ratio analysis – main strength ratios: direct the users focus of attention identify and highlight...
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Ratio Analysis – main strength
Ratios: direct the user’s focus of attention identify and highlight areas of good and bad
performance identify areas of significant change.
Compare like with like
Comparing current financial ratios with: financial ratios for a preceding period budgeted financial ratios for the current period financial ratios for other profit centres within the company financial ratios for other companies within the same sector.
Importance of uniformity
Comparison is possible only if there is Uniformity in the preparation of accounts An awareness of any differences in international
accounting policies.
Need to understand how ratios are defined
Implications of any given ratio requires a clear definition of its constituent parts. Definitions of ratios may vary from source to source e.g. concepts and terminology are not universally defined.
Awareness of underlying trends ROCE remains a constant 10% over the years 20X1–20X3 Net profit increased by 50% in both 20X2 and 20X3 This trend is not ascertainable in the ROCE ratio.
Return on
Net profit Capital employed capital employed
£ £
20X1 100,000 1,000,000 10%
20X2 150,000 1,500,000 10%
20X3 225,000 2,250,000 10%
Review of ratio analysis
• Six Primary ratios
– Investment ratios
– Operating ratios
– Liquidity ratios
2007 2006EBIT 1,230 1,889Shareholders' Funds 3,549 2,725Capital Employed 4,579 3,715Sales 7,435 7,156
Rolls Royce Group figures in £millions
Primary investment level ratios
Primary investment ratio (operating return on equity)
Earnings before interest and tax
Shareholders’ funds
2007 20061,230/3,549 1,889/2,7250.347 0.69334.7% 69.3%
Primary investment level ratios
• Primary financing ratio (Financial leverage multiplier)
Capital employed Shareholders’ funds
• Effect on profit of assets funded by other sources.
2007 20064,579/3,549 3,715/2,7251.290 1.363129% 136%
Primary operating level ratios
Return on capital employed
Earnings before interest and tax Capital employed
• No single definition of capital employed• Use for strategic planning.
2007 20061,230/4,579 1,889/3,7150.269 0.50826.9% 50.8%
Primary operating level ratios
Primary utilisation ratio (asset turnover)
Sales Capital employed
Sales increasing
Assets decreasing
• Fixed asset replaced?
• Inventory falling? 2007 20067,435/4,579 7,156/3,7151.624 1.926162.4% 192.6%
Can be based purely on assets
Primary operating level ratios
Primary efficiency ratio
Earnings before interest and taxSales
• Company pricing policy
• Type of industry
• High volume/low profits?2007 20061,230/7,435 1,889/7,1560.165 0.26416.5% 26.4%
Why Pyramid of ratios?
EBIT/Shareholders' funds = 0.347 = CE/Shareholders funds X EBIT/CE = 1.290 X 0.269 = 0.347 AND EBIT/CE = 0.269 = Sales/CE X EBIT/Sales = 1.624 X 0.165 = 0.269
0.347
1.290 X 0.269
1.624 X 0.165
Primary liquidity ratio
Current ratio
Current assets Current liabilities
Current ratio
What if Current ratio increases?
Growth: inventory buildup expecting sales growth Decline: inventory buildup result of falling sales Expansion: permanent increase in scale Inefficiency: poor control over working capital.
Subsidiary ratios
Gearing ratios (Financial Risk ratios)
Liquidity ratios
Asset utilization ratios (Efficiency ratios)
Investment ratios
Profitability ratios.
Subsidiary ratios – gearing
Subsidiary ratios – liquidity
Quick ratio – identify the company norm
The following is an extract from the 2003 Annual Report of Barloworld:
2003 2002 2001 2000 1999 1998 1997
Quick ratio 0.8 0.7 0.8 0.9 1.1 0.7 0.8
Subsidiary ratios – Investment
Earnings per share – usein strategic planning
The 2002 Annual Report of Gamma Holding NV states:
Gamma Holding aims to maximize shareholder value, taking into account the interests of the employees and other stakeholders in the company.
In doing so, Gamma Holding strives to offer its shareholders an attractive return based on continuous growth of earnings per share of an average 10% over a number of years whilst maintaining healthy balance sheet ratios and generating positive cash flows.
Furthermore, the company aims to achieve an average return on capital employed (including goodwill) of 15%.
PE – a measure of market confidence
Market price also takes into account anticipated changes in the earnings arising from their assessment of macro events such as
political factors, e.g. imposition of trade embargoes and sanctions
economic factors, e.g. the downturn in manufacturing activity company related events, e.g. possibility of organic or acquired
growth and the implication of financial indicators for future cash flow estimates.
VT Group plc P/E ratios
Market price & EPS in pence
2007 2006 2005 2004Market Price 491.50 451.50 317.00 262.00EPS 24.81 23.59 18.27 9.00
P/E ratio 19.81 19.14 17.35 29.11
PE ratio – implication of financial indicators
Balance sheet: change in debt/equity ratio in relation to prior periods new borrowings to finance expansion debt restructuring following inability to meet current repayment terms; adequacy of working capital low acid test (quick) ratio in relation to prior periods indicating liquidity
difficulties change in current ratio in relation to prior periods, i.e. higher
indicating a build-up of slow-moving inventory and lower possible inventory-outs
contingent liabilities that could be damaging if they crystallize non-current assets being increased or not being replaced.
PE ratio – implicationof financial indicators
Income statement: change in sales trend limited product range, products moving out of patent protection period expanding product range changes in technology beneficial or otherwise to company; high or low capital expenditure/depreciation ratio indicating that
productive capacity is not being maintained loss of key suppliers/customers, e.g. loss of longstanding Marks &
Spencer contracts change in ratio of R&D to sales
In short
Many factors can impact on P/E ratio. Overconfident management Over ambitious forecasts can impact on P/E
Capital Radio plc Example2000EPS = 26.3pMarket Price of Ordinary Shares at Balance Sheet date = £14.382001EPS = 23.8pMarket Price of Ordinary Shares at Balance Sheet date = £5.20P/E Ratio200014.38 / 0.263 = 54.7 times20015.20 / 0.238 = 21.8 times
Subsidiary ratios – asset utilization
7,435/4,206 = 1.77
7,435/7,253 = 1.03
7,435/2,499 = 2.98
6,003/2,203 = 2.72
7,435/889 = 8.36
6,003/778 = 7.72
Debtors (receivables) – note 12Creditors (payables) – note 15
Rolls Royce figures 2007 2006
1.98
0.99
2.63
3.02
8.28
8.51
Focussing on key industry ratios
Somerfield Stock & Cost of Sales Stock in Balance Sheet 2000 – 372.6 2001 – 329.9
Cost of Sales from P&L 2000 – 5415.5 2001 – 4523.5
Applying the ratios
2001 4523.5 = 13.7 times in the year 329.9 2000 5415.5 = 14.5 times in the year 372.6
Diagnosis? – what might be going wrong & why?
Prognosis
Stock availability
When basic items are not available on the shelves, it is frustrating for any shopper. For Kwik Save’s target market, who keep relatively small stocks at home, it is particularly frustrating and encourages them to shop elsewhere. We have sharply increased the availability of everyday and promotional items through improvements in distribution and stores’ internal replenishment procedures.
During October, we reappraised the frozen food lines that we stock, simplifying the offer to ensure high availability and good presentation for the most popular products. This worked well, and we are now applying the same principles elsewhere in the store – making ranges simpler and more disciplined while still providing the choice that today’s consumers require.
We are also increasing the focus on brands, taking Kwik Save back to its roots by offering the biggest brands at lowest prices.
To give customers a lower-cost choice we have been offering Somerfield own-label products, but this has confused many customers. We are phasing this policy out, replacing all Somerfield lines with value alternatives by this Autumn.
Prognosis
Investing behind the scenes We are investing in our IT and distribution systems to achieve higher
availability and service to stores at lower cost.
Our IT strategy is to simplify and clarify our systems – focusing investment initially on updating our distribution and Kwik Save store systems. By June this year, all Kwik Save units were linked into our store IT system.
During the year we opened a completely rebuilt and enlarged distribution depot near York. The depot is over 500,000 sq ft in size and handles ambient, chilled and frozen products. It is operated by an outsourced logistics specialist. The new year will see the increasing use of multi-temperature vehicles, significantly increasing both depot and store productivity. In the South West we outsourced some of our logistics operations, ensuring that staff transferred to the outsourcing organisations on equivalent terms.
Did it work?
Calculating ratios for the next 2 years
2002 report – 13.9 times per year 2003 report – 15.6 times per year
Moral:
Identify ratios important to your industry.
Ensure they do not deteriorate.
If they do – It will be noticed!
Subsidiary ratios – profitability
Industry specific metrics
To remain competitive you will need to continually re-invest in R&D and Product Development
For high tech businesses the spend range is between 5% and 10% of revenues
Early on you will be much closer to 10% This is why you need healthy gross margins
R&D spending
R&D as percentage of Sales
0.00
5.00
10.00
15.00
20.00
25.00
2003 2004 2005 2006 2007
Percentage
BAE
Meggitt
RR
VT
Smiths
2003 2004 2005 2006 2007BAE 20.42 18.91 13.15 10.12 10.20Meggitt 4.97 5.78 3.86 8.59 7.97RR 4.98 4.85 4.27 5.17 5.12VT 0.40 0.21 0.14 0.15 0.04Smiths 4.24 5.00 4.76 3.08 2.42
Impact on Profit margins?
Profit Margins
-5.00
0.00
5.00
10.00
15.00
20.00
25.00
2003 2004 2005 2006 2007
Per
cen
tag
e
BAE
Meggitt
RR
VT
Smiths
2003 2004 2005 2006 2007BAE 2.78 -2.55 6.32 6.97 8.63Meggitt 10.44 11.81 14.30 19.39 12.00RR 3.19 5.15 7.22 19.44 9.86VT 2.42 4.87 7.12 7.82 6.31Smiths 7.11 10.98 10.27 3.76 11.85
Segmental AnalysisImplication for future cash flows
Illustration from Royal Ten Cate NV
Implication for future cash flows
• Illustration from Royal Ten Cate NV (contd.)
RevenuesOperating resultReturn oncapital employed (%)
Segmental analysis – geographical segments
Factors to consider
Political conditions Economic conditions Exchange control regulations Currency risks.
Implication for share valuation
Different risks
Problems for conglomerates
Differential PE for different segments.
Selected share movement
Share Price Movement
0100200300400500600700800
Dat
e
30/0
9/20
04
31/0
1/20
05
31/0
5/20
05
30/0
9/20
05
31/0
1/20
06
31/0
5/20
06
29/0
9/20
06
31/0
1/20
07
30/0
5/20
07
28/0
9/20
07
31/0
1/20
08
30/0
5/20
08
Pen
ce
BAE
Meggitt
RR
VT
Implication for share valuation
Non-financial ratios
Operational statistics
Trend Analysis
Consideration will be given to the following: Horizontal analysis between two periods Trend analysis over a series of periods Historical summaries Vertical analysis – common size statements.
Horizontal analysis
Trend Analysis
Trend analysis series of periods
Trend Analysis
Vertical analysis – Income Statement
Vertical analysis – Balance Sheet
Multivariate analysis – Altman’s Z-score
Less than 1.8: Bankruptcy risk is highBetween 1.8 and 2.7: Bankruptcy risk is fairBetween 2.7 and 3.0: Bankruptcy risk is possible, but
not likely in the near-futureHigher than 3.0: Bankruptcy risk is low
Tesco Group plc
Application of Altman’s Z Score Z-Score Data
£millions(A) PBIT 2,869(B) Total Assets 24,807(C) Net Sales 42,641(D) MV of Equity (shares X MV) 35,445(E) Total Liabilities 14,301(F) Working Capital -3,576(G) Retained Earnings 5,693
Note: No of shares at 2007 = 7,947,349,558
A/B X 3.3 0.382C/B X 0.999 1.717D/E X 0.6 1.487F/B X 1.2 -0.173G/B X 1.4 0.321
Z Score = 3.734
Bankruptcy risk is LOW
Who’d have predicted that!