The PPT About The Financial Decision Making----2

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Lesson5FinancialAnalysisandInterpretation.pptx

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MN7029 – Financial Decision Making

Welcome to Week 2.1!

Lecture recordings

This session is being recorded

You can access the weekly recording from Weblearn

This Photo by Unknown Author is licensed under CC BY-SA

Learning Outcomes

Look for clues in a company's financial statements about performance

Identify and calculate major ratios used for assessing financial performance

Discuss the use and limitations of such financial ratios.

Interpreting financial performance

	Yr 1	Yr 2	Yr 3	Yr 4	Yr 5	Yr 6
Sales	50,000	100,000	120,000	150,000	180,000	210,000
Cost of sales	25,000	40,000	55,000	82,000	100,000	120,000
Profit	25,000	60,000	65,000	68,000	80,000	90,000

What can you tell me about this company’s performance?

Consider the following….

In 2022 Marks & Spencer made £10.9bn in revenue and £391.7m in profit before tax

In 2021 Boden made £256m in revenue and £14m in profit

Which company is performing better?

Consider the following….

How about if I told you in 2-21 M&S made £9.2bn in revenue and a loss of £209m and 2019 Boden made £295m in revenue and a profit of £14m?

Or showed you this graph of M&S share price over the last year?

We learned in Session 2 that different groups of people use financial information for different reasons…

Interpreting financial performance

	Yr 1	Yr 2	Yr 3	Yr 4	Yr 5	Yr 6
Sales	50,000	80,000	120,000	150,000	180,000	210,000
		60%	50%	25%	20%	17%
Cost of sales	25,000	40,000	55,000	82,000	100,000	120,000
		60%	37.5%	49%	22%	20%
Profit	25,000	40,000	65,000	68,000	80,000	90,000
		60%	62.5%	5%	18%	12.5%

What can you tell me about this company’s performance now?

Types of financial analysis

Scanning

Trend analysis

Common sized statements

Financial ratios

Financial Ratios

A ratio relates one figure in the financial statements to another (e.g. operating profit compared to sales revenue).

Means of assessing health of the company.

Comparison tools e.g. between periods or companies.

Eliminate the problem of scale.

Identify strength/weaknesses but do not explain them.

Ensure they are meaningful relationships.

Variations in choice and calculation.

Figure 3.1 The key aspects of financial health

Categories of Ratio

Profitability – indication of how well company is generating profit or wealth for shareholders.

Efficiency (or activity) – how well the particular resources e.g. inventory have been used in the business.

Liquidity – relationship between liquid resources and what is due to be paid.

Financial gearing – relationship between shareholder capital and borrowing.

Investment – measuring return and performance of shares

Historical and Projected Financial Statement Users

Current/potential investors

Employees

Lenders

Suppliers

Customers

Government and regulators

The public

Management

Profitability – indication of how well company is generating profit or wealth for shareholders.

Efficiency (or activity) – how well the particular resources e.g. inventory have been used in the business.

Liquidity – relationship between liquid resources and what is due to be paid.

Financial gearing – relationship between shareholder capital and borrowing.

Investment – measuring return and performance of shares

Ratios

Comparison with what?

Past periods

Improvement/deterioration in performance;

Long term trends;

But may not expose inefficiencies in comparison to other businesses;

Does not consider trading conditions.

Similar businesses

Compare efficiency to competitors;

But may be differences in accounting policies;

May not be able to get the information or sufficiently useful breakdown.

Planned performance

Helps to set budgets and track achievement.

Calculating the ratios

Please have p94 Financial Management for Decision Making (9th edn) open (p87 in 8th edn).

Financial statements relating to Alexis Plc.

Profitability ratios

Profit for the year less any preference dividend Ordinary share capital + Reserves

Return on ordinary shareholders’ funds (ROSF)

Operating profit Share capital + Reserves + Non-current liabilities

Return on capital employed (ROCE)

Operating profit Sales revenue

Operating profit margin

Gross profit Sales revenue

Gross profit margin

× 100

Operating/Gross profit margin

Operating profit margin relates the profit to the sales revenue (notice that this ratio compares two income statement items).

Operating profit is used as it excludes financing costs but includes all general costs of running the business.

This ratio varies according to type of business e.g. supermarket versus jeweller.

Businesses often use target operating margins in budgets.

Gross profit margin relates the gross profit to the sales revenue (again this ratio compares two income statement items).

Measures profitability in producing goods before other general expenses.

2018

Gross profit margin =

= 22.1%

Op profit margin = 100%

=10.8%

2019

Gross profit margin =

= 15.3%

Op profit margin = 100%

=1.8%

Return on Ordinary Shareholders’ Funds

Return on ordinary shareholders funds ratio (ROSF) compares the profit for the year with the owners’ average stake in the business.

An average figure is used for shareholder funds as it should be more representative but you may need to rely on year end if that is not available;

Business seek to generate as high as possible value for ROSF.

ROSF for 2019

×100

= 2.0%

ROSF for 2018

×100

= 33.0%

Return on Capital Employed

Return on Capital Employed (ROCE) compares the operating profit for the year with the average long term capital (so shareholder funds and long term loans).

We use Profit Before Interest and Tax as the top figure as this ratio is looking at the return to everyone before deductions of financing interest.

Again, an average figure is used for shareholder funds as it should be more representative but you may need to rely on year end if that is not available;

An important ratio as it compares inputs through capital with outputs (operating profit).

ROCE for 2018

×100

= 34.7%

ROCE for 2018

×100

= 5.9%

Profitability Summary

Overall profitability indicators have declined quite severely

Both gross and operating profits declined, but operating profit declined proportionately more – what has caused increase in operating expenses? Could it be due to increasing employee numbers?

Revenue has increased, but cost of sales proportionately more – again what has caused this?

	2018	2019
ROSF	33%	2%
ROCE	34.7%	5.9%
Gross Profit Margin	22.1%	15.3%
Operating Profit Margin	10.8%	1.8%

Efficiency ratios

Formula

Average inventories turnover period

Average settlement period for trade receivables

Average settlement period for trade payables

Sales revenue to capital employed

Sales revenue per employee

Average inventories held Cost of sales

Average trade receivables Credit sales revenue

Average trade payables Credit purchases

Sales revenue Number of employees

Sales revenue________________ Share capital + Reserves + Non-current liabilities

× 365

Average inventories turnover:

2018: ×365 = 56.6 days

2019: ×365 = 56.7 days

Average receivables settlement:

2018: ×365 = 37.7 days

2019: ×365 = 34.9 days

Average payables turnover:

2018: × 365 = 44.9 days

2019: × 365 = 47.2 days

Sales Revenue to Capital Employed (2019): =3.36

Sales Revenue to Capital Employed (2018): =3.2

Summary of Efficiency Ratios

	2018	2019
Average inventories turnover period	56.6 days	56.7 days
Average settlement period for trade receivables	37.7 days	34.9 days
Average settlement period for trade payables	44.9 days	47.2 days
Sales revenue to capital employed (net asset turnover)	3.20 times	3.36 times
Sales revenue per employee	£160,057	£143,962

Figure 3.6 The main elements of the ROCE ratio

Source: Atrill, P. and McLaney, E. (2010) Accounting and Finance for Non-specialists, 7th edn, Pearson Education.

Operating profit margin ratio

Sales revenue to capital employed

Operating profit/Long term capital

Liquidity ratios

Current ratio

Acid test ratio

Formula

Current assets Current liabilities

Current assets (excluding inventories) Current liabilities

Acid Test ratio:

2018: = 0.8 times

2019: = 0.6 times

Current ratio:

2018: = 1.9 times

2019: = 1.6 times

Gearing ratios

Long-term (non-current) liabilities Share capital + Reserves + Long-term (non-current) liabilities

Gearing ratio

Formula

Interest cover ratio

Operating profit Interest payable

× 100

Gearing ratio:

2018: 100 = 26.2%

2019: 100 = 36%

Interest cover

2018: = 13.5 times

2019: 1.5 times

Investment ratios

Formula

Dividend payout ratio

Dividend cover ratio

Dividend yield ratio

Earnings for the year available for dividends Dividends announced for the year

Dividends announced for the year Earnings for the year available for dividends

× 100

Dividend per share Market value per share

× 100

Investment ratios (Continued)

Formula

Price/earnings ratio (P/E)

Earnings per share

Earnings available to ordinary shareholders Number of ordinary shares in issue

Market value per share Earnings per share

What is a dividend?

Company X

Management

Employees

Shareholders

A payment to shareholders out of retained profit

Decided by directors

Directors may choose to keep profit in the business for growth

Dividend payout ratio:

2018: × 100% = 24.2%

2019: × 100% = 363%

Dividend payout ratio:

2018: = 4.1 times

2019: = 0.3 times

Dividend yield ratio:

2018: × 100% = 2.7%

2019: × 100% = 4.5%

Earnings per share:

2018: = 27.5p

2019: = 1.8p

Price/Earnings Ratio:

2018: = 9.1 times

2019: = 83.3 times

Earnings Ratios

EPS relates the earnings for a period to the number of shares in issue;

This is a key ratio for investment analysts and they will track this over time to assess a business;

P/E ratio then relates the EPS to the market value of the share – the higher the ratio the greater the confidence in the future earnings and the more the investors are willing to pay in relation to its current earnings.

Figure 3.10 Tesco: The Leahy years

1.0

2.0

5.0

4.0

3.0

1.60

1.87

2.04

2.62

1.74

1.56

2.10

6.52

4.37

3.06

2.51

Dividend yield (%)

6.0

1.64

Aerospace/Defence

Auto parts

Beverage (Soft)

Coal & Related Energy

Drugs (Pharmaceutical)

Entertainment

Healthcare products

Household products

Oil/Gas Distribution

Total market

Utility (Water)

Publishing & Newspapers

7.0

Figure 3.11 Average dividend yield ratios for business in a range of industries

Source: Charts compiled from data in Damodaran, A., ‘Useful data sets’, www.stern.nyu.edu/~adamodar/New_Home_Page/data.html, accessed 9 January 2019.

Figure 3.12 Average price/earnings ratios for businesses in a range of industries

11.39

26.73

74.89

29.61

88.72

52.05

29.16

105.67

12.66

32.81

46.52

30.91

Aerospace/Defence

Auto parts

Beverage (Soft)

Drugs (Pharmaceutical)

Entertainment

Healthcare products

Household products

Oil/Gas Distribution

Total market

Utility (Water)

Publishing & Newspapers

Current PE (times)

10.00

20.00

30.00

40.00

50.00

60.00

70.00

80.00

90.00

100.00

Coal & Related Energy

Source: Charts compiled from data in Damodaran, A., ‘Useful data sets’, www.stern.nyu.edu/~adamodar/New_ Home_Page/data.html, accessed 9 January 2019.

Figure 3.14 Current ratio of three leading businesses

Current ratio

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

2018

2010

2009

2008

2011

2012

2013

2014

2015

2016

2017

Tesco plc

J. Sainsbury plc

William Morrison

Source: Ratios calculated from information in the annual reports of the three businesses for each of the years 2008 to 2018.

Which ratios will be important for different industries?

Overtrading

Overtrading occurs where a business is operating at an unsustainable level

May be due to expanding businesses that have not prepared, misjudgement on sales or costs levels, lack of access to further finance

Can cause liquidity problems and company may run out of cash

Can be spotted in low current ratios; low inventory turnover ratio, high settlement ratio for payables

Company must ensure that finance available is consistent with level of operations.

Overtrading and financial ratios

Current ratio

Acid test ratio

Average settlement period for trade receivables

Average inventories turnover period

Overtrading may lead to a lower than expected:

Average settlement period for trade payables

Sales to capital employed ratio

Overtrading may lead to a higher than expected:

Using Ratios to Predict Failure

An analyst will look at a combination of ratios to judge the health of a business.

Is it possible to develop a mathematical formula for failure?

Beaver’s research showed that some ratios exhibited differences between businesses that subsequently failed and this that didn’t.

Zmijewski found connection between failure and rates of return and gearing, but not liquidity in his study.

The Z-score model

where:

a = Working capital/Total assets

b = Accumulated retained profits/Total assets

c = Operating profit/Total assets

d = Book (statement of financial position) value of ordinary and preference shares/Total liabilities at book (statement of financial position) value

e = Sales revenue/Total assets

1.2a + 1.4b + 3.3c + 0.6d + 1.0e

Z =

Limitations of ratio analysis

Over-reliance on ratios

Basis for comparison

Quality of financial statements

Statement of financial position ratios

Inflation

Creative accounting

What’s Next…

5.30pm to 7.30pm – Cost behaviour, pricing and budgets (incl 10 minutes break).

The PPT About The Financial Decision Making----2

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