# Ratios & Trend Analysis

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Ratios & Trend Analysis
Week 7 MN20018

Accounting ratios and ratio analysis
Six key ratios Pyramid of ratios Other important ratios

Ratio Analysis Application of pyramid of ratios Segmental analysis
Inter-firm comparisons and industry averages Non-financial ratios Interpretation problems when using consolidated financial statements.

Ratio Analysis – main strength
Ratios: direct the user’s focus of attention identify and highlight areas of good and bad performance identify areas of significant change.

Caveat Beware creative accounting View that:
Every company in the country is fiddling its profits. Myth that the financial statements are an accurate reflection of the company’s trading performance for the year. Accounts are little more than an indication of the broad trend

Compare like with like Comparing current financial ratios with:
financial ratios for a preceding period budgeted financial ratios for the current period financial ratios for other profit centres within the company financial ratios for other companies within the same sector

Importance of uniformity
Comparison is possible only if there is Uniformity in the preparation of accounts and An awareness of any differences in international accounting policies

How are ratios are defined?
Implications of any given ratio requires a clear definition of its constituent parts. Definitions of ratios may vary from source to source e.g. concepts and terminology are not universally defined.

Awareness of underlying trends
ROCE remains a constant 10% over the years 20X1–20X3 Net profit increased by 50% in both 20X2 and 20X3 This trend is not ascertainable in the ROCE ratio. Return on Net profit Capital employed capital employed £ £ 20X1 100,000 1,000,000 10% 20X2 150,000 1,500,000 10% 20X3 225,000 2,250,000 10%

Review Ratio Analysis Six Primary ratios Investment ratios
Operating ratios Liquidity ratios

Primary investment level ratios
Primary investment ratio Earnings before interest and tax Shareholders’ funds

Primary investment level ratios
Primary financing ratio Capital employed Shareholders’ funds Financial leverage multiplier Effect on profit of assets funded by other sources

Primary operating level ratios
Return on capital employed Earnings before interest and tax Capital employed No single definition of capital employed Use for strategic planning

ROCE target – VIAG AG VIAG made excellent progress in 1998 towards reaching its stated profitability goal. Return on capital employed increased significantly from 6.5% in 1997 to 7.0% in … The goal is to increase the Group’s return on capital employed to at least 10% by the year 2003. The target figures we have adopted are based on our own experience and on the results of our leading competitors.

ROCE definition not uniform
Capital employed is defined on the basis of very restrictive criteria, as evidenced by the fact that Bayernwerk’s accruals for decommissioning are included in the capital employed totalling DM59.5 billion. We are legally obliged to establish these accruals for decommissioning expenses, which account for 20% of capital employed. Consequently, VIAG’s return on equity and capital costs tend to be lower than those of other industrial corporations.

Primary operating level ratios
Primary utilisation ratio (asset turnover) Sales Capital employed Sales increasing Assets decreasing Fixed asset replaced? Inventory falling?

Primary operating level ratios
Primary efficiency ratio Earnings before interest and tax Sales Company pricing policy Type of industry High volume/low profits?

Primary liquidity ratio
Current ratio Current assets Current liabilities

Current ratio What if Current ratio increases?
Growth: Inventory buildup expecting sales growth Decline: Inventory buildup result of falling sales Expansion: Permanent increase in scale Inefficiency: Poor control over working capital

Subsidiary ratios Gearing ratios Liquidity ratios
Asset utilisation ratios Investment ratios Profitability ratios

Subsidiary ratios – Gearing

Subsidiary ratios – Liquidity

Quick ratio – identify the company norm
The following is an extract from the 2003 Annual Report of Barloworld: Quick ratio

Subsidiary ratios – Investment

Earnings per share – use in strategic planning
The 2002 Annual Report of Gamma Holding NV states: Gamma Holding aims to maximise shareholder value, taking into account the interests of the employees and other stakeholders in the company. In doing so, Gamma Holding strives to offer its shareholders an attractive return based on continuous growth of earnings per share of an average 10% over a number of years whilst maintaining healthy balance sheet ratios and generating positive cash flows. Furthermore, the company aims to achieve an average return on capital employed (including goodwill) of 15%.

PE – a measure of market confidence
Market price also takes into account anticipated changes in the earnings arising from their assessment of macro events such as political factors, e.g. imposition of trade embargoes and sanctions economic factors, e.g. the downturn in manufacturing activity company­related events, e.g. possibility of organic or acquired growth and the implication of financial indicators for future cash flow estimates

PE ratio – implication of financial indicators
Balance sheet: change in debt/equity ratio in relation to prior periods new borrowings to finance expansion debt restructuring following inability to meet current repayment terms adequacy of working capital low acid test (quick) ratio in relation to prior periods indicating liquidity difficulties change in current ratio in relation to prior periods, i.e. higher indicating a build-up of slow-moving inventory and lower possible inventory-outs contingent liabilities that could be damaging if they crystallise – non-current assets being increased or not being replaced

PE ratio – implication of financial indicators
Income statement: change in sales trend limited product range, products moving out of patent protection period expanding product range changes in technology beneficial or otherwise to company high or low capital expenditure/depreciation ratio indicating that productive capacity is not being maintained loss of key suppliers/customers, e.g. loss of longstanding Marks & Spencer contracts change in ratio of R&D to sales

Subsidiary ratios – Asset utilisation

Subsidiary ratios – Profitability

Segmental Analysis Important for inter-period comparison
Quality of earnings Specific risks Possible long-term growth prospects Inter-company difficulties Determination of segments Allocation of costs

Factors to consider Nature of products Nature of production processes Class of customer Distribution methods

Implication for future cash flows
Illustration from Royal Ten Cate NV

Implication for future cash flows
Revenues Operating result Return on capital employed % Illustration from Royal Ten Cate NV (cont)

Segmental Analysis – Geographical segments
Factors to consider Political conditions Economic conditions Exchange control regulations Currency risks

Reportable segment: criteria
Majority of sales to external customers AND External sales 10% or more of total sales OR Assets 10% or more of total assets Profit or loss 10% or more of total profit or loss

Implication for share valuation
Different risks Problems for conglomerates Differential PE for different segments

Ratios from FAME Turnover % Profit margin
Allied Domecq 4,308, Pubmaster , Lower quartile Median Upper quartile

Non-financial ratios Operational statistics

Trend Analysis Horizontal analysis between two periods
Trend analysis over a series of periods Historical summaries Vertical analysis – common size statements

Trend Analysis Multivariate analysis – Z-scores H-scores A-scores
Balanced scorecards Valuing shares of an unquoted company – quantitative process Valuing shares of an unquoted company – qualitative process Shareholder value analysis Financial reporting and risk

Trend Analysis Horizontal analysis

Trend Analysis Trend analysis series of periods

Vertical analysis – Income statement

Vertical analysis – Balance Sheet

Multivariate analysis
Single value score Benchmark criteria applied to this score Combination of ratios e.g. Working capital/Total assets Sales/Total assets Weighted for predictive capability e.g. Working capital/Total assets Weight 0.012 Sales/Total assets Weight 0.999

Multivariate analysis – types of scores
Z-scores Altman’s Z-scores Taffler’s Z-scores PAS-score A-scores

Balanced scorecards – Four perspectives
Financial perspective Customer perspective Internal business perspective Innovation and learning perspective

Financial perspective
How do shareholders see us? Return on capital employed Cash flows Project profitability

Customer perspective How do customers see us? Price Quality
Guaranteed supply

Innovation and learning perspective
How well will we compete? Staff morale New business from innovation

What do we need to be best at? Presenting to potential customers Tendering success rate

Valuing shares of unquoted company – quantitative
Maintainable income Extrapolate from past five years Yields required Required earnings yield – majority holding Required dividend yield – minority holding Adjustment for adverse factors lack of marketability High gearing Calculate Economic value and NRV

Valuing shares of unquoted company – qualitative
Factors to consider Management change Revenue investment Inflation rate Competitive pressures

Shareholder Value Analysis
Growing interest Accounting measures (EPS) not related to share value Linkage with executive remuneration

Shareholder Value Analysis – annual reports

EVA – make operational Geveke av Amsterdam – extract from 1999 Annual Report

EVA – achieving increases
Increase NOPAT Reduce WACC Improve utilisation of capital

Financial reporting of risk
Effect of information on risk management Reduces cost of capital Improves accountability Improves investor protection Assists in making informed predictions

Professional risk assessors
Companies are given a rating that can range from AAA for companies with a strong capacity to meet their financial commitments down to D for companies that have been unable to make contractual payments or have filed for bankruptcy with more than ten ratings in between, e.g. BBB for companies that have adequate capacity but which are vulnerable to internal or external economic changes.

How ratings are set Internal company factors may include:
an appraisal of the financial reports to determine: trading performance, e.g. specific financial targets such as return on equity and return on assets; earnings volatility; past and projected performance; how well a company has coped with business cycles cash flow adequacy, e.g. EBITDA interest cover; EBIT interest cover; free operating cash flow capital structure, e.g. gearing ratio; debt structure; implications of off balance sheet financing

How ratings are set – internal factors
a consideration of the notes to the accounts to determine possible adverse implications, e.g. contingent liabilities, heavy capital investment commitments which may impact on future profitability, liquidity and funding requirements; meetings and discussions with management; monitoring expectation, e.g. against quarterly reports, company press releases, profit warnings; monitoring changes in company strategy, e.g. changes to funding structure with company buyback of shares, new divestment or acquisition plans and implications for any debt covenants.

How ratings are set – external factors
External factors may include: growth prospects, e.g. trends in industry sector; technology possible changes; peer comparison capital requirements, e.g. whether company is fixed capital or working capital intensive; future tangible fixed asset requirements; R&D spending requirements competitors, e.g. the major domestic and foreign competitors; product differentiation; what barriers there are to entry

How ratings are set – external factors (cont)
Keeping a watching brief on macroeconomic factors, e.g. environmental statutory levies, tax changes, political changes such as restrictions on the supply of oil, foreign currency risks; Monitoring changes in company strategy, e.g. implication of a company embarking on a heavy overseas acquisition programme which changes the risk profile, e.g. difficulty in management control and in achieving synergies, increased foreign exchange exposure.

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