Chapter 28

1. Chapter 28 Review of Financial Ratio Analysis

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

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?

4. Initial impression of the sector Possible risk of: A significant fall in revenue Plant closures Redundancy costs

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

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.

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 significantrelationship between the two items being compared. A ratio focuses attention on the relationship. Ratios require additional investigation of the underlying data being used.

8. Caveat Beware creative accounting View 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.

9. Compare like with like Comparing current financial ratios with: Financial ratios for a preceding period Budgeted financial ratios for the current period Financial ratios for other profit centres within the company Financial ratios for other companies within the same sector (industry).

10. 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.

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?

12. Awareness of underlying trendsHow 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%

13. Review ratio analysis • Three primary ratios: • Investment ratios • Operating ratios • Liquidity ratios.

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.

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.

16. ROE driven by Financial leverage multiplier Capital employed Shareholders’ funds Return on capital employed where capital employed = total assets

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

18. Return on capital employed • 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.

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%.

20. Calculation of ROCE 2003 2002 Return on capital employed 9.19% 8.95% Financial leverage multiplier 2.56 2.53 Return on equity 23.5 22.6

21. Calculation of ROCE (Continued) ROCE is calculated as the product of: the % return on sales and the asset turnover.

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?

23. Primary operating level ratios Primary utilisation ratio (asset turnover) Sales Capital employed Improved by: Sales increasing Assets decreasing Fixed asset replaced? Inventory falling?

24. Sales/capital employed increasing Sales increasing Volume increase Price increase Possible Effect on profits Price reductions Sales promotions.

25. Sales/capital employed increasing (Continued) Assets decreasing Non-current assets Disposal? Impairment? Inventory Run down of inventory? Possible stock outs?

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.

27. Current ratio – what if it increases? Good reasons Growth: Inventory buildup expecting sales growth Expansion: Permanent increase in scale.

28. Current ratio – what if it increases? (Continued) Poor reasons: Decline: Inventory buildup result of falling sales Inefficiency: Poor control over working capital.

29. Subsidiary ratios Gearing ratios Liquidity ratios Asset utilisation ratios Investment ratios Profitability ratios.

30. Subsidiary ratios – gearing (leverage) • Analysing long-term financial stability – to indicate a company’s capacity to meet long-term obligations (solvency)

31. There are a number of different formulae used to express the gearing ratios Long-term debt to Capital employed ratio The debt ratio – (total debt / total assets) (c) The debt-to-equity ratio – (total debt / total equity) (d) The equity ratio – (equity / assets).

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.

33. Subsidiary ratios – gearing (leverage) • 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

34. Subsidiary ratios – gearing (leverage) • 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.

35. Subsidiary ratios – gearing (leverage) • 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.

36. Subsidiary ratios – gearing (leverage) • 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.

37. Subsidiary ratios – gearing (leverage) • 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.

38. Subsidiary ratios – gearing (leverage) • 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.

39. Subsidiary ratios – gearing (leverage) • 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.

40. Subsidiary ratios – gearing (leverage) • 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.

41. Subsidiary ratios – gearing (leverage) • 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

42. Subsidiary ratios – liquidity • analysing stability – to indicate a company’s capacity to meet short-term obligations

43. Subsidiary ratios – liquidity • 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.

44. Subsidiary ratios – liquidity • 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?

45. Subsidiary ratios – liquidity • 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.

46. Subsidiary ratios – liquidity • 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.

47. Subsidiary ratios – liquidity • 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.

48. Subsidiary ratios – liquidity • 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

49. Subsidiary ratios – liquidity • 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?

50. Subsidiary ratios – liquidity • Current and liquidity ratios of seven New Zealand companies (2006 figures) • CompanyCurrent ratioLiquidity 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.