Ratios

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Ratios Trend Analysis

• Week 7
• MN20018

2
Accounting ratios and ratio analysis

• Six key ratios
• Pyramid of ratios
• Other important ratios

3
Ratio Analysis

• Application of pyramid of ratios
• Segmental analysis
• Inter-firm comparisons and industry averages
• Non-financial ratios
• Interpretation problems when using consolidated
  financial statements.

4
Ratio Analysis main strength

• Ratios
• direct the users focus of attention
• identify and highlight areas of good and bad
  performance
• identify areas of significant change.

5
Caveat

• Beware creative accounting
• View that
• Every company in the country is fiddling its
  profits.
• Myth that the financial statements are an
  accurate reflection of the companys trading
  performance for the year.
• Accounts are little more than an indication of
  the broad trend

6
Compare like with like

• Comparing current financial ratios with
• financial ratios for a preceding period
• budgeted financial ratios for the current period
• financial ratios for other profit centres within
  the company
• financial ratios for other companies within the
  same sector

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Importance of uniformity

• Comparison is possible only if there is
• Uniformity in the preparation of accounts and
• An awareness of any differences in international
  accounting policies

8
How are ratios are defined?

• Implications of any given ratio requires a clear
  definition of its constituent parts.
• Definitions of ratios may vary from source to
  source e.g. concepts and terminology are not
  universally defined.

9
Awareness of underlying trends

• ROCE remains a constant 10 over the years
  20X120X3
• 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
10
Review Ratio Analysis

• Six Primary ratios
• Investment ratios
• Operating ratios
• Liquidity ratios

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Primary investment level ratios
Primary investment ratio
Earnings before interest and tax
Shareholders funds
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Primary investment level ratios

• Primary financing ratio
• Capital employed
• Shareholders funds
• Financial leverage multiplier
• Effect on profit of assets funded by other sources

13
Primary operating level ratios

• Return on capital employed
• Earnings before interest and tax
• Capital employed
• No single definition of capital employed
• Use for strategic planning

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ROCE target VIAG AG

• VIAG made excellent progress in 1998 towards
  reaching its stated profitability goal.
• Return on capital employed increased
  significantly from 6.5 in 1997 to 7.0 in 1998.
  
• The goal is to increase the Groups return on
  capital employed to at least 10 by the year
  2003.
• The target figures we have adopted are based on
  our own experience and on the results of our
  leading competitors.

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ROCE definition not uniform

• Capital employed is defined on the basis of very
  restrictive criteria, as evidenced by the fact
  that Bayernwerks accruals for decommissioning
  are included in the capital employed totalling
  DM59.5 billion.
• We are legally obliged to establish these
  accruals for decommissioning expenses, which
  account for 20 of capital employed.
• Consequently, VIAGs return on equity and capital
  costs tend to be lower than those of other
  industrial corporations.

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Primary operating level ratios

• Primary utilisation ratio (asset turnover)
• Sales Capital
  employed
• Sales increasing
• Assets decreasing
• Fixed asset replaced?
• Inventory falling?

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Primary operating level ratios

• Primary efficiency ratio
• Earnings before interest and tax
• Sales
• Company pricing policy
• Type of industry
• High volume/low profits?

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Primary liquidity ratio

• Current ratio
• Current assets
• Current liabilities

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Current ratio

• What if Current ratio increases?
• Growth Inventory buildup expecting sales growth
• Decline Inventory buildup result of falling
  sales
• Expansion Permanent increase in scale
• Inefficiency Poor control over working capital

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Subsidiary ratios

• Gearing ratios
• Liquidity ratios
• Asset utilisation ratios
• Investment ratios
• Profitability ratios

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Subsidiary ratios Gearing
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Subsidiary ratios Liquidity
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Quick ratio identify the company norm

• The following is an extract from the 2003 Annual
  Report of Barloworld
• 2003 2002 2001 2000 1999 1998 1997
• Quick ratio 0.8 0.7 0.8 0.9 1.1 0.7 0.8

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Subsidiary ratios Investment
25
Earnings per share use in strategic planning

• The 2002 Annual Report of Gamma Holding NV
  states
• Gamma Holding aims to maximise shareholder value,
  taking into account the interests of the
  employees and other stakeholders in the company.
• In doing so, Gamma Holding strives to offer its
  shareholders an attractive return based on
  continuous growth of earnings per share of an
  average 10 over a number of years whilst
  maintaining healthy balance sheet ratios and
  generating positive cash flows.
• Furthermore, the company aims to achieve an
  average return on capital employed (including
  goodwill) of 15.

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PE a measure of market confidence

• Market price also takes into account anticipated
  changes in the earnings arising from their
  assessment of macro events such as
• political factors, e.g. imposition of trade
  embargoes and sanctions
• economic factors, e.g. the downturn in
  manufacturing activity
• companyrelated events, e.g. possibility of
  organic or acquired growth and the implication of
  financial indicators for future cash flow
  estimates

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PE ratio implication of financial indicators

• Balance sheet
• change in debt/equity ratio in relation to prior
  periods
• new borrowings to finance expansion
• debt restructuring following inability to meet
  current repayment terms
• adequacy of working capital
• low acid test (quick) ratio in relation to prior
  periods indicating liquidity difficulties
• change in current ratio in relation to prior
  periods, i.e. higher indicating a build-up of
  slow-moving inventory and lower possible
  inventory-outs
• contingent liabilities that could be damaging if
  they crystallise non-current assets being
  increased or not being replaced

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PE ratio implication of financial indicators

• Income statement
• change in sales trend
• limited product range, products moving out of
  patent protection period
• expanding product range
• changes in technology beneficial or otherwise to
  company
• high or low capital expenditure/depreciation
  ratio indicating that productive capacity is not
  being maintained
• loss of key suppliers/customers, e.g. loss of
  longstanding Marks Spencer contracts
• change in ratio of RD to sales

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Subsidiary ratios Asset utilisation
30
Subsidiary ratios Profitability
31
Segmental Analysis

• Important for inter-period comparison
• Quality of earnings
• Specific risks
• Possible long-term growth prospects
• Inter-company difficulties
• Determination of segments
• Allocation of costs

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Segmental Analysis Business segments

• Factors to consider
• Nature of products
• Nature of production processes
• Class of customer
• Distribution methods

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Implication for future cash flows

• Illustration from Royal Ten Cate NV

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Implication for future cash flows
Revenues Operating result Return on capital
employed

• Illustration from Royal Ten Cate NV (cont)

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Segmental Analysis Geographical segments

• Factors to consider
• Political conditions
• Economic conditions
• Exchange control regulations
• Currency risks

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Reportable segment criteria

• Majority of sales to external customers
• AND
• External sales 10 or more of total sales
• OR
• Assets 10 or more of total assets
• Profit or loss 10 or more of total profit or
  loss

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Implication for share valuation

• Different risks
• Problems for conglomerates
• Differential PE for different segments

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Ratios from FAME

• Turnover Profit margin
• Allied Domecq 4,308,000 10.56
• Pubmaster 58,430 9.73
• Lower quartile 9.8
• Median 10.6
• Upper quartile 11.4

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Non-financial ratios

• Operational statistics

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Trend Analysis

• Horizontal analysis between two periods
• Trend analysis over a series of periods
• Historical summaries
• Vertical analysis common size statements

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Trend Analysis

• Multivariate analysis Z-scores
• H-scores
• A-scores
• Balanced scorecards
• Valuing shares of an unquoted company
  quantitative process
• Valuing shares of an unquoted company
  qualitative process
• Shareholder value analysis
• Financial reporting and risk

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Trend Analysis

• Horizontal analysis

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Trend Analysis

• Trend analysis series of periods

44
Vertical analysis Income statement
45
Vertical analysis Balance Sheet
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Multivariate analysis

• Single value score
• Benchmark criteria applied to this score
• Combination of ratios e.g.
• Working capital/Total assets
• Sales/Total assets
• Weighted for predictive capability e.g.
• Working capital/Total assets Weight 0.012
• Sales/Total assets Weight 0.999

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Multivariate analysis types of scores

• Z-scores
• Altmans Z-scores
• Tafflers Z-scores
• PAS-score
• A-scores

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Balanced scorecards Four perspectives

• Financial perspective
• Customer perspective
• Internal business perspective
• Innovation and learning perspective

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Financial perspective

• How do shareholders see us?
• Return on capital employed
• Cash flows
• Project profitability

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Customer perspective

• How do customers see us?
• Price
• Quality
• Guaranteed supply

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Innovation and learning perspective

• How well will we compete?
• Staff morale
• New business from innovation

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Internal business perspective

• What do we need to be best at?
• Presenting to potential customers
• Tendering success rate

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Valuing shares of unquoted company quantitative

• Maintainable income
• Extrapolate from past five years
• Yields required
• Required earnings yield majority holding
• Required dividend yield minority holding
• Adjustment for adverse factors
• lack of marketability
• High gearing
• Calculate Economic value and NRV

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Valuing shares of unquoted company qualitative

• Factors to consider
• Management change
• Revenue investment
• Inflation rate
• Competitive pressures

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Shareholder Value Analysis

• Growing interest
• Accounting measures (EPS) not related to share
  value
• Linkage with executive remuneration

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Shareholder Value Analysis annual reports
57
Economic Value Added (EVA)
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EVA make operational
Geveke av Amsterdam extract from 1999 Annual
Report
59
EVA achieving increases

• Increase NOPAT
• Reduce WACC
• Improve utilisation of capital

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Financial reporting of risk

• Effect of information on risk management
• Reduces cost of capital
• Improves accountability
• Improves investor protection
• Assists in making informed predictions

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Professional risk assessors

• Companies are given a rating that can range from
  AAA for companies with a strong capacity to meet
  their financial commitments
• down to D for companies that have been unable to
  make contractual payments or have filed for
  bankruptcy
• with more than ten ratings in between, e.g. BBB
  for companies that have adequate capacity but
  which are vulnerable to internal or external
  economic changes.

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How ratings are set

• Internal company factors may include
• an appraisal of the financial reports to
  determine
• trading performance, e.g. specific financial
  targets such as return on equity and return on
  assets earnings volatility past and projected
  performance how well a company has coped with
  business cycles
• cash flow adequacy, e.g. EBITDA interest cover
  EBIT interest cover free operating cash flow
• capital structure, e.g. gearing ratio debt
  structure implications of off balance sheet
  financing

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How ratings are set internal factors

• a consideration of the notes to the accounts to
  determine possible adverse implications, e.g.
  contingent liabilities, heavy capital investment
  commitments which may impact on future
  profitability, liquidity and funding
  requirements
• meetings and discussions with management
• monitoring expectation, e.g. against quarterly
  reports, company press releases, profit warnings
• monitoring changes in company strategy, e.g.
  changes to funding structure with company buyback
  of shares, new divestment or acquisition plans
  and implications for any debt covenants.

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How ratings are set external factors

• External factors may include
• growth prospects, e.g. trends in industry sector
  technology possible changes peer comparison
• capital requirements, e.g. whether company is
  fixed capital or working capital intensive
  future tangible fixed asset requirements RD
  spending requirements
• competitors, e.g. the major domestic and foreign
  competitors product differentiation what
  barriers there are to entry

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How ratings are set external factors (cont)

• Keeping a watching brief on macroeconomic
  factors, e.g. environmental statutory levies, tax
  changes, political changes such as restrictions
  on the supply of oil, foreign currency risks
• Monitoring changes in company strategy, e.g.
  implication of a company embarking on a heavy
  overseas acquisition programme which changes the
  risk profile, e.g. difficulty in management
  control and in achieving synergies, increased
  foreign exchange exposure.