Financial Management Report

MBA4032021Week2.pdf

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MBA403 FINANCIAL AND ECONOMIC

INTERPRETATION AND COMMUNICATION

Week 2:

ANALYSING FINANCIAL STATEMENTS

Week 2:

ANALYSING FINANCIAL

STATEMENTS

• Purpose of Ratio Analysis

• Financial Stability Ratios

• Efficiency Ratios

• Profitability Ratios

• Investment Ratios

• Horizontal and Vertical Analysis

• Retaining the ‘Big Picture’

INTERPRETATION

ANALYSIS

INSIGHTS

COMMUNICATION

PURPOSE OF FINANCIAL ANALYSIS

“Knowing your numbers can help you transform all of your business relationships and give you a significant competitive advantage”

(Bill Gates)

FINANCIAL STATEMENTS

SUSTAINABILTY REPORTS

EXTERNAL SOURCES OF

INFORMATION

BUSINESS STRATEGY

DECISION MAKING

STAKEHOLDER ENGAGEMENT

NON-FINANCIAL DATA

ECONOMIC & BUSINESS

ENVIRONMENT

DEBT

RETURN

PROFIT

TURNOVER

MARGIN

PURPOSE OF RATIO ANALYSIS

• Interpretation of the financial statements is essential for internal and external stakeholders.

• Ratio analysis allows us to combine and compare data from the financial statements in order to gain deeper insights.

“.. you have to understand the nuances of accounting. It’s the language of business” (Warren Buffett)

Is the business

using its assets

efficiently to

generate sales, cash

and profit?

Examine the

company’s financial

structure and

resources and the

risks arising from its

debt obligations

Assess profitability

versus sales, assets

and shareholder

equity

Profitability Ratios

Ratios used to analyse

the investment merit

of a business or share

opportunity

RATIO CATEGORIES

Investment Ratios Financial

Stability Ratios Efficiency Ratios

READ THE ATTACHED STORY

FROM NEWS.COM.AU

(AUGUST 25, 2020) AND CONSIDER THE

FOLLOWING QUESTIONS

LIABILITIES

Australia’s second airline went into voluntary administration in April (2020), with a debt pile of around $6.8 billion, following years of financial trouble and amid the COVID-19 pandemic..

Deloitte’s final report to creditors charted the airline’s rocky financial history, concluding its difficulties “were due to an already highly leveraged balance sheet, resulting from past years of losses, that was unable to support the business impact caused by COVID-19”.

It cited a number of contributing factors for its struggles, including a higher cost base compared to Qantas, high labour costs and its use of various different aircraft types.

Deloitte’s report also flagged that Virgin Australia may have traded while it was insolvent in the early days of the pandemic, before it went into voluntary administration on April 21.

CASE STUDY

What do you understand by the following terms:

• leverage (or gearing)?

• being insolvent?

• liquidity?

READ THE ATTACHED STORY

FROM NEWS.COM.AU

(AUGUST 25, 2020) AND CONSIDER THE

FOLLOWING QUESTIONS

Liquidity vs SolvencyVIDEO:

CASE STUDY

What do you understand by the following terms:

• leverage (or gearing)?

The use of debt by a company constitutes financial leverage. Because interest payments are essentially a fixed cost, leverage tends to magnify the effect of changes in operating profit (also known as EBIT: Earnings Before Interest & Tax) on net profit.

• being insolvent?

• liquidity?

VIDEO:

READ THE ATTACHED STORY

FROM NEWS.COM.AU

(AUGUST 25, 2020) AND CONSIDER THE

FOLLOWING QUESTIONS

https://www.youtube.com/watch?v=ypa5kOeIHPc

• DEBT RATIO: a measure of gearing or leverage. How much debt is the business carrying?

• Too much debt: the business may struggle to meet the required repayments if revenue deteriorates. Remember: banks are less forgiving than shareholders!

• Too little debt: may reflect overly conservative management, a lack of business opportunity or banks failing to approve loans.

ANALYSING FINANCIAL

STATEMENTS

• Financial Stability Ratios

• Efficiency Ratios

• Profitability Ratios

• Investment Ratios

FINANCIAL STABILITY RATIOS

TOTAL LIABILITIES

TOTAL ASSETS

• Ideal range is 30%-50% but will vary by industry and according to the economic environment

• Can also be calculated as debt / total assets

DEBT RATIO

• DEBT TO EQUITY RATIO: a measure of debt financing versus equity financing.

• An indication of the relative ‘degree of control’ over the business – creditors versus shareholders.

• Again varies by industry but a 50% debt ratio implies a 100% debt / equity ratio.

• QUESTION: what does a 30% debt ratio imply in terms of debt / equity?

ANALYSING FINANCIAL

STATEMENTS

• Financial Stability Ratios

• Efficiency Ratios

• Profitability Ratios

• Investment Ratios

FINANCIAL STABILITY RATIOS

TOTAL LIABILITIES

TOTAL EQUITY

• Can be quite variable

• Ideal range is 40%-100% but will vary by industry and environment

• Can also be calculated as debt / total equity

DEBT TO EQUITY RATIO

• CURRENT RATIO: a measure of liquidity, or the ability of the business to meet its short term commitments.

• Too high a ratio may indicate a ‘lazy’ balance sheet - cash accumulating in the absence of investment opportunities or returning it to shareholders

• Other liquidity ratios include:

➢ Quick Ratio

➢ Interest Cover Ratio

ANALYSING FINANCIAL

STATEMENTS

• Financial Stability Ratios

• Efficiency Ratios

• Profitability Ratios

• Investment Ratios

FINANCIAL STABILITY RATIOS

TOTAL CURRENT ASSETS

TOTAL CURRENT LIABILITIES

• Should be comfortably above 1, up to a level of 2

• Some companies can successfully operate with a ratio below 1

• For example, a high turnover supermarket can purchase inventory and turn it into cash, at a profit, quickly

CURRENT RATIO

GO TO THE BALANCE SHEETS

OF VIRGIN AUSTRALIA AND

HARVEY NORMAN IN THE MBA403 RESOURCES TO

CALCULATE THESE RATIOS

RATIO ACTIVITY

For Virgin Australia (FY19) and Harvey Norman (FY20), calculate the following Ratios.

• Debt ratio

• Current ratio

What can you conclude about the financial stability of the two businesses?

• ASSET TURNOVER: a measure of the volume of business undertaken and efficiency.

• The higher the asset turnover ratio, the more efficient the company is at using its assets to generate sales.

• Higher turnover will tend to be associated with higher profitability, assuming a positive profit margin on sales.

ANALYSING FINANCIAL

STATEMENTS

• Financial Stability Ratios

• Efficiency Ratios

• Profitability Ratios

• Investment Ratios

EFFICIENCY RATIOS

SALES

TOTAL ASSETS

• Different industries will have different ratios

• Consider an internet business with a low asset requirement versus a power generation or toll road business

ASSET TURNOVER

• INVENTORY TURNOVER: how high are inventory levels?

• This ratio measures how much of a year’s production or purchases is held as inventory OR how many days it takes to sell an item of inventory?

• A high number (in days) may indicate the business has too much inventory which may be out of date or difficult to sell.

• A low number (which indicates higher turnover) will improve cashflow.

ANALYSING FINANCIAL

STATEMENTS

• Financial Stability Ratios

• Efficiency Ratios

• Profitability Ratios

• Investment Ratios

EFFICIENCY RATIOS

AVERAGE INVENTORY

COST OF GOODS SOLD

INVENTORY TURNOVER (days)

• Average inventory is the average of beginning and end-period inventory levels

• Will vary by sector. However, >90 days is relatively high

• Consider factors such as the frequency of new models or perishables versus non-perishables

x 365

• AGE OF ACCOUNTS RECEIVABLE: how effective is the business at receiving cash from its debtors?

• A high age of accounts receivable is likely to be associated with cashflow issues and the potential for ‘bad debts’.

• Improved credit policies and procedures may be required.

ANALYSING FINANCIAL

STATEMENTS

• Financial Stability Ratios

• Efficiency Ratios

• Profitability Ratios

• Investment Ratios

EFFICIENCY RATIOS

ACCOUNTS RECEIVABLE

SALES (ON CREDIT)

AGE OF ACCOUNTS RECEIVABLE

• 30 days is in the acceptable range

• 45 days, as an average, is concerning

• Debts of 60 days are reportable as a ‘default’

x 365

GO TO WOOLWORTHS’ FY20 FINANCIAL

STATEMENTS IN THE MBA403

RESOURCES TO CALCULATE THESE

RATIOS

RATIO ACTIVITY

For Woolworths (FY20), calculate the following Ratios.

What do the ratios tell you about the nature of the Woolworths business?

• Current ratio

• Asset turnover

• Inventory turnover

• Age of accounts receivable

• RETURN ON SALES: a measure of profit margin or the profit earned per dollar of sales.

• This ratio can provide management with useful insights into pricing and costs.

• The numerator depends on the purpose and can be gross profit, operating profit, net profit, etc.

• Given the focus on business performance, we use EBIT (Earnings Before Interest & Tax) here as it removes the cost of finance and tax payable.

ANALYSING FINANCIAL

STATEMENTS

• Financial Stability Ratios

• Efficiency Ratios

• Profitability Ratios

• Investment Ratios

PROFITABILITY RATIOS

• Different industries / products will have different return on sales

• Consider the return on sales for a high value, low turnover business versus a low value, high turnover business. Can you think of examples of each?

RETURN ON SALES

x 100 PROFIT (EBIT)

SALES

• RETURN ON EQUITY: the underlying percentage return accruing to shareholders.

• Here we use Net Profit after all expenses, being the income accruing to the owners.

• RoE is important in comparing alternative investments.

• Would you expect a higher or lower RoE when

➢ investing in a risky venture?

➢ the general level of interest rates is low?

ANALYSING FINANCIAL

STATEMENTS

• Financial Stability Ratios

• Efficiency Ratios

• Profitability Ratios

• Investment Ratios

PROFITABILITY RATIOS

• While a high RoE is desirable, the RoE that is considered acceptable will depend on many factors

• A 10% ROE may be reasonable in today’s economic circumstances

• Average equity is the average of beginning and end-period equity

RETURN ON EQUITY

x 100 NET PROFIT

AVERAGE EQUITY

GO TO THE WOOLWORTHS AND HARVEY NORMAN

FINANCIAL STATEMENTS IN THE

MBA403 RESOURCES TO

CALCULATE RETURN ON EQUITY

CALCULATION AND DISCUSSION

• For Woolworths and Harvey Norman, calculate the FY20 Return on Equity

• Are the results attractive in the context of the current level of interest rates and the 2020 COVID-induced recession?

• What would you expect from these businesses going forward?

• PRICE EARNINGS RATIO: relates a company’s share price to its earnings or profit per share.

• The P/E ratio is widely used in valuing investment opportunities.

• A higher P/E indicates that the share is more expensive.

• While there is no definitive guide as to the appropriate P/E ratio, comparisons can be made horizontally (relative to previous periods) and vertically (relative to competitors or a sector average).

ANALYSING FINANCIAL

STATEMENTS

• Financial Stability Ratios

• Efficiency Ratios

• Profitability Ratios

• Investment Ratios

INVESTMENT RATIOS

SHARE PRICE

EARNINGS PER SHARE

• Earnings per share (EPS) equals total profit, or earnings, divided by the number of shares on issue.

• EPS will typically be reported below the Income Statement

• The inverse of the P/E ratio is the earnings yield which is similar to the earlier Return on Equity

PRICE EARNINGS RATIO

• DIVIDEND YIELD: the annual percentage return shareholders receive in the form of dividends.

• Some investors (particularly those seeking regular income) value dividends over uncertain capital gains (reinforced by Australia’s dividend imputation tax rules).

• While a high dividend yield is attractive, if a company pays excessive dividends it may experience cashflow issues or compromise long term growth due to insufficient investment.

ANALYSING FINANCIAL

STATEMENTS

• Financial Stability Ratios

• Efficiency Ratios

• Profitability Ratios

• Investment Ratios

INVESTMENT RATIOS

• Dividend Yield (along with P/E ratio) is often used to evaluate the investment merit of specific shares

• As with our other ratios, an attractive Dividend Yield depends on many factors yet will be influenced by the level of interest rates in the economy

DIVIDEND YIELD

x 100 DIVIDEND PER SHARE

SHARE PRICE

GO TO THE WOOLWORTHS AND HARVEY NORMAN

FINANCIAL STATEMENTS IN THE

MBA403 RESOURCES TO

CALCULATE RETURN ON EQUITY

RESEARCH AND DISCUSSION

• For Woolworths (ASX code: WOW) and Harvey Norman (ASX code: HVN), go to bloomberg.com and find the current P/E Ratio and Dividend Yield

• Which do you regard as the more attractive investment, and why?

HORIZONTAL ANALYSIS

• HORIZONTAL ANALYSIS: measuring a company’s performance through time

• Makes use of ‘time series’ data to identify changes or trends

V E

R T

IC A

L A

N A

LY S

IS VERTICAL ANALYSIS: comparing a company’s performance to an appropriate standard, guideline or benchmark, including:

related businesses competitors

industry average alternative investments

RETAINING THE BIG PICTURE

“However tight things are, you still need to have the big picture at the forefront of your mind” (Richard Branson)

RETAINING THE BIG PICTURE

Financial statements and ratios provide valuable insights but always retain the ‘big picture’. This may include factors such as the:

trends in revenue, profits and expenses,

underlying drivers of the business and economic conditions,

competitive landscape and regulatory backdrop, and

business strategy and key business risks.

RETAINING THE BIG PICTURE

Aside from the financial statements, the Annual Report provides valuable information in the Chairman, CEO and Directors Reports along with the Operating and Financial Review.

“Total sales grew by 11.6% to $7,918.9 million, with Australian sales accelerating from March as customers spent more time working and learning at home..”

“Underlying EBIT grew 30.5% to $486.5m, with strong operating leverage from the elevated sales growth and disciplined cost control more than offsetting the .. costs associated with ensuring team members and customers remained safe during Covid-19”

(JB Hi-Fi Limited Operating & Financial Review, Annual Report, Year ended 30 June 2020)

Next Workshop:

DATA & INVESTMENT EVALUATION (I)