FINANCIAL ANALYSIS.

FINANCIAL ANALYSIS

‘Did not one of your fellow craftsmen, the late Sir Mark Webster Jenkinson, say only a few years ago that “backers of horses have better information available than speculations on share”?’ (Jenkinson, c1930)

LEARNING OUTCOMES UNDERSTAND THE OBJECTIVES OF FINANCIAL STATEMENT ANALYSIS IDENTIFY THE EXTERNAL INFLUENCES AFFECTING A BUSINESS ENTITY COMPARE DIFFERENT TECHNIQUES FOR ANALYSING AND INTERPRETING FINANCIAL STATEMENTS CALCULATE KEY RATIOS FOR EVALUATING ALL ASPECTS OF A BUSINESS, INCLUDING PERFORMANCE AND CAPITAL STRUCTURE DESCRIBE THE RESULTS OF THE ANALYSIS, WITH EXPLANATION OF THE CAUSES CONSIDER THE BENEFITS AND LIMITATIONS OF FINANCIAL ANALYSIS

Objective of Financial Analysis
To examine a firm’s financial information in order to forecast the firm’s ability to maximise future earnings Future is uncertain, so we must forecast: The expected future earnings The risk associated with achieving these expected earnings

So, in order to ‘extract’ the information they need and to analyse it
Financial analysis allows users to assess the overall financial performance and position of a business So, financial analysis is used in order to evaluate a business AND the effectiveness of the decisions made by management!

External influences A business entity is affected by many outside influences. The state of the economy in which it operates has a major influence on the entity Changes in a particular industry in which the entity operates also impact on its Financial position and results

When evaluating a business, one needs to consider RISK

RISK Risk is the potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome). . A probability or threat of damage, injury, liability, loss, or any other negative occurrence that is caused by external or internal vulnerabilities, and that may be avoided through preemptive action.

The probability that an actual return on an investment will be lower than the expected return. Financial risk can be divided into the following categories: Basic risk, Capital risk, Country risk, Default risk, Delivery risk, Economic risk, Exchange rate risk, Interest rate risk, Liquidity risk, Operations risk, Payment system risk, Political risk, Refinancing risk, Reinvestment risk, Settlement risk, Sovereign risk, and Underwriting risk.

The performance of a business must be considered in relation to the risks associated with that business

Risks affecting business operations
Business risk is reflected by business operations There is a risk that unexpected outcomes could affect the incomes and expenses of a business leading to unexpected effects on profit

In addition to business risk, businesses also face FINANCIAL RISK
Financial risk results as a result of how the business chooses to fund itself In other words, has the business selected funding through EQUITY or DEBT or a combination of the two? What risk does debt-financing expose a business to?

Financial risk When a business using debt to finance operations, it is required to pay interest on the debt Financial risk is the risk that the business will not generate sufficient profits to make the interest payments Does an increase in earnings increase or decrease this risk?

Using financial analysis
There are two main approaches that can be used to evaluate a business: Comparability Ratio analysis A combination of the two is often used, too.

Comparability Other companies that are similar Prior year results
What do you understand by the term “comparability” To what information can the financial result of a business be compared during analysis? Other companies that are similar Prior year results Industry averages Budgeted results

Common-size Financial Statements
Are prepared using percentages for each item on the financial statements instead of showing the actual amounts In the case of the Income Statement, the sales are shown as 100%, with all other items shown as a percentage of sales In the case of the Balance Sheet, the totals of both the assets equity & liabilities section are shown as 100%, and individual items are shown as a percentage !!!

Common-size financial statements
Indicates the percentage of sales absorbed by each expense item Indicates relationships between the various components in the SOFP Income statement Balance sheet

USES of Common-size AFS
Reveals the relation between the various elements in the components of a financial report Useful for users who wish to compare different business entity’s Used to perform a trend analysis for the same business over a period of time

UEL Ltd SOCI for year ended 31 December
All figures stated as a percentage of revenue Common size F/S UEL Ltd SOCI for year ended 31 December X6 X5 Revenue 100.00% Cost of sales 69.07% 65.00% Gross profit 30.92% 34.99% Net operating costs 18.92% 22.06% Operating profit from trading activities 12.00% 12.93% Net costs from non-trading activities 1.01% 0.00% Operating profit 13.01% Dividend received 0.03% Interest income 1.04% 0.91% Interest paid 3.12% 3.95% Profit before taxation 10.96% 9.92% Taxation 3.77% 3.43% Profit attributable to ordinary shareholders 7.19% 6.49%

UEL Ltd Statement of financial position at 31 December
Common size F/S UEL Ltd Statement of financial position at 31 December X6 X5 Assets Non-current assets Property, plant and equipment 47.54% 61.59% Investments 0.33% 0.35% Current assets Inventories 4.48% 5.46% Trade receivable 30.99% 32.54% Accrued income 0.08% 0.03% Cash and Cash equivalents 16.55% 0.00% Total assets 100.00% All figures stated as a percentage of total assets

Comparative statements
Shows how the financial statements for each of the required number of years, side-by- side. Highlights changes in the individual items from year to year. The percentage increase or decrease in an individual item is calculated as follows: Current year amount – prior year amount x 100% Prior year amount

Financial Ratios One of the most common tools of managerial decision making Is a comparison of number to another – mathematically, it is a simple division problem Involves the comparison of various figures from the financial statements in order to gain information financial performance, position and the efficiency of management It’s the interpretation rather than the calculation, that makes it a useful tool for management Serves as indicators, clues, or red flags regarding note worthy relationships between variables used the business entity’s performance

Use and users of Ratio Analysis
Trend analysis Spot trends that are cause for concern Serve as red flags for troublesome issues Benchmarks for performance measurement Competitors Industry averages Assist in forming judgment on key areas Monitor performance and pinpoint strengths and weaknesses Track individual firm performance over time Make comparative judgments regarding firm performance

Ratio analysis How it is calculated What it measures
There are numerous ratios that can be prepared during financial analysis We can’t look at all of them, but we will focus on the main ones Our approach for each ratio will be: How it is calculated What it measures How it is expressed What it reveals

Liquidity Asset management Debt management Profitability
Primary sections of a business: Liquidity Asset management Debt management Profitability Du Pont analysis Market ratios

Liquidity There are several ratios which are used to measure whether a business entity has sufficient liquid resources to enable it to meet its short-term liabilities: Main concern in business is ability to pay accounts as they become due. Liquidity refers to the speed with which current assets are converted into cash. This cash is then used to finance short-term debt, such as amounts owing to suppliers.

Liquidity A company with enough liquid assets is more likely to settle debts on time. To measure liquidity, we compare the size of current assets to current liabilities. Why? Current assets are usually easily convertible into cash and this cash is used to settle short-term debts (current liabilities).

Current ratio Current Assets Current Liabilities
Measures how many times current assets of business exceed current liabilities Higher the ratio, the more likely the business is able to settle debts on time!

UEL Limited X6 X5 Current Assets 43 601 177 28 672 370
Current Liabilities Current Ratio 3.35 times 1.81 times Current Assets = Current Liabilities Current Ratio for X6 is 3.35 times

Acid test (quick) ratio
Current Assets - inventory Current Liabilities Inventory least convertible into cash Measures how many times the current assets (less inventory) of the business exceed the current liabilities Higher the ratio, the more likely the business is to be able to settle debts on time!

UEL Limited X6 X5 Current Assets 43 601 177 28 672 370 Inventory
Current Liabilities Acid test Ratio 3.06 times 1.55 times Current Assets – Inventory = ( – ) Current Liabilities Acid test Ratio for X6 is 3.06 times

Asset Management The primary purpose of business is to generate profit
To do so, business must successfully manage the assets used in the business (a process referred to as asset management). Assets are by definition income- generating items.

Asset Management Measures how successfully assets have been used to generate profit in the business. Measures are sometimes called turnover measures or asset utilisation measures. Measure how efficiently or productively assets are used to generate sales.

Days inventory on hand Inventory x 365 Cost of Sales
How quickly can the business sell products? Ratio expressed in days

UEL Limited X6 X5 Inventory 3 750 000 4 120 000 Cost of Sales
Days inventory on hand 16 days 19 days Inventory Cost of Sales x 365 = x 365 = 16 days DO NOT FORGET TO ROUND UP TO A COMPLETE DAY!

Inventory turnover ratio
Cost of Sales Inventory How any times the inventory was sold during the year If we sell R worth of goods over a year and have a closing balance of inventory of R 400, how quickly will the inventory be sold? Inventory turnover ratio is 5 Which is better, a high or a low ratio?

UEL Limited X6 X5 Cost of Sales Inventory Inventory turnover ratio 23 times 19 times Cost of Sales Inventory = = 23 days

Debtors collection period
Trade receivables x 365 Credit sales How quickly is cash collected from debtors Ratio is expressed in days The shorter the period, the quicker cash is received from debtors What are the risks if the period is too short or too long?

Debtors collection period 191 days 186 days
UEL Limited X6 X5 Trade Receivables Credit Sales Debtors collection period 191 days 186 days Assume Revenue consists only of Sales Income and 40% of sales are on credit. Trade Receivables, use amount GROSS of the Allowance for Doubtful Debts. Trade receivables Credit Sales x 365 = ( x 40%) x 365 Debtors collection period for X6 = 79 days

Creditors payment period
Trade payables x 365 Credit purchases Measures how long the business takes, in days, to pay its creditors Good for the business to have a high ratio What are risks if too high! Cost of Sales= OB Inventory + Purchases – CB Inventory Purchases = Cost of Sales – OB Inventory + CB Inventory

UEL Limited X6 X5 Trade Payable Credit purchases 60% of purchases are on credit Creditors payment period 19 days 22 days Trade payables Credit purchases x 365 = ( x 60%) x 365 Creditors collection period for X6 = 19 days

Working Capital Cycle The debtors’ collection period + days inventory on hand measure the time delay between the purchase of inventory and the collection of cash from the credit sale of inventory. i.e. how long is cash tied up in inventory and trade receivables.

Working Capital Cycle BUT what if we did not pay cash for the inventory but purchased on credit i.e. 90 day terms What is the time difference between when cash leaves (pay for inventory) and when we receive cash (sell inventory on credit)?

Debtors collection period
Working Capital Cycle Days inventory on hand Debtors collection period Creditors payment period

Working Capital Cycle X6 = 188 days

Total asset turnover Sales Total assets
Looks at efficiency of all the assets together Shows how well assets have been used to generate Sales The Sales relative to the asset base

UEL Limited X6 X5 Sales 123 999 879 120 607 873 Total Assets
Total asset turnover 1.48 times 1.60 times Sales Total Assets = = 1.48 times Total asset turnover = 1.48 times

Fixed asset turnover rate
Fixed Assets?? Generally, Property, Plant and Equipment Sales Fixed assets Similar to Total asset turnover Only Fixed assets’ efficiency is assessed Fixed asset turnover = Sales / PPE How efficiently is PPE used to generate sales

UEL Limited X6 X5 Sales Property, Plant and Equipment Fixed asset turnover 3.11 times 2.59 times Sales PPE = = 3.11 times Fixed asset turnover = 3.11 times

Debt Management What is the risk of debt in a business?
Too much debt: business may be unable to repay the debt or interest BUT debt is useful in a business Can purchase more assets to used to generate profits Let’s have a look at some ratios associated with Debt

Debt ratio Total debt Total Assets
X 100 Assess the risk in terms of how many of the assets are funded by debt Ratio expressed as a percentage NOTE: Total debt includes non-current AND current liabilities The higher the percentage, the higher the debt financing and the higher the risk

UEL Limited X6 X5 Total debt (liabilities section) Total assets Debt ratio 35.85% 50.16% Total debt Total assets x 100 = x = 35.85% Debt ratio= 35.85%

Debt-equity ratio LT Liabilities Total equity x 100
To determine what portion of the long- term sources of financing is debt or equity-funded, the debt-equity ratio is used Debt = long-term liabilities Equity = Capital and reserves on SoFP Debt-equity = / x 100 Ratio expressed as a percentage

LT debt (non-current liabilities) 17 000 000 22 000 000
UEL Limited X6 X5 LT debt (non-current liabilities) Capital and reserves Debt-equity ratio 31.11% 57.05% LT debt Capital and reserves x 100 = x 100 = % Debt-equity ratio= 37.11%

Interest cover PBIT Interest expense
A risk associated with debt financing is being unable to meet interest payments This ratio shows how many times the profit before interest and tax generated covers the interest expense associated with debt-financing

UEL Limited X6 X5 Profit before interest and tax Interest expense Interest cover 4.51 times 3.50 times PBIT_____ Interest expense = = 4.51 times Interest cover = 4.51 times

Profitability ratios What is the objective of a business?
To maximise the return on shareholders’ investments Therefore, businesses seek to generate as high a profit as possible Let’s have a look at a few ratios that can help this in this regard.

Gross profit margin (on sales)
Sales x 100 Selling price – Cost price = mark-up (or, on a total basis, the gross profit) Gross profit is what is used to cover other expenses The higher this ratio (a percentage) the better!! – but need to be competitive

UEL Limited X6 X5 Sales 123 999 879 120 607 873 - Cost of sales
( ) ( ) Gross profit Gross profit margin 30.92% 34.99% Gross profit Sales x 100 = x 100 = 30.92% Gross profit margin = 30.92%

Net margin (on sales) / Profit margin
Profit for the period Sales x 100 Profit = gross profit + other income - operating expenses Profit shows how much Sales income has NOT been absorbed by the businesses expenses The higher the profit margin (expressed as a percentage), the better!

UEL Limited X6 X5 Profit for the period 8 921 247 7 830 116 Sales
Profit margin 7.19% 6.49% Profit for the period Sales x 100 = x 100 = 7.19% Profit margin = 7.19%

Return on Assets There are a number of ratios that evaluate how well a business has used its assets to generate a return (i.e. Profit after tax) One can investigate the return (PAT) on: Total Assets Non-current Assets Ratios are expressed as a percentage

UEL Limited X6 X5 Profit after tax Total assets Return on total assets 10.66% 10.39% Profit after tax Total assets x 100 = x 100 = 10.66% Return on total assets= 10.66%

Return on Equity (ROE) Profit ordinary shareholders
Ordinary shareholders’ equity x 100 Often considered to be the most important ratio, evaluates a business on it’s objective Has the business generated a return on amounts invested by owners?

Profit ordinary shareholders Ordinary shareholders’ equity x 100 =
UEL Limited X6 X5 Profit attributable to ordinary shareholders Ordinary shareholders’ equity Return on equity 16.63% 20.85% Profit ordinary shareholders Ordinary shareholders’ equity x 100 = x 100 = 16.63% Return on equity = 16.63%

Du Pont Analysis A Du Pont analysis allows for the three main drivers of ROE to be investigated separately and then in total The three main drivers are: Return on total assets; Profit margin; and The equity multiplier It breaks down ROE (returns investors receive from an entity), and enables the analyst to understand the source of superior or inferior return by either internal or external comparisons

Du Pont Analysis The three drivers are also known as the levers of ROE as they can all improve ROE Profit margin – cost efficiency Total asset turnover – volume of sales generated from the asset base Equity Multiplier – the effect use of debt to generate a higher return

Earnings before interest and tax
Operating income Fixed assets Other current assets Asset Turnover Current assets Assets Inventory Return on Investment Operating Income Accounts receivable Profit Margin Cash & equivalents Operating expenses Earnings before interest and tax Non- operating Income Operating income DuPont Model

The following amounts are relevant to our calculations:
UEL Limited X6 X5 Sales Total Assets Net Profit Total Equity Return on equity 16.63% 20.85%

Du Pont Analysis ROE = Profit Total equity EM = TAT = Total Assets
Sales Total Assets EM = Total Assets Total equity PM = Profit Sales

Du Pont Analysis ROE = 8 921 247 53 640 857 = 16.63% PM = 8 921 247
= 0.07 TAT = = 1.48 EM = = 1.559

Du Pont Analysis What does each element of the analysis tell us?
Total Asset Turnover: Per Rand invested in assets, how many Rands in Sales has the business generated? For Handbags for Africa: roughly R1.48

Du Pont Analysis Profit Margin:
How efficient has the business been in controlling its costs? In other words, for every R1 generated in Sales, how much is translated into profit? For Handbags for Africa: R0.07

Du Pont Analysis Equity Multiplier:
Is there potential for the business to use additional leverage to generate returns to investors? The ratio shows the effect of leverage in the business For handbags for Africa, for each R1 of Equity there are R1.56 Assets

Equity Multiplier Is a financial leverage ratio which is calculated by dividing total assets by the shareholders equity It tells us the per RAND value of assets in comparison to the per RAND value of equity The higher the ratio, the lower the financial leverage The lower the ratio, the higher the financial leverage

Market ratios The ratio analysis we’ve looked at so far relies on historical data based solely on the accounting records Other ratios that use alternate sources of information can also provide useful insight into the business These ratios use the MARKET price of the business (i.e. The shares of the business are listed)

Handbags for Africa had an EPS of 4.5867 (X6) (4.6059: X5)
Earnings yield (EY) Earnings per Share Market price per share x 100 This ratio shows the difference between the share price (in the market) and the (EPS): Profit attributable to ordinary shareholders / Number of shares in issue earnings per share (calculated using accounting numbers) NOTE: Use year-end share price in the market Ratio expressed as a percentage Handbags for Africa had an EPS of (X6) (4.6059: X5)

UEL Limited X6 X5 Earnings per share 458.67 460.59 Market price per share 3 668 3 499 Earnings yield 12.50% 13.16% EPS (in cents) Market price per share (in cents) = = 12.50% Earnings yield = 12.50%

Price earnings ratio (PE ratio)
Market price (at year-end) EPS One of the most widely used ratios in financial analysis It shows the amount that investors are willing to pay for each Rand of earnings (in terms of accounting numbers) reported

UEL Limited X6 X5 Market price per share 3 668 3 499 Earnings per share 458.67 460.59 PE ratio 7.99 times 7.59 times Market price per share (in cents) EPS (in cents) = = 7.99 times PE ratio = 7.99 times

Dividends per share (in cents):
Dividend yield (DY) Dividends per share______ Market price per share at year-end x 100 Shows what percentage of the share price has been distributed to owners as a dividend Dividends per share (in cents): X6: 147.4 X5: 144.8

UEL Limited X6 X5 Dividends per share 147.4 144.8
Market price per share 3 668 3 499 Dividend yield 4.02% 4.14% Dividends per share (in cents) Market price per share (in cents) = = 4.02% Dividend yield = 4.02%

Return to shareholders
(DPS + change in market price per share) Market price per share at year-end x 100 There are two ways in which shareholders are able to generate returns Capital appreciation (increase in market price) Cash (in the form of dividends)

UEL Limited X6 Dividends per received 147.4 Market price per share (CB) 3 668 Market price per share (OB) 3 499 Increase in market price per share 169 Return to shareholder 9.04% (DPS + Change in market price of share) Market price per share (OB) x 100 = ( ) 3 499 Return to shareholder = 9.04%

Market-to-book ratio MV per share NAV per share
This ratio differentiates the value placed on a business by accounting records (usually historically-based information) and by the market (based on expectation of future performance) Market value (in total) is also referred to as Market Capitalisation Accounting value is encompassed in NAV

UEL Limited X6 X5 Number of shares in issue (Class A) Net asset value (excl Class B) NAV per Class A share 2 313 2 032 Market value per share 3 668 3 499 Market-to-book ratio 1.58 times 1.72 times Market price per share (in cents) NAV per share (in cents) = = 1.58 times Market-to-book ratio = 1.58 times

Dividend cover Profit after tax Dividends Dividend per share
EPS Dividend per share Determine the portion of earnings retained for future growth and portion distributed in the form of dividends The higher the ratio, the greater the amount of earnings retained for future growth

UEL Limited X6 X5 Earnings per share 458.6 460.5 Dividend per share
147.4 144.8 Dividend cover 3.11 times 3.18 times EPS (in cents) Dividend per share (in cents) = = 3.11 times Dividend cover = 3.11 times

FINANCIAL ANALYSIS.

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FINANCIAL ANALYSIS.

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