2 Accounting ratios and ratio analysis Six key ratiosPyramid of ratiosOther important ratios
3 Ratio Analysis Application of pyramid of ratios Segmental analysis Inter-firm comparisons and industry averagesNon-financial ratiosInterpretation problems when using consolidated financial statements.
4 Ratio Analysis – main strength Ratios:direct the user’s focus of attentionidentify and highlight areas of good and bad performanceidentify areas of significant change.
5 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
6 Compare like with like Comparing current financial ratios with: financial ratios for a preceding periodbudgeted financial ratios for the current periodfinancial ratios for other profit centres within the companyfinancial ratios for other companies within the same sector
7 Importance of uniformity Comparison is possible only if there isUniformity in the preparation of accounts andAn awareness of any differences in international accounting policies
8 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.
9 Awareness of underlying trends ROCE remains a constant 10% over the years 20X1–20X3Net profit increased by 50% in both 20X2 and 20X3This trend is not ascertainable in the ROCE ratio.Return onNet 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%
10 Review Ratio Analysis Six Primary ratios Investment ratios Operating ratiosLiquidity ratios
11 Primary investment level ratios Primary investment ratioEarnings before interest and taxShareholders’ funds
12 Primary investment level ratios Primary financing ratioCapital employedShareholders’ fundsFinancial leverage multiplierEffect on profit of assets funded by other sources
13 Primary operating level ratios Return on capital employedEarnings before interest and taxCapital employedNo single definition of capital employedUse for strategic planning
14 ROCE target – VIAG AGVIAG 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.
15 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.
16 Primary operating level ratios Primary utilisation ratio (asset turnover)Sales Capital employedSales increasingAssets decreasingFixed asset replaced?Inventory falling?
17 Primary operating level ratios Primary efficiency ratioEarnings before interest and taxSalesCompany pricing policyType of industryHigh volume/low profits?
18 Primary liquidity ratio Current ratioCurrent assetsCurrent liabilities
19 Current ratio What if Current ratio increases? Growth: Inventory buildup expecting sales growthDecline: Inventory buildup result of falling salesExpansion: Permanent increase in scaleInefficiency: Poor control over working capital
25 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%.
26 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 aspolitical factors, e.g. imposition of trade embargoes and sanctionseconomic factors, e.g. the downturn in manufacturing activitycompanyrelated events, e.g. possibility of organic or acquired growth and the implication of financial indicators for future cash flow estimates
27 PE ratio – implication of financial indicators Balance sheet:change in debt/equity ratio in relation to prior periodsnew borrowings to finance expansiondebt restructuring following inability to meet current repayment termsadequacy of working capitallow acid test (quick) ratio in relation to prior periods indicating liquidity difficultieschange in current ratio in relation to prior periods, i.e. higher indicating a build-up of slow-moving inventory and lower possible inventory-outscontingent liabilities that could be damaging if they crystallise – non-current assets being increased or not being replaced
28 PE ratio – implication of financial indicators Income statement:change in sales trendlimited product range, products moving out of patent protection periodexpanding product rangechanges in technology beneficial or otherwise to companyhigh or low capital expenditure/depreciation ratio indicating that productive capacity is not being maintainedloss of key suppliers/customers, e.g. loss of longstanding Marks & Spencer contractschange in ratio of R&D to sales
31 Segmental Analysis Important for inter-period comparison Quality of earningsSpecific risksPossible long-term growth prospectsInter-company difficultiesDetermination of segmentsAllocation of costs
32 Segmental Analysis – Business segments Factors to considerNature of productsNature of production processesClass of customerDistribution methods
33 Implication for future cash flows Illustration from Royal Ten Cate NV
34 Implication for future cash flows RevenuesOperating resultReturn oncapital employed %Illustration from Royal Ten Cate NV (cont)
35 Segmental Analysis – Geographical segments Factors to considerPolitical conditionsEconomic conditionsExchange control regulationsCurrency risks
36 Reportable segment: criteria Majority of sales to external customersANDExternal sales 10% or more of total salesORAssets 10% or more of total assetsProfit or loss 10% or more of total profit or loss
37 Implication for share valuation Different risksProblems for conglomeratesDifferential PE for different segments
40 Trend Analysis Horizontal analysis between two periods Trend analysis over a series of periodsHistorical summariesVertical analysis – common size statements
41 Trend Analysis Multivariate analysis – Z-scores H-scores A-scores Balanced scorecardsValuing shares of an unquoted company – quantitative processValuing shares of an unquoted company – qualitative processShareholder value analysisFinancial reporting and risk
46 Multivariate analysis Single value scoreBenchmark criteria applied to this scoreCombination of ratios e.g.Working capital/Total assetsSales/Total assetsWeighted for predictive capability e.g.Working capital/Total assets Weight 0.012Sales/Total assets Weight 0.999
47 Multivariate analysis – types of scores Z-scoresAltman’s Z-scoresTaffler’s Z-scoresPAS-scoreA-scores
48 Balanced scorecards – Four perspectives Financial perspectiveCustomer perspectiveInternal business perspectiveInnovation and learning perspective
49 Financial perspective How do shareholders see us?Return on capital employedCash flowsProject profitability
50 Customer perspective How do customers see us? Price Quality Guaranteed supply
51 Innovation and learning perspective How well will we compete?Staff moraleNew business from innovation
52 Internal business perspective What do we need to be best at?Presenting to potential customersTendering success rate
53 Valuing shares of unquoted company – quantitative Maintainable incomeExtrapolate from past five yearsYields requiredRequired earnings yield – majority holdingRequired dividend yield – minority holdingAdjustment for adverse factorslack of marketabilityHigh gearingCalculate Economic value and NRV
54 Valuing shares of unquoted company – qualitative Factors to considerManagement changeRevenue investmentInflation rateCompetitive pressures
55 Shareholder Value Analysis Growing interestAccounting measures (EPS) not related to share valueLinkage with executive remuneration
58 EVA – make operationalGeveke av Amsterdam – extract from 1999 Annual Report
59 EVA – achieving increases Increase NOPATReduce WACCImprove utilisation of capital
60 Financial reporting of risk Effect of information on risk managementReduces cost of capitalImproves accountabilityImproves investor protectionAssists in making informed predictions
61 Professional risk assessors Companies are given a rating that can range from AAA for companies with a strong capacity to meet their financial commitmentsdown to D for companies that have been unable to make contractual payments or have filed for bankruptcywith 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.
62 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 cyclescash flow adequacy, e.g. EBITDA interest cover; EBIT interest cover; free operating cash flowcapital structure, e.g. gearing ratio; debt structure; implications of off balance sheet financing
63 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.
64 How ratings are set – external factors External factors may include:growth prospects, e.g. trends in industry sector; technology possible changes; peer comparisoncapital requirements, e.g. whether company is fixed capital or working capital intensive; future tangible fixed asset requirements; R&D spending requirementscompetitors, e.g. the major domestic and foreign competitors; product differentiation; what barriers there are to entry
65 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.