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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.