1. Ratios & Trend Analysis
Week 7
MN20018

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

3. 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.

4. 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.

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 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

7. 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

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 20X1–20X3
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%

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

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

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

13. 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

14. 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.

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 employed
Sales increasing
Assets decreasing
Fixed asset replaced?
Inventory falling?

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

18. Primary liquidity ratio
Current ratio
Current assets
Current liabilities

19. 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

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

21. Subsidiary ratios – Gearing

22. Subsidiary ratios – Liquidity

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

24. Subsidiary ratios – Investment

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 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

27. 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

28. 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

29. Subsidiary ratios – Asset utilisation

30. Subsidiary ratios – Profitability

31. 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

32. Segmental Analysis – Business segments
Factors to consider
Nature of products
Nature of production processes
Class of customer
Distribution methods

33. Implication for future cash flows
Illustration from Royal Ten Cate NV

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

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

36. 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

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

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

39. Non-financial ratios
Operational statistics

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

41. 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

42. Trend Analysis
Horizontal analysis

43. Trend Analysis
Trend analysis series of periods

44. Vertical analysis – Income statement

45. Vertical analysis – Balance Sheet

46. 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

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

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

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

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

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

52. Internal business perspective
What do we need to be best at?
Presenting to potential customers
Tendering success rate

53. 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

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

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

56. Shareholder Value Analysis – annual reports

57. Economic Value Added (EVA)

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

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

60. Financial reporting of risk
Effect of information on risk management
Reduces cost of capital
Improves accountability
Improves investor protection
Assists 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 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.

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 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

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 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

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.