10 analysis and interpretation of financial statements · 2016. 2. 24. · analysis and...

Sources of informationAll companies listed on the New Zealand Stock Exchange (NZX) are required to produce audited financial reports annually. In addition, they must also provide half-yearly interim reports of their financial activities. The information that must be included in these reports, and the ways in which it must be disclosed, were discussed in Chapter 4.

A listed company’s annual report, which includes the financial statements, and its accompanying footnotes and schedules, is the main means by which the company communicates information about its operations and prospects to interested parties. Information available from this source includes:• management’s analysis of the past year’s operations• thefinancial statements – Income, Changes in Equity, Balance Sheet, and

Cash Flow• theNotes to the financial statements, including the Statement of Accounting

Policies which gives the principal accounting policies and procedures used by the company

• theauditor’s report• asummary of operations for the past 5 or 10 years.

Sources of company information

Analysis and interpretation of financial statements

Financial statements, and other financial and non-financial information, are used by various parties to evaluate an entity’s financial performance and condition. This chapter discusses the techniques commonly used to analyse and interpret this information and to communicate conclusions derived from the information to interested parties.

After studying this chapter you should be able to:

• identify and use sources of financial and non-financial data of listed New Zealand companies

• calculate and explain ratios and percentages that measure effectiveness in operating efficiency, financial structure and return on investment, for shareholder investment

• discuss the quality of a company’s earnings, assets and working capital

• prepare reports commenting on problems identified, remedies available and managerial performance

• This chapter uses the financial statements of Steel & Tube Holdings Ltd for 2010 to illustrate many of the financial ratios discussed. These are given on the accompanying CD-ROM.

10

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283Analysis and interpretation of financial statements

Other sources of information about companies include:• financial advisory services – such as financial analysts, credit agencies,

investment bankers and sharebrokers. These people publish financial data about most publicly listed companies. Included in these publications are analyses of the data, and in the case of sharebrokers, often a recommendation as to whether you should buy, hold, or sell shares in the company

• national business newspapers such as The National Business Review.• thebusiness sections of the daily newspapers• business periodicals• theInternet; numerous newswires, such as Reuters and Bloomberg, are available

through the Internet• exchanges – companies listed on the NZX are required to file certain information

with the Exchange. The NZX produces publications and news reports incorporating this data

• government departments – all companies are required to prepare financial statements, but only those companies that issue securities or are overseas-owned or -controlled must file their annual reports with the Companies Office (a business unit of the Ministry of Economic Development). The general public may inspect these reports. An increasing number of companies have their annual reports published on the Internet, and as the impact of eXtensible Business Reporting Language (XBRL) takes hold, users will be able to tap into entities’ reporting databases and extract the data they need.

As the financial statements on the accompanying CD-ROM show, a great deal of information is included in the financial reports of public companies – financial statements, Notes to the financial statements, auditor’s report, chairman’s and CEO’s reports, an analysis of operations, and for some companies a 5-year summary of key financial data. It is necessary to dig into this information to ascertain the company’s financial position, the success of its operations, and the policies and strategies of management, to gain an insight into its future prospects. However, many of the ratios covered in introductory accounting courses cannot be calculated from the information provided in the financial statements of public companies. This is because a lot of information, such as cost of sales and gross profit margins, is confidential to the company concerned. Publication of this information may help competitors outperform and undercut their opposition. Nevertheless, financial analysts do ‘manipulate’ this information and make certain assumptions so that a realistic picture of the company and its performance can be ascertained.

The users and their needs – objectives of financial analysis

There have been many studies undertaken to identify the users of financial reports and their needs. Generally, the results of these studies identify three basic groups:• resourceproviders – investors, suppliers and employees• recipients of goods or services – customers• partiesperformingareview or supervisory function – managers and regulatory

bodies.

Objectives of financial analysis

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284 Chapter 10

At times, these users can belong to more than one group simultaneously. For example, ratepayers of a city council are resource providers (through the rates they pay), recipients of the goods and services provided by the city council (library services, waste collection and so on), and reviewers of the services provided (through the ballot box).

The various external user groups have differing needs for information. Consequently, each tends to concentrate on particular aspects of the business’s financial picture.

Resource providersThe needs of the resource providers can be encapsulated in the following questions:

1 Would an investment in the company provide acceptable returns?

2 How risky would the investment be?

3 Should an existing investment in the company be sold?

4 Are cash flows large enough to meet all interest and loan repayment commitments?

5 Does the company compete effectively in its operating environment?

6 Would the company be a good customer?

Lenders, short-term creditors and employees are interested in the business’s liquidity because they want to be sure they will be paid on time. Can a company produce sufficient cash to pay its current liabilities as they fall due, and have enough over to meet its day-to-day operating expenses? Liquidity management focuses on the use of the business’s current assets and current liabilities.

Long-term lenders and investors (shareholders or owners) are interested in the financial stability of the business. These users assess the financial structure of the business and its prospects for operating at a level that provides enough cash to meet interest payments, debt repayments and dividends on an ongoing basis, as well as the everyday needs for cash.

RecipientsThe needs of recipients of the company’s goods and services can be encapsulated in these questions:

1 Is the quality of the goods or services satisfactory?

2 Are the goods or services provided in a timely manner?

3 Will the company continue to provide goods or services for the foreseeable future – especially if a long-term contract is being considered?

4 Does the company compete effectively in its operating environment?

Reviewers

User groups exercising review or supervisory functions want to know:

1 Does the company meet all its legal requirements?

2 Is the company compliant with social and environmental issues?

Bank credit analysts are interested in whether borrowing businesses can make their interest and loan repayments on time. They emphasise tests that measure liquidity – the ability to meet short-term financial obligations.

Needs of resource providers

Needs of recipients

Needs of reviewers

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Financial securities analysts are concerned about future earnings and dividends. These items have a major impact on share prices, which represent shareholder wealth, and so these analysts are more concerned about the long-term viability of the business.

The aim of the analysis of a company’s financial statements is to find answers to these questions.

Analysing business performanceAccountants and managers of businesses need to be aware of what external analysts look for if, and when, (for example) the business needs to raise extra finance. In order to bargain effectively for external funds, managers need to know all the aspects of financial analysis used by the suppliers of capital to evaluate the business.

Types of ratio comparisonsFinancial analysis is more than the calculation of ratios – it also involves the interpretation of the values that have been calculated. Questions such as ‘Is the ratio too high, or too low?’ can only be answered when there is a standard or a basis to measure the ratios against. These standards can be industry averages, or previous year’s figures of the entity being assessed. Two types of comparison can be made – cross-sectional and time-series.• Cross-sectional analysis is where the financial ratios of different companies within

the same industry are compared. It is a means of comparing how well the company is performing against its competitors. Comparison of these ratios (especially when considered beside industry averages) highlights deviations from the norm – thereby indicating areas that require further investigation. Whether the figure being compared is better or worse than the standard is immaterial, because positive deviations can be indicators of problems just as much as negative deviations can. For example, a high asset turnover ratio could arise because production plant is being used at the expense of providing downtime for maintenance – leading to early breakdowns and thus lost production.

• Time-series analysis is where performance over time is being assessed. The current year’s performance is compared with previous years’ performance to ascertain whether or not the company is progressing as expected. Trends can be isolated, and as with cross-sectional analysis, can be investigated if they are not as expected.

To assist in these two types of analysis, it is normal to undertake horizontal and vertical analyses of the financial statements. Horizontal analysis is where changes in various items within the financial statements are compared from year to year. For example, in the Income Statement, the change in sales or revenues from year 1 to year 2 is compared. Vertical analysis reveals the relationship of items within the financial statement to a base item. For example, in the Balance Sheet, individual items are expressed as a percentage of total assets, or of total liabilities and shareholders’ funds.

Assessment of past performance and current positionKnowing about past performance and the current position of the business helps the user to assess and predict its future performance and condition.

Analysing business performance

Types of ratio comparisons

Assessmeent of past performance and current position

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286 Chapter 10

Past performance is often a good indicator of future performance. The trends shown by past sales, expenses, net profit, cash flow, and return on investment offer a way of judging the performance of management. They also provide a means of assessing possible future performance.

An analysis of the current position shows whether the company can remain in business and continue to perform. The assets it owns and the liabilities that need to be paid are disclosed. The current position also indicates how much cash is available, how much debt the business has in relation to its owner’s equity, or capital, and the levels of inventories and accounts receivable.

Assessment of future riskPast and present information is useful only if it can help predict the future. Investors evaluate the potential profit-making ability of a business because this affects the value of the investment and the dividends the business will pay. Creditors look at the potential debt-paying ability (or liquidity) of the business.

It is easier to predict the future potential of some businesses than it is for others. Many factors can affect future risk: for example, the difficulty in assessing future profitability and liquidity. If an investor can confidently predict that next year’s net profit will be between $1,500,000 and $1,750,000, the investment is less risky than if the net profit can only be predicted to fall somewhere between $1,000,000 and $2,000,000. An investment in an established and stable business is less risky than one in a newly established business. The past and current performance of the established business will give a guide to its future performance. If there is no past history, the newly established business has to ‘prove itself’. An investor in the newly established business will require a higher rate of return for taking this greater risk. Similarly, a creditor who has granted the new business a loan will charge a higher rate of interest on the loan to compensate for the extra risk. The creditor will also seek security (such as a mortgage or debenture over the business’s assets) for the loan.

Evaluating the quality of a business’s earnings, assets, and working capitalThe current and expected net profits of a business are important to the analysis of a business’s prospects. Two of the most widely used indicators in evaluating an investment in a company’s shares are:• expectedchangesinearningspershare,and• expectedreturnonequity.The quality of the net profit figure reported by a business, which is affected by (i) the accounting methods and estimates chosen by the business’s management team, and/or (ii) the nature of any non-operating items in the Income Statement, is a very important component in both of these measures.

The accounting methods and estimates usedIn Chapters 5 and 6, various alternatives for assessing the values of non-current assets and inventory were discussed. These methods attempt to match the costs of the assets to the periods in which the costs contribute to the production of revenues. These are estimates, and the period or periods that they benefit cannot

Assessment of future risk

Evaluating the quality of a business’s propects

Accounting methods and estimates

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be identified conclusively. They are also subjective – one method is not necessarily better than another. For these reasons, it is important that the financial statement user understands the effects of different accounting methods on the calculation of net profit and financial position.

Example 10.1

Suppose two corner grocery stores (Anna Ltd and David Ltd) produced the following simplified Income Statements. Both stores have identical inventories and non-current assets, and similar operations. Anna uses first-in first-out (FIFO) for inventory valuation and straight line depreciation rates for ascertaining net income. David uses weighted average cost for inventory valuation and diminishing value depreciation rates for calculating net income. The Income Statements are given below.

Income Statements

Anna David

$ $ $ $

Sales 2,000,000 2,000,000

Goods available for sale 1,200,000 1,200,000

less: Ending inventory 240,000 200,000

Cost of sales 960,000 1,000,000

Gross profit 1,040,000 1,000,000

less: Operating expenses 680,000 680,000

Depreciation expense 160,000 280,000

Total expenses 840,000 960,000

Net profit 200,000 40,000

Although they have the same sales, opening inventory, operating expenses and non-current assets, Anna’s net profit is five times David’s net profit. The reason for this is the different accounting policies followed by these two people. Choosing different accounting policies, and making different estimates for the useful lives and residual values of assets, has led to different net profit figures.

There can be many valid reasons for differences such as those shown in Example 10.1. Users of the financial statements need to be aware of the differences that can occur as a result of the methods of accounting chosen by management.

Provided the accounting policies and principles applied are fully disclosed, many of these differences can be allowed for and the financial statements from one period to another can be compared (for the same entity). Consistency from period to period must also be maintained. If an accounting policy has been changed, then the nature of the change and its monetary effects should be explained in the Notes to the financial statements.

Where there are different entities (such as Anna and David) using different policies, comparisons can be made provided the user is aware of the differences and makes allowances for them.

Non-operating profitsThe Income Statements of most companies show revenue from operations and then make adjustments for other revenue (revenues from non-operating activities, if there

Non-operating profits

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288 Chapter 10

are any of these) to get total income. Because other revenue can have a major effect on the net profit of the company, users need to be aware of these adjustments when interpreting a company’s net profit.

The impact of inflationTransactions are recorded in financial statements on the historical cost basis. You may remember from prior learning that non-current assets may be re-measured (revalued) periodically, but that is not what we are talking about here. In analysing and interpreting statements, you must take inflation into consideration. For example, sales may have increased from $2,000,000 in 20X1 to $2,400,000 in 20X2, and to $3,100,000 in 20X3. How much of these increases are due to changes in the value of the dollar, and how much to increased volume of sales (actual number of units sold)? If the volume of sales has not increased, the dollar increase has merely been an attempt to keep selling prices in line with increased costs.

Quality of assets and working capitalA satisfactory level of net profit may be a good indication of a business’s long-run ability to pay its debts and dividends. However:• thecompositionoftheassets• theirconditionandliquidity• therelationshipbetweencurrentassetsandcurrentliabilities(thedifference

between these is working capital), and• thetotalamountofdebtowing

must also be considered. For example, a business may be profitable but unable to pay its debts on time. Sales may be satisfactory, but plant and equipment may be deteriorating because of poor maintenance or replacement policies. Substantial losses may be in prospect because of slow-moving inventories and poor collection policies for accounts receivable. These are just a few of the factors to be considered in looking at a business’s Balance Sheet and assessing the quality of the items included in it.

Using ratios to make business decisionsFinancial ratios can be analysed in many ways. This text looks at four categories of analysis:

1 analysing stability – to indicate a company’s capacity to meet short-term obligations (liquidity) and long-term obligations (solvency)

2 analysing activity – to indicate how effectively a company is using its assets3 analysing profitability – to indicate a company’s net returns on assets and sales4 analysing financial market ratios – to indicate whether an investment should be

made in a company.

No single ratio gives enough information to judge the financial condition and performance of a company. Further, if reasonable judgements are to result when analysing a group of ratios, seasonal factors affecting the business must also be considered. Underlying trends may be assessed only through a comparison of raw figures and ratios for the same time of each year. Ratios from a single year are of little use – ratios from several years are needed. As mentioned above, many companies provide a 5-year review of their results.

Inflation

Quality of assets and working capital

Using ratios to make business decisions

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Example 10.2

To illustrate the ratios to be discussed, the financial statements of Steel & Tube Holdings Ltd for 2010, (see CD-ROM financial statements files), will be used. (Note that the actual figures in Steel & Tube’s financial statements are quoted in millions of dollars – but the last three zeros have been omitted from the figures used in the worked examples below.)

Financial stability ratiosFinancial stability ratios measure the extent of a business’s total debt burden by examining the adequacy of funds, the solvency of the business, and the ability to meet short-term and long-term commitments.

If a business becomes insolvent, the shareholders lose their investment and unsecured creditors suffer financial loss. If a business is running into financial difficulties, long-term creditors are usually protected by a debenture trust deed or a mortgage over specific assets as security for the loans advanced, and realise this security by selling the assets to recover the amounts owing. Short-term creditors facing this situation will withdraw credit facilities to the company. Either of these actions could precipitate the firm’s liquidation.

If this situation is to be avoided, early indications of financial distress are needed. There are two types of ratio that do this with regard to short-term solvency:

1 ratios that relate current assets to current liabilities (dealt with in this section), and

2 ratios that indicate the utilisation of short-term assets (dealt with in the section on asset utilisation, page ***281).

Liquidity ratios

Liquidity ratios look at the relationships between the components of working capital. The most commonly used ratios are:

1 working capital

2 current ratio

3 liquidity (quick or acid test) ratio.

Working capital

Working capital = Current assets – Current liabilities

Working capital is used as a measure of a business’s ability to meet its short-term commitments. The larger the working capital, the better able the business is to pay its obligations. However, the working capital figure does not give a complete picture of the business’s working capital position. For example, consider two companies with equal working capital:

Financial stability ratios

Ratios for measuring liquidity

Working capital

Company A $

Company B $

Current assets 200,000 400,000

Current liabilities 100,000 300,000

Working capital 100,000 100,000

Working capital is a measure of the ability to finance current operations.

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290 Chapter 10

Current ratio

The current ratio is the ratio of current assets to current liabilities. It indicates a business’s ability to service its current obligations. The formula is:

Current ratioCurrent assets

Current liabilities=

An unusually high figure suggests that current assets are not being used economically, while a low figure suggests that the business may have problems meeting its bills.

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. To indicate how important the composition of these assets is, consider the following two companies:

Company A $

Company B $

Cash and securities 1,000 4,000

Receivables 2,000 25,000

Inventories 27,000 1,000

Total current assets 30,000 30,000

Current liabilities 15,000 15,000

Current ratio 2 : 1 2 : 1

Both companies have a current ratio of 2 : 1, but 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. Although Company A has a favourable ratio, it may not be able to meet its current liabilities as these fall due for payment.

Current ratio

The working capital of Steel & Tube is:

Working capital = Current assets – Current liabilities

= $146,740 – $71,638

= $75,102

Both companies have $100,000 of working capital. Company A’s current liabilities equal its working capital. However, Company B’s current liabilities are three times its working capital. Company A has the better working capital position, because its working capital is a bigger percentage of current assets and current liabilities.

The current ratio for Steel & Tube is:

Current ratio =Current assets

Current liabilitiees

=146,74071,638

= 2.04

Steel & Tube has $2.04 of current assets for every $1 of current liabilities. It could still pay its short-term obligations even if the value of its current assets were to fall by as much as 51% [1 – (1/2.04)].

Current ratio is a measure of immediate ability to pay debts.

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Increases in the current ratio could indicate poor inventory management, poor credit control, or unfavourable prices for purchases. Poor production planning and increases in sales due to high discounting leading to increased accounts receivables are other reasons for the current ratio increasing.

Decreases in the current ratio could indicate improved inventory control, increases in cash sales and improved production planning.

Liquidity (quick or acid test) ratio

The liquidity ratio is the ratio of liquid assets to current liabilities.

Liquidity ratioLiquid assets

Current liabilitie=

ss

Liquid (or quick) assets are cash, marketable securities, and accounts receivable – the assets that can be turned into cash quickly (i.e. current assets less inventory). It is a conservative measure and 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.

Inventories are the least liquid of the current assets. In the event of liquidation, they are unlikely to reach their full value. Prepaid items, such as unexpired insurance premiums, are included in current assets. However, once paid, it is unlikely that they could be recovered as cash to pay current debts.

There is also debate on what should be included in current liabilities. Should all current liabilities be included (the conservative view), or just those that could be termed ‘quick’ liabilities (i.e. those liabilities that require to be met immediately)? For example, should bank overdraft be included? It is argued that this is a form of permanent capital as long as the business stays within its overdraft limit and has a history of regular cash inflows to its operating bank accounts which periodically reduce the overdraft to somewhere near zero. Other liabilities that cause debate about their inclusion are taxes payable and dividends payable. Again, the argument hinges on when these items will become payable.

Liquidity ratio

For Steel & Tube the ratio is:

Liquidity ratioLiquid assets

Current liabilitie=

ssCurrent assets Inventory

Current liabilities= −

= 1146 740 84 22771 638

0 87

, ,,

.

−

=

Steel & Tube has $0.87 of liquid assets available to meet each $1 of its current obligations.

What is an acceptable current ratio or liquidity ratio?

The answer depends on the type of business. For example, these ratios for ten New Zealand companies listed on NZX (taken from their year 2010 financial statements as indicated) are shown in Table 10.1. There is quite a range here. A current ratio of 2 : 1 and a liquidity ratio of greater than 1 : 1 are generally accepted as being sound. However, the type of business and size of the company, the season of the year, and the composition of the current assets need to be considered carefully.

The liquidity ratio is a more rigorous measure of short-term solvency than the current ratio.

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292 Chapter 10

Table 10.1 Current and liquidity ratios of ten New Zealand companies

Company Industry Current ratio Liquidity ratio

Air New Zealand Transport 1.05 0.95

Briscoe Group Ltd 2010 Retailing 2.75 1.36

Cavalier Group Ltd 2010 Carpet manufacturing 2.21 0.92

Fletcher Building Ltd 2010 Construction 1.67 0.89

Freightways Ltd 2010 Transport 1.05 0.95

Hellaby Holdings Ltd 2010* Investment 1.33 0.36

Infratil Ltd 2010** Infrastructure & utilities 0.83 0.80

Michael Hill International 2010 Manufacturing & Jewellery 3.61 0.33

Steel and Tube Holdings Ltd 2010 Construction service 2.04 0.87

Telecom NZ 2010 Communications 0.79 0.75

* Hellaby has pledged its inventories as security for its loans. Includeed in current liabilities is an amount of $49,644 for capital notes. There are several options available to the noteholders includeing rollover and conversion to ordinary shares. If this amount is removed from current liabilities, the liquidity ratio improves to 0.69.

** If unsecured subordinaterd bonds to its 51% owned Trustpower subsidiary are removed, these ratios fall to 0.74 and 0.73 respectively.

Other 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. Steel & Tube Holdings falls into this category – as Note 12 to its financial statements shows, all of its borrowings are provided by its bank.

• Seasonal trade patterns – for businesses with seasonal trade patterns, these 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.1 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.

Leverage (debt) ratios

Leverage ratios measure the extent to which:

1 borrowed funds are used to finance the business, and

2 earnings can decline before the business is unable to meet its fixed charges.

Ratios for measuring leverage (debt)

1 Normal credit terms in New Zealand require payment on the 20th of the month following the date of the sale.

Leverage ratios measure ability to finance debt in the long term.

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Leverage ratios measure the business’s long-term solvency – the ability of the business to meet all of its liabilities. They show the likelihood of the business surviving over a long number of years. The purpose of this analysis is to give an early warning if a business is on the road to failure. Falling profitability and liquidity ratios are also key signs of possible failure.

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. Leverage ratios are as important as liquidity ratios for indicating financial strength and sound management.

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:• debttototalassetsratio• debttoequityratio• timesinterestearned• fixedchargecoverage• cashflowtodebtratios.

Debt to total assets ratio

The 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:

Debt to total assets ratioTotal debt (all liab= iilities)

Total assets

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, however, may seek higher leverage because this increases the return on their investment. But 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 total assets ratio


Debt to total assets ratioTotal debtTotal asse

=tts

=

=

72 610218 15933 28

,,

. %

Creditors have a claim of 33.3 cents for each asset dollar.

The debt to total assets ratio measures financial stability in terms of risk to creditors.

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294 Chapter 10

Times interest earned (Interest cover)

Times interest earned is 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:

Times interest earnedNet operating profit

Inter=

eest charges

Net operating profit 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. Interest is a tax-deductible expense.

A low times interest earned ratio suggests that 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. Also, because it has a fixed interest charge, it limits the cost of financing and presents a situation where leverage can be used to advantage. For example, if the business can earn more than the interest cost, the business will make an overall profit. In times of inflation, debt (which is a fixed dollar amount) can be repaid with ‘cheaper’ dollars than the ones originally borrowed. The same number of dollars is repaid but, because of inflation, the dollars used to repay the debt are worth less in buying power than the ones originally borrowed. However, if the business does not earn a return on its assets equal to the cost of interest, it operates at a loss.

Times interest earned

Steel & Tube has no long-term debt in 2010. In 2009, the ratio was:

Debt to equity ratioDebt

Equity=

=

=

5 000150 1430

,.

.003 1:

For each dollar of funding provided by the shareholders, lenders are providing 3 cents towards funding the Group’s assets and activities. Note 12 to Steel & Tube’s financial statements indicates that the company has a substantial loan facility available to it from its bankers.

Debt to equity ratio

The debt to equity ratio is calculated as follows:

Debt to equity ratioDebt

Equity (or shareholder=

ss funds)'

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.

A high ratio implies that a large proportion of long-term assets are financed by debt. Long-term creditors prefer to see a low to moderate debt to equity ratio. 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.

Debt to equity ratio

The debt to equity ratio is another measure of financial stability in terms of risk to creditors long term.

Times interest earned measures ability to pay interest.

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Fixed charge coverage

The fixed charge coverage is similar to the times interest earned, but includes other obligations such as lease payments in the calculation. The ratio is calculated as follows:

Fixed charge coverageNet operating profit Othe= + rr obligations

Interest charges Other obligation+ ss

Fixed charge coverage


Times interest earnedNet operating profit

Inter=

eest charges

times

=

=

15 9191 710

9 3

,,.

Steel & Tube earns 9.3 times as much profit before taxes as it needs to pay its interest bills.

For Steel & Tube the calculation is:

Fixed charge coverageNet operating profit Othe= + rr obligations

Interest charges Other obligation+ ss

times

= ++

=

15 919 9 2601 710 9 260

2 3

, ,, ,.

Steel & Tube’s total fixed charges are well covered by its EBIT.


Cash flow to debt ratioCash flow

Total liabilit=

iies

=

=

26 85372 6100 37

,,

.

A fixed charge is a cash flow that the company cannot avoid without breaking its contractual agreements. It is important that this ratio is sound.

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 to debt ratioCash flow

Total liabilit=

iies

For this ratio, cash flow is usually defined as the cash generated from the operations of the business that is shown in the Cash Flow Statement. A reasonable estimate of this figure is net profit after tax plus depreciation. This ratio is useful in assessing the creditworthiness of a business seeking short-term or intermediate-term debt.

Cash flow to debt ratios

Fixed charge coverage is a more rigorous measure of ability to meet obligations.

Cash flow to debt ratios measure ability to service debt both short-term and long-term.

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Asset utilisation ratiosAsset 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. If investments in assets are too large, it means that funds tied up in the assets are not being used as productively as they should be; the business has more assets than it needs to operate efficiently. If investment is too small, the business may be providing poor service to its customers or producing a poor-quality product. In this case, the business is overstretching its limited asset base to meet customer demands.

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:• inventoryturnover• days’salesininventory• accountsreceivableturnover• averagecollectionperiod(ordayssalesoutstanding)• cashconversioncycle• non-currentassetturnover• totalassetsturnover.The business’s ability to meet its current liabilities depends on its ability to turn inventories and accounts receivable into cash. Thus, the various inventory and accounts receivable activity ratios provide important information in assessing the business’s short-term solvency situation and management of its working capital. Sales are critical events in the cash flow cycle, and so the rate at which inventories are sold is vital to the survival of the business. If most of the sales are made on credit, the rate at which the accounts receivable are collected is also crucial to the business’s survival.

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,

Ratios for measuring utilisation of assets

For Steel & Tube this ratio is:

Cash flow to long-term debt ratioCash flow

Long=

--term debt

=

=

26 853972

27 63

,

.

These last two ratios show that Steel & Tube, on current activity, can repay its long-term debt in a little under 1 month, and all of its liabilities in a little under 3 years. Consequently, Steel & Tube appears to be in very good financial health. A trend statement of these ratios would give a much better indication.

The cash flow to long-term debt ratio can also be used for evaluating the long-term solvency of a company. The ratio is calculated as follows:

Cash flow to long-term debt ratioCash flow

Long=

--term debt

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but not when undergoing an external analysis. Consequently, 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

Inventory turnover measures the number of times inventory is sold and replaced during the year.

A high turnover can indicate better liquidity or superior merchandising. It could also suggest a shortage 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. A low figure can also indicate poor liquidity, possible overstocking, or obsolete stock. A low figure may also be an indicator of a planned inventory build-up in the case of material shortages. The ratio is calculated as follows:

Inventory turnoverCost of goods soldAverage in

=vventory

Because inventory may have changed significantly during the year, especially if there are seasonal fluctuations, a yearly average should be used – and not the year-end figures taken directly from the Balance Sheet.2 Inventories are valued in terms of their cost, and so cost of goods sold is used in calculating inventory turnover. A major problem occurs when calculating this figure for public companies because they do not publish their cost of sales figures. Sales is a less accurate figure to use because it includes the profit mark-ups, which will vary between products for businesses selling a variety of merchandise. However, this figure may be used when the cost of goods figure is not available.

Inventory turnover

2 Often, you will not have enough comparative figures to enable averages to be calculated. In these cases, you should use the year-end figures in the financial statements.


Inventory turnoverCost of goods soldAverage in

=vventory

=

=

304 48887 532

3 48

,,

.

Steel & Tube turns inventory over about 3.5 times a year. Without knowing the industry average, it is difficult to tell whether this is good or bad. Steel & Tube supplies a range of steel products to the construction, manufacturing, industrial and rural markets in New Zealand and Australia, and so this figure should be a reasonable representation of the true situation. 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. However, for internal management purposes, The Warehouse management will have sales and inventory figures available for the various types of goods the company handles. Further, many companies, including The Warehouse, do

Inventory turnover measures how often inventory is replaced during a year.

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298 Chapter 10

not disclose their cost of sales figures and so their sales figures are used as a surrogate for cost of sales in this calculation. Consequently an inventory turnover figure calculated using sales will be higher than would be calculated if cost of goods sold is used.

Another example is Briscoe Group. Using its 2010 annual report, Briscoe’s inventory turnover for the group was 4.1 times (calculated by taking cost of sales ($250,227) and dividing by average end-of-year inventory levels [(63,353 + $57,460)/2]). Briscoe’s financial year is to 31 January, at which point 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 were used.

Days’ sales in inventory

Days’ sales in inventory shows the length of time (in days) that it takes to sell inventory. It is an alternative way of describing inventory turnover. The formula for calculating this ratio is:

Days sales in inventoryEnding inventory

(Cost’ =

oof goods sold / 365)

Because ending inventory is used, if sales are affected by seasonal patterns the result may be misleading. Further, if the days’ sales in inventory is understated, the liquidity of the inventory will be overstated.

Days’ sales in inventory


Days sales in inventoryEnding inventory

(Cost’ =

oof goods sold / 365)

d

=

=

84 227304 488 365

101

,( , / )

aays

Steel & Tube has enough inventory on hand to meet 101 days of sales.

Accounts receivable turnover and average collection period

Accounts receivable turnover and average collection period (or days sales outstanding) ratios measure how long it takes from the time the sale is made until the cash is collected from the customer. The formula for accounts receivable turnover is:

Accounts receivable turnoverSales

Average accou=

nnts receivable

The formula for average collection period is:

Average collection periodNumber of days in the= year

Accounts receivable turnover

Either of these ratios may be used as an indicator of a business’s liquidity. 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.

Accounts receivable turnover and average collection period

Days’ sales in inventory is an alternative way of describing inventory turnover.

Accounts receivable turnover is a measure of liquidity in terms of cash collection.

Average collection period also measures liquidity in terms of cash collection.

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As with the average inventory figure, any large variations from month to month with the accounts receivable figure will affect the usefulness of this ratio. If the business’s receivables appear to be turning over more slowly than for the rest of the industry, further research is needed and the quality of the receivables should be closely examined.

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, or 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 sooner the business receives the cash due on sales, the sooner it can put that money to work earning greater returns for the business. The cost of a long collection period is a return (interest) lost on these funds, or is the cost of interest paid if the business has to borrow while awaiting receipt of the receivables cash.

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. This is 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

The cash conversion cycle (CCC) is the time the company’s cash is tied up between payment for production inputs (raw materials and other inventories) and receipt of payment from the sale of the finished product. The formula is:

CCC = Days’ sales in inventory + Average collection period – Average payables period

Average payables period is the time it takes to pay accounts payable, and is calculated as follows:

Average payables periodAccounts payableAnnual

=ppurchases

× 365

Cash conversion cycle (CCC)

The ratios for Steel & Tube are:

Accounts receivable turnoverSales

Average accou=

nnts receivable

times

=

=

379 99364 460

5 9

,,

.

Average collection periodNumber of days in the= year

Accounts receivable turnover

=

=

3655 961 92

.. days

The cash conversion cycle measures the delay between payments for inputs and receipts from sales.

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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

Non-current asset turnover measures the productivity of the business’s property, plant and equipment. The formula is:

Non-current asset turnoverSales

Net property, p=

llant and equipment

A low ratio indicates that the 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, causing the business to lose a portion of its market share or prevent it from producing competitively.

Assets that have been depreciated to close to zero, and labour-intensive operations, may also 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.

Fixed asset turnover

Steel & Tube’s annual purchases for 2010 were:

$

Opening inventory 90,837

plus Sales3 379,993

470,830

less Closing inventory 84,227

Purchases 386,603

For Steel & Tube, the calculations are:

Average payables periodAccounts payableAnnual purchases

3= × 665

333,501386,603

365

31.63 days=

CCC = Days’ sales in inventory + Average collection period – Average payables period

= 101 + 61.92 – 31.63

= 131.29 days

This represents the number of days Steel & Tube’s cash is tied up in its operations. The shorter this period is, the sooner cash becomes available for other uses – such as investing in new assets.

3 As Steel & Tube does not disclose purchases, annual sales is used – this will produce a lower annual payments period because the sales figure inflates purchases by the mark-up (difference between purchase cost and sales price) applied.

Fixed asset turnover measures efficient use of plant, property and equipment.

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Total assets turnover

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 for calculating the ratio is:

Total assets turnoverSales

Total assets=

Total assets turnover


Non-current asset turnoverSales

Net property, p=

llant and equipment

times

=

=

3 797 99351 458

7 38

, ,,

.

For every $1 of net property, plant and equipment, there were sales of $7.38.


Total assets turnoverSales

Total assets=

= 3 797 9, , 993218 159

1 74.

.= times

Profitability ratiosProfitability ratios are designed to assist in the evaluation of management performance. Since earning profit is a major objective of a company, poor performance here indicates a basic failure that, if not corrected, could result in the business going into liquidation.

Investors become shareholders for one purpose – to obtain a greater return (in dividends and capital growth) on the investment than they can get from another investment of similar risk. An evaluation of a business’s past profitability may give an investor a better understanding for decision making. A business’s profitability usually also affects its liquidity position. However, a business can make a profit but not have enough cash available to meet its liabilities.

There are many measures of profitability, including:• grossprofitmargin(ormark-up)• netoperatingmargin• profitmarginonsales• expensesasapercentageofsales• percentagechangeinsales• returnontotalassets• returnonequity.

Ratios for measuring profitability

Total assets turnover measures effective use of total assets to generate sales.

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302 Chapter 10

Each of these ratios relates earnings to sales, assets, or equity. Creditors, owners, and management pay close attention to them because, 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.

Gross profit margin and mark-up

The gross profit margin reflects the effectiveness of pricing policy and of production efficiency. The formula is:

Gross profit marginGross profit

Sales=

The mark-up expresses the gross profit margin in terms of the cost of goods sold, rather than in terms of sales. It shows the average mark-up between the price of inventories and the retail sales price of the final goods. This mark-up should be enough to cover the business’s expenses and leave the desired net profit for the period. The formula is:

Mark-upGross profit

Cost of goods sold=

However, if the gross margin is increased by raising the price of the business’s output, the product may become uncompetitive and the company may lose sales. It may be advantageous for the company to lower prices (or lower the cost of goods sold, by reducing manufacturing expenses) and therefore gross margin, if this action will increase sales and total profits.

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.

Net operating margin

The net operating margin measures the effectiveness of both production and sales in generating pre-tax income for the business. For any given level of sales, the higher this ratio, the better. The formula is:

Net operating marginNet operating profit

Sales= or

EBITSales

Non-operating income and expense items are excluded because these are not directly related to the production or sales functions of the business. Because businesses operating in the same industry can finance their activities in different ways, net operating profit before interest and tax (i.e. earnings before interest and tax, or EBIT) is used so that relevant comparisons can be made.

Gross profit margin and mark-up

Net operating margin

Gross profit margin measures effectiveness of pricing and production in terms of sales.

Net operating margin measures generation of pre-tax income from production and sales.

Mark-up expresses the gross profit margin in terms of cost of goods sold.

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Profit margin on sales

The 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:

Profit margin on salesNet profit before taxes

S=

aales

By itself, the ratio provides little useful information, because it mixes the effectiveness of sales in producing profits (reflected by the net operating margin) with the effects of non-operating activities (which are included in net profit before tax).

Profit margin on sales


Net operating marginEBITSales15,919379,9934.19

=

= %


Profit margin on salesNet profit before taxes

S=

aales

=

=

14 209379 9933 74

,,

. %


Return on total assetsNet profit before taxes

T=

ootal assets

=

=

14 209218 1596 51

,,

. %

Return on total assets

Return on total assets measures the return to shareholders and other investors (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. However, heavily depreciated plant and equipment, large amounts of intangible assets, or unusual revenue or expense items can cause distortions to the ratio. The formula is:

Return on total assetsNet profit before taxes

T=

ootal assets

Return on total assets

Profit margin on sales measures ability to recover costs to produce a reasonable profit.

Return on total assets measures overall effectiveness in employing resources.

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Other ratios

In addition to the above ratios, analysts may also 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 can also be a useful indicator of sales growth. However, 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.

Investor ratiosInvestment analysts are interested in the market price and performance of a company’s shares because these items indicate what investors think of a company. Market price is the price people are willing to buy and sell the shares of a company for. It provides information about how investors see the potential risk and return connected with owning a part of the company. However, market price alone does not give this information. Companies are quite diverse: they have different numbers of issued shares, differing levels of profits and dividends, and differing future prospects. All of these factors are built into the market price of a company’s shares. To get the necessary information to enable an investment decision to be made, the following ratios need to be considered:• earningspershare• price/earningsratio• dividendpershare• dividendyield• dividendcover• nettangibleassetbackingpershare.

Other ratios

Ratios for investors

Return on equity

Return on equity (ROE) measures the return available to the shareholders.The objective of management is to generate the maximum return on shareholders’

investment. While this ratio serves as an indicator of management performance, it should be used in conjunction with other indicators. 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. The formula is:

Return on equityNet profit after taxes and pre= fference dividiends

Shareholders funds (or net’ wworth)

Net profit after taxes and preference dividends is used because this is the amount available for distribution to the ordinary shareholders.

Return on equity (ROE)

For Steel & Tube the return on equity is:

Return on equityNet profit after taxes and pre= fference dividiends

Shareholders funds (or net’ wworth)

=

=

5 714145 5493 93

,,

. %

Return on equity measures management performance but should be used together with other indicators.

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The figure for the number of shares on issue can be difficult to determine – especially if there are convertible securities, share options or warrants on issue. These create a problem in that an allowance should be made for the likely number of shares that will be taken up by holders of these securities at the option date. Accounting policies can also affect the calculation of EPS because of the effect a change in accounting policies can have on the net profit figure.

Price/earnings (P/E) ratio

The price/earnings ratio measures the ratio of the current market price of the ordinary shares to the EPS of the ordinary shares. This ratio is useful for comparing different companies. When a company’s P/E ratio is higher than that of other companies, this indicates that investors are expecting its profits (and hence dividends and share price) to grow more quickly than those of the other companies.

P/E ratioMarket price per shareEarnings per sh

=aare (EPS)

Price/earnings (P/E) ratio

Earnings per share (EPS)

EPS is probably the most widely quoted of all financial statistics. EPS is the amount of net profit per share of the company’s ordinary shares. The formula is

EPSNet profit after taxes and preference divid= eends

Number of ordinary shares issued

The net profit available for paying dividends to the ordinary shareholders is used. Preference dividends and taxes are deducted because the preference shareholders and the IRD have prior claims on the profit.

Earnings per share (EPS)

Steel & Tube has no preference shareholders and so there is no preference dividend to be paid. Steel & Tube’s ratio is:

EPSNet profit after taxes

Number of ordinary sh=

aares issued

per share

=

=

5 71488 1580 065

,, *

$ .

* See Notes 14 and 15 of Steel & Tube’s 2010 financial statements.

If we assume the current market price of Steel & Tube’s shares at balance date was $4.95, then the P/E ratio is:

P/E ratioMarket price per share

EPS=

=

=

2 480 0653

..88 15.

EPS measures how much is available per share for return to the shareholder.

The P/E ratio measures how quickly profits are expected to grow.

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Dividend yield

Dividend yield is the ratio of DPS to the share’s market price. It measures the percentage of the share’s value that is returned each year as dividends to the shareholder. Preference shareholders, whose main reason for investing is to receive dividends, pay special attention to this ratio. The formula is:

Dividend yieldDividends per share (DPS)

Current=

share price

Dividend yield

The P/E ratio changes from day to day as the market price of the shares changes. It will also change from period to period as the company’s earnings change. It tells how much the investing public is willing to pay for $1 of Steel & Tube’s EPS. An investor who wants to buy Steel & Tube shares is willing to pay 38.15 times the EPS according to the worked example. The investor is prepared to wait for 38.15 years to recover the price paid for the share – assuming that neither Steel & Tube’s earnings nor number of shares issued changes in the meantime, and all available earnings are paid out as dividends. (EPS is calculated from the annual results: if it takes 1 year to earn $1, it will take 38.15 years to earn 38.15 times that $1.)

Dividends per share (DPS)

Dividends per share shows how much of the net profit is paid to shareholders for each ordinary share they hold. Normally, DPS will be less than EPS because companies prefer to retain part of the net profit to help fund future expansion. The formula is:

DPSDividends paid to ordinary shareholders

Numb=

eer of ordinary shares

Dividends per share (DPS)

For Steel & Tube:

DPSDividends paid to ordinary shareholders

Numb=

eer of ordinary shares

=

=

7 51188 1580 085

,,

$ .

Using the market price of $2.48, the ratio for Steel & Tube is:

Dividend yieldDPS

Current share price=

= 0 0852 48..

== 3 42. %

An investor who buys Steel & Tube shares for $2.48 will receive a return of 3.43% on the investment. However, this is only part of the actual return the shareholder will receive. When the share is sold, the percentage change in the market price must also be allowed for in calculating the final return the investor receives. This, of course could be negative if the share price drops, and is the gamble stockmarket investors take.

DPS measures actual return per share to ordinary shareholders.

Dividend yield measures the percentage of a share’s value that is returned to the shareholder.

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Steel & Tube has $0.76 available to meet each dollar of dividend paid (or to be paid). This does not cover the current dividend payments. Steel & Tube is expecting an improvement in the economic outlook and expects its cash flows to remain strong – hence its high dividend payout relative to its current net profits. A low dividend cover would normally suggest that the company either has no major capital expenditure plans or is not retaining enough of its earnings to meet future investment plans.

An alternative method of calculating dividend cover is:

Dividend coverEarnings per shareDividend per s

=hhare

Dividend cover

Dividend cover shows how many times the net profit after tax and preference dividends covers the dividend payout to ordinary shareholders. The ratio is calculated as follows:

Dividend coverNet profit after tax and prefere= nnce dividends

Dividend payout

Dividend cover

For Steel & Tube the dividend cover is:

Dividend coverNet profit after tax and prefere= nnce dividends

Dividend payout

t

=

=

5 7147 5110 76

,,. iimes

Using the figures calculated previously, this gives Steel & Tube a dividend cover of:

Dividend coverEarnings per shareDividend per s

=hhare

=

=

0 0650 0850 76

.

.$ .

Net tangible asset backing per share (NTA)

This is also called the book value per share. The NTA shows how much the shareholder can expect to get back should the company cease operations. It assumes that the value of the assets shown in the Balance Sheet is a fair indication of the price that would be obtained if they were sold. The formula is:

NTATotal net assets Intangible assets

Number of= −

ordinary shares

Alternatively:

NTAShareholders funds Intangible assets

Number= −’

of ordinary shares

Net tangible asset backing per share (NTA)

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308 Chapter 10

Inter-relationship of ratiosRatios must be evaluated together, not individually. For example, a company may have a low current ratio (poor liquidity) but better than average debt, interest coverage, and profitability ratios. This suggests that the company is in a good position to raise extra long-term debt or equity that could be used to repay short-term debt and so improve the current ratio and, therefore, liquidity. On the other hand, the company may have a high fixed assets ratio that suggests unused capacity. Some of the assets may be able to be sold, thereby providing additional funds to improve the liquidity position. Even if short-term liabilities are not reduced, creditors will note that the company has underlying strength, which will enable it to meet the liabilities as they fall due. Short-term creditors are concerned with both the liquidity and the overall positions of the company. The current and quick ratios alone do not reveal the whole situation.

Reporting and the usefulness of ratio analysis

A very important aspect of financial statement analysis and interpretation is reporting the findings of the 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, as the following comments indicate.

The ratios discussed have been developed for a particular company, Steel & Tube, at a specific point in time – 30 June 2010. They may have little meaning unless compared with standards. For instance, the current ratio of Steel & Tube of 2.04 : 1 shows the relationship between current assets and current liabilities as at 30 June, and the liquidity ratio of 0.87 : 1 shows the company’s ability to meet its immediate liabilities. Whether these ratios are too high, or too low, cannot be determined unless they are related to the industry averages or some other criteria. It is important to remember this when reporting on the financial statements of a business.

PitfallsThere are many pitfalls to the various ratios discussed. Some of these, including the accounting policies applied by the company and those companies with which the

Inter-relationship of ratios

Reporting and the usefulness of ratio analysis

Pitfalls to ratios

The ratio for Steel & Tube is:

NTAShareholders funds Intangible assets

Number= −’

of ordinary shares

= −

=

145 549 19 96188 158

1 42

, ,,

$ .

The company’s liabilities (including any preference share capital) are deducted from total assets before this calculation is made.

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ratios are being compared, have been discussed. Companies of the same size in the same industry should be used for comparison. The increasing diversification of company operations, the accelerated changes in technology, and the rapid changes in company sizes make it very hard to find a suitable company within an industry with which valid comparisons can be made.

Further, in analysing the financial condition of the company, recent and past ratios should be compared. A ratio may fluctuate considerably over time. There are many reasons for this. Legislation, international affairs, competition, scandals, resignation of a senior manager and many more factors can turn profits into losses, or vice versa. To be most useful, ratios should be analysed over a period of years to take account of a representative group of these factors.

A single figure, therefore, or ratios for any one year may give a misleading indication of financial condition. Even ratios for two years may not give a representative view of the company’s performance. For example, the quick ratio may show a steady increase over a period of 10 years, but a two-year period early in the 10-year span might show a small decline. An evaluation based on the two-year period could lead to a wrong decision. Ratios calculated over a number of years, when compared with each other, can show the direction in which the company’s financial condition is trending.

LimitationsRatios are useful, but they have limitations. For example, a doctor’s thermometer might show that a patient has a temperature of 39.9 degrees Celsius – indicating there is something wrong with the patient. However, it does not tell the doctor what is wrong. Similarly, a sudden fall in a business’s working capital ratio tells you there may be something wrong, but it does not identify the problem. The figures that make up this ratio have to be analysed to find out what current assets might have decreased or what liabilities have increased. If current assets have fallen, which ones are involved? Is it cash? Are accounts receivable down? Or are inventories too low? If inventories have fallen, there may be a problem for sales. If there are not enough inventories on hand, sale items cannot be produced and sold. This leads to a fall in accounts receivable and a fall in the cash inflow. Thus, the first warning sign may merely be the tip of the iceberg. Just because accounts receivable have fallen does not necessarily mean that the business has improved its collection procedures from its debtors or that this is the cause of a fall in cash receipts. 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.

Uncertainty clouds business decisions. A decision maker can never be sure how a decision will turn out. For example, a careful analysis of ratios and other information may suggest that surplus cash be invested in the shares of a particular company because it is expected to produce high returns. However, a competitor may introduce a new and improved product – leaving the company just invested in with a product that can no longer be sold.

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 ratios

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310 Chapter 10

• Ratioanalysispointstopossibleproblems–itdoesnotprovethataproblemexists.

• Forratiostobecomparable,theymustallbetakenfromfinancialstatementscoveringthesameaccounting period in any year.

• Projectionsmadefrompasttrendsneedtobetreatedwithcaution.

• Althoughtwobusinessesmaybeinthesameindustry,theymaynotbestrictlycomparable.

• Businesseswithinthesameindustryandwithsimilaroperationsmayusedifferentaccountingpoliciesand procedures.

• Inflationcanaffectthewayratiosareanalysedandinterpreted.

• Foraratiotobeuseful,theremustbeasignificantrelationshipbetweentheitemsbeingcompared.

• Nosingleratiogivesenoughinformationtojudgethefinancialconditionandperformanceofacompany.

• Ratiosfromasingleyearareoflittleuse–ratiosforseveralyearsareneeded.

• Ratiosmustbeevaluatedtogether,notindividually.

• Ratioanalysiscannotpredictthefuture.

Figure 10.1 Summary of financial analysis ratios.

Analysing the Cash Flow StatementCash Flow Statements can be investigated using horizontal and vertical analyses, as Figure 10.2 shows.

Anna Corporation Cash Flow Statements for the years ending 31 December 20X1, 20X2 and 20X3

20X3 20X2 20X1$ $ $

Cash flows from operating activities

Cash was provided from:

Receipts from customers 870,000 750,000 690,000

Payments to suppliers and employees –764,000 –655,000 –620,000

Cash generated from operations 106,000 95,000 70,000

Taxes paid –31,000 –27,000 –24,000

Net cash flow from operating activities 75,000 68,000 46,000

Cash flows from investing activities


Sales of marketable securities 40,000 35,000 55,000

Interest received 4,000 1,000 1,000

Dividends received 6,000 8,000 8,000

Collections on loans 12,000 7,000 5,000

Proceeds from sale of plant 75,000 60,000 60,000

137,000 111,000 129,00

Cash was applied to:

Purchases of marketable securities –65,000 –40,000 –20,000

Loans made –17,000 –7,000 –5,000

Purchases of equipment –160,000 –70,000 –90,000

–242,000 –117,000 –115,000

Net cash used in investing activities –105,000 –6,000 14,000

Analysing the Cash Flow Statement

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Analysts can use the Cash Flow Statement to identify danger signals about the company’s financial situation. In all three years, Anna Corporation’s operations, shown in Figure 10.2, have provided less in net cash inflows than has been received from the sale of fixed assets and marketable securities. Can the company remain in business by generating the majority of its cash by selling property, plant and equipment? Obviously, no! These assets are needed to manufacture the company’s products in the future. Anna has also borrowed $345,000 in these three years. No company can survive for long on borrowed funds. These have to be repaid. As the Cash Flow Statements show, Anna has repaid $257,000 of borrowed money over the three years. In addition, interest expense is incurred as a result of borrowing, and Anna has paid $218,000 in interest and dividends on money obtained from other people (debt providers and shareholders). Successful companies – such as The Warehouse Group and Steel & Tube – generate the greatest percentage of their cash from operations, not from selling their fixed assets or from borrowing money.

These conditions may only be temporary for Anna Corporation, but they need investigating. The trend over the three-year period shows a gradual improvement in the net cash flows from operations. However, Anna Corporation is still very reliant on the cash flows received from its investing and financing activities.

The most important information that a Cash Flow Statement provides is a summary of the company’s use of cash. How a company spends its cash today determines its sources of cash in the future. The company may wisely use its cash to buy assets that will generate future income. However, if a company invests unwisely, cash will eventually run short.

Anna’s Cash Flow Statement reveals problems. Is the company retaining enough of its income to finance future operations without excessive borrowing? While it bought assets to replace those sold (a good point), its payment for dividends and interest equalled its net cash inflow of $75,000 in 20X3. In 20X1 and 20X2, these outflows

Anna Corporation Cash Flow Statements for the years ending 31 December 20X1, 20X2 and 20X3

20X3 20X2 20X1$ $ $

Cash flows from financing activities


Proceeds from short-term debt 45,000 50,000 52,000

Proceeds from long-term debt 100,000 50,000 50,000

Cash proceeds from issue of shares 50,000 – –

195,000 100,000 102,000

Cash was applied to:

Payments to settle short-term debts –55,000 –50,000 –52,000

Payments to settle long-term debts – –50,000 –50,000

Interest paid –10,000 –12,000 –13,000

Dividends paid –65,000 –60,000 –58,000

–130,000 –172,000 –173,000

Net cash available from financing activities 65,000 –72,000 –71,000

Net increase (decrease) in cash 35,000 –10,000 –11,000

Figure 10.2 Anna Corporation’s Cash Flow Statements.

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312 Chapter 10

exceeded the net operating cash flows and so the company will need to look very closely at whether it can maintain the high level of dividend payments while its net operating cash flows continue to be supplemented by the cash flows from asset sales.

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. Analysts seek answers to questions such as those above and analyse the information in the Cash Flow Statement, together with that provided in the Income Statement and Balance Sheet, to get a well-rounded picture of the business.

An inspection of the Statements of Cash Flows for the years ending 31 July 2000 through 2009 for The Warehouse Group shows that the company has been able to meet all of its cash requirements from the net inflows from its operations and financing activities. In all ten years, the company has been able to increase its assets from its investing activities and repay its borrowing commitments as these have matured. Thus, despite The Warehouse Group’s liquidity ratio being considerably less than 1 in each year, the company has a strong cash flow stream to enable it to carry out its business operations efficiently and effectively.

Summary

• Creditorsandinvestorsusefinancialstatementanalysistojudgethepast performance and current financial position of a business. This analysis also allows the future potential and risk associated with the business to be judged.

• Themajorsourcesofcompany information are published reports such as annual reports and interim financial statements, reports filed with the Companies Office of the Ministry of Economic Development, business periodicals, and credit and investment advisory services.

• Past and present data are analysed and used for assessing the likely results of the planned future activities of the business.

• Themainclassifications into which ratios are categorised are

1 asset utilisation – analysing operating efficiency and activity

2 financial stability – analysing financial structure and capacity to meet obligations

3 return on investment – analysing business profitability and financial market ratios

• Accountingpolicies,economicandpoliticalfactors,diversificationandrapidlychanging technology, and company size all have an effect on the interpretation of accounting data.

• Net profit is an important component in many ratios used to evaluate businesses. The quality of reported net profit, value of assets and working capital are all influenced by decisions made by management.

• TheCash Flow Statement shows the net cash inflow or outflow caused by a company’s operating, investing and financing activities. By analysing the inflows and outflows of cash listed in this statement, an analyst can see where a business’s cash comes from and how it is being spent.

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Net profitNet profitNet profitNet profitNet profit is an important component in many ratios used to evaluate businesses.The quality of reported net profit, value of assets and working capital are allinfluenced by decisions made by management.The Cash Flow StatementCash Flow StatementCash Flow StatementCash Flow StatementCash Flow Statement shows the net cash inflow or outflow caused by acompany’s operating, investing and financing activities. By analysing the inflowsand outflows of cash listed in this statement, an analyst can see where a business’scash comes from and how it is being spent.

Stability: measure total debt burden

Liquidity

Leverage(debt) ratios

Working capital = Current asssets – Current liabilities

Current ratio =Current assets

Current liabilities

Liquid assetsCurrent liabilities

Liquidity (quick or acid test) ratio =

Debt to total assets ratio = Total debt (all liabilities)Total assets

Debt to equity ratio = DebtEquity (or shareholder’s funds)

Times interest earned = Net operating profitInterest charges

Fixed charge coverage = Net operating profit + Other obligationsInterest charges + Other obligations

Cash flow to debt ratio = Cash flowTotal liabilities

Inventory turnover = Cost of goods soldAverage inventory

Accounts receivable turnover = SalesAverage accounts receivable

Average collection period = Number of days in the yearAccounts receivable turnover

Average payables period = Accounts payableAnnual purchases

¥ 365

SalesNet property, plant and equipment

Total assets turnover = SalesTotal assets

Asset utilisation: show how much use the business makes of its assets in generating sales

297Analysing and interpreting financial statements

Table 10.2 Summary of financial analysis ratios

Days’ sales in inventory = Ending inventory(Cost of goods sold / 365)

Cash conversion cycle (CCC) = Days’ sales in inventory+ Average collection period – Average payables period

Fixed asset (property, plant and equipment) turnover =

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314 Chapter 10

Figure 10.3 Summary of financial analysis ratios.

Chapter 10298

Gross profit margin = Gross profitSales

Mark-up = Gross profitCost of goods sold

Net operating profitSales

Net operating margin = ( )EBITSales

or

Net profit before taxesSales

Profit margin on sales =

Net profit before taxesTotal assets

Return on total assets (return on investment) =

Net profit after taxes and preference dividendShareholders’ funds (or net worth)

Return on equity =

Profitability: designed to assist in the evaluation of management performance

Investor ratios: indicate what investors think of a company

Table 10.2 continued

Net profit after taxes and preference dividendsNumber of ordinary shares issued

Earnings per share (EPS) =

Market price per shareEarnings per share (EPS)

Price / earnings (P / E) ratio =

Dividends paid to ordinary shareholdersNumber of ordinary shares

Dividends per share (DPS) =

Dividends per share (DPS)Current share price

Dividend yield =

Shareholders’ equity – Intangible assetsNumber of ordinary shares issued

Net tangible asset backing per share (NTA) =

Total net assets – Intangible assetsNumber of ordinary shares issued

or NTA =

Review

Check your understanding of Chapter 10 by attempting the following review questions and exercises.

Questions

1 As a creditor, or prospective lender to a company, what sorts of ratios would you be interested in? Why?

2 How can ratio analysis be used for cross-sectional purposes?

3 How can time-series ratio analysis be used?

4 Should deviations or trends that indicate better than expected performance be investigated? Explain your answer.

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5 What are some of the more important sources of financial information for groups interested in the financial affairs of a company?

6 Over the past year, Flamboyant Fashions Ltd’s current ratio has increased while its total assets turnover ratio has fallen. However, its sales, liquidity ratio and fixed assets turnover ratio have remained constant. Explain these changes.

7 What is the main objective, and which ratios are most important, for each of the following groups of people when evaluating financial ratios?

a Managers.

b Shareholders.

c Long-term creditors.

d Short-term creditors.

8 Why would the inventory turnover ratio be more important when analysing Sanford Ltd than Steel and Tube Holdings Ltd?

9 For each of the following transactions, show the effect on current assets, the current ratio, and net income. Show an increase with a +, a decrease with a –, and no effect or indeterminate effect with a 0.

Current assets

Current ratio

Net income

a Cash received from a share issue

b Goods sold for cash

c Plant is sold for less than carrying value

d Goods are sold on credit

e Accounts payable are paid

f Ordinary shares are repurchased for cash

g A short-term bank loan is raised

h Accounts receivable are sold for cash at a discount

i Marketable securities are sold below cost

j Advances are made to employees

k Current operating expenses are paid

l Short-term promissory notes are issued to creditors in exchange for overdue accounts payable

m Furniture is sold for more than carrying value

n Capital notes are issued to pay off accounts payable

o A fully depreciated asset is retired

p A cash dividend is paid

q Accounts receivable are collected

r Equipment is purchased with convertible notes

s Goods are purchased on credit

t Last year’s income tax is paid

u Estimated taxes payable are increased

10 What is the purpose of asset management ratios? Briefly identify the main ones and explain how each one is calculated and what it is used for.

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316 Chapter 10

Exercises

1 Here are the financial statements for Able-Baker Limited.

Able-Baker Limited Income Statements for the years ending 31 December

20X4 20X5$000 $000

Sales 240,500 278,000

Cost of sales –192,400 –224,000

Gross profit 48,100 54,000

Selling & Administrative expenses –12,000 –14,100

Depreciation –4,000 –6,000

Operating profit 32,100 33,900

Interest expense –2,000 –3,000

Net profit before tax 30,100 30,900

Tax 9,900 10,200

Net profit after tax 20,200 20,700

Able-Baker Limited Balance Sheets as at 31 December

20X4 20X5$000 $000

Current assets:

Cash 10,500 7,500

Accounts receivable 15,000 21,000

Inventory 25,500 32,000

Total current assets 51,000 60,500

Non-current assets:

Property, plant and equipment 75,000 103,500

Accumulated depreciation –20,000 –26,000

Net property, plant and equipment 55,000 77,500

Total assets 106,000 138,000

Current liabilities:

Accounts payable 12,000 18,000

Notes payable – bank 12,200 19,700

Other accrued expenses 2,000 3,000

Total current liabilities 26,200 40,700

Long-term debt 22,000 25,000

Total liabilities 48,200 65,700

Shareholders’ funds:

Paid up ordinary capital (400,000 shares) 1,600 1,600

Asset revaluation reserve 10,000 10,000

Retained earnings 46,200 60,700

Total shareholders’ funds 57,800 72,300

Total liabilities and shareholders’ funds 106,000 138,000

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a Calculate the return on assets (ROA), net profit margin and asset turnover ratios for the 20X4 and 20X5 years, and explain the reasons for the changes in ROA.

b Do a vertical analysis of the Income Statements for the years 20X4 and 20X5. Indicate what caused the changes in net profit margin for 20X5 and calculate the net profit after tax, assuming Able-Baker Limited had:

i maintained its 20X4 net profit margin for 20X5, and

ii maintained its 20X4 ROA in 20X5.

c Calculate the necessary ratios for 20X4 and 20X5 to highlight Able-Baker’s performance in the following areas:

i profitability

ii activity and utilisation

iii liquidity

iv financial stability

and explain what happened to Able-Baker in these two years.

Note: use the year-end figures in the Balance Sheets for these calculations and assume a 365-day year.

Additional information:

• Daily purchases in 20X4 and 20X5 were $600,000.

• Lease payments were $4 million in 20X4 and $6 million in 20X5.

• Debt principal repayments were $1.5 million in 20X4 and $3 million in 20X5.

2 The following data apply to Canvastown Antiques Ltd (CAL):

Cash and marketable securities $150,000

Non-current assets $425,000

Sales $1,500,000

Net profit (after tax) $75,000

Liquidity ratio 1.5 times

Current ratio 2.0 times

Average collection period 40 days

Return on equity 14%

CAL is totally financed by ordinary equity, current liabilities and long-term debt.

Required:

Calculate CAL’s:

a accounts receivable

b current liabilities

c current assets

d total assets

e return on assets

f ordinary equity, and

g long-term debt.

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318 Chapter 10

3 A friend of yours is considering investing in Small Manufacturers Ltd, and has obtained the following financial statements for you to evaluate. To help with the evaluation, he has also provided you with some industry averages that are relevant to the company.

Small Manufacturers Ltd Balance Sheet

As at 31 December 20X5

$ $

Cash 144,000

Accounts receivable 878,000

Inventories 1,788,000

Total current assets 2,810,000

Land and building 476,000

Machinery 264,000

Other non-current assets 122,000

Total non-current assets (net) 862,000

Total assets 3,672,000

Accounts payable 864,000

Accruals 340,000

Total current liabilities 1,204,000

Long-term debt 809,000

Total debt 2,013,000

Ordinary shares 1,150,000

Retained earnings 509,000

Total shareholders’ funds 1,659,000

Total liabilities and equity` 3,672,000

Small Manufacturers Ltd Income Statement

For year ending 31 December 20X5

$ $

Sales 8,580,000

less: Cost of sales 7,160,000

Gross operating profit 1,420,000

General administrative & selling expenses 472,640

Depreciation 318,000

Other expenses 268,000 1,058,640

Earnings before tax 361,360

Tax 59,624

Net profit 301,736

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Other information:

Earnings per share $0.30

Dividends per share $0.06

Price/earnings ratio 5 times

Market price per share $1.50

Industry averages:

Liquidity ratio 1.0 : 1

Current ratio 2.7 : 1

Inventory turnover 7 times

Average collection period 32 days

Fixed assets turnover 13 times

Total assets turnover 2.6 times

Return on assets 12.5%

Return on equity 22.2%

Debt ratio 50%

Net profit margin 5.0%

Price/earnings ratio 6 times

Required:

a Briefly comment on Small Manufacturers Ltd’s strengths and weaknesses as disclosed by the above data.

b If the company was able to reduce its inventory levels and its cost of goods sold expenses, what effect would this have on its other ratios? (Note: calculations are not required to answer this question.)

4 The following information has been extracted from the 31 December 20X5 financial statements of Calico Operations Ltd:

20X4 20X5$ $

Sales 5,380 5,128

Gross profit 1,844 2,638

Taxation 100 330

Net profit after tax 130 404

Proposed dividend 200 200

Total shareholders’ funds 3,088 3,292

Non-current assets (net) 2,392 2,204

Long-term debt – 600

Current assets

Accounts receivable 718 974

Inventory 1,644 1,692

Current liabilities

Bank 788 202

Accounts payable 678 576

Dividends payable 200 200

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320 Chapter 10

Required:

Using appropriate ratios and percentages, comment on the operating results of the company for the year ending 31 December 20X5.

5 Following are the financial statements for Wholesale Distributors Ltd for the years 20X7 and 20X8. Assuming the 20X7 results provide a suitable comparison of results for the previous 6 years of trading, write a report to the directors:

a commenting on the operating results for 20X8

b commenting on the company’s current financial position, and

c making recommendations for improvements.

Wholesale Distributors Ltd Income Statement

For the years ending 31 December 20X7 and 20X8

20X7 20X8

$ $ $ $

Sales 1,000,000 1,250,000

Opening inventory 150,000 175,000

Purchases 875,000 1,125,000

1,025,000 1,300,000

less Closing inventory 175,000 300,000

Cost of goods sold 850,000 1,000,000

Gross profit 150,000 250,000

Expenses:

Selling 52,500 75,000

Administration 30,000 82,500 32,500 107,500

Earnings before interest and tax 67,500 142,500

Interest expense 15,000 17,500

Net profit before tax 52,500 125,000

Tax 17,500 41,000

Net profit after tax 35,000 84,000

Wholesale Distributors Ltd Statement of Changes in Equity

For the years ending 31 December 20X7 and 20X8

20X7 20X8$ $

Opening equity 162,500 177,500

Net profit 35,000 84,000

197,500 267,500

less Distributions to owners 20,000 44,000

Equity at end of period 177,500 $217,500

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Wholesale Distributors Ltd Balance Sheet

As at 31 December 20X7 and 20X8

20X7 20X8

$ $ $ $

Equity

Share capital 150,000 150,000

Asset revaluation reserve 2,500 2,500

Retained earnings 25,000 65,000

Total equity 177,500 217,500

Represented by:

Current assets

Bank 5,000 –

Accounts receivable 125,000 250,000

Prepayments 2,500 5,000

Inventories 175,000 307,500 300,000 555,000

Current liabilities

Bank overdraft – 52,500

Accounts payable 125,000 217,500

Taxes payable 17,500 41,000

Dividends payable 20,000 162,500 44,000 355,000

Working capital 145,000 200,000

Non-current assets

Land 52,500 52,500

Plant and equipment 197,500 197,500

Accumulated depreciation 142,500 55,000 157,500 40,000

252,500 292,500

Less Term liabilities 75,000 75,000

Total net assets 177,500 217,500

Notes:

i All sales are on credit.

ii There is no provision for doubtful accounts receivable.

iii There were no additions or sales of non-current assets in 20X8.

iv The bank has set a limit of $37,500 on the overdraft.

v The company is forecasting a further increase in sales of 20% for the year 20X9.

6 Bloggs Company Ltd has maintained the following relationships between items in its financial statements for the past 5 years.

Gross margin rate on net sales 33.4%

Net profit before tax to sales 3.3%

Rate of selling expenses to net sales 14.9%

Other expenses to net sales 11.7%

Accounts receivable turnover 7.02 times

Inventory turnover 4.84 times

Liquidity ratio 1.3 : 1

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322 Chapter 10

Current ratio 2.2 : 1

Composition of quick assets:

Cash 8.6%

Marketable securities 18.9%

Accounts receivable 72.5%

Total tangible assets turnover 0.62 times

Ratio of net intangible assets to total assets (after depreciation) 4%

Ratio of accumulated depreciation to non-current assets 26.3%

Ratio of accumulated amortisation to intangible assets 65%

Ratio of accounts receivable to accounts payable 94.25%

Ratio of shareholders’ funds to working capital 6.6:1

Average interest rate on term liabilities 10.764%

Dividends paid $150,000

Bloggs had a net profit before tax of $138,000 for the year ending 31 December 20X5 which gives an earnings per share of $0.06.

Additional information:

• issued capital (at inception of company) = 2,300,000 $1 shares

• all sales and purchases were on credit

• market value of shares on 31 December 20X5 was $0.95

• there are accrued expenses of $2,976.

Required:

a Prepare the expected Income Statement and Balance Sheet for the year ended 31 December 20X5.

b Calculate the following for 20X5:

i rate of return on shareholders’ funds

ii price/earnings ratio

iii dividends per share

iv dividend yield.

Final check

Now that you have worked through the chapter, can you:

• identify and use sources of financial and non-financial data of listed New Zealand companies?

• calculate and explain ratios and percentages that measure effectiveness in:

— operating efficiency?

— financial structure?

— return on investment?

— for shareholder investment?

• discuss the quality of a company’s earnings, assets and working capital?

• prepare reports commenting on problems identified, remedies available and managerial performance?

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10 analysis and interpretation of financial statements · 2016. 2. 24. · analysis and...

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