Business analysis

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Business analysis

• Concepts
• 2008 revision

2
References

• Making the most of your tax accounts
• John Warrington Milk Development Council
• Financial Management Accounting
• Pauline Weetman Financial Times/Pitman
• Applied Farm Management
• J Turner and M Taylor BSP
• Business analysis with Excel
• Conrad Carlburg QUE
• Using your accounts
• Family Farm Series ATB
• Financial Management for Farmers and Rural
  Managers
• Martin F Warren Stanley Thornes
• Interpreting Company Reports and Accounts
• G. Holmes and A. Sugden Prentice Hall

3
Comparative analysis
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Comparative analysis
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Comparative analysis

• A comparison of results with other information
  sources
• Internal
• previous years accounts
• current budgets
• External
• Independent surveys

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Comparative analysis

• Comparison has to be on a like for like basis
• Farm Income
• debt free tenant farmer without salaried
  management
• Management and Investment Income
• Net Farm Income

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Management and Investment Income

• The reward for the farmers (and spouse)
  management and interest on the tenants capital
  employed on the farm

8
Management and Investment Income

• Overdraft interest
• Mortgage interest
• Management fee
• -
• Notional rent

Overdraft interest, Mortgage interest and
Management fee will have been included in
EXPENDITURE and are deductions which reduce
Profit. By adding them back to profit the
deduction is cancelled and has no effect on the
measure of output (MII).
Notional rent is an additional deduction to
convert all farms to a tenanted basis. This
allows for like for like comparisons Deducting
notional rent from profit reduces the measure of
output (MII).
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Management and Investment Income (example)
Includes 5 000 overdraft
100 000
80 000
20 000

• Overdraft interest
• Mortgage interest
• Management fee
• -
• Notional rent

5 000
25 000
10
Net Farm Income

• The return to farmer and spouse on tenant type
  capital for their labour and management
• Calculated as if all farms are tenanted

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Overhead costs NFI vs MII vs Profit
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Comparative analysis

• Gross Margins
• Gross margin per head (GM per hd)
• Gross margin per hectare (GM per ha)
• Overheads
• Overhead cost per hectare
• Overhead costs per 100 output
• Overhead costs as a proportion of gross margin

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Gross Margin per head to Gross Margin per hectare

• Gross Margin per head (/hd)
• X
• Stocking rate (no./ha)
• Gross Margin per hectare (/ha)

14
Proportional analysis

• Assessment of technical and financial efficiency
  of the business
• Costs are expressed as a of total output
• Commonly used for dairy herd analysis

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Proportional analysis example
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Unit cost of production

• Used when large proportion of output from one
  source
• Dairy production
• Output and costs divided by total litres produced
• Beef production
• Output and costs divided by total kg meat produced

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Unit cost of production (1)
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Reductionalist theory

• Break down results into individual components
• Allows physical and financial analysis to proceed

19
Sensitivity analysis

• Analyse effect of change (in advance) on
  enterprise profitability
• Sensitive items cause large changes e.g.
  commodity prices
• Insensitive items cause small changes e.g. vet
  and med, sundries

response
sensitivity
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Sensitivity analysis
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Sensitivity analysis example

• Cow yield 6000 litres
• Milk price 16 ppl
• 100 cows in herd
• Vet and Med 15 per cow
• Assess the effect of 10 change in milk price vs
  Vet and Med

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Sensitivity analysis change in margins

• Milk
• 10 x 16ppl x 6000 litres x 100 cows
• 9600
• Vet. and Med.
• 10 x 15 per hd x 100 cows
• 150

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Business analysis

• Methods

24
Quote
.published accounts are utterly and absolutely
useless.
Clive Jenkins Union Leader
25
Purpose of business analysis

• Identify strengths and weaknesses
• Is the business sustainable?
• Short term
• Cash flow, Operational requirements
• Long term
• Profitability, Equity

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Core analysis

• Profit
• Capital
• Cash

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Analysing profit
REVENUE
CLOSING VALUATION
PROFIT
EXPENDITURE
OPENING VALUATION
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Why does a business need a profit?

• Profit provides for-
• Personal drawings
• Taxation
• Repayment of borrowed money
• Replacement of machines
• Investment or expansion purposes

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Profit sufficiency

• Profit requirements are specific to a business
• A business with profit sufficiency provides
  adequate cover for personal and investment needs

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Profit sufficiency example
PROFIT
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Analysing Profit

• Have you a profit or a loss ?
• Is the profit sufficient ?
• Does profit cover private drawings ?
• How was the profit earned ?
• Are there extraordinary items ?

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Profit does not cover private drawings

• Private drawings and taxation
• Lifestyle?

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How was profit earned ?

• Sales
• Costs
• Valuations
• Depreciation
• Level of investment
• What are the main contributory elements?

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Sales example
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Analysis overall
A negative value would indicate a decrease in
sales
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Individual component analysis
Is this misleading?
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Proportional analysis of sales (Year 1)
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Proportional analysis of sales (Year 2)
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Sales and Costs

• Breakdown into physical and financial aspects
• How do they compare to last year?
• How do they compare to budget?
• How do they compare to others?
• What are the main contributory elements?

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Comparative time frame
current
accounts
budgets
more accurate
less accurate
more accurate
less accurate
41
Valuations

• Are they realistic?
• Retained or unsold livestock increase Closing
  Valuation and Profit
• Knock on effect for following year
• Valuations are an unsustainable source of profit

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Valuation as a source of Profit
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Depreciation and investment (1)

• Investing in machinery and buildings increases
  depreciation charge
• High depreciation costs indicate high levels of
  investment
• Low depreciation charges indicate low levels of
  investment

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Depreciation and investment (2)

• High depreciation could indicate over investment
• High depreciation could indicate compensatory
  investment
• Low depreciation might trigger compensatory
  investment in the future

45
Depreciation vs investment
46
Are there extraordinary items?

• Unexpected items of revenue
• Rare (windfall)
• Unexpected items of expenditure
• Common
• building repairs
• high replacement rate
• Labour
• Likely to increase with uncertainty in weather
  patterns

47
Analysing gross margins

• A measure of enterprise productivity
• Physical efficiency
• Financial efficiency

48
Relationship between Profit and Gross Margin
Enterprise Output
Gross Margin
Variable Costs
Profit
Other Enterprise Gross Margins
Fixed Costs (Overheads)
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Physical and Financial analysis

• Comparative
• Per ha
• Per 100 working capital
• Per 100 hours labour
• Published information

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Strengths of gross margins

• Simple to construct and use
• Useful tool for business planning
• Indicates inter enterprise strength and weakness

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Weaknesses of gross margins

• Does not produce profit figure
• Overheads excluded
• Gross margin must be interpreted in relation to
  overhead cost
• Profit is not proportional to gross margin
• Does not allow for compensatory or detrimental
  relationships between enterprises

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Profit is not proportional to gross margin
Lower Fixed Costs result in higher proportion of
Gross Margin as Profit
Higher Fixed Costs result in lower proportion of
Gross Margin as Profit
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Scatter graph analysis
HI
LO
INTENSIVE
Highly profitable business
Efficient business
HI
EXTENSIVE
Gross Margin per ha
Less efficient business
Loss making business
LO
Total Overhead costs per ha
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Dairy herds FBS 2003/04
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Constructing the breakeven line
Breakeven line where Gross MarginOverheads
(750,750)
(500,500)
Gross Margin per ha
(0,0)
Total Overhead costs per ha
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Zone of profitability
Breakeven line where Gross MarginOverheads
GM gtOverheads PROFIT
Overheads gtGM LOSS
Gross Margin per ha
Total Overhead costs per ha
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Breakeven does not usually pass through the
averages
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Coping with uncertainty

• Less values near the mean
• Greater proportion of distribution away from the
  mean
• Unpredictable behaviour of biological, physical
  and financial systems

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Analysing Capital

• Capital is a resource
• The balance sheet provides a snapshot of capital
  in a business
• Net worth is an indication of the size the
  business and the amount of resource available

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Establishing long term stability and viability

• The potential to survive adverse trading
  conditions
• Sufficient proprietor capital
• Potential to raise creditor finance
• Solvency
• Favourable equity ratios

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Establishing long term stability and viability (1)

• The ability of a business to meet its trading
  commitments on time
• Liquidity
• Capacity of the business to make an adequate
  return on capital employed
• Return on capital

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Establishing long term stability and viability (2)

• The ability of a business to generate sufficient
  profits that cover personal drawings, loan
  repayment, reinvestment and taxation.

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Solvency

• The first indicator of balance sheet strength
• Assets gt Liabilities

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Solvency (1)

• A solvent and profitable business might not be
  healthy
• Downturn in profits could erode low proprietor
  capital

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Ratio analysis

• Short term analysis
• Liquidity ratio
• Current ratio
• Equity ratios

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Ratio analysis

• Longer term analysis
• Liquidity ratio
• Current ratio
• Owner equity ratio
• Debt/Equity ratio

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Liquidity ratio

• The availability of cash in the near future i.e.
  can short term debts be covered without selling
  live or deadstock
• cash debtors creditors overdraft
• ideal ratio 1 1

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Current ratio

• Similar to Liquidity ratio. Can current
  liabilities be met without selling fixed assets
  or raising long term loans?
• Current assets Current liabilities
• ideal ratio 2 1

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Current ratio (1)

• Acceptable ratio dependent on composition of
  current assets
• A lower ratio may be acceptable if you have a
  high proportion of cash and debtors (i.e. liquid
  assets) in current assets as opposed to high
  proportion of growing crops or stock (i.e. less
  liquid assets)

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A lower Current ratio
?
?
Which is acceptable ?
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Current ratio (2)

• Low ratios may be acceptable if creditors are
  willing to wait for payment
• Large quantities of underutilized cash sitting in
  a bank account produce high ratios and indicate
  poor cash management

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Acid test

• Highlights liquidity of current assets
• Might explain low current ratio
• Identifies the ratio of very high liquid assets
  to current liabilities

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Acid test (1)
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Acid test (2)

• Which are the liquid assets?
• Some debtors excluded when extended credit
  operative
• Unused overdraft can be considered a liquid asset
• Guide ratio 11

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Factors that affect liquidity

-
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Working capital ratio

• Capital required to fund a production cycle
• Ratio gives indication of amount of additional WC
  required to fund increase in sales

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Working capital ratio (1)
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Working capital ratio example

• Current assets 110,000
• Current liabilities 60,000
• Sales 250,000 projected to increase by 75,000
• Calculate change in working capital

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Working capital example (1)
Every 100 of additional sales will require 20
additional working capital therefore increasing
sales by 75,000 increases working capital
requirement by 15,000
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Equity ratios

• The proportion of a proprietors equity in a
  business
• Exposure of a business to outside creditors
• Traditionally high in the land based sector

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Be careful with terms
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Equity ratios (1)

• Equity to total capital employed
• Owner equity ratio
• Equity to equity plus long term debt
• Equity to long term debt
• Gearing
• Total borrowing to equity
• Debt/equity ratio

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Owner equity ratio

• Proportion of capital supplied by the owner
• Can be expressed as a

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Owner equity ratio - example
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Equity to equity plus long term debt

• Proportion of long term capital supplied by the
  owner

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Gearing
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Gearing (1)

• Measure of the drain on resources by long term
  debt
• Normal lt25
• Critical 25-30
• Trouble ahead gt30

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Debt/Equity ratio
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Performance ratios

• A measure of the return on resource utilised by
  the business

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Return on Capital
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Return on Capital (1)
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You can manipulate numbers
WHICH ONE DO YOU CHOOSE ?
Profit 10 000 Assets100 000 Liabilities
20 000
10
12.5
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You can manipulate numbers AGAIN
WHICH ONE DO YOU CHOOSE ?
Profit 10 000 Assets100 000 Liabilities
50 000
10
20
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Interpretation of ratios

• Identify unusual information
• Identify reason for unusual information
• Identify trends
• Corroborate information by using other sources
• Use ratio analysis as a tool for creating
  questions (table 5.6 p70 Turner and Taylor)

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Limits of ratio analysis

• Ratios indicate trends away from expectation
• No two businesses are alike
• Ratios are not an answer they are a platform on
  which to ask more questions

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Business trends

• Deriving conclusions about the health of a
  business from a single balance sheet or TPLA are
  difficult
• Information is best from
• Studying a series of statements from the business
• Investigating trends between statement components

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References on ratio analysis

• Financial management for farmers and rural
  managers Martyn Warren Blackwell Science Chapter
  3 pp 28-41
• Applied Farm Management Turner and Taylor BSP
  Chapter 5 pp 52-78

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Rental equivalents

• The financial commitment of a business and the
  cost of owning or renting land

Rent and rates Overdraft interest Loan and
mortgage interest Capital repayments Hire
purchase and leasing charges
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Rental equivalent measures
From Applied Farm Management Turner and Taylor
p229-230
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Disposal of funds statement

• Traces flow of cash through business during year
• Monitor of changes in assets and liabilities
• Looks at sources and uses of cash

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Disposal (Flow) of Funds Statement
102
Sources of cash

• Trading activities
• Profits
• External sources
• Grants
• Increase in liabilities
• More overdraft/loan cash available
• Reduction in assets
• Realise asset into cash

103
Uses of cash

• Losses
• Loss of wealth
• External uses
• Removed from trading horizon
• Reduction in liabilities
• Pay off debt
• Increase in assets
• Make the business less liquid by investing

104
Using the disposal of funds statement

• Significant increases in liabilities
• Growth of fixed assets at expense of current
  assets
• Growth in fixed assets financed though short term
  liabilities
• Excessive private drawings

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Cash flow analysis

• Cash is the most sensitive financial indicator
• Warns of trading difficulties as they happen
• Indicator of business liquidity

106
Cash flow analysis
budget
actual good
time
actual bad
107
Cash flow analysis weak 1st 6 months
108
Cash flow analysis consistent cash flow
109
Cash flow analysis

• Inconsistent cash flow usually leads to increased
  interest charges and lower profits
• Limits ability to deal with uncertainty
• Limits capacity to plan capital spending

110
Variance analysis

• Measures discrepancies in cash flow between
  budgeted and actual
• It accounts for
• VOLUME (size of enterprise)
• OUTPUT (yield) or INPUT per unit volume
• PRICE per unit produced or consumed

111
Variance analysis (1)

• Favourable variance
• Increase in output
• Decrease in input
• Unfavourable variance
• Decrease in output
• Increase in input

112
Variance analysis (2)

• Two way
• PRICE vs INPUT/OUTPUT
• Three way
• PRICE vs INPUT/OUTPUT vs VOLUME

113
Two way analysis
/t

• Budget
• Cereal yield 8t/ha
• Cereal price 90/t
• Actual
• Cereal yield 9t/ha
• Cereal price 85/t

90
BUDGET
Unfavourable variance due to price
85
ACTUAL
Favourable variance due to quantity
t/ha
8
9
114
Two way analysis (1)

• Actual revenue 9t/ha x 85/t 765
• Budget revenue 8t/ha x 90/t 720
• Difference 45

115
Two way analysis (2)
Example
Total variance 45
116
Three way analysis
117
Three way analysis (1)

• Budget
• Cereal yield 8t/ha
• Cereal price 90/t
• Cereal area 22 ha
• Actual
• Cereal yield 9t/ha
• Cereal price 85/t
• Cereal area 25 ha

• Calculate the variance

118
Limits of variance analysis

• Time consuming and complicated
• OK if limit analysis to major items
• Not suitable for inter farm comparisons
• Formula is imprecise

119
Favourable price and quantity variance
price
Interaction price x quantity
ACTUAL
favourable variance due to price
BUDGET
favourable variance due to quantity
Attributed to price alone
quantity
120
Unfavourable price and quantity variance
price
Interaction price x quantity
BUDGET
unfavourable variance due to price
ACTUAL
unfavourable variance due to quantity
Attributed to quantity alone
quantity
121
Favourable quantity and unfavourable price
variance
Price variance diff price x budget quantity
price
Over estimation
BUDGET
Quantity variance diff quantity x actual price
ACTUAL
quantity
122
A health warning

• It is not always possible to calculate/construct
  every analysis technique.
• Calculated analyses are often in conflict with
  each other
• Interpretation is not always clear
• Always ask why and find an explanation
• Commonsense must prevail