Transcript Ratio Analysis

Slide 13.1
Chapter 13
Ratio analysis
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.2
Summary of the chapter
•
•
•
•
•
Overview
Ratio analysis
Interpretation of ratio analysis
Formal calculations are only the start
Ratios must be interpreted
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.3
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
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.4
One-year growth – Craigielaw
Sales
(revenue)
Growth
% Growth
Year 7
Year 6
Year 5
£m
£m
£m
2,100
2,260
(160)
2,149
111
(160/2260) × 100
(111/2149) × 100
= −7.1%
= 5.2%
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.5
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.6
Comparisons
(i) Compare with earlier years.
• Identification of a trend?
• Does it represent an improvement?
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.7
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 forwardlooking aspects in OFR.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.8
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.9
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.10
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.11
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.12
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
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.13
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
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.14
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.15
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.16
Peter Television example
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.17
Income statement
Year 2
£m
£m
Year 1
£m
£m
Sales (revenue)
720
600
Cost of sales
432
348
Gross profit
288
252
Distribution costs
(72)
(54)
Administrative expenses
(87)
(81)
(159)
(135)
Operating profit
129
117
Interest payable
(24)
(24)
Profit before tax
105
93
Taxation
42
37
Profit for the period
63
56
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.18
Statement of financial position
Year 2
£m
Year 1
£m
£m
£m
Land and buildings
600
615
Plant and equipment
555
503
1,155
1,118
Inventory (stock)
115
82
Trade receivables (debtors)
89
61
Prepayments
10
9
6
46
220
198
Bank
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.19
Statement of financial position
(Continued)
Year 2
£m
£m
Year 1
£m
£m
Trade payables (creditors)
(45)
(30)
Taxation
(21)
(19)
Accruals
(29)
(25)
(95)
(74)
Net current assets
125
124
1,280
1,242
(400)
(400)
880
842
Ordinary shares of £1
500
500
Retained profits
380
342
880
842
6% debentures
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.20
Statement of changes in equity
£m
Share capital and reserves end yr 1
842
Less dividend paid
(25)
Add profit year 2
63
Share capital and reserves end yr 2
880
Directors’ report
Directors propose a dividend of 6.0 pence per share.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.21
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 Year 2 figures
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.22
Investor ratios
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.23
Earnings per share
profit after tax for ordinary shareholders
number of ordinary shareholders
Earnings per share
63
= 12.6 pence
500
Most often quoted measure of company performance
and progress
Measure percentage increase from year to year
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.24
Price earnings ratio
share price
earnings per share
Price earnings ratio 277 pence
= 22 times
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.25
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.26
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.27
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.28
Management performance
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.29
Return on shareholders’ equity
Profit after tax
Share capital + reserves
x 100%
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.30
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.31
Operating profit on sales
Operating profit (before interest and tax)
Sales (revenue)
x 100%
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.32
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.33
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.34
Non-current (fixed) assets usage
Sales (revenue)_____
Non-current (fixed) assets
Non-current (fixed) assets usage
720 = 0.62 times
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.35
Liquidity and working capital
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.36
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.37
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.38
Inventory (stock) holding period
Average inventories (stock) held
Cost of sales
x 365 days
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.39
Customers (debtors) collection period
Trade receivables (debtors)
Credit sales (revenue)
x
365
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.40
Suppliers payment period
Trade payables (creditors)
Credit purchases
x
365
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
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.41
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.42
Working capital cycle
Working capital cycle
Inventory (stock) holding period +
Customers collection period –
Suppliers payment period
Inventory (stock) holding
83.2 days
Debtor collection
45.1 days
127.3 days
35.3 days
92.0 days
Creditor payment
Finance needed for
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.43
Gearing
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.44
Gearing
Long-term loans
Ordinary share capital + reserves
x 100%
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.45
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.46
Cash flow statement
• See Supplement to Chapter 13 in the book
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011
Slide 13.47
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.
Pauline Weetman, Financial and Management Accounting, 5th edition © Pearson Education 2011