 1.0 0.8 0.7 0.8 0.9 1.1

Rule of thumb is 1:1

Consider the company norm

Slide 28.54

Activity utilisation ratios

Asset utilisation Asset utilisation, or activity, ratios show how

much use the business makes of its assets in generating sales.

They indicate whether the business’s investments in current and long-term assets are too large or too small.

These ratios also indicate the ability of the business to turn assets, especially inventories and accounts receivable, into cash and are, therefore, further indicators of solvency.

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Activity ratios include: inventory turnover days’ sales in inventory accounts receivable turnover average collection period (or days’ sales

outstanding) cash conversion cycle non-current asset turnover total assets turnover

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To avoid the problems of seasonal fluctuations in the sizes of inventories and accounts receivable, the monthly balances of these items should be taken and averaged when calculating ratios relating to these.

This is possible for internal analysis, but not when undergoing an external analysis.

Most external analysis uses either the end-of-year figures available in the published financial statements of companies, or an average of the opening and closing figures that are provided in the published reports.

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Inventory turnover change

analysing activity – to indicate how effectively a company is using its assets

Is it a proactive decision?Is it reactive such as responding to economic

changes?Has there been misrepresentation?Refer to narrative for clues.

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Inventory turnover

Inventory turnover measures the number of times inventory is sold and replaced during the year.

Why is COGS used? Because inventories are valued in terms of their

cost. The sales figure includes the profit mark-ups

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Inventory turnover

A high turnover can indicate: better liquidity or superior merchandising of needed inventory for sales, which in turn could mean unhappy or lost customers A low turnover implies: a large investment in inventories relative to the amount

needed to service sales poor liquidity, possible overstocking, or obsolete stock. may also be an indicator of a planned inventory build-up

in the case of material shortages

Slide 28.60

Inventory turnover

What are some problems involved with using COGS? For companies such as The Warehouse Group, for example,

the average turnover of the food items sold will be much higher than the turnover of electrical appliances – yet both of these types of goods are included in the turnover figure

Many companies do not disclose their cost-of-sales figures and so their sales figures are used as a surrogate for cost of sales in this calculation. An inventory turnover figure calculated using sales will be higher than would be calculated if cost of sales is used.

Another example is the Briscoe Group whose financial year is to 28 January. It is likely to have sold down inventories after the Christmas rush and New Year sales. Consequently, this turnover figure is likely to be higher than would be the case if average end-of-month inventory figures are used.

Slide 28.61

Accounts receivable turnover

Days’ sales in inventory shows the length of time (in days) that it takes to sell

inventory. The formula for calculating this ratio is:

if sales are affected by seasonal patterns, the result may be misleading. if the days’ sales in inventory is understated, the liquidity

of the inventory will be overstated.

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Accounts receivable turnover measure of liquidity in terms of cash collection. The

formula is:

Average collection period measures liquidity in terms of cash collection. The

formula is:

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The higher the turnover figure (or the lower the collection period), the more successful the business is in collecting cash, and the better off its operations are.

Any large variations from month to month with the accounts receivable figure will affect the usefulness of this ratio

These ratios also indicate the business’s credit policy.

If customers are given more time to pay, the collection period will generally be longer.

Slide 28.64


A long collection period may also arise because of weaknesses in the billing procedures, ineffective incentives to get customers to pay on time, poor selection of customers to whom credit is extended.

A longer collection period can only be justified if it leads to greater sales, and if the profit on these extra sales covers the cost of

extending the credit.

Slide 28.65


The average collection period is affected by the pattern of sales.

If sales are rising, the ratio is more current than if sales are steady or falling. Why?

Because a greater proportion of the sales are billed in the current period.

If sales are falling over time, the ratio will show higher average collection periods, or older debts outstanding.

If there is a rapid change in the pattern of sales or if there is a fluctuating pattern to sales behaviour, the average collection period is not a realistic portrayal of the liquidity of receivables.

Slide 28.66

Cash conversion cycle

measures the delay between payments for inputs and receipts from sales.

Average payables period is the time it takes to pay accounts payable and is calculated as follows:

Slide 28.67

Cash conversion cycle

In interpreting the cash conversion cycle figure, it is important to look at the trend in all three of its components.

If shorter periods in processing inventories and/or accounts receivable are off-set by a longer period in paying accounts payable, any efficiencies gained from the improvement(s) in inventory and accounts receivables ratios could be eliminated.

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Non-current (Fixed asset or property, plant and equipment) turnover

measures the productivity of the business’s property, plant and equipment. The formula is:

A low ratio indicates: assets are being used inefficiently, or there is unused capacity available.

Slide 28.69

Non-current (Fixed asset or property, plant and equipment) turnover Over-investment in property, plant and equipment :

may require the business to assume higher interest charges, which may result in inadequate working capital.

Under-investment in property, plant and equipment (which can give a higher ratio) may result in: insufficient capacity and a deterioration of existing equipment

Assets that have been depreciated to close to zero, and labour-intensive operations, may cause a distortion of this ratio because these factors will produce a higher ratio (the carrying, or book, value of the assets is low) – suggesting the assets are being used extremely efficiently.

Slide 28.70

Non-current (Fixed asset or property, plant and equipment) turnover

Total assets turnover shows how well the business is using its total assets

to generate sales. It should only be used to compare businesses within specific industry groups and in conjunction with other operating ratios to determine the effective employment of assets. The formula is:

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Subsidiary ratios – investment

Slide 28.72

Earnings per share

Elliott & Elliott covered this in ch 27

We also looked at the other investment ratios when discussing ch 27

Slide 28.73

Earnings per share – use in strategic planning Gamma Holding NV 2002

Gamma aims to maximise shareholder valueStrives for continuous growth of EPS of 10% while maintaining healthy balance sheet ratios and generating positive cash flowsAims to achieve an average ROCE of 15%.

Slide 28.74

PE – a measure of market confidence

Market price takes into account macro events: Political factors

– imposition of trade embargoes or sanctions

Economic factors – downturn in manufacturing activity

Company related events – possibility of organic or acquired growth

the implication of financial indicators for future cash flow estimates.

Slide 28.75

PE ratio – implication of financial indicators

Statement of financial position:Change in debt/equity ratio in relation to prior

periodsNew borrowings for finance expansionDebt restructuring following inability to meet

current repayment terms Contingent liabilities that could be damaging if

they crystallise – non-current assets being increased or not being replaced.

Slide 28.76

PE ratio – implication of financial indicators (Continued)

Adequacy of working capitalLow acid test (quick) ratio in relation to prior

periods indicating possible liquidity difficultiesChange in current ratio in relation to prior

periods, i.e. higher indicating a build-up of slow moving inventory and lower possible stock-outs.

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PE ratio – implication of financial indicators – income statement

Income statement: Change in sales trend Limited product range, products moving out of patent

protection period Expanding product range Changes in technology beneficial or otherwise to company High or low capital expenditure/depreciation ratio

indicating that productive capacity is not being maintained Loss of key suppliers/customers, e.g. loss of longstanding

Marks & Spencer contracts Change in ratio of R&D to sales.

Slide 28.78

Profitability ratios

Profitability ratios are designed to assist in the evaluation of management performance.

Poor performance indicates a basic failure that, if not corrected, could result in the business going into liquidation.

A business’s past profitability may give a better understanding for decision making.

Profitability usually also affects a firm’s liquidity position.

A business can make a profit but not have enough cash available to meet its liabilities. Why?

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Measures of profitability include: gross profit margin (or mark-up) net operating margin profit margin on sales expenses as a percentage of sales percentage change in sales return on total assets return on equity.

Each of these ratios relates earnings to sales, assets, or equity.

Why do creditors, owners, and management pay close attention to them?

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Answer: Without profits, a business could not attract

outside capital. If these ratios are not adequate, creditors and

owners become concerned about the business’s future, and may withdraw their funds.

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Gross profit margin and mark-up Reflects the effectiveness of pricing policy and of

production efficiency. The formula is:

Mark-up expresses the gross profit margin in terms of the cost of goods sold, rather than in terms of sales.

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These ratios indicate managerial efficiency in selling the company’s merchandise.

Because there are usually wide variations between businesses, it is the trend rather than a comparison between businesses that is more important here – especially if the types of activity undertaken are not very similar.

As listed companies do not disclose their cost of sales, the gross profit margin and mark-up ratios normally cannot be reliably measured. Consequently, they are ratios used by management for internal purposes, rather than by investors and creditors, for assessing performance.

Slide 28.83


Net operating margin Measures the effectiveness of production and sales in

generating pre-tax income. The higher this ratio is, the better. Formula is:

Non-operating income and expense items are excluded - these are not directly related to the production or sales functions of the business.

Businesses finance their activities in different ways, so earnings before interest and tax (EBIT) is used so that relevant comparisons can be made.

Slide 28.84


Profit margin on sales Indicates management’s ability to operate the business

well enough to recover both fixed and variable costs, and leave a margin of reasonable profit for the shareholders. The formula is:

The ratio mixes the effectiveness of sales in producing profits (reflected by the net operating margin) with the effects of non-operating activities (included in net profit before tax).

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Other ratios Compare various expenses as a percentage of

sales to ascertain whether a particular expense has an undue effect on net profit.

The year-on-year percentage change in sales may be a useful indicator of sales growth. The effect of inflation on sales price needs to be

considered when using this ratio. A better indicator for ascertaining the change in sales

trend is the change in volume (units) sold.

Slide 28.86

Using ratios to make business decisions

Inter-relationship of ratios Ratios must be evaluated together, not

individually – why? Because of the interactions and

interrelationships between the various items that make up the ratios

Eg. Short-term ratios may suggest impending problems but long-term ratios suggest strength and vice versa

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Reporting and the usefulness of ratio analysis Calculating ratios and commenting on the trends

from one period to another is not difficult. Interpreting the ratios – that is, explaining why the

trends have occurred, and suggesting how these can be changed or improved is much more difficult, and much more important

Need to compare with standards – eg industry averages

Look for possible reasons for variations – good and bad – and how interactions might have an effect

Slide 28.88


Pitfalls Accounting policies applied by the company and those

with whom the ratios are being compared - are these consistent?

Companies of the same size in the same industry should be used for comparison.

Increasing diversification of company operations, Accelerated changes in technology, and Rapid changes in company sizes make it very hard to find a suitable company within an

industry with which valid comparisons can be made.

Slide 28.89


Recent and past ratios should be compared. A ratio may fluctuate considerably over time, with many reasons for this. Legislation, international affairs, competition, scandals, resignation of a senior manager

and many more factors can turn profits into losses Ratios should be analysed over a period of 5 – 10 years. A single figure, or ratios for any one year may give a

misleading indication of financial condition and company performance.

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Limitations Ratios have limitations. A ratio may indicate something is wrong, but it

does not identify the problem. The figures that make up the ratio have to be

analysed to find out which items (assets and/or liabilities) have changed.

Each item that goes into the ratio – as well as those that impinge on these items – must be analysed to see what has caused the change. Other factors, such as competitors and the state of the economy, also need to be considered.

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Ratio analysis cannot predict the future, but knowledge gained from studying ratios and related information can help you give informed recommendations and make informed decisions.

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Slide 28.93

Limitations of ratio analysis

Ratios are useful flags but there are limitations that the reader needs to bear in mind – these include limitations:

• relating to the underlying financial statements:

– the reliability of the financial statements that are themselves made suspect

• window dressing e.g. dispatching goods at the end of the period knowing that they are defective, so that they appear in the current year’s sales, and accepting that they will be returned later in the next period.

Slide 28.94

Limitations of ratio analysis (Continued)

– The possibility that the accounts are subject to fundamental uncertainty which could affect the going concern concept – there might be full disclosure in the notes but ratios might not be accurate predictors of earnings and solvency.

• Arising because ratios make use of the statement of financial position figures

– The end of year figures are static and might not be a fair reflection of normal relationships such as when a business is seasonal.

Slide 28.95


• E.g. a toy manufacturer might have little inventory after supplying wholesalers in the lead up to Christmas.

• Any ratios based on the inventory figure such as inventory turnover could be misleading if calculated at say a 31 December year end.

• Invalidating intercompany comparisons, such as:– Use of different measurement bases e.g.

• Non-current assets reported at historical cost or revaluation

• Revaluations carried out at different dates.

Slide 28.96


– Use of off-balance sheet finance e.g.

• Structuring the terms of a lease to ensure that it is treated as an operating lease and not as a finance lease

• Special purpose enterprises to keep debts off the statement of financial position.

– Use of different commercial practices e.g.

• Factoring accounts receivable, so that cash is increased – a perfectly normal transaction but one which could cause the comparative ratio of days credit allowed to be significantly reduced.

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• Invalidating intercompany comparisons, such as:– Applying different accounting policies e.g.

• Adopting different depreciation methods such as straight line and reducing balance

• Adopting different inventory valuation methods such as FIFO and weighted average

– Assuming different degrees of optimism/pessimism while making judgment-based adjustments to non-current and current assets e.g.• On the impairment review of intangible and tangible

non-current assets• On writing down inventory and accounts receivable.

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• Invalidating intercompany comparisons, such as:– Having different definitions for ratios e.g.

• The numerator for ROCE may be operating profit, profit before interest and tax, profit before interest, profit after tax etc

• The denominator for ROCE may be total assets, total assets less intangibles, net assets etc

– The use of norms can be misleading e.g. • A current ratio of 2:1 may be totally inappropriate for

a company like Tesco which does not have long inventory turnover periods – as its sales are for cash it would also not produce trade receivable collection period ratios.

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• Invalidating intercompany comparisons, such as:– Making appropriate choice of comparator companies for

benchmarking – this is a simple idea but more difficult in practice e.g.• How to find companies with a similar trade?• How to set criteria for selection?• Should it be

– The industry average ratios – but these may be based on many companies operating under very different economies of scale or companies with

– Similar amount of capital employed or– Similar amount of sales or– Some other criteria.

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Analysing the Cash Flow Statement a Cash Flow Statement provides is a summary of the

company’s use of cash Cash Flow Statements can be investigated using

horizontal and vertical analyses, as Illustration 10.1 in the handout shows.

Look closely at the Anna Corporation example in the handout

A business cannot survive if it relies on selling assets and/or borrowing to meet its cash flow needs

Successful companies generate the greatest percentage of their cash from operations, not from selling their fixed assets or from borrowing money.

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Analysts are particularly interested in an entity’s free cash flow – the net cash flow from operating and investing activities.

If an entity continually has positive cash flow from these two activities combined, it means it can pay dividends and/or repay debt without risk – even if, like The Warehouse Group, its liquidity ratio is considerably less than one each year.

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Review questions

1. (a) Explain the uses and limitations of ratio analysis when used to interpret the published financial accounts of a company.

(b) State and express two ratios that can be used to analyse each of the following:

(i) profitability

(ii) liquidity

(iii) management control.

(c) Explain briefly points which are important when using ratios to interpret accounts under each of the headings in (b) above.

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Review questions (Continued)

4. Discuss why a company might decide to report EBITDA in addition to operating profit.

7. Discuss why an increasing current ratio might not be an indicator of better working capital management.

Documents

Slide 28.1 Chapter 28 Review of Financial Ratio Analysis