Analysing Financial Statements Share Investment Analysing Financial Statements

Using Ratios Ratios are used to summarise the data on financial statements in order to capture in one number a particular aspect of operations. These numbers usually take three forms Ratios (one value compared to another) Percentages (ratios expressed as a value out of 100) Amounts (in £) In order to see whether a particular value shows a good or a bad investment, you will need to view it in context. The yellow post-its on the slides try to put the ratio in context.

The Different types of Ratio We will look at three different types of Ratio used in Financial Analysis: 1. Profitability How successful is the business? 2. Liquidity Is the flow of cash sufficient to meet obligations? 3. Investment Does the company represent a good investment for shareholders?

The Different Types of Ratio 1. Profitability

Profitability Ratios Profitability Ratios attempt to measure whether or not the business is financially successful. The amount of of profit made by a company in a particular year may give a distorted picture of the company’s position. A £1.5m profit generated on a turnover of £10m, can look very good. The same profit on a turnover of £100m looks poor. However there may be reasons why the first company has generated so much profit; there could be a one-off sale of assets, for example, which have increased in value.

Example Spreadsheet The Spreadsheet Ratio Analysis gives the full set of examples and the details of the calculations carried out. We will look at one example of each type of calculation

Gross Profit or Gross Margin This is simply the percentage return that the company has made on its sales or services, only taking into consideration what it cost us to sell the items or to undertake the services. Profit made on what we have sold Total Income for the Year This profit is the largest that we can reasonably claim; it is the difference between the money coming in, and the expenditure incurred in order to make the sale or to render the service.

Activity Two Solutions Gross Margin% In the spreadsheet:

Gross Margin% The P & L Account Shows: Sales £2,240,000 Gross Profit £494,600 (NB Gross Profit = Turnover – Cost of Sales) Gross Margin% = 494600 x 100 = 22.1% 2240000 The company makes 22p for every £1 it brings in. This can be used to pay overheads etc.

Net Profit or Net Margin This is simply the real percentage return that the company has made on its sales or services, this time taking into account all operating costs . In other words.. Actual Profit made on what we have sold Total Income for the Year This profit is a more conservative estimate. It takes into consideration the overheads (fixed costs) required to run the business.

Activity Two Solutions Net Margin% In the spreadsheet:

Net Margin% The P & L Account Shows: Sales £2,240,000 Net Profit after Tax and Dividends £118,200 (NB Net Profit = Turnover – Cost of Sales- Overheads) Net Margin% = 118200 x 100 = 10.8% 2240000 After paying all outstanding costs, the company makes 11p for every £1 it brings in.

Return on ordinary Shareholders’ Funds ROSF is the profit after tax expressed as a percentage of the shareholder’s investment. Actual Profit made (after tax) Total Amount of Shareholders’ claims This measure indicates to shareholders the growth of their investment.

Activity Two Solutions ROSF% In the spreadsheet:

ROSF% The P & L Account Shows: Net Profit after Tax and Dividends £118,200 Share Capital £300,000 Reserves £197,500 £497,500 ROSF% = 118200 x 100 = 31.8% 497500 The company is making 32p for every £1 invested by shareholders.

Return on Capital Employed ROCE is the profit (before tax) expressed as a percentage of the total money invested in the company (this includes Long Term Loans). Actual Profit made (before tax) Total Amount Invested This measure indicates the extent to which all funds have been gainfully employed.

Activity Two Solutions ROCE% In the spreadsheet:

ROCE% The P & L Account Shows: Net Profit (before Tax & Interest) £242,600 Share Capital £300,000 Reserves £197,500 LT Loans £200,000 £697,500 ROCE% = 242600 x 100 = 34.8% 697500 Including loans, the company makes 35p for every £1 invested in the business.

Summary of the Profitability Ratios We look at four ratios: ______________________________________________________________________________________________________________________________________________ Gross Margin% = Gross Profit x 100 Sales Net Margin% = Net Profit before tax & interest x 100 Return on Ordinary Shareholders Funds (ROSF) = Net Profit after tax and preference dividends x100 (Share Capital + Reserves) Return on Capital Employed (ROCE) = Net Profit before tax and interest x100 (Share Capital + Reserves+ LT Loans)

The Different Types of Ratio 2. Liquidity

Liquidity Ratios These Ratios seek to answer the question: ‘Can the business pay its way?’ All of these ratios look at the flow of cash in the company, and try to determine whether or not, at a particular point in time, the business has enough cash to pay what it owes. Liquidity = amount of stock, debt etc., which can be easily converted into cash

Example Spreadsheet The ratios in this section refer to the items in the second part of the spreadsheet

Current Ratio The Current Ratio is simply the total current Assets compared to the total current Liabilities. Current Assets Current Liabilities In order to be solvent, a company should have a ratio greater than 1, in other words, in the day-to-day workings of the company, there should be enough resources available to pay our debts.

Current Ratio In the spreadsheet (Liquidity):

Current Ratio Current Ratio = 574300 = 1.8 321800 Current Assets : Trade Debtors £240,800 Bank Account £33,500 Closing Stock Value £300,000 £574,300 Current Liabilities: Trade Creditors £221,400 Dividends Owing £40,200 Corporation Tax Owing £60,200 £321,800 Current Ratio = 574300 = 1.8 321800 The business owns almost twice as much as it owes

Acid-Test Ratio Current Assets Current Liabilities The Acid Test Ratio is simply the Current Assets (minus the Stock) compared to the total current Liabilities. Current Assets Current Liabilities Some Authorities argue that if a company has to sell all its stock to cover its debt, it has a cash-flow problem. Therefore, this ratio too should be greater than 1.

Acid Test Ratio In the spreadsheet (Liquidity ):

Acid Test Ratio Acid Test Ratio = 274300 = 0.9 321800 Current Assets excluding Stock : Trade Debtors £240,800 Bank Account £33,500 £274,300 Current Liabilities: Trade Creditors £221,400 Dividends Owing £40,200 Corporation Tax Owing £60,200 £321,800 Acid Test Ratio = 274300 = 0.9 321800 Excluding stock, the business owns almost as much as it owes..

Summary of the Liquidity Ratios We look at two ratios: ______________________________________________________________________________________________________________________________________________ Current ratio = Current Assets (Over 1 for solvency) Current Liabilities e.g. Current ratio of 1.5 = £1.50 owned for every £1 owed Acid test = Current Assets excluding stock

The Different Types of Ratio 3. Investment

Investment Ratios These ratios all seek to measure the value of the shareholder’s investment in the company, and the return on that investment. It should be noted that the money the shareholder may have paid for the shares, may not reflect either their current market value, or the actual stake it represents in the company. For example, shares in TSB were originally sold at £1.00 each in the 1980s. This represents the capital invested in the company. If you had bought these shares in 1996 you would have paid around £11.00 per share. Currently they are trading at around £6.00 per share.

Spreadsheet The spreadsheet uses the figures given in sections 2 and 3 above , and the additional figures below, to callculate and comment on shareholder value for the two years shown: YEAR 1 YEAR 2 Number of Ordinary Shares 600,000 668,200 Preference Dividends/Shares NIL NIL Market Price Per Share 2.50 3.50

Dividend per Share From the spreadsheets: This is the amount in pence that each shareholder gets for each share that they own. Dividend per Share From the spreadsheets:

Dividend per Share Dividend per Share = 40200 600000 = £0.067 Dividends Announced £40,200 Number of Shares 600,000 Dividend per Share = 40200 600000 = £0.067 Each shareholder gets 6.7p for each share they own.

Dividend Payout From the spreadsheets: This is the proportion of the profits that has been distributed to shareholders. Dividend Payout From the spreadsheets: Here we are assuming that these are ordinary, rather than preferential dividends

Dividend Payout Net Profit £242,600 Interest - £24,000 Tax - £60,200 Net profit after interest/tax £158,400 Dividends Announced £40,200 Dividend Payout = 40200 x 100 158400 = 25.4% One quarter of the total profit is paid out in dividends to shareholders.

This is the rate of return that shareholders are getting on their investment through dividends. Dividend Yield From the spreadsheet and the first example in this section: Dividends Announced £40,200 Number of Shares 600,000 Dividend per Share = 40200 600000 = £0.067 In addition, we will be assuming a tax rate of 20%

Dividend Yield Dividend per share £0.067 Market Price per Share £2.50 Tax Rate 20% Dividend Yield = 0.067/(1 – 0.2) x 100 2.50 = 3.35% NB: 20% = 0.2 Shareholders are currently getting a rate of return of 3.35% on their investment at market value (compare Inflation ~ 2%)

Earnings per Share From the spreadsheets: This is the amount in pence that the company is earning per share. Earnings per Share From the spreadsheets: Here we are again assuming that these are ordinary, rather than preferential dividends

Earnings per Share Net Profit £242,600 Interest - £24,000 Tax - £60,200 Net profit after interest/tax £158,400 Number of shares issued: 600,000 Earnings per Share: = 158400 600000 = £0.264 The company is making about 26p for every share that is held.

This is the time in years it will take to earn an amount equal to the original investment. Price/Earnings Ratio From the spreadsheet, and the 4th ratio in this set: Net Profit £242,600 Interest - £24,000 Tax - £60,200 Net profit after interest/tax £158,400 Number of shares issued: 600,000 Earnings per Share: = 158400 600000 = £0.264

Price/Earnings Ratio Market Price per share: £2.50 Earnings per share: £0.264 Price/Earnings Ratio: = 2.50 0.264 = 9.45 The market price of a share is about 10 times the profit made by the share. (may be better the other way round – each share earns about one-tenth of its current market value in a year)

Comparison of Ratios Share Price P/E Date 2/8/00 22/9/01 283.5 17.5 In 2000 was a poor investment, and the share price dropped dramatically. In 2001 the investment improved, but still it was not as good a bet as the supermarkets. Comparison of Ratios Share Price P/E Date 2/8/00 22/9/01 SAFEWAY 283.5 17.5 319 14 SAINSBURY 322 17.6 327 18.2 TESCO 221 21.9 238 19.6 MAN UTD. 321 54.4 122 20.3

Summary of the Investment Ratios Dividend per share = _Dividends announced__ Number of issued shares _____________________________________________________________________________________________________________________________________________ Dividend payout = Dividends announced x 100 . Net profit after interest/tax/pref.dividends Dividend Yield = Dividend per share/(1-tax rate) x 100 Market value per share Earnings per share = Net profit after interest/tax/pref.dividends Dividend Cover ratio = Net profit after interest/tax/pref.dividends Dividends announced Price/earnings ratio = Market price per share Earnings per share

Example of Analysis Using Financial ratios

Analysing a Company’s Performance The next slide shows five different ratios calculated from the published accounts of J. Sainsbury PLC, summarising the company’s performance over the five-year period 1996-2000 As you look through these figures, you should ask yourself: What trends can be detected? Is the company improving its performance? Would you consider investing in the company?

Ratio Analysis - J Sainsbury Plc 1996 1997 1998 1999 2000 TURNOVER (£ million) 13,499 13,312 15,496 16,378 17,414 PROFIT BEFORE TAX 764 651 728 755 580 NET MARGIN (%) 5.6% 4.6% 4.7% 4.6% 3.3% EARNINGS PER SHARE 26.8p 22.0p 25.1p 29.2p 18.3p DIVIDEND PER SHARE 12.1p 12.3p 13.9p 14.32p 14.32p DIVIDEND COVER 2.21 1.78 1.8 2.03 1.27 Figures taken from J Sainsbury Plc Website - 2 August 2000 Dividend cover is the reciprocal form of the Dividend Payout Ratio

Ratio Analysis: J Sainsbury Plc Axis scales have been modified to enable comparisons to be made Ratio Analysis: J Sainsbury Plc

Comparison of ratios It can be noted from the previous slides that while the turnover has increased steadily over the five-year period, the profit before tax, fluctuates somewhat, with a sharp downturn in 2000. The downward trend is even more evident from the net margin, which has down a steady reduction over the 5 years. On the other hand, the dividend per share rose steadily over the first 4 years, and maintaining this level in 2000. However, the earnings per share shows a much less impressive performance.

The Limitations of Ratios Analyses which only use ratios only give a limited vision: The quality of base data in financial statements may be suspect. Ratios can measure relative performance, but do not allow for scale (see Sainsbury example). They give only a basis for comparison – we need to compare like with like. Some ratios ( balance sheet - e.g.) measuring at a single point in time, and not over a period. One off events such as disposal of assets can give rise to major distortions.