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Intro to Financial Management of the Organisation

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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?

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