1. Intro to Financial Management of the Organisation
Week 4
More Ratios & Expanding the Annual Report

2. Groups of Ratios
Different Classes of ratios are available for different classes of user
Profitability
Efficiency
Liquidity
Gearing
Investor ratios

3. Profitability Ratios Return on Capital Employed (ROCE)
Net profit before interest and tax X 100
Share capital + reserves + long term loans
A ratio that indicates the efficiency and profitability of a company's capital investments.
ROCE should always be higher than the rate that the company borrows at, otherwise any increase in borrowings will reduce shareholders' earnings

4. Net Profit Margin
Net profit before interest and tax X 100
Sales
Relationship between turnover and “controllable” profit. How are management controlling business expenses?

5. Efficiency Ratios Average settlement period for debtors
Trade debtors X 365
Credit sales
Means : How quickly an average debtor takes to pay. Shown in days.
The quicker debtors pay up the better.
Normal terms .v. actuality

6. Efficiency Ratios Average settlement period for creditors
Trade creditors X 365
Credit purchases
Means : How long, on average, it takes a business to pay its trade creditors in days
Deferring paying creditors is free credit

7. Gearing (leverage) Ratios
Gearing ratio
Long term liabilities X 100
Share capital + reserves + long term liabilities
Means : contribution of long-term lenders to the long-term capital structure

8. A risky business Borrowing is a risk because…
Interest has to be paid whether the investment is a success or not.
Even if a company is making a loss it still has to pay interest
Borrowing is thus a risk
The more of their capital that is borrowed
The bigger the risk.
The higher the gearing ratio, the bigger the proportion of the companies money that is borrowed and therefore the bigger the risk.
A company with a high gearing ratio is in a very dangerous situation if interest rates are going up.
Their interest payable bill will be rising with no corresponding increase in sales revenue.
The first thing to suffer is profit

9. Gearing Ratios Interest Cover Profit before interest and tax
Interest payable
Means : Amount of profit available to cover interest payments
What’s Hot : the higher, the more funds available to meet interest payments.
So long term lenders more secure

10. Investor Ratios Dividends per share Dividends announced during period
Number of shares in issue
Means : cash return an investor can expect from shares held in a company
Tip: Frequently shown in notes to accounts

11. Investor Ratios Dividend payout ratio
Dividends announced for the year X 100
Earnings for the year available for dividends
Means : Proportion of earnings paid out to shareholders as dividends

12. Investor Ratios Earnings per Share (EPS)
Earnings available to ordinary shareholders
Number of ordinary shares in issue
The earnings of a company is its profit, and so if we change the wording of earnings per share to profit per share the meaning should become a lot clearer.
It is literally the amount of profit that has on average been earned by each share.

13. FRS 14 – Earnings per Share
FRS 14 requires that EPS is shown as a footnote to the profit and loss account of a quoted company.
FRS 14 defines EPS as: “Basic earnings per share should be calculated by dividing the net profit or loss for the period attributable to ordinary shareholders by the weighted average number of shares outstanding during the period.”
The trend of EPS is a better indicator of progress than the trend in profit. In order to maintain EPS at the same level after a share issue a company must deploy the proceeds of the issue at least as profitably as the original capital

14. Investor Ratios Price/Earnings ratio (P/E ratio)
Market value of shares
EPS
Means : compares market value of the share with its earnings.
What’s Hot : A high figure shows the market’s confidence in the future earnings potential of the company.
The higher the confidence, the more investors will be prepared to pay for shares in relation to the current earnings level.

15. Price/Earnings ratio (P/E ratio)
Recognised by many investors as the KEY investor ratio
Capital Radio plc Example
2000
EPS = 26.3p
Market Price of Ordinary Shares at Balance Sheet date = £14.38
2001
EPS = 23.8p
Market Price of Ordinary Shares at Balance Sheet date = £5.20

16. Capital Radio plc P/E Ratio
2000
14.38 / = 54.7 times
2001
5.20 / = 21.8 times

17. What do the Directors say? 1
The Chief Executive (upbeat)
This year has been challenging for Capital Radio, as the media industry faced difficult trading conditions resulting from the economic slowdown.
Our revenues came under pressure as advertising demand fell, requiring us to take a prudent look at the management of our cost base.
Though the current market conditions may prevail for some time our strong radio brands, healthy balance sheet and focused management team will ensure we weather the downturn.
We are confident of the long-term prospects for radio advertising and retain our belief in the importance of aggressively expanding our national presence.
Pass the Bucket…
Cool people Hot ideas Real insight

18. What do the Directors say? 2
Finance Director
Total revenue of £123.2 million was down 1% on the previous year (down 6% on a like for like basis).
Underlying Group profit before tax was £30.1million, down 27%, in line with the guidance we gave at the end of September.
The tax charge on our underlying profitability for the year was 28.5% (2000: 26.3%).
Our underlying earnings per share were down 33% at 26.3p. Our underlying earnings per share has declined due to a combination of the difficult trading conditions and the planned short-term dilution caused by the acquisitions of Century Radio and Beat.

19. What do the Directors say? 2a
Revenue from our established stations was £106.8 million, down 9%, which resulted in the operating profit from our established stations being down 16% at £39.6 million.
Development stations losses were £3.0 million compared to a £1.9 million charge in the previous financial year
But.. With the interim dividend of 6.0p per share, our total dividend per share for the year is unchanged at 18.5p.

20. Benjamin Graham’s Analysis
P/E Ratios are a measure of stock market performance
Calculated US average ratios for the periods
Lowest = 9.5 ( )
Highest was 18.1 ( )
Compared these calculations to the rates available on high-class bonds
(A P/E ratio of 20 = an earnings yield of 5%
Eg 100 / PE ratio = Earnings Yield)

21. Can we predict potential bankruptcy?
Edward Altman (1968 & 1981)
Calculation of Z-Score
Historic Basis
Key ratios + weightings = Z-Score
Note: use as part of an evaluation

22. Altman’s Z-Score RATIO FORMULA WEIGHT FACTOR Return on Total Assets
Earnings Before Interest and Taxes
Total Assets
x. 3.3
Sales to Total Assets
Net Sales Total Assets
x 0.999
Equity to Debt
Market Value of Equity Total Liabilities
x 0.6
Working Capital to Total Assets
Working Capital Total Assets
x 1.2
Retained Earnings to Total Assets
Retained Earnings Total Assets
x1.4

23. The Interpretation of Z Score:
Z-SCORE ABOVE 3.0
The company is safe based on these financial figures only.
Z-SCORE BETWEEN 2.7 and 2.99
Grey area/ Zone of ignorance.
This zone is an area where one should exercise caution.
Z-SCORE BETWEEN 1.8 and 2.7
Good chances of the company going bankrupt within 2 years of operations from the date of financial figures given.
Z-SCORE BELOW 1.80
Probability of financial embarrassment is very high.

24. Worked Example – Somerfield 2001
Return on Assets
11.6/ = X3.3 =
Sales to Total Assets
4612.5/ – X0.999 =
Equity to Debt
1509.3/800 = X 0.6 =
Working Capital to Total Assets
(75.2)/ = (0.0498) X 1.2 = (0.0598)
Retained Earning to Total Assets
548.9/ = X 1.4 =
Total of Weighted Scores =

25. Expanding the Annual Report
Inflation Adjustments
Is it an issue?
Current Cost Accounting
Adjustment of profit by replacement costs of stocks/fixed assets
Current Purchasing Power
Adjustment of profit by an index (usually Retail Price Index)

26. Value Added Statements
Alternative Method of Stating the Profit & Loss Account
Shows “Value Created” rather then profit made
Capital Radio Example

27. Environmental Accounting
Companies have a responsibility for the damage that they (may) cause to the environment
The (potential) effects depend on the type of company
Companies should deal with this
in the accounts
In the annual report

28. Why?
Whether for moral, economic, legal or pragmatic reasons, every organisation is having to make an increasingly explicit assessment of its environmental and social impact and to attempt to re-position itself as the terms of the social contract between business and society come under increasing scrutiny.

29. Should accounts & reports deal with these issues?
Pragmatic – accounting
Provision for the costs of remedying past contamination should be recognised when an entity is legally or constructively obliged to rectify the damage
Abandonment costs - full provision for the total costs should be made when the environmental damage is inflicted.

30. Should accounts & reports deal with these issues?
Moral Responsibility
There is no FRS that deals with Environmental Reports
Individual accounting bodies and environmental groups have provided guidance
Environmental Report can appear
In annual report or
As distinct report circulated with annual report

31. Suggested Contents CEO statement Organisational profile
Key environmental impacts
Environmental policy statements
Management system and procedures
Performance and compliance
Targets and achievements
Independent verification statement

32. Objective should be…
The provision of information about the environmental impact and operational performance of an entity that is useful to relevant stakeholders in assessing their relationship with the reporting entity
It should be transparent information on the company’s policies and successes
Which means….

33. Concern for the planet… (or profits?)
Benefits from this greater transparency may include:
an increase in the number of customers who consider, respect or share the same values
being placed on ‘preferred suppliers’ lists of companies that consider environmental responsibility upstream to their own operations
stronger relationships with stakeholders by involving them in the reporting process and
general public approval, thus lowering reputational risk.
ACCA Singapore advice publication

34. Examples – the pathetic..
African Gold plc
No policy
Firestone Diamonds plc
A detailed environmental management programme report covering rehabilitation of both historical and planned mining operations has been completed and submitted to the Department of Minerals & Energy for approval.
Why? RSA legislation.

35. Examples – and the top notch
EMI
The Body Shop

36. Crawling on the bandwagon?
Yearly percentage of companies producing a corporate environmental report % % % %

37. The Audit Problem
Auditors have no guidelines on auditing the Environmental Report
Social Audit Ltd – hidden agenda
Role Conflict – auditors as employees of shareholders/stewardship of funds
Do we need audit guidelines?
Do we need environmental reports?
Should they be highlighted as simply public relations?