Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.1 Chapter 3 Analysing and interpreting financial statements LEARNING OUTCOMES You should be able to: Calculate key ratios for assessing the financial performance and position of a business and explain the significance of the ratios calculated Identify the major categories of ratios that can be used for analysis purposes Discuss the limitations of ratios as a tool of financial analysis Discuss the use of ratios in helping to predict financial failure

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.2 ProfitabilityInvestment LiquidityEfficiency Financial gearing Financial ratios The key aspects of financial health

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.3 Similar businesses for the same period Planned performance Past periods Ratios may be compared with: Ratios benchmarks

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.4 Profitability ratios Profit for the year less any preference dividend × 100 Ordinary share capital + Reserves Return on ordinary shareholders’ funds (ROSF) Operating profit × 100 Share capital + Reserves + Non-current liabilities Return on capital employed (ROCE) Operating profit × 100 Sales revenue Operating profit margin Gross profit × 100 Sales revenue Gross profit margin

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.5 BA’s operating profit margin – 5 Operating profit margin % Target

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.6 Efficiency ratios Formula Average inventories turnover period Average settlement period for receivables Average settlement period for payables Sales revenue to capital employed Sales revenue per employee Average inventories held × 365 Cost of sales Average trade receivables × 365 Credit sales revenue Average trade payables × 365 Credit purchases Sales revenue Number of employees Sales revenue________________ Share capital + Reserves + Non-current liabilities

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.7 The main elements of the ROCE ratio multiplied by equals Return on capital employed Sales revenue Long-term capital employed Operating profit Sales revenue Source: P. Atrill and E. McLaney, Accounting and Finance for Non-Specialists, 7th edn, Financial Times Prentice Hall, 2010, p. 206.

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.8 Liquidity ratios Current ratio Acid test ratio Formula Current assets Current liabilities Current assets (excluding inventories) Current liabilities

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.9 Gearing ratios Long-term (non-current) liabilities × 100 Share capital + Reserves + Long-term (non-current) liabilities Gearing ratio Formula Interest cover ratio Operating profit Interest payable

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.10 Investment ratios Formula Dividend payout ratio Dividend cover ratio Dividend yield ratio Dividends announced for the year × 100 Earnings for the year available for dividends Earnings for the year available for dividend Dividends announced for the year Dividend per share/(1 – t ) × 100 Market value per share

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.11 Investment ratios (Continued) Formula Price/earnings ratio (P/E) Earnings per share Earnings available to ordinary shareholders Number of ordinary shares in issue Market value per share Earnings per share

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.12 Average dividend yield ratios for businesses in a range of industries Oil and gas Construction and materials Chemicals Industrial engineering Pharmaceuticals and biotechnology Tobacco Food and Drug Retailers Electricity Life insurance/ Assurance Media Travel and leisure Beverages Average for all SE listed businesses % Source: Constructed from data appearing in the Financial Times, 3/4 April 2010

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.13 Average price/earnings ratios for businesses in a range of industries Oil and gas Construction and materials Chemicals Industrial engineering Pharmaceuticals and Biotechnology Tobacco Food and Drug Retailers Electricity Life insurance/ Assurance Media Travel and leisure Beverages Average for all SE listed businesses times Source: Constructed from data appearing in the Financial Times, 3/4 April 2010

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.14 Graph plotting current ratio against time Current ratio William Morrison plc J. Sainsbury plc Tesco plc

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.15 Average (mean) ratios of failed and non-failed businesses

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.16 Scatter diagram showing the distribution of failed and non-failed businesses Current ratio ROCE ratio Failed businesses Non-failed businesses Source: P. Atrill and E. McLaney, Accounting: An Introduction, 7th edn, Financial Times Prentice Hall, 2009.

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.17 The Z score model where: a = Working capital/Total assets b = Accumulated retained profits/Total assets c = Operating profit/Total assets d = Book (statement of financial position) value of ordinary and preference shares/Total liabilities at book (statement of financial position) value e = Sales revenue/Total assets 0.717a b c d e Z =

Peter Atrill, Financial Management for Decision Makers, 6 th Edition, © Pearson Education Limited 2012 Slide 3.18 Limitations of ratio analysis Over-reliance on ratios The basis for comparison Quality of financial statements Statement of financial position ratios Inflation Creative accounting