Review of Financial Ratio Analysis

Review of Financial Ratio Analysis
Chapter 28 Review of Financial Ratio Analysis

Objectives By the end of the chapter, you should be able to:
calculate operating, liquidity and activity ratios from an annual report; discuss the implication of the ratios; describe and draft a report using inter-firm and industry comparative ratios; critically discuss the strengths and weaknesses of ratio analysis; calculate EBITDA and EBITDA margins for management control purposes.

Initial impressions Impact of economic conditions
Is liquidity likely to be under pressure? Are debt covenants likely to be broken? Will assets need to be sold to reduce debt?

Initial impression of the sector
Possible risk of: A significant fall in revenue Plant closures Redundancy costs

Initial impressions – misrepresentation?
What are the pressures on management to: Understate liabilities Overstate inventories Overstate trade receivables Overstate bank balances Understate impairment losses.

Initial look as prelude to more systematic look
Need for an extremely inquisitive and enquiring frame of mind Some issues will be quickly evident, e.g. A company has made losses in the past 2 years or It has a declining sales turnover or A large overdraft or A greatly increased accounts payable figure.

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. For a ratio to be useful, there must be a significant relationship between the two items being compared. A ratio focuses attention on the relationship. Ratios require additional investigation of the underlying data being used.

Caveat Beware creative accounting View that:
Every company in the country is fiddling its profits It is a 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.

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 (industry).

Importance of uniformity
Comparison is possible only if there is: Uniformity in the preparation of accounts – IFRS helping to achieve this An awareness of any differences in international accounting policies – US SEC still has not adopted IFRSs.

Need to understand how ratios are defined
Implications of any given ratio requires a clear definition of its constituent parts Which profit is being used? EBIT? EBITDA? NOPAT? Definitions of ratios may vary from source to source, e.g. concepts and terminology are not universally defined How is capital employed defined?

Awareness of underlying trends How to interpret a constant ROCE?
ROCE remains a constant 10% over the years 20X7–20X9 Net profit and capital employed 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%

Review ratio analysis Three primary ratios: Investment ratios
Operating ratios Liquidity ratios.

Primary investment level ratios
Return on equity: Earnings before interest and tax Shareholders’ funds Measures the return available to the shareholders. The objective of management is to generate the maximum return on shareholders’ investment. This ratio serves as an indicator of management performance, but should be used in conjunction with other indicators.

Return on equity A high return, normally associated with effective management, could indicate an under-capitalised company. A low return, usually an indicator of poor management performance, could reflect a highly capitalised, conservatively operated business. Net profit after taxes and preference dividend is used because this is the amount available for distribution to the ordinary shareholders.

ROE driven by Financial leverage multiplier Capital employed
Shareholders’ funds Return on capital employed where capital employed = total assets

Primary operating level ratios
Return on capital employed Earnings before interest and tax Capital employed No single definition of capital employed Often used for strategic planning. Also known as: Return on total assets, or Return on investment

Return on capital employed
Measures the return to shareholders and lenders on the total investment they have in the business. It is a measure of the overall effectiveness of management in employing the resources available to the business. Heavily depreciated plant and equipment, large amounts of intangible assets, or unusual revenue or expense items can cause distortions to the ratio. Is also known as return on investment.

Use of ROCE as a target The Royal Mint’s financial performance improved for the second consecutive year in 2007–08, with a pre-exceptional operating profit of £9.6m The return on capital employed of 11.5% was substantially above the financial ministerial target of 7.2%.

Calculation of ROCE 2003 2002 Return on capital employed 9.19% 8.95%
Return on capital employed 9.19% % Financial leverage multiplier Return on equity

Calculation of ROCE (Continued)
ROCE is calculated as the product of: the % return on sales and the asset turnover.

Asset turnover The asset turnover ratio measures the number of times that ₤1 of assets results in a ₤1 of revenue If asset turnover increases, then either the total value of revenue is increasing or the capital asset base is decreasing, or both Has increased sales been achieved at the expense of the profit margin? Has a reduction in the capital asset base adversely affected productive capacity?

Primary operating level ratios
Primary utilisation ratio (asset turnover) Sales Capital employed Improved by: Sales increasing Assets decreasing Fixed asset replaced? Inventory falling?

Sales/capital employed increasing
Sales increasing Volume increase Price increase Possible Effect on profits Price reductions Sales promotions.

Sales/capital employed increasing (Continued)
Assets decreasing Non-current assets Disposal? Impairment? Inventory Run down of inventory? Possible stock outs?

Current ratio a short-term measure of a company’s liquidity position comparing current assets with current liabilities. no rule of thumb measure, such as 2:1, that can be applied. appropriate ratio depends on the industry sector and each individual company’s experience.

Current ratio – what if it increases?
Good reasons Growth: Inventory buildup expecting sales growth Expansion: Permanent increase in scale.

Current ratio – what if it increases? (Continued)
Poor reasons: Decline: Inventory buildup result of falling sales Inefficiency: Poor control over working capital.

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

Subsidiary ratios – gearing (leverage)
Analysing long-term financial stability – to indicate a company’s capacity to meet long-term obligations (solvency)

There are a number of different formulae used to express the gearing ratios
Long-term debt to Capital employed ratio The debt ratio – (total debt / total assets) (c) The debt-to-equity ratio – (total debt / total equity) (d) The equity ratio – (equity / assets).

Definition of gearing for text
For the purposes of illustrations in this chapter we are defining gearing as long-term debt to Capital employed. A number of companies report the debt/equity ratio as their preferred choice and include total debt rather than long-term debt if a company relies heavily on overdraft facilities.

Leverage (debt) ratios Leverage ratios measure the extent to which: borrowed funds are used to finance the business, and earnings can decline before the business is unable to meet its fixed charges. Leverage ratios measure the business’s long-term solvency – the ability of the business to meet all of its liabilities Leverage ratios are calculated by comparing fixed charges and earnings from the Income Statement, or by relating debt and equity items in the Balance Sheet

Creditors use them to see whether the business’s profit can support interest and other fixed charges and whether there are enough assets available to pay off debt if the business fails. Shareholders are interested because the higher the debt, the higher the interest expense and, therefore, the less profit available to them. If borrowing and interest are excessive, the business may become insolvent. The various types of leverage ratios are: • debt to total assets ratio • debt to equity ratio • times interest earned • cash flow to debt ratios.

Debt to total assets ratio Measures the percentage of funds provided by creditors, and shows the protection provided by the shareholders for the creditors. It is calculated as follows: The higher the ratio, the greater the risk being assumed by the creditors. A lower ratio suggests long-term financial stability. A company with a low ratio also has greater flexibility to borrow in the future.

Creditors prefer low-to-moderate ratios because these indicate greater safety for their claims on the company. Shareholders may seek higher leverage because this increases the return on their investment. A highly leveraged company can also affect the shareholders’ returns unfavourably. If profits are not enough to cover interest expenses, shareholders will not receive any dividends and the company could become insolvent and be liquidated.

Debt to equity ratio The debt to equity ratio is calculated as follows: Debt may be defined as either total debt or long-term debt. Most analysts tend to use long-term rather than total debt for this ratio.

Long-term creditors prefer to see a low-to-moderate debt to equity ratio. Why? This means that there is greater protection for them and more at stake for the shareholders. There is, therefore, greater motivation for the owners to ensure the business operates profitably.

Times interest earned (Interest cover) A measure of the degree of protection creditors have from default on interest payments. It shows the business’s ability to meet its interest payments. The ratio is calculated as follows: Net operating profi t is earnings before interest and taxes (EBIT). EBIT is used because the ability of the business to pay interest is not affected by the company’s tax liability. What does a low times interest earned ratio suggest? The business may have difficulty in raising additional finance if the need arises.

If debt is bad, why have any? Despite its riskiness, debt is a flexible means of financing certain business operations. Because it has a fixed interest charge, it limits the cost of financing and presents a situation where leverage can be used to advantage. Eg, if the business can earn more than the interest cost, it will make an overall profit. In times of inflation, debt (which is a fixed dollar amount) is repaid with ‘cheaper’ dollars than the ones originally borrowed. The dollars used to repay the debt are worth less in buying power than the ones originally borrowed. But, if the business does not earn a return on its assets equal to the cost of interest, it operates at a loss.

Cash flow to debt ratios A measure of the ability of a business to service its debt is the relationship of annual cash flows to the amount of debt outstanding. The ratio is calculated as follows: Cash flow is defined as the cash generated from the operations of the business that is shown in the Cash Flow Statement The cash flow to long-term debt ratio can also be used for evaluating the long-term solvency of a company

Subsidiary ratios – liquidity
analysing stability – to indicate a company’s capacity to meet short- term obligations

Liquidity ratios Liquidity ratios look at the relationships between the components of working capital. The most commonly used ratios are: 1 working capital Working capital = Current assets – Current liabilities 2 current ratio a measure of immediate ability to pay debts. 3 liquidity (quick or acid test) ratio. the ratio of liquid assets to current liabilities.

Working capital Working capital = Current assets – Current liabilities used as a measure of a business’s ability to meet its short-term commitments. Which company has the better working capital?

The current ratio is the ratio of current assets to current liabilities. The make-up and quality of the current assets is a crucial factor in using this ratio as an indicator of the business’s liquidity. Consider the following two companies.

Company B is more able to meet its current obligations. It does not have to convert inventories to cash. It must still collect its receivables, but this is easier than converting inventories into sales to create receivables that must then be collected as cash.

What can cause the current ratio to increase? Decrease? Increases could indicate poor inventory management, poor credit control, unfavourable prices for purchases, poor production planning and increases in sales due to high discounting leading to increased accounts receivables. Decreases could indicate improved inventory control, Increases in cash sales, and improved production planning.

Liquidity (quick or acid test) ratio Liquid (or quick) assets are cash, marketable securities, and accounts receivable – the assets that can be turned into cash quickly It shows a business’s ability to meet its current obligations promptly. When the ratio is less than 1, it implies dependency on inventories and other current assets that have been excluded from the formula to liquidate short-term debt

The formula is: Should all current liabilities be included, or just those that could be termed ‘quick’ liabilities (i.e. those liabilities that require to be met immediately)? Bank overdraft, Taxes payable, Dividends payable? When must these be paid?

Current and liquidity ratios of seven New Zealand companies (2006 figures) Company Current ratio Liquidity ratio Cavalier Corporation Ltd Michael Hill International Ltd Nuplex Industries Ltd Provenco Group Ltd Steel and Tube Holdings Ltd Trustpower Ltd The Warehouse Group Ltd 1 These companies purchase their inventories on credit, but the majority of their sales are cash sales. Consequently, they are able to operate satisfactorily with a low liquidity ratio 2 Because of the nature of this company’s’ business, it does not hold any inventories, hence the current and liquid ratios are identical.

What is an acceptable current ratio or liquidity ratio? Factors that need to be considered when evaluating short-term solvency include: the size of operating costs – the financial statements do not usually show how much cash is needed for operating expenses such as salaries, rent and expenses other than those required to be disclosed. If these expenses are large and the liquid assets are few, the business could have problems meeting them. bank credit – if the business has an excellent credit record and facility with its banker, lower current and liquidity ratios can be carried. The Warehouse Group would fall into this category – hence its ability to operate with a liquidity ratio of 0.45 : 1.

seasonal trade patterns –ratios can be distorted through the seasonal build-up, or run-down, of inventories and accounts receivable to meet sales demands when they peak. As retailers, The Warehouse and Briscoe Groups will carry much larger inventories over the Christmas shopping period than at other times of the year. However, these companies also increase certain types of inventories for other times during the year – such as Mother’s Day. the type of business – for manufacturers and wholesalers, a larger ratio is needed because most of these firms’ sales are on credit, and it will be up to 51 days from the date of sale before cash payment is due to be received. Retailers, however, have a considerable volume of cash sales to supplement the credit sales and so will have a greater ability to meet cash liabilities as they fall due. Therefore, they can operate with a lower liquidity ratio.

Quick ratio – identify the company norm
The following is an extract from the 2008 Annual Report of Barloworld: Quick ratio Rule of thumb is 1:1 Consider the company norm

Activity utilisation ratios
Asset utilisation Asset utilisation, or activity, ratios show how much use the business makes of its assets in generating sales. They indicate whether the business’s investments in current and long-term assets are too large or too small. These ratios also indicate the ability of the business to turn assets, especially inventories and accounts receivable, into cash and are, therefore, further indicators of solvency.

Activity ratios include: inventory turnover days’ sales in inventory accounts receivable turnover average collection period (or days’ sales outstanding) cash conversion cycle non-current asset turnover total assets turnover

To avoid the problems of seasonal fluctuations in the sizes of inventories and accounts receivable, the monthly balances of these items should be taken and averaged when calculating ratios relating to these. This is possible for internal analysis, but not when undergoing an external analysis. Most external analysis uses either the end-of-year figures available in the published financial statements of companies, or an average of the opening and closing figures that are provided in the published reports.

Inventory turnover change
analysing activity – to indicate how effectively a company is using its assets Is it a proactive decision? Is it reactive such as responding to economic changes? Has there been misrepresentation? Refer to narrative for clues.

Inventory turnover Inventory turnover measures the number of times inventory is sold and replaced during the year. Why is COGS used? Because inventories are valued in terms of their cost. The sales figure includes the profit mark-ups

Inventory turnover A high turnover can indicate:
better liquidity or superior merchandising of needed inventory for sales, which in turn could mean unhappy or lost customers A low turnover implies: a large investment in inventories relative to the amount needed to service sales poor liquidity, possible overstocking, or obsolete stock. may also be an indicator of a planned inventory build-up in the case of material shortages

Inventory turnover What are some problems involved with using COGS?
For companies such as The Warehouse Group, for example, the average turnover of the food items sold will be much higher than the turnover of electrical appliances – yet both of these types of goods are included in the turnover figure Many companies do not disclose their cost-of-sales figures and so their sales figures are used as a surrogate for cost of sales in this calculation. An inventory turnover figure calculated using sales will be higher than would be calculated if cost of sales is used. Another example is the Briscoe Group whose financial year is to 28 January. It is likely to have sold down inventories after the Christmas rush and New Year sales. Consequently, this turnover figure is likely to be higher than would be the case if average end-of-month inventory figures are used.

Accounts receivable turnover
Days’ sales in inventory shows the length of time (in days) that it takes to sell inventory. The formula for calculating this ratio is: if sales are affected by seasonal patterns, the result may be misleading. if the days’ sales in inventory is understated, the liquidity of the inventory will be overstated.

measure of liquidity in terms of cash collection. The formula is: Average collection period measures liquidity in terms of cash collection. The formula is:

The higher the turnover figure (or the lower the collection period), the more successful the business is in collecting cash, and the better off its operations are. Any large variations from month to month with the accounts receivable figure will affect the usefulness of this ratio These ratios also indicate the business’s credit policy. If customers are given more time to pay, the collection period will generally be longer.

A long collection period may also arise because of weaknesses in the billing procedures, ineffective incentives to get customers to pay on time, poor selection of customers to whom credit is extended. A longer collection period can only be justified if it leads to greater sales, and if the profit on these extra sales covers the cost of extending the credit.

The average collection period is affected by the pattern of sales. If sales are rising, the ratio is more current than if sales are steady or falling. Why? Because a greater proportion of the sales are billed in the current period. If sales are falling over time, the ratio will show higher average collection periods, or older debts outstanding. If there is a rapid change in the pattern of sales or if there is a fluctuating pattern to sales behaviour, the average collection period is not a realistic portrayal of the liquidity of receivables.

Cash conversion cycle measures the delay between payments for inputs and receipts from sales. Average payables period is the time it takes to pay accounts payable and is calculated as follows:

Cash conversion cycle In interpreting the cash conversion cycle figure, it is important to look at the trend in all three of its components. If shorter periods in processing inventories and/or accounts receivable are off-set by a longer period in paying accounts payable, any efficiencies gained from the improvement(s) in inventory and accounts receivables ratios could be eliminated.

Non-current (Fixed asset or property, plant and equipment) turnover
measures the productivity of the business’s property, plant and equipment. The formula is: A low ratio indicates: assets are being used inefficiently, or there is unused capacity available.

Over-investment in property, plant and equipment : may require the business to assume higher interest charges, which may result in inadequate working capital. Under-investment in property, plant and equipment (which can give a higher ratio) may result in: insufficient capacity and a deterioration of existing equipment Assets that have been depreciated to close to zero, and labour-intensive operations, may cause a distortion of this ratio because these factors will produce a higher ratio (the carrying, or book, value of the assets is low) – suggesting the assets are being used extremely efficiently.

Total assets turnover shows how well the business is using its total assets to generate sales. It should only be used to compare businesses within specific industry groups and in conjunction with other operating ratios to determine the effective employment of assets. The formula is:

Subsidiary ratios – investment

Earnings per share Elliott & Elliott covered this in ch 27
We also looked at the other investment ratios when discussing ch 27

Earnings per share – use in strategic planning Gamma Holding NV 2002
Gamma aims to maximise shareholder value Strives for continuous growth of EPS of 10% while maintaining healthy balance sheet ratios and generating positive cash flows Aims to achieve an average ROCE of 15%.

PE – a measure of market confidence
Market price takes into account macro events: Political factors – imposition of trade embargoes or sanctions Economic factors – downturn in manufacturing activity Companyrelated events – possibility of organic or acquired growth the implication of financial indicators for future cash flow estimates.

PE ratio – implication of financial indicators
Statement of financial position: Change in debt/equity ratio in relation to prior periods New borrowings for finance expansion Debt restructuring following inability to meet current repayment terms Contingent liabilities that could be damaging if they crystallise – non-current assets being increased or not being replaced.

PE ratio – implication of financial indicators (Continued)
Adequacy of working capital Low acid test (quick) ratio in relation to prior periods indicating possible 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 stock-outs.

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.

Profitability ratios Profitability ratios are designed to assist in the evaluation of management performance. Poor performance indicates a basic failure that, if not corrected, could result in the business going into liquidation. A business’s past profitability may give a better understanding for decision making. Profitability usually also affects a firm’s liquidity position. A business can make a profit but not have enough cash available to meet its liabilities. Why?

Profitability ratios Measures of profitability include:
gross profit margin (or mark-up) net operating margin profit margin on sales expenses as a percentage of sales percentage change in sales return on total assets return on equity. Each of these ratios relates earnings to sales, assets, or equity. Why do creditors, owners, and management pay close attention to them?

Profitability ratios Answer:
Without profits, a business could not attract outside capital. If these ratios are not adequate, creditors and owners become concerned about the business’s future, and may withdraw their funds.

Profitability ratios Gross profit margin and mark-up
Reflects the effectiveness of pricing policy and of production efficiency. The formula is: Mark-up expresses the gross profit margin in terms of the cost of goods sold, rather than in terms of sales.

Profitability ratios These ratios indicate managerial efficiency in selling the company’s merchandise. Because there are usually wide variations between businesses, it is the trend rather than a comparison between businesses that is more important here – especially if the types of activity undertaken are not very similar. As listed companies do not disclose their cost of sales, the gross profit margin and mark-up ratios normally cannot be reliably measured. Consequently, they are ratios used by management for internal purposes, rather than by investors and creditors, for assessing performance.

Profitability ratios Net operating margin
Measures the effectiveness of production and sales in generating pre-tax income. The higher this ratio is, the better. Formula is: Non-operating income and expense items are excluded - these are not directly related to the production or sales functions of the business. Businesses finance their activities in different ways, so earnings before interest and tax (EBIT) is used so that relevant comparisons can be made.

Profitability ratios Profit margin on sales
Indicates management’s ability to operate the business well enough to recover both fixed and variable costs, and leave a margin of reasonable profit for the shareholders. The formula is: The ratio mixes the effectiveness of sales in producing profits (reflected by the net operating margin) with the effects of non-operating activities (included in net profit before tax).

Profitability ratios Other ratios
Compare various expenses as a percentage of sales to ascertain whether a particular expense has an undue effect on net profit. The year-on-year percentage change in sales may be a useful indicator of sales growth. The effect of inflation on sales price needs to be considered when using this ratio. A better indicator for ascertaining the change in sales trend is the change in volume (units) sold.

Using ratios to make business decisions
Inter-relationship of ratios Ratios must be evaluated together, not individually – why? Because of the interactions and interrelationships between the various items that make up the ratios Eg. Short-term ratios may suggest impending problems but long-term ratios suggest strength and vice versa

Reporting and the usefulness of ratio analysis Calculating ratios and commenting on the trends from one period to another is not difficult. Interpreting the ratios – that is, explaining why the trends have occurred, and suggesting how these can be changed or improved is much more difficult, and much more important Need to compare with standards – eg industry averages Look for possible reasons for variations – good and bad – and how interactions might have an effect

Pitfalls Accounting policies applied by the company and those with whom the ratios are being compared - are these consistent? Companies of the same size in the same industry should be used for comparison. Increasing diversification of company operations, Accelerated changes in technology, and Rapid changes in company sizes make it very hard to find a suitable company within an industry with which valid comparisons can be made.

Recent and past ratios should be compared. A ratio may fluctuate considerably over time, with many reasons for this. Legislation, international affairs, competition, scandals, resignation of a senior manager and many more factors can turn profits into losses Ratios should be analysed over a period of 5 – 10 years. A single figure, or ratios for any one year may give a misleading indication of financial condition and company performance.

Limitations Ratios have limitations. A ratio may indicate something is wrong, but it does not identify the problem. The figures that make up the ratio have to be analysed to find out which items (assets and/or liabilities) have changed. Each item that goes into the ratio – as well as those that impinge on these items – must be analysed to see what has caused the change. Other factors, such as competitors and the state of the economy, also need to be considered.

Ratio analysis cannot predict the future, but knowledge gained from studying ratios and related information can help you give informed recommendations and make informed decisions.

Limitations of ratio analysis
Ratios are useful flags but there are limitations that the reader needs to bear in mind – these include limitations: relating to the underlying financial statements: the reliability of the financial statements that are themselves made suspect window dressing e.g. dispatching goods at the end of the period knowing that they are defective, so that they appear in the current year’s sales, and accepting that they will be returned later in the next period.

Limitations of ratio analysis (Continued)
The possibility that the accounts are subject to fundamental uncertainty which could affect the going concern concept – there might be full disclosure in the notes but ratios might not be accurate predictors of earnings and solvency. Arising because ratios make use of the statement of financial position figures The end of year figures are static and might not be a fair reflection of normal relationships such as when a business is seasonal.

E.g. a toy manufacturer might have little inventory after supplying wholesalers in the lead up to Christmas. Any ratios based on the inventory figure such as inventory turnover could be misleading if calculated at say a 31 December year end. Invalidating intercompany comparisons, such as: Use of different measurement bases e.g. Non-current assets reported at historical cost or revaluation Revaluations carried out at different dates.

Use of off-balance sheet finance e.g. Structuring the terms of a lease to ensure that it is treated as an operating lease and not as a finance lease Special purpose enterprises to keep debts off the statement of financial position. Use of different commercial practices e.g. Factoring accounts receivable, so that cash is increased – a perfectly normal transaction but one which could cause the comparative ratio of days credit allowed to be significantly reduced.

Invalidating intercompany comparisons, such as: Applying different accounting policies e.g. Adopting different depreciation methods such as straight line and reducing balance Adopting different inventory valuation methods such as FIFO and weighted average Assuming different degrees of optimism/pessimism while making judgment-based adjustments to non-current and current assets e.g. On the impairment review of intangible and tangible non-current assets On writing down inventory and accounts receivable.

Invalidating intercompany comparisons, such as: Having different definitions for ratios e.g. The numerator for ROCE may be operating profit, profit before interest and tax, profit before interest, profit after tax etc The denominator for ROCE may be total assets, total assets less intangibles, net assets etc The use of norms can be misleading e.g. A current ratio of 2:1 may be totally inappropriate for a company like Tesco which does not have long inventory turnover periods – as its sales are for cash it would also not produce trade receivable collection period ratios.

Invalidating intercompany comparisons, such as: Making appropriate choice of comparator companies for benchmarking – this is a simple idea but more difficult in practice e.g. How to find companies with a similar trade? How to set criteria for selection? Should it be – The industry average ratios – but these may be based on many companies operating under very different economies of scale or companies with – Similar amount of capital employed or – Similar amount of sales or – Some other criteria.

Analysing the Cash Flow Statement a Cash Flow Statement provides is a summary of the company’s use of cash Cash Flow Statements can be investigated using horizontal and vertical analyses, as Illustration 10.1 in the handout shows. Look closely at the Anna Corporation example in the handout A business cannot survive if it relies on selling assets and/or borrowing to meet its cash flow needs Successful companies generate the greatest percentage of their cash from operations, not from selling their fixed assets or from borrowing money.

Analysts are particularly interested in an entity’s free cash flow – the net cash flow from operating and investing activities. If an entity continually has positive cash flow from these two activities combined, it means it can pay dividends and/or repay debt without risk – even if, like The Warehouse Group, its liquidity ratio is considerably less than one each year.

Review questions 1. (a) Explain the uses and limitations of ratio analysis when used to interpret the published financial accounts of a company. (b) State and express two ratios that can be used to analyse each of the following: (i) profitability (ii) liquidity (iii) management control. (c) Explain briefly points which are important when using ratios to interpret accounts under each of the headings in (b) above.

Review questions (Continued)
4. Discuss why a company might decide to report EBITDA in addition to operating profit. 7. Discuss why an increasing current ratio might not be an indicator of better working capital management.

Review of Financial Ratio Analysis

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