1 Share Investment Analysing Financial Statements.

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Share Investment

Analysing

Financial Statements

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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 yellow post-its on the slides try to put the ratio in context.

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The Different types of Ratio

We will look at three different types of Ratio used in Financial Analysis:

1. ProfitabilityHow successful is the business?

2. LiquidityIs the flow of cash sufficient to meet obligations?

3. InvestmentDoes the company represent a good investment

for shareholders?

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The Different Types of Ratio

1. Profitability

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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.

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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

Managing Finance & Budgets - Ratio Analysis

Profitability (Activity 2) Year 1 Year 2 Profitability (Activity 2) Year 1 Year 2

Sales 2,240,000 2,681,200 Gross Margin% 22.1% 22.7%Cost of Sales 1,745,400 2,072,000 Net Margin% 10.8% 9.2%

Gross Profit 494,600 609,200 ROSF 31.8% 25.8%Overheads 252,000 362,800 ROCE 34.8% 35.4%Net Profit 242,600 246,400

Interest 24,000 6,200Tax 60,200 76,000

Dividends 40,200 60,000Net profit after tax and dividends 118,200 104,200

Share Capital 300,000 334,100Reserves 197,500 301,700LT Loans 200,000 60,000

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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 soldTotal 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.

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Activity Two SolutionsGross Margin%

In the spreadsheet:

Profit & Loss Data Year 1 Year 2

Sales 2,240,000 2,681,200Cost of Sales 1,745,400 2,072,000

Gross Profit 494,600 609,200Overheads 252,000 362,800Net Profit 242,600 246,400

Interest 24,000 6,200Tax 60,200 76,000



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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%

2240000The company makes 22p for every £1 it brings in. This can be used to pay overheads etc.

The company makes 22p for every £1 it brings in. This can be used to pay overheads etc.

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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.

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Activity Two SolutionsNet Margin%

In the spreadsheet:




Interest 24,000 6,200Tax 60,200 76,000



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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%

2240000After paying all outstanding costs, the company makes 11p for every £1 it brings in.

After paying all outstanding costs, the company makes 11p for every £1 it brings in.

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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.

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Activity Two SolutionsROSF%

In the spreadsheet:




Interest 24,000 6,200Tax 60,200 76,000



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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%

497500The company is making 32p for every £1 invested by shareholders.

The company is making 32p for every £1 invested by shareholders.

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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.

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Activity Two SolutionsROCE%

In the spreadsheet:




Interest 24,000 6,200Tax 60,200 76,000



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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.

Including loans, the company makes 35p for every £1 invested in the business.

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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 Sales______________________________________________________________________________________________________________________________________________

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)

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2. Liquidity

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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

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Example Spreadsheet

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

Liquidity (Activity 3) Year 1 Year 2 Liquidity (Activity 3) Year 1 Year 2

Trade Debtors 240,800 210,200 Current Assets 574,300 622,000Bank Account 33,500 41,000 Current Liabilities 321,800 364,800

Opening Stock Value 241,000 300,000 Current Ratio 1.8 1.7Closing Stock Value 300,000 370,800 Acid Test 0.9 0.7

Trade Creditors 221,400 228,800Dividends owing 40,200 60,000

Corporation tax owing 60,200 76,000Net Cashflow from Operations 231,000 251,400

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Current Ratio

The Current Ratio is simply the total current Assets compared to the total current Liabilities.

Current AssetsCurrent 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.

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Current Ratio

In the spreadsheet (Liquidity):

Trade Debtors 240,800 210,200Bank Account 33,500 41,000

Opening Stock Value 241,000 300,000Closing Stock Value 300,000 370,800



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Current Ratio

Current Assets : Trade Debtors £240,800 Bank Account £33,500 Closing Stock Value £300,000

£574,300Current 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

The business owns almost twice as much as it owes

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Acid-Test Ratio

The Acid Test Ratio is simply the Current Assets (minus the Stock) compared to the total current Liabilities.

Current AssetsCurrent 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.

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Acid Test Ratio

In the spreadsheet (Liquidity ):

Trade Debtors 240,800 210,200Bank Account 33,500 41,000

Opening Stock Value 241,000 300,000Closing Stock Value 300,000 370,800



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Acid Test Ratio

Current Assets excluding Stock : Trade Debtors £240,800 Bank Account £33,500

£274,300Current 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..

Excluding stock, the business owns almost as much as it owes..

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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

Current Liabilities______________________________________________________________________________________________________________________________________________

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3. Investment

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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.

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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

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Dividend per Share

From the spreadsheets:

Shareholder Value Data Year 1

Number of ordinary shares 600,000Market price per share 2.50

Profit & Loss Data Year 1

Sales 2,240,000Cost of Sales 1,745,400

Gross Profit 494,600Overheads 252,000Net Profit 242,600

Interest 24,000Tax 60,200

Dividends 40,200Net profit after tax and dividends 118,200

Share Capital 300,000Reserves 197,500LT Loans 200,000

This is the amount in pence that each shareholder gets for each share that they own.

This is the amount in pence that each shareholder gets for each share that they own.

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Dividend per Share

Dividends Announced £40,200

Number of Shares 600,000

Dividend per Share = 40200600000

= £0.067

Each shareholder gets 6.7p for each share they own.

Each shareholder gets 6.7p for each share they own.

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Dividend Payout

From the spreadsheets:Profit & Loss Data Year 1






Here we are assuming that these are ordinary, rather than preferential dividends

Here we are assuming that these are ordinary, rather than preferential dividends

This is the proportion of the profits that has been distributed to shareholders.

This is the proportion of the profits that has been distributed to shareholders.

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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.

One quarter of the total profit is paid out in dividends to shareholders.

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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

= £0.067In addition, we will be assuming a tax rate of 20%

In addition, we will be assuming a tax rate of 20%

This is the rate of return that shareholders are getting on their investment through dividends.

This is the rate of return that shareholders are getting on their investment through dividends.

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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% = 0.2NB: 20% = 0.2

Shareholders are currently getting a rate of return of 3.35% on their investment at market value (compare Inflation ~ 2%)

Shareholders are currently getting a rate of return of 3.35% on their investment at market value (compare Inflation ~ 2%)

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Earnings per Share

From the spreadsheets:Profit & Loss Data Year 1








Here we are again assuming that these are ordinary, rather than preferential dividends

Here we are again assuming that these are ordinary, rather than preferential dividends

This is the amount in pence that the company is earning per share.

This is the amount in pence that the company is earning per share.

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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.

The company is making about 26p for every share that is held.

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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

This is the time in years it will take to earn an amount equal to the original investment.

This is the time in years it will take to earn an amount equal to the original investment.

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Price/Earnings Ratio

Market Price per share: £2.50 Earnings per share: £0.264

Price/Earnings Ratio: = 2.50 0.264

= 9.45The 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)

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)

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Comparison of Ratios

Share Price

P/E Share Price

P/E

Date 2/8/00 2/8/00 22/9/01 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

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.

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.

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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 Number of issued shares_____________________________________________________________________________________________________________________________________________

Dividend Cover ratio = Net profit after interest/tax/pref.dividends Dividends announced _____________________________________________________________________________________________________________________________________________

Price/earnings ratio = Market price per share Earnings per share

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Example of AnalysisUsing Financial ratios

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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?

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Ratio Analysis - J Sainsbury Plc

1996 1997 1998 1999 2000

TURNOVER (£ million) 13,499 13,312 15,496 16,37817,414

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 2000Dividend cover is the reciprocal form of the Dividend Payout Ratio

Dividend cover is the reciprocal form of the Dividend Payout Ratio

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Ratio Analysis: J Sainsbury Plc

1996 1997 1998 1999 2000

TURNOVER (£ million)

PROFIT BEFORE TAX

NET MARGIN (%)

EARNINGS PERSHARE

DIVIDEND PER SHARE

DIVIDEND COVER

Axis scales have been modified to enable comparisons to be made

Axis scales have been modified to enable comparisons to be made

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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.

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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.

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1 Share Investment Analysing Financial Statements.

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