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

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Presentation on theme: "Ratio Analysis – main strength Ratios: direct the users focus of attention identify and highlight areas of good and bad performance identify areas of significant."— Presentation transcript:

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

2 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.

3 Importance of uniformity Comparison is possible only if there is Uniformity in the preparation of accounts An awareness of any differences in international accounting policies. Need to understand how 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.

4 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 profitCapital employedcapital employed £ £ 20X1100,0001,000,00010% 20X2150,0001,500,00010% 20X3225,0002,250,00010%

5 Review of ratio analysis Six Primary ratios –Investment ratios –Operating ratios –Liquidity ratios EBIT1,2301,889 Shareholders' Funds3,5492,725 Capital Employed4,5793,715 Sales7,4357,156 Rolls Royce Group figures in £millions

6 Primary investment level ratios Primary investment ratio (operating return on equity) Earnings before interest and tax Shareholders funds ,230/3,5491,889/2, %69.3%

7 Primary investment level ratios Primary financing ratio (Financial leverage multiplier) Capital employed Shareholders funds Effect on profit of assets funded by other sources ,579/3,5493,715/2, %136%

8 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 ,230/4,5791,889/3, %50.8%

9 Primary operating level ratios Primary utilisation ratio (asset turnover) Sales Capital employed Sales increasing Assets decreasing Fixed asset replaced? Inventory falling? ,435/4,5797,156/3, %192.6% Can be based purely on assets

10 Primary operating level ratios Primary efficiency ratio Earnings before interest and tax Sales Company pricing policy Type of industry High volume/low profits? ,230/7,4351,889/7, %26.4%

11 Why Pyramid of ratios? EBIT/Shareholders' funds = = CE/Shareholders funds X EBIT/CE = X = AND EBIT/CE = = Sales/CE X EBIT/Sales = X = X X 0.165

12 Primary liquidity ratio Current ratio Current assets Current liabilities

13 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.

14 Subsidiary ratios Gearing ratios (Financial Risk ratios) Liquidity ratios Asset utilization ratios (Efficiency ratios) Investment ratios Profitability ratios.

15 Subsidiary ratios – gearing

16 Subsidiary ratios – liquidity

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

18 Subsidiary ratios – Investment

19 Earnings per share – use in strategic planning The 2002 Annual Report of Gamma Holding NV states: Gamma Holding aims to maximize 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%.

20 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.

21 VT Group plc P/E ratios Market price & EPS in pence Market Price EPS P/E ratio

22 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 crystallize non-current assets being increased or not being replaced.

23 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

24 In short Many factors can impact on P/E ratio. Overconfident management Over ambitious forecasts can impact on P/E Capital Radio plc Example 2000 EPS = 26.3p Market Price of Ordinary Shares at Balance Sheet date = £ EPS = 23.8p Market Price of Ordinary Shares at Balance Sheet date = £5.20 P/E Ratio / = 54.7 times / = 21.8 times

25 Subsidiary ratios – asset utilization 7,435/4,206 = ,435/7,253 = ,435/2,499 = ,003/2,203 = ,435/889 = ,003/778 = 7.72 Debtors (receivables) – note 12 Creditors (payables) – note 15 Rolls Royce figures

26 Focussing on key industry ratios Somerfield Stock & Cost of Sales Stock in Balance Sheet 2000 – – Cost of Sales from P&L 2000 – –

27 Applying the ratios = 13.7 times in the year = 14.5 times in the year Diagnosis? – what might be going wrong & why?

28 Prognosis Stock availability When basic items are not available on the shelves, it is frustrating for any shopper. For Kwik Saves target market, who keep relatively small stocks at home, it is particularly frustrating and encourages them to shop elsewhere. We have sharply increased the availability of everyday and promotional items through improvements in distribution and stores internal replenishment procedures. During October, we reappraised the frozen food lines that we stock, simplifying the offer to ensure high availability and good presentation for the most popular products. This worked well, and we are now applying the same principles elsewhere in the store – making ranges simpler and more disciplined while still providing the choice that todays consumers require. We are also increasing the focus on brands, taking Kwik Save back to its roots by offering the biggest brands at lowest prices. To give customers a lower-cost choice we have been offering Somerfield own- label products, but this has confused many customers. We are phasing this policy out, replacing all Somerfield lines with value alternatives by this Autumn.

29 Prognosis Investing behind the scenes We are investing in our IT and distribution systems to achieve higher availability and service to stores at lower cost. Our IT strategy is to simplify and clarify our systems – focusing investment initially on updating our distribution and Kwik Save store systems. By June this year, all Kwik Save units were linked into our store IT system. During the year we opened a completely rebuilt and enlarged distribution depot near York. The depot is over 500,000 sq ft in size and handles ambient, chilled and frozen products. It is operated by an outsourced logistics specialist. The new year will see the increasing use of multi-temperature vehicles, significantly increasing both depot and store productivity. In the South West we outsourced some of our logistics operations, ensuring that staff transferred to the outsourcing organisations on equivalent terms.

30 Did it work? Calculating ratios for the next 2 years 2002 report – 13.9 times per year 2003 report – 15.6 times per year Moral: Identify ratios important to your industry. Ensure they do not deteriorate. If they do – It will be noticed!

31 Subsidiary ratios – profitability

32 Industry specific metrics To remain competitive you will need to continually re-invest in R&D and Product Development For high tech businesses the spend range is between 5% and 10% of revenues Early on you will be much closer to 10% This is why you need healthy gross margins

33 R&D spending BAE Meggitt RR VT Smiths

34 Impact on Profit margins? BAE Meggitt RR VT Smiths

35 Segmental Analysis Implication for future cash flows Illustration from Royal Ten Cate NV

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

37 Segmental analysis – geographical segments Factors to consider Political conditions Economic conditions Exchange control regulations Currency risks.

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

39 Selected share movement

40 Implication for share valuation

41 Non-financial ratios Operational statistics

42 Trend Analysis Consideration will be given to the following: Horizontal analysis between two periods Trend analysis over a series of periods Historical summaries Vertical analysis – common size statements.

43 Horizontal analysis Trend Analysis

44 Trend analysis series of periods Trend Analysis

45 Vertical analysis – Income Statement

46 Vertical analysis – Balance Sheet

47 Multivariate analysis – Altmans Z-score Less than 1.8:Bankruptcy risk is high Between 1.8 and 2.7:Bankruptcy risk is fair Between 2.7 and 3.0:Bankruptcy risk is possible, but not likely in the near-future Higher than 3.0:Bankruptcy risk is low

48 Tesco Group plc Application of Altmans Z Score Z-Score Data £millions (A) PBIT2,869 (B) Total Assets24,807 (C) Net Sales42,641 (D) MV of Equity (shares X MV)35,445 (E) Total Liabilities14,301 (F) Working Capital-3,576 (G) Retained Earnings5,693 Note: No of shares at 2007 = 7,947,349,558 A/B X C/B X D/E X F/B X G/B X Z Score =3.734 Bankruptcy risk is LOW Whod have predicted that!

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