Ratio Analysis: Interpreting Key Indicators for Trend Analysis and Comparison

1. Chapter 13 Ratio analysis

2. Summary of the chapter • Overview • Ratio analysis • Interpretation of ratio analysis • Formal calculations are only the start • Ratios must be interpreted

3. Overview Identification of important trends over time. Five year period, consider trends in key indicators: • Sales (revenue) • Net assets • Operating profit • Profits after tax • Earnings per share

4. One-year growth – Craigielaw

5. Purpose of ratio analysis Absolute figures are of little value. They only provide insights if they can be compared with other relevant amounts in ratios, for example, • Sales as a percentage of gross profits. Allows prediction of likely increase in profit given an increased level of sales. • Profit as a percentage of sales. • Is the profit level satisfactory? Need ‘standards’ for comparison.

6. Comparisons (i) Compare with earlier years. • Identification of a trend? • Does it represent an improvement?

7. Comparisons (Continued) (ii) Compare it with the company's plan. • Is it in line with the company’s expectations as budgeted? • Not generally available in detail to an outside investor. • But company might indicate forward-looking aspects in OFR.

8. Comparisons (Continued) (iii) Compare with those of other companies in the same industry. • External standard. • No two companies are exactly alike, in products or in markets. • Different accounting policies used, for example, depreciation, inventory (stock) valuation.

9. Comparisons (Continued) (iv) Compare with industrial average. • All the disadvantages of average figures. • Our company might be placed in a particular part of the market and so it is of limited value to compare with average of the industry. • Accounting policies may be different. • But provides a starting point.

10. Accounting policies Ensure that the company has used consistent accounting policies over time, especially: • inventory (stock) valuation. • non-current (fixed) asset revaluation. • depreciation. Normally, companies will adjust earlier reported profit figures (comparative figures) if a major change has taken place.

11. Inflation No explicit attempt to take into account the effect of inflation: • Sales last year £100m, this year £105m. • Company claims growth rate 5%. • Is adjustment needed? • Inflation, say, 2%, then real growth 3%. • Costs, for example, average earnings rising 5% per annum.

12. Other sources Many sources of information about competing companies’ performance, for example, • trade journals • industry surveys • press comment • competitors and customers tell tales • commercial analysis services • Centre for Interfirm Comparison • Reuters and Bloombergs

13. Ratio’s only a starting point • What did we expect? What did we find? • How does the company explain the difference? • Do we believe it? • What is our intuition? • Look for corroboration, e.g. link to cash flow statement

14. Ratio’s only a starting point (Continued) Indicates questions to ask. For example, why has profit margin fallen? Might be due to product market conditions; or specific problems of the company; or change in product mix. Very often segmental information is needed.

15. Systematic analysis Investor ratios:An aid to judging a company as a stock market investment. Management performance: An aid to judging how well the company is being run by management. Liquidity:Aids judgement of the adequacy of company's cash and near cash resources. Gearing: (called ‘Leverage’ in American texts) Measure of the company's financial risk.

16. Peter Television example

17. Income statement Year 2 £m

18. Statement of financial position Year 2 £m

19. Year 2 Year 1 £m £m £m £m Trade payables (creditors)  (45)  (30) Taxation (21) (19) Accruals  (29)  (25) (95) (74) Net current assets  125  124 1,280 1,242 6% debentures (400) (400) 880 842 Ordinary shares of £1 500 500 Retained profits 380 342 880 842 Statement of financial position (Continued)

20. Statement of changes in equity Directors’ report Directors propose a dividend of 6.0 pence per share.

21. Share prices Share price used in ratio analysis is the value soon after the profits of the company have been announced to the market. The announcement is by press release called the Preliminary Announcement. For a 31 December year end the press release might be in the following March. Market price at 1 March Year 2 202 pence Use to evaluate Year 1 figures Market price at 1 March Year 3 277 pence Use to evaluate Year2figures

22. Investor ratios

23. Earnings per share profit after tax for ordinary shareholders number of ordinary shareholders Earnings per share 63 500 Most often quoted measure of company performance and progress Measure percentage increase from year to year = 12.6 pence

24. Price earnings ratio share price earnings per share • Price earnings ratio 277 pence • 12.6 pence • Compares the amount invested by the shareholder in the company with the earnings per share. Number of years current profit represented by share price. • Reflects market's confidence in future prospects of the company. • Compare with average P/E for the industry, given daily in the Financial Times. • Commonly used as a basis for investment decisions. = 22 times

25. Dividend per share Dividend payable to ordinary shareholders Number of issued shares Dividend per share 30 = 6 pence per share 500 • Of immediate interest to many investors. Dividend is the most immediate reward for share ownership. • Most companies attempt to maintain a consistently increasing trend. • Reduction in dividend per share is often only proposed by management as a last resort.

26. Dividend cover (payout ratio) earnings per share dividend per share • Dividend cover 12.6 p = 2.1 times • 6.0 p • Number of times dividend can be paid out of current earnings. • The higher the dividend cover, the ‘safer’ the dividend.

27. Dividend yield Dividend per share x 100% Share price • Dividend yield 6.0 x 100% = 2.17% • 277 • Compares dividend per share with the amount invested by the shareholder. • Might seem low yield compared to other types of investment. • Dividends are not the only benefit from share ownership. There is an expectation of an increase in share price. Retained profits generate growth in future profits.

28. Management performance

29. Return on shareholders’ equity Profit after tax x 100% Share capital + reserves • Return on shareholders’ equity • 63 x 100% = 7.2% • 880 • Performance of company from the shareholders' perspective. • Essential to use profit after tax and after interest charges.

30. Return on capital employed Operating Profit (before interest and tax) x 100% (Total assets – current liabilities) • Return on capital employed • 129 x 100 = 10.1% • 1,280 • Performance of company as a whole. • Measure of management efficiency. • Relates to all sources of long term finance.

31. Operating profit on sales Operating profit (before interest and tax) x 100% Sales (revenue) • Operating profit on sales • 129 x 100 = 17.9% • 720 • ‘Operating profit margin’ the higher the better. • Reflects • degree of competitiveness in the market economic situation. • ability to distinguish products. • ability to control expenses.

32. Gross profit ratio Gross profit x 100% Sales (revenue) • Gross profit percentage 288 x 100 = 40% • 720 • Concentrates on costs of making goods and services ready for sale. • Small changes in this ratio can be highly significant. • There tends to be a ‘normal’ value for each industry.

33. Total assets usage Sales (revenue) Total assets • Total assets usage 720 = 0.52 times • (1,155 + 220) • Indicates how well a company has used its productive capacity. • Use in trends of what has happened over time.

34. Non-current (fixed) assets usage 720 1,155 Interpreted as how many £s of sales have been generated by each £ of assets i.e. 62 pence of sales for each £1 of non-current (fixed) asset investment. = 0.62 times Non-current (fixed) assets usage Sales (revenue)_____ Non-current (fixed) assets

35. Liquidity and working capital

36. Current ratio Current assets:current liabilities Current Ratio 220:95 = 2.3:1 Are short-term assets adequate to settle short-term liabilities? If less than 1:1, look closely at cash flow. Ability to generate daily cash might make this ratio adequate, for example, a retailer selling to the public must look at norm for the industry. Usually between 1.5:1 and 2:1 for manufacturing industry.

37. Acid test Current assets minus inventory (stock):Current liabilities The acid-test (220 – 115) : 95 = 1.11:1 Places emphasis on the most liquid assets. Excludes inventory (stock). Expected around 1:1 but varies from industry to industry.

38. Inventory (stock) holding period Average inventories (stock) held x 365 days Cost of sales Inventory (stock) holding period (115 + 82)/2 x 365 = 83 days 432 How quickly goods move through the business: Generally, the shorter the better, but too short may risk being ‘out of stock’. Assumption that year end figures represent normal level for year.

39. Customers (debtors) collection period Trade receivables (debtors) x 365 Credit sales (revenue) Customers collection period 89 x 365 = 45.1 days 720 Speed of collecting from credit customers. Compare with the credit period given, or the normal credit period for the industry.

40. Suppliers payment period Trade payables (creditors) x 365 Credit purchases Purchases = Cost of sales + closing inventory (stock) – opening inventory (stock) 432 + 115 – 82 = 465 (If no purchases figure, use cost of sales) Suppliers payment period 45 x 365 = 35.3 days 465

41. Suppliers payment period (Continued) • (If no purchases figure, use cost of sales) • Suppliers payment period • 45 x 365 = 35.3 days • 465 • Paying too fast – risk of cash shortage. • Paying too slowly – risk of losing supplier. • Companies must disclose this information in the directors’ report.

42. Working capital cycle

43. Gearing

44. Gearing Long-term loans x 100% Ordinary share capital + reserves Debt/equity ratio 400 x 100 = 45.5% 880 Most often quoted in the financial press. A high figure indicates reliance on sources of long-term loan finance. ‘Long-term loan’ includes short-term portion of loans, in current liabilities in balance sheet. Also, bank overdraft, if a permanent feature. Interest payments must always be met, so company has exposure to interest rate movements.

45. Interest cover profit before interest and taxes interest charge Interest cover 129 = 5.38 times 24 Indicates how ‘safe’ the annual interest payments are in relation to profit. Indicates how many times profits can fall before the company is unable to cover payments out of current profits.

46. Cash flow statement • See Supplement to Chapter 13 in the book

47. Definitions EBITDA Earnings before deducting: • Interest • Taxation • Depreciation • Amortisation • An approximation to cash flow Free cash flow • No precise definition but used to reflect operating cash flow minus capital expenditure – ‘free’ for future investment or for paying dividends.