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Ratios & Trend Analysis

Week 7MN20018

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Accounting ratios and ratio analysis

Six key ratios Pyramid of ratios Other important ratios

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Ratio Analysis

Application of pyramid of ratios Segmental analysis Inter-firm comparisons and industry

averages Non-financial ratios Interpretation problems when using

consolidated financial statements.

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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.

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Caveat

Beware creative accounting View that:

Every company in the country is fiddling its profits.

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

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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

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Importance of uniformity

Comparison is possible only if there is Uniformity in the preparation of

accounts and An awareness of any differences

in international accounting policies

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How are 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.

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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 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%

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Review Ratio Analysis

• Six Primary ratios

– Investment ratios

– Operating ratios

– Liquidity ratios

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Primary investment level ratios

Primary investment ratio

Earnings before interest and tax

Shareholders’ funds

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Primary investment level ratios

• Primary financing ratio

Capital employed

Shareholders’ funds

• Financial leverage multiplier

• Effect on profit of assets funded by other sources

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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

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ROCE target – VIAG AG VIAG made excellent progress in 1998

towards reaching its stated profitability goal. Return on capital employed increased

significantly from 6.5% in 1997 to 7.0% in 1998. …

The goal is to increase the Group’s return on capital employed to at least 10% by the year 2003.

The target figures we have adopted are based on our own experience and on the results of our leading competitors.

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ROCE definition not uniform Capital employed is defined on the basis of

very restrictive criteria, as evidenced by the fact that Bayernwerk’s accruals for decommissioning are included in the capital employed totalling DM59.5 billion.

We are legally obliged to establish these accruals for decommissioning expenses, which account for 20% of capital employed.

Consequently, VIAG’s return on equity and capital costs tend to be lower than those of other industrial corporations.

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Primary operating level ratios

Primary utilisation ratio (asset turnover) Sales

Capital employed

Sales increasing

Assets decreasing

• Fixed asset replaced?

• Inventory falling?

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Primary operating level ratios

Primary efficiency ratio

Earnings before interest and tax

Sales

• Company pricing policy

• Type of industry

• High volume/low profits?

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Primary liquidity ratio

Current ratio

Current assets

Current liabilities

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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

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Subsidiary ratios Gearing ratios

Liquidity ratios

Asset utilisation ratios

Investment ratios

Profitability ratios

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Subsidiary ratios – Gearing

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Subsidiary ratios – Liquidity

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Quick ratio – identify the company norm

The following is an extract from the 2003 Annual Report of Barloworld:

20032002 2001 20001999 19981997

Quick ratio 0.8 0.7 0.8 0.9 1.1 0.70.8

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Subsidiary ratios – Investment

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Earnings per share – use in strategic planning

The 2002 Annual Report of Gamma Holding NV states:Gamma Holding aims to maximise 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%.

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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

company related events, e.g. possibility of organic or acquired growth and the implication of financial indicators for future cash flow estimates

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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 crystallise – non-current assets being increased or not being replaced

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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

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Subsidiary ratios – Asset utilisation

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Subsidiary ratios – Profitability

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Segmental Analysis Important for inter-period comparison

Quality of earnings Specific risks Possible long-term growth prospects

Inter-company difficulties Determination of segments Allocation of costs

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Segmental Analysis – Business segments

Factors to consider

Nature of products

Nature of production processes

Class of customer

Distribution methods

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Illustration from Royal Ten Cate NV

Implication for future cash flows

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Implication for future cash flows

• Illustration from Royal Ten Cate NV (cont)

RevenuesOperating resultReturn oncapital employed %

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Segmental Analysis – Geographical segments

Factors to consider

Political conditions Economic conditions Exchange control regulations Currency risks

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Reportable segment: criteria

Majority of sales to external customers

AND External sales 10% or more of total

salesOR

Assets 10% or more of total assets Profit or loss 10% or more of total

profit or loss

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Implication for share valuation Different risks

Problems for conglomerates

Differential PE for different segments

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Ratios from FAME

Turnover % Profit margin

Allied Domecq 4,308,000 10.56Pubmaster 58,430 9.73

Lower quartile 9.8Median 10.6Upper quartile 11.4

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Non-financial ratios Operational statistics

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Trend Analysis

Horizontal analysis between two periods

Trend analysis over a series of periods

Historical summaries Vertical analysis – common size

statements

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Trend Analysis Multivariate analysis – Z-scores H-scores A-scores Balanced scorecards Valuing shares of an unquoted company –

quantitative process Valuing shares of an unquoted company –

qualitative process Shareholder value analysis Financial reporting and risk

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Trend Analysis

Horizontal analysis

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Trend Analysis

• Trend analysis series of periods

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Vertical analysis – Income statement

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Vertical analysis – Balance Sheet

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Multivariate analysis Single value score

Benchmark criteria applied to this score Combination of ratios e.g.

Working capital/Total assets Sales/Total assets

Weighted for predictive capability e.g. Working capital/Total assets Weight 0.012 Sales/Total assets Weight 0.999

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Multivariate analysis – types of scores Z-scores

Altman’s Z-scores

Taffler’s Z-scores

PAS-score

A-scores

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Balanced scorecards – Four perspectives

Financial perspective

Customer perspective

Internal business perspective

Innovation and learning perspective

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Financial perspective

How do shareholders see us?

Return on capital employed

Cash flows

Project profitability

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Customer perspective How do customers see us?

Price

Quality

Guaranteed supply

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Innovation and learning perspective

How well will we compete?

Staff morale

New business from innovation

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Internal business perspective

What do we need to be best at?

Presenting to potential customers

Tendering success rate

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Valuing shares of unquoted company – quantitative Maintainable income

Extrapolate from past five years Yields required

Required earnings yield – majority holding Required dividend yield – minority holding Adjustment for adverse factors

lack of marketability High gearing

Calculate Economic value and NRV

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Valuing shares of unquoted company – qualitative

Factors to consider

Management change Revenue investment Inflation rate Competitive pressures

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Shareholder Value Analysis

Growing interest

Accounting measures (EPS) not related to share value

Linkage with executive remuneration

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Shareholder Value Analysis – annual reports

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Economic Value Added (EVA)

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EVA – make operationalGeveke av Amsterdam – extract from 1999 Annual Report

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EVA – achieving increases

Increase NOPAT

Reduce WACC

Improve utilisation of capital

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Financial reporting of risk

Effect of information on risk management

Reduces cost of capital Improves accountability Improves investor protection Assists in making informed

predictions

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Professional risk assessors

Companies are given a rating that can range from AAA for companies with a strong capacity to meet their financial commitments

down to D for companies that have been unable to make contractual payments or have filed for bankruptcy

with more than ten ratings in between, e.g. BBB for companies that have adequate capacity but which are vulnerable to internal or external economic changes.

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How ratings are set Internal company factors may include: an appraisal of the financial reports to determine: trading performance, e.g. specific financial

targets such as return on equity and return on assets; earnings volatility; past and projected performance; how well a company has coped with business cycles

cash flow adequacy, e.g. EBITDA interest cover; EBIT interest cover; free operating cash flow

capital structure, e.g. gearing ratio; debt structure; implications of off balance sheet financing

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How ratings are set – internal factors a consideration of the notes to the accounts to

determine possible adverse implications, e.g. contingent liabilities, heavy capital investment commitments which may impact on future profitability, liquidity and funding requirements;

meetings and discussions with management; monitoring expectation, e.g. against quarterly

reports, company press releases, profit warnings; monitoring changes in company strategy, e.g.

changes to funding structure with company buyback of shares, new divestment or acquisition plans and implications for any debt covenants.

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How ratings are set – external factors

External factors may include: growth prospects, e.g. trends in industry

sector; technology possible changes; peer comparison

capital requirements, e.g. whether company is fixed capital or working capital intensive; future tangible fixed asset requirements; R&D spending requirements

competitors, e.g. the major domestic and foreign competitors; product differentiation; what barriers there are to entry

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How ratings are set – external factors (cont) Keeping a watching brief on macroeconomic

factors, e.g. environmental statutory levies, tax changes, political changes such as restrictions on the supply of oil, foreign currency risks;

Monitoring changes in company strategy, e.g. implication of a company embarking on a heavy overseas acquisition programme which changes the risk profile, e.g. difficulty in management control and in achieving synergies, increased foreign exchange exposure.