Test of Professional Skills

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1 Test of Professional Skills Pre-Course Study Advanced Finance 2015 The following material must be covered before classes start: Module 10 Analysis of Financial Statements Module 11 Raising Finance CA Education uniquely trains and examines all students of ICAS.

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3 TPS Advanced Finance Module 10 Module 10 Analysis of Financial Statements 1 Copyright ICAS 2015 Analysis of Financial Statements Assumed knowledge or revision area Concentrate on relationships between ratios Usually one third of allotted marks are for calculation while two thirds are for interpretation 2 Copyright ICAS 2015 Analysis of Financial Statements Ratio analysis can help identify the main issues in respect of the profitability, liquidity, efficiency and risk of the organisation No accounting standards on the subject You can calculate any ratios you want to You must be consistent and you must compare like with like Different stakeholders will be interested in different ratios 3 Copyright ICAS

4 TPS Advanced Finance Module 10 Chinette Ltd Statement of profit and loss Statement of financial position Notes AFIN used only IFRS formats and terminology. Summary of different terminology included in Appendix 1. 4 Copyright ICAS 2015 Profitability Ratios Return on capital employed Return on equity Net profit margin Asset turnover Gross margin 5 Copyright ICAS 2015 Return on Capital Employed ( ROCE ) Profit before finance costs and tax ( PBIT ) x 100% Capital Employed ROCE gives an indication as to how efficient the organisation is at generating profits from its capital. Also known as primary ratio. 6 Copyright ICAS

5 TPS Advanced Finance Module 10 Potential Problems 1. Different definitions - capital employed refers to the funds provided by shareholders, long-term lenders and minority interests. We will use: Capital employed = total assets less current liabilities 2. Sensitive to the valuation of the organisation s non-current assets 3. Bank overdrafts include in non-current liabilities if used as long-term finance. 7 Copyright ICAS 2015 ROCE of Chinette 20X x 100 2,243 1,701 20X4 x 100 =33% =32% ROCE well above commercial borrowing rates. 8 Copyright ICAS 2015 Return on Equity Profit for the period x 100% Total equity 9 Copyright ICAS

6 TPS Advanced Finance Module 10 Return on Equity of Chinette 20X x 100 1,974 1,431 20X4 x 100 =28% =29% To determine whether this ratio is as healthy as it appears it would be necessary to compare the above percentages with the equivalent for competitors and the industry average. 10 Copyright ICAS 2015 ROCE breakdown Net Profit Margin Profit before finance costs and tax ( PBIT ) x 100% Revenue Considers PBIT as a percentage of revenue Asset Turnover Revenue Capital Employed Provides information about the efficiency of the company at generating revenue from its capital. 11 Copyright ICAS 2015 ROCE breakdown These two ratios together make up ROCE: ROCE = Net profit margin x Asset Turnover PBIT x 100 = PBIT x 100 x Revenue Capital employed Revenue Capital employed 12 Copyright ICAS

7 TPS Advanced Finance Module 10 Interpretation of ROCE Company X Company Y Capital employed Revenue PBIT ROCE 50% 50% Net profit margin 10% 25% Asset turnover 5 2 Although X has a lower profit margin than Y, X uses its assets more efficiently. Y will make a greater profit per item sold but will sell fewer goods during the year. 13 Copyright ICAS 2015 Net Profit Margin of Chinette 20X x 100 6,200 5,800 20X4 x 100 =12% =9% Asset Turnover of Chinette 20X5 20X4 6,200 5,800 2,243 1,701 =2.8 = Copyright ICAS 2015 Gross Margin Gross Profit x 100% Revenue Measures the ability of the business to sell goods for more than they cost to make Expect this ratio to remain fairly stable over time and for competitors to show similar gross margins. 15 Copyright ICAS

8 TPS Advanced Finance Module 10 Gross Margin of Chinette 20X5 1,400 1,200 x 100 6,200 5,800 20X4 x 100 =23% =21% Gross margin of Chinette has improved by nearly 10% An explanation of this increase would probably be referred to in either the operating and financial review or the Chairman s statement. 16 Copyright ICAS 2015 Liquidity Ratios Current ratio Quick ratio 17 Copyright ICAS 2015 Current Ratio Current assets Current liabilities Assesses the organisation s ability to meet its short-term debts Important to consider the trend of the ratio over time If continually falling this could mean that the company is, in the worst case, heading for insolvency 18 Copyright ICAS

9 TPS Advanced Finance Module 10 Current ratio of Chinette 20X5 20X4 *2,183 *2,097 1,585 1,790 =1.4 =1.2 * Excludes the trade receivables due after one year. Current ratio of Chinette appears reasonable Increase in the ratio however hides the fact that Chinette has considerably less cash this year than last year as apparent from the balance sheet 19 Copyright ICAS 2015 Quick Ratio Current assets inventory Current liabilities Also known as the acid test ; and Inventory is excluded as it is not always considered liquid. Quick Ratio of Chinette 20X5 20X4 1,783 1,747 1,585 1, Copyright ICAS 2015 Management / Activity Ratios Designed to provide information about the efficiency of management at controlling elements of an organisation s working capital. For example: days trade receivables days trade payables inventory turnover or days inventory 21 Copyright ICAS

10 TPS Advanced Finance Module 10 Days Trade Receivables Trade receivables x 365 Credit sales Measures the effectiveness of the business in collecting its debts Caution re VAT Trend important if the ratio is seen to be continually increasing over time this could indicate problems with credit control and bad debts Compare to credit terms offered to customers. 22 Copyright ICAS 2015 Days Trade Receivables of Chinette 20X5 *1,615 *1,617 x 365 **7,440 **6,960 20X4 x days 85 days * Including trade receivables due after one year. ** grossing up sales to include VAT. 23 Copyright ICAS 2015 Useful Calculation How much cash could be released if days trade receivables were reduced, that is, if Chinette reduced their days trade receivables from 79 days to 60 days. 1. take year end trade receivables balance of 1, divide by 79 (= value of 1 days worth of trade receivables) 3. multiply by 19 (= value of 19 days worth of trade receivables) 1,615 x 19 = Thus Chinette could free up approximately 388,000 if they reduce days trade receivables to Copyright ICAS

11 TPS Advanced Finance Module 10 Days Trade Payables Trade payables x 365 Credit purchases and overheads* * Cost of sales often used as denominator. A steady increase in the ratio may highlight the fact that the company is making better use of interest free credit or it could be because the organisation has no cash with which to pay its supplier. Compare to credit terms offered by suppliers. 25 Copyright ICAS 2015 Days Trade Payables of Chinette 20X5 1,200 1,090 x 365 *5,760 *5,520 20X4 x days 72 days * Grossed up cost of sales to include VAT. Chinette are taking longer to collect debts than to pay their own debts and thus Chinette is a net provider of funds. 26 Copyright ICAS 2015 Inventory Turnover Cost of sales Inventory This ratio calculates an approximation of the number of times inventory was sold during the year. Days inventory which calculates the number of days inventory is held for, is essentially the inverse of the above: Inventory x 365 Cost of Sales Adding together the number of days receivables and days inventory you should get a rough idea of the length of time it takes the organisation to convert inventory into cash. 27 Copyright ICAS

12 TPS Advanced Finance Module 10 Inventory Turnover of Chinette 20X5 20X4 4,800 4, times 13 times Again the effect of inventory turnover increasing by 1 could be quantified. That is: 4,800 = Therefore, inventory would be 369k as opposed to 400k if inventory turnover had been in line with the previous year. 28 Copyright ICAS 2015 Risk Ratios Gearing Ratio [Long-term debt + preference shares] x 100 Total equity OR [Long-term debt + preference shares] x 100 Capital employed 29 Copyright ICAS 2015 Gearing Ratio of Chinette 20X x 100 1,973 1,431 20X4 x % 19% 30 Copyright ICAS

13 TPS Advanced Finance Module 10 Debt Ratio Total debt x 100% Total assets As a very general rule 50% is thought to be an acceptable level in the UK. A debt ratio of 50% is essentially saying that half the assets of the organisation have been financed by debt. 20X5 1,855 2,060 x 100 3,828 3,491 20X4 x % 59% 31 Copyright ICAS 2015 Interest Cover PBIT Interest charges* * Use interest charges and not net finance costs. Interest Cover for Chinette 20X5 20X times 13.8 times 32 Copyright ICAS 2015 Conclusions Chinette is a fairly healthy company. Shareholders are getting a good return on their investment Profitability is strong and improving and consequently, as the company has relatively little long-term debt, it can afford the interest payments comfortably Working capital is an area for concern. In particular days receivables appear high and given the level of days payable Chinette is a net provider of funds. 33 Copyright ICAS

14 TPS Advanced Finance Module 10 Other Ratios Potential shareholders are interested in: The security of any investment The return of that investment Use other ratios to evaluate investments. 34 Copyright ICAS 2015 Earnings per Share Earnings per share is traditionally calculated as: Profit attributable to ordinary shareholders Number of ordinary shares in issue Complications when new shares are issued, when other financing tools, such as debentures, are converted, etc. 35 Copyright ICAS 2015 PE Ratio Share price Earnings per share Shows how many times the earnings per share an investor is prepared to pay to buy a share. Useful to compare across different companies. Inverse of PE ratio = earnings yield 36 Copyright ICAS

15 TPS Advanced Finance Module 10 Dividend Cover A measure of how many times the dividends actually paid out divide into the profits that could have been paid out: Profits available to ordinary shareholders Dividends paid Important indicator for a potential investor Shows what size of dividend an investor might expect to receive Indicates how far earnings would have to fall before the dividend paid out by the company would be reduced 37 Copyright ICAS 2015 Debt Provider Ratios Asset cover Compares the amount that could be raised from a forced sale of the company s assets with the amount to be lent by the bank. Cash flow cover Cash flow cover ratio compares the net cash flow to the interest and principal repayments. Banks would look for both ratios to be greater than Copyright ICAS 2015 Sources of Ratios Industry comparisons can be sourced from: Financial Times Financial Analysis Made Easy (on CD Rom at libraries) Dun & Bradstreet Extel Internet It is VITAL that you know the bases for these calculations before you use them in order to check that you are comparing like with like. 39 Copyright ICAS

16 TPS Advanced Finance Module 10 Indicators of Financial Distress Ratio analysis Ratio analysis is often used to determine whether the financial performance of a company indicates any potential financial distress issues. Other relevant pieces of information - Management - Audit report - Employees - Directors remuneration - Loans - Provision for liabilities and charges - Intangible assets and revaluation reserve 40 Copyright ICAS 2015 Z-Score The Altman Z-Score is calculated as follows: Z = 1.2(net working capital / total assets) + 1.4(retained earnings / total assets) + 3.3(profit before interest and tax / total assets) + 0.6(market capitalisation / total liabilities) + 1.0(revenue/ total assets) On formula sheet. Sign of health = >3, possible signs of distress = <3 41 Copyright ICAS 2015 A-Score Makes use of a list of questions which have associated scores If the company scores more than 25 it could be heading for failure A-Score questions are divided into three sections concerned with defects, mistakes and symptoms 42 Copyright ICAS

17 Contents ANALYSIS OF FINANCIAL STATEMENTS 10.1 INTRODUCTION LEARNING OBJECTIVES THE PURPOSE OF RATIO ANALYSIS PROFITABILITY RATIOS Return on Capital Employed ( ROCE ) Return on Equity ( ROE ) Net Profit Margin and Asset Turnover Gross Margin LIQUIDITY RATIOS Current Ratio Quick Ratio MANAGEMENT/ACTIVITY RATIOS Days trade receivables Days trade payables Inventory Turnover CAPITAL RISK RATIOS Gearing Ratio Debt Ratio Interest Cover Summary of Chinette s Ratio Analysis OTHER RATIOS Shareholder Ratios Earnings Per Share PE Ratio Debt Provider Ratios Other Sources of Ratios LIMITATIONS OF RATIO ANALYSIS INDICATORS OF FINANCIAL DISTRESS Ratio Analysis Z-Score A-Score SUMMARY AND REVIEW Appendix ICAS 2015

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19 ANALYSIS OF FINANCIAL STATEMENTS Notes 10.1 INTRODUCTION Students should already be familiar with the financial analysis either from their degree or from the Test of Competence Finance course. In this module, although a lot of the material will be revision, the emphasis will be on the interpretation of ratios. The calculation of ratios is relatively straightforward, but their interpretation can be quite difficult and therefore in exams, more marks are usually awarded for interpretation rather than the calculation of the ratios. Completion of this module in conjunction with Modules 4 and 5, 8, 9, 19 and 20 achieves learning outcome 1 of the syllabus to evaluate the plans, actions and financial position of clients. Note that during this course only IFRS compliant financial statement formats will be used. A summary of some of the differences in the terminology that can be used is included in Appendix LEARNING OBJECTIVES On completion of this module you should be able to: 1. calculate ratios based a set of financial statements; 2. select ratios that would be of interest to particular stakeholders in a business; 3. evaluate accounting ratios; and 4. consider the indicators of financial distress THE PURPOSE OF RATIO ANALYSIS The financial statements of an organisation can provide a lot of financial information that is difficult to interpret. The statement of profit or loss may show an increase in pre-tax profits over the last year but this does not necessarily mean that the organisation is making optimum use of its capital base. Ratio analysis has the following uses: to review the performance of an organisation over time (common size analysis); to compare the performance of the organisation with specific competitors; to compare the performance of the organisation with published industry averages; to use the analysis of past performance to help forecast future performance; and to highlight problems in a company and recommend corrective action. TPS Advanced Finance Module 10 3

20 Notes A common factor in the above list is that ratios are used for the purpose of comparison. This means that you must have a benchmark with which to compare the calculated ratios. This benchmark could be: ratios calculated from previous years financial statements; industry average ratios; ratios calculated from the financial statements of competitors; and expected values based on the common sense and experience of the analyst. Ratio analysis is a useful tool for any of the stakeholders in an organisation. A supplier will want to ensure that its new customer can pay for goods, so will be interested in the liquidity of the business. Potential shareholders will be interested in the efficiency of the organisation at generating profits as they will want to ensure that their investment in the organisation provides a better return than that of a bank deposit. Lenders and shareholders will be interested in the risk of the organisation to assess the security of their investment. Management will obviously be interested in all aspects but may be particularly interested in the ratios that highlight the efficiency of the business. We can group the accounting ratios into four categories: profitability ratios; liquidity ratios; management or activity ratios; and risk ratios. To illustrate the calculation and interpretation of the ratios an extract from the draft accounts of Chinette Ltd ( Chinette ) will be used. Chinette is a company that makes luxury confectionery. Chinette Ltd Statement of profit or loss for the year ended 30 June 20X5 20X5 20X4 Note Revenue 6,200 5,800 Cost of sales (4,800) (4,600) Gross profit 1,400 1,200 Administration expenses (668) (650) Operating profit Net finance costs 1 (45) (30) Profit before tax Tax expense (144) (109) Profit for the period TPS Advanced Finance Module 10

21 A dividend of 41,000 was declared in 20X5. Notes Chinette Ltd Statement of financial position as at 30 June 20X5 20X5 20X4 Note Assets Non-current assets Intangible assets Property, plant and equipment 1,400 1,100 1,600 1,300 Current assets Inventories Trade receivables 2 1,825 1,721 Cash and cash equivalents ,228 2,191 Total assets 3,828 3,491 Equity and liabilities Equity attributable to equity holders Share capital Share premium Retained earnings 1, Total equity 1,973 1,431 Non-current liabilities 12% Debentures 20X Current liabilities Trade payables 1,200 1,090 Other payables ,585 1,790 Total liabilities 1,855 2,060 Total equity and liabilities 3,828 3,491 Notes to the Accounts 1. Finance costs Payable on bank overdrafts and other loans Payable on debenture stock Receivable on short-term deposits (2) (10) TPS Advanced Finance Module 10 5

22 Notes 2. Trade Receivables 20X X4 000 Amounts falling due within one year: Trade receivables 1,590 1,537 Prepayments and accrued income ,780 1,627 Amounts falling due after one year: Trade receivables Prepayments Total 1,825 1,721 When analysing the financial performance of organisations it is often necessary to make use of the notes to the accounts as well as the statement of profit or loss and the statement of financial position. One approach to analysing company performance is to perform a line-by-line comparison of the accounts with those of the previous year. This is sometimes called common size analysis. However, ratios provide a useful means of relating individual items in the financial statements to each other. Ratios will give a better analysis if the numbers used in their calculation are meaningful, for example, days trade receivables should only include trade receivables. There are no agreed definitions for any of the ratios. No accounting standards have ever been published on the subject. If you refer to text books on ratio analysis you may find different definitions for ratios of the same name. The important issue is to ensure that when calculating ratios you are consistent, and when comparing ratios you are comparing like with like and that the ratio is relevant. Note, in exam questions usually one third of the allocated marks are for the calculation of ratios, while two thirds of the marks are for interpretation PROFITABILITY RATIOS The most commonly calculated ratios that consider the profitability of organisations are: return on capital employed; return on equity; net profit margin; asset turnover; and gross margin. 6 TPS Advanced Finance Module 10

23 These ratios are designed to give an indication of the efficiency of the company at generating profits or revenue from available resources. Notes Return on Capital Employed ( ROCE ) Profit before finance costs and tax (PBIT) x 100% Capital employed Sometimes known as the primary ratio, this ratio measures the return made by the organisation from the amount of available capital. ROCE gives an indication as to how efficient the organisation is at generating profits from its capital. PBIT is also known as operating profit. Capital employed refers to the funds provided by shareholders, long-term lenders and minority interests. Note therefore, that capital employed is equal to total assets less current liabilities. One major problem with ROCE is that it is particularly sensitive to the valuation of noncurrent assets. A company can appear to have a very high ROCE but this may be due to the fact that its non-current assets are recorded at original cost on the statement of financial position. By revaluing these assets to their higher market value then the ROCE will automatically fall. When comparing ROCE s of different companies it is essential to adjust for any differences in the valuation policies. Consider also whether the bank overdraft of a company is being used to fund its longterm activities. If this is the case then although the overdraft is accounted for as a current liability, it should be treated as an non-current liability within the ROCE calculation. As well as looking at the movement from previous years and comparing it with other organisations, the analyst may compare the calculated ROCE with commercial depositing rates. If the ROCE is higher, then the company is making a better return from trading activities than it would if it had invested its capital in deposit accounts. ROCE of Chinette: 20X5 20X x 100 2,243 1,701 x 100 =33% =32% ROCE is well above commercial borrowing rates which indicates that an investment in this organisation gives a higher return than from a deposit account. However, we have no further information on the property values within the financial extracts. ROCE may be overvalued if the non-current assets are undervalued. TPS Advanced Finance Module 10 7

24 Notes Return on Equity ( ROE ) Similar to ROCE but specifically looking at the profits made by the organisation for the shareholders. The ROE is calculated as: Profit for the period x 100% Total equity Note that non-current debt and its costs are excluded from both the top and bottom line of this ratio. ROE of Chinette: 20X5 20X x 100 1,973 1,431 x 100 =28% =29% Shareholders should be satisfied with what appears to be a healthy return on their invested capital. To determine whether this ROE is as healthy as it appears it would be necessary to compare the above percentages with the equivalent for competitors and the industry average Net Profit Margin and Asset Turnover Net profit margin = PBIT x 100% Revenue The net profit margin ratio simply considers PBIT as a percentage of revenue. Although a low margin may indicate that the business is suffering from high costs this is not necessarily the case. Before interpreting the calculated net profit margin you should first calculate the asset turnover ratio: Asset turnover = Revenue Capital employed The asset turnover ratio provides useful information about the efficiency of the company at generating revenue from its capital. These two ratios together make up ROCE: ROCE = Net profit margin x Asset turnover PBIT PBIT x Revenue = Capital employed Revenue Capital employed 8 TPS Advanced Finance Module 10

25 Two separate companies could have the same ROCE but quite different profit margins and asset turnovers. Consider the following: Notes Example Company X Company Y Capital employed Revenue PBIT ROCE 50% 50% Net profit margin 10% 25% Asset turnover 5 2 Although X has a lower profit margin than Y, X uses its assets more efficiently. Y will make a greater profit per item sold but will sell fewer goods during the year. The above example is typical of food retailers. X could be an example of one of the supermarket multiples whereas Y could be a specialist food shop with relatively few outlets. From the above example you can see the trade-off between net profit margin and asset turnover. Consequently, some companies can afford to squeeze their profit margins if they are certain they can achieve a consistent and high level of sales. Net profit margin of Chinette: 20X5 20X x 100 6,200 5,800 x 100 =12% =9% Asset turnover of Chinette: 20X5 20X4 6,200 5,800 2,243 1, The improved net profit margin has been offset by a 17.6% fall in the asset turnover. The increase in the available capital has not been matched with the equivalent increase in revenue. The efficiency of management at generating revenue from available resources has fallen over the last year. But on the basis of the higher revenue that has been made, Chinette has improved its profit per item sold. If ROCE moves from one year to the next you should calculate net profit margin and asset turnover to provide more information. TPS Advanced Finance Module 10 9

26 Notes Gross Margin Gross profit x 100% Revenue It is not always possible to be able to calculate this ratio given the information published in the statutory financial accounts. It is a useful ratio however, as it measures the ability of the business to sell goods for more than they cost to make. You might expect this ratio to remain fairly stable over time and for competitors to show similar gross margins. If the organisation is experiencing a fall in the percentage this may mean that the company is unable to control its production costs or achieve optimum selling prices or quantities. Gross margin of Chinette: 20X5 20X4 1,400 1,200 x 100 6,200 5,800 x 100 =23% =21% The gross margin of Chinette has improved by nearly 10% between 20X4 and 20X5. This is quite a large increase which may have arisen from the rationalisation of production costs or perhaps a lucrative sales contract with higher than usual sales value. An explanation of this increase would probably be referred to in either the operating and financial review or the Chairman s statement. It will also be interesting to see, in future years, whether the 23% gross margin can be maintained LIQUIDITY RATIOS The two ratios most often calculated when assessing the liquidity of an organisation are: current ratio; and quick ratio / acid test. These ratios are designed to provide information regarding the company s ability to pay for its liabilities. They can highlight the fact that a company may not be able to pay its debts as they fall due. Liquidity is crucial for the survival of an organisation. Organisations can still exist if they make losses (at least in the short to medium term) but an organisation cannot exist without cash. 10 TPS Advanced Finance Module 10

27 Current Ratio Notes Current assets Current liabilities This ratio looks at the working capital of the organisation. It assesses the organisation s ability to meet it short-term debts as, in theory, the organisation could sell its current assets to pay for its current liabilities. There is no particular ideal level for the current ratio. Some publications will suggest that the current ratio should be about 1.5 but the ideal level will depend on the industry. The supermarket multiples have been operating comfortably with a current ratio of less than 0.5 for many years (retailers have very low trade receivables as transactions are settled in cash immediately). On the other hand, companies involved in heavy engineering may operate with a current ratio in excess of 2.5 because of high levels of work in progress. Rather than focusing on the actual number it is more important to consider the trend of the ratio over time. If the number is continually falling this could mean that the company is, in the worst case, heading for insolvency. If the number is continually rising management may not be properly managing the working capital of the organisation. Too much money tied up in inventory and/or trade receivables can result in the unnecessary costs of deteriorating and obsolete inventory and bad debts. Current ratio of Chinette: 20X5 20X4 * 2,183 * 2,097 1,585 1,790 =1.4 =1.2 * Excludes the trade receivables and prepayments due after one year. The current ratios of Chinette appear reasonable. The increase in the ratio however hides the fact that Chinette has considerably less cash this year than last year. The analyst should also review the cash flow statement to see if there are any potential problems with the movement of Chinette s cash reserves Quick Ratio Current assets - inventory Current liabilities Also known as the acid test, this ratio is a better measure of the organisation s liquidity. In this ratio, inventory is excluded as it is not always considered liquid. A TPS Advanced Finance Module 10 11

28 Notes heavy engineering company is unlikely to be able to turn inventory into cash at short notice. Some publications say that the acid test should be at least 0.8. However, as with the current ratio, different industries will operate successfully at different levels of quick ratios. The acid test of some supermarket multiples is around Quick ratio of Chinette: 20X5 20X4 1,783 1,747 1,585 1,790 =1.1 =1.0 As with the current ratio there is nothing to suggest that Chinette has any liquidity problems. One area that neither of the above liquidity ratios consider is the extent of the organisation s overdraft limit. The fact that the organisation can have immediate access to funds (which are not evident from the statement of financial position) can significantly change the overall view of the organisation s liquidity MANAGEMENT/ACTIVITY RATIOS Management ratios are designed to provide information about the efficiency of management at controlling the business. The following ratios are some of the more helpful ratios at assessing the efficiency of management: days trade receivables; days trade payables; and inventory turnover or days inventory Days Trade Receivables Trade receivables x 365 Credit sales This ratio measures the effectiveness of the business in collecting its debts. The ratio calculates the approximate number of days that credit customers are taking to pay their debts. There should be a relationship between days trade receivables and the numbers of days credit offered by a business. VAT must be considered when calculating days trade receivables. Unless the question tells you to ignore VAT you should either strip the VAT out of your trade receivables (by multiplying by 5/6) or else gross up credit sales to include VAT (by multiplying by 1.2). This assumes that revenue and purchases are standard rated 12 TPS Advanced Finance Module 10

29 assume this unless told otherwise. If the question tells you to ignore VAT then this step does not need to be taken. Notes The trend of this number is important and if the ratio is seen to be continually increasing over time without an organisation extending its credit terms this could indicate problems with credit control and bad debts. The problems that can arise in the calculation of the days trade receivables ratio include the decision to use: average receivables or year-end receivables; credit sales or total revenue; and total trade receivables or only those due within one year. The decisions will depend on the availability of information and how the benchmarks have been calculated. Days trade receivables of Chinette: 20X5 20X4 * 1,615 * 1,617 x 365 ** 7,440 6,960 x 365 =79 days =85 days * Including trade receivables due after one year. ** Grossing up sales to include VAT at 20%. Even if the long-term trade receivable amount is adjusted for, the days trade receivables number appears rather high (although this level must be compared with the credit terms offered by Chinette and with the industry as a whole). Although there is an improvement from the previous year Chinette seems to have poor credit control. This may also mean that they have significant bad debts. A useful calculation to make at this point is to work out how much cash could be released if days trade receivables were reduced, that is, if Chinette reduced their days trade receivables from 79 days to 60 days how much cash would be freed up? Take the year end trade receivable balance of 1,615 and divide by 79 to give the value of one day s trade receivables and multiply by 19 days. 1,615 x 19 = Thus Chinette could free up approximately 388,000 if they reduced days trade receivables to 60. It is more meaningful to advise a company by telling them the TPS Advanced Finance Module 10 13

30 Notes impact in cash terms of taking specific action rather than just saying cut days trade receivables from 79 to 60. This will always earn you marks in the exams Days Trade Payables Trade payables x 365 Credit purchases and overheads* * Cost of sales often used as denominator. In theory, this ratio calculates an approximation of the number of days credit the business is taking from its suppliers. However, given the information available from the financial statements, it is very difficult to calculate this ratio meaningfully. The value for purchases can be calculated as cost of sales - opening stock + closing stock. The value for credit overheads may be impossible to obtain. The trend in the days trade payables ratio is important. A steady increase may highlight the fact that the company is making better use of interest free credit or it could be because the organisation has no cash with which to pay its suppliers. It may also indicate that the business is taking longer to pay its debts and therefore risking its credit worthiness. The problems given above for the calculation of days trade receivables are also applicable to the calculation of days trade payables. The statement of financial position figure of trade payables will include VAT whereas the statement of profit or loss figures of credit purchases, overheads and cost of sales will not. Days trade payables of Chinette: 20X5 20X4 1,200 1,090 x 365 * 5,760 * 5,520 x 365 =76 days =72 days * Grossed up cost of sales to include VAT at 20% This is a very approximate calculation, as cost of sales has been used as the denominator, but the important issue is the fact that the value is increasing and this could indicate problems with suppliers. Another point worth considering is that Chinette is taking longer to collect debts than to pay its debts and thus Chinette is a net provider of funds. This is not good working capital management. Again it would be beneficial to quantify any changes in days trade payables in cash terms. 14 TPS Advanced Finance Module 10

31 Note: Notes Module 2 provides information on the Late Payment of Commercial Debts (Interest) Act 1998 which may be applied to all overdue accounts Inventory Turnover Cost of sales Inventory This ratio calculates an approximation of the number of times inventory was sold during the year. The number used for inventory in the ratio can be either the year-end value or the average value. Different industries will show very different numbers for inventory turnover. A heavy engineering business may have inventory turnover of less than one. A retail business may have inventory turnover greater than 10. Once again, the trend of this number over time is important. A decrease in the ratio may highlight a slowdown in trading or a build-up of inventory levels. This may indicate that management have an excessive amount of money tied up in inventory. Inventory days, which calculates the number of days inventory is held for, is essentially the inverse of the above: Inventory x 365 Cost of sales By adding together the number of days trade receivables and days inventory you should get a rough idea of the length of time it takes the organisation to convert inventory into cash. A continual increase in this number could indicate liquidity problems. Inventory turnover of Chinette: 20X5 20X4 4,800 4, times 13 times Inventory turnover has fallen over the last year. This could be the result of a one-off event during the year, for example, a product recall because of a health scare. The fall could also be the result of a slow-down in demand for luxury confectionery. If this ratio continues to fall this could indicate serious problems for the company. TPS Advanced Finance Module 10 15

32 Notes Again, as with the previous two efficiency ratios, the effect of the inventory turnover movement could be quantified. That is: 4,800 = Therefore inventory would be 369k as opposed to 400k if inventory turnover had been in line with the previous year CAPITAL RISK RATIOS Shareholders and lenders will be particularly interested in ratios that provide a measure of risk. The more debt a company has, the greater is its exposure to risk. This is because interest must be paid irrespective of whether the organisation is making profits or not. The three risk ratios of most importance are: gearing (leverage) ratio; debt ratio; and interest cover Gearing Ratio Long-term debt + preference shares x 100% Total equity or Long-term debt + preference shares x 100% Capital employed Gearing, which is concerned with the capital structure of the organisation, has many definitions. The gearing ratio shows what proportion of the assets of the company (i.e., non-current assets and net current assets) have been financed by lenders rather than shareholders. The higher the level of gearing, the greater the risk that there will be insufficient profits available to pay dividends to the shareholders. Highly geared companies are more sensitive to changes in interest rates. The profits of a highly geared company will suffer the most if interest rates are increased, but shareholders gain with highly geared companies in periods of low interest rates. In the above definitions, preference shares have essentially been classified as debt rather than equity. While preference shares are not debt, their owners do have priority on the profits and net assets of the organisation. The preference shares have been classified in this way because the gearing ratio is designed to show the ordinary shareholders the risks that they are exposed to. Preference shares should be classified as debt if they are redeemable. 16 TPS Advanced Finance Module 10

33 There is an argument that when preference shares are irredeemable, or are convertible to ordinary shares then they should be treated as equity and not debt, and should be excluded from the gearing calculation. Notes There is no defined level above which an organisation is deemed risky as many other factors must be taken into account. Certain organisations can operate safely at relatively high levels of gearing, for example, those with steady profits and substantial tangible assets which can be used as fixed security for loans. Gearing ratio (Debt/Equity) of Chinette: 20X5 20X x 100 1,973 1,431 x 100 =14% =19% The gearing of Chinette has fallen because there has been a very small reduction in long-term liabilities and an increase in the overall level of equity. Given the above levels Chinette is exposed to relatively little risk and consequently the company could probably secure additional loans fairly easily should the need arise. Note: In exams you will be told whether gearing should be calculated as (debt/equity) or (debt/debt + equity) Debt Ratio Total debt x 100% Total assets Total debt includes non-current and current liabilities and total assets includes noncurrent and current assets. As a very general rule, 50% debt is thought to be an acceptable level in the UK. A debt ratio of 50% is essentially saying that half the assets of the organisation have been financed by debt. Although this is a useful benchmark, companies can operate quite safely at debt ratios higher than this. If an organisation s debt ratio is already high and increasing further then this may give cause for concern. Debt ratio of Chinette: 20X5 20X4 1,855 2,060 x 100 3,828 3,491 =48% x =59% 100 TPS Advanced Finance Module 10 17

34 Notes The debt ratio of Chinette is quite high because of the level of current liabilities. Given the gearing ratio (as calculated above) and the fact that the debt ratio has fallen there are few grounds for concern in this area Interest Cover PBIT Interest charges (nb: not net finance costs) The ability of a company to operate safely at relatively high levels of debt depends on it being able to afford the interest payments. High debt and gearing ratios are not automatically a problem if the company can easily cover all interest charges. The interest cover ratio determines the number of times that the company can afford to pay its interest charges. The ratio shows how much profits can fluctuate before interest payments are threatened. The ideal level of cover depends on the current economic conditions. If the economy is in decline then interest cover should be higher than when the economy is stable or in a state of growth. Interest cover of Chinette 20X5 20X =15.6 times =13.8 times Chinette is exposed to very little risk. It can easily afford the interest charges and profits would have to fall considerably before the company was in danger of defaulting on its interest payments Summary of Chinette s Ratio Analysis The table below summarises Chinette s ratios: Ratio 20X5 20X4 ROCE 33% 32% ROE 28% 29% Net profit margin 12% 9% Asset turnover 2.8 times 3.4 times Gross margin 23% 21% Current ratio Quick ratio Days trade receivables 79 days 85 days Days trade payables 76 days 72 days Inventory turnover 12 times 13 times 18 TPS Advanced Finance Module 10

35 Gearing ratio 14% 19% Debt ratio 48% 59% Interest cover 15.6 times 13.8 times Notes The above ratios, when reviewed together, allow the analyst to build up a picture of the company s main strengths and weaknesses. The analyst should be aware that the ratios interlink and ensure that any conclusions reached take all relevant ratios into account. Before drawing any conclusions, the analyst should remember the following: The ratios have been calculated for only two years and therefore it is impossible to determine whether the movement in the ratios, as summarised above, is part of an overall trend or a one-off movement; Other sources of information, which are not available, could provide further details to support conclusions; and Industry averages have not been given. Chinette appears to be a fairly healthy company. In comparison with commercial borrowing rates, shareholders are getting a good return on their investment. However this may not be a fair reflection as the non-current assets of the company may not have been revalued and this could alter the ROCE and ROE considerably. Profitability is strong and improving and consequently, as the company has relatively little long-term debt, it can afford interest payments comfortably. However the increased profitability has resulted in a relative fall in asset turnover which means that the company s efficiency at generating revenue has fallen. In addition to this, inventory turnover has fallen perhaps because of increased prices. Although the movement in these numbers is not great, this is an area that needs to be monitored in the future. One area for concern, however, is working capital as failure to manage it may mean the company is not sustainable. In particular, days trade receivables appear high and, given the level of days trade payables, Chinette is a net provider of funds (although only just). This is poor working capital management. As the management of working capital is fundamental to any organisation this is an area that requires further scrutiny. Fortunately as profits are good, the company is currently able to cope with bad debt expenses but this may not be possible in the future. Profits, liquidity and gearing appear to be in good health but the company needs to reassess its management of working capital. This is an area that can lead to the collapse of otherwise successful companies. TPS Advanced Finance Module 10 19

36 Notes 10.8 OTHER RATIOS The ratios calculated above provide an overall picture of a company that might be of use to a variety of stakeholders in a business. However some stakeholders will be more interested in specific parts of the business than others Shareholder Ratios A potential shareholder in a company will be interested primarily in: 1. the security of any investment; and 2. the return on that investment. In addition to the ratios previously mentioned, a potential shareholder will be interested in: Earnings Per Share Earnings per share is traditionally calculated as: Profit attributable to ordinary shareholders Number of ordinary shares in issue Profit attributable to ordinary shareholders is a company s profit after tax and after any preference dividends. There are a number of scenarios which could affect the calculation of this key ratio. These will include when new shares are issued or when other financing tools (such as debentures) are converted into ordinary shares. You will cover this in detail in the Financial Reporting course PE Ratio It is calculated as: Share price Earnings per share and indicates the value of the share price as a multiple of the earnings per share. It shows how many times the earnings per share an investor is prepared to pay to buy a company share and is a useful comparison across different companies. The higher the PE, the more valuable the earnings of the company Earnings Yield The earnings yield is the inverse of the PE ratio. 1 = Earnings per share PE Share price 20 TPS Advanced Finance Module 10

37 Dividend Cover Notes Dividend cover is a measure of how many times the dividends actually paid divide into the profits that could have been paid out as a dividend by the company. Profits available for distribution to ordinary shareholders Dividends paid It is an important indicator for a potential investor as it shows what size of dividend an investor might expect to receive, given a specific level of company profits. Alternatively it indicates how far earnings would have to fall before the dividend paid out by the company would be reduced Dividend Yield The dividend yield measures the annual return received in dividends as a percentage of the current share price. Remember, it is not a measure of the total return to the shareholder because: it ignores the growth in capital value of the share; and it is based on the current share price which is not necessarily the same price that the shareholder paid to obtain the share. The formula is set out below: Dividend per share x 100% Share price Internal Rate of Return ( IRR ) The internal rate of return on a particular project may be defined as the discount rate required to equate the present value of future returns with the outlay needed to secure them. A shareholder will review the IRR of the potential investment and ensure that it is high enough for them to consider investing. If you are unfamiliar with the term, refer back to your Test of Competence or university notes. IRR will be covered in more detail in Advanced Finance module Debt Provider Ratios Banks are usually prepared to lend to businesses that show good profitability, liquidity and reasonable levels of gearing. The lender will also be interested in the security of their debt and in the cash flow of the business. They will therefore also review: TPS Advanced Finance Module 10 21

38 Notes Asset Cover A bank will want to ensure that, should the company to which they have lent go into liquidation, the bank has security over enough of the assets of the business that the debt can be repaid. The asset cover ratio will compare the amount that could be raised from a forced sale of the company s assets with the amount to be lent by the bank. The ratio should be at least 1 to ensure that the bank can get its money back Cash flow Cover A bank will review the forecast cashflows of the company to ensure that both the capital repayments and interest payments can be repaid comfortably. The cash flow cover ratio compares the net cash flow in a specific period to the interest and principal repayments during that period. A ratio greater than 1 ensures that the payments could be made but a bank will look for better coverage than this, usually 1.5 to Other You may calculate any ratios that you wish. You may wish to analyse utilisation of the factory (for example revenue per square metre) or employee statistics (average wage per employee, turnover per employee). However, ensure that you have a clear purpose behind any calculation that you perform and are comparing your ratios to something meaningful Sources of Ratios Industry comparisons can be sourced from: Financial Times; Financial Analysis made easy (on CD Rom at libraries); Dun & Bradstreet; Extel; and Internet. It is VITAL that you know the basis upon which the industry averages have been calculated before you use them in order to check that you are comparing like with like. You should now be able to achieve learning objectives 1 and TPS Advanced Finance Module 10

39 10.9 LIMITATIONS OF RATIO ANALYSIS Notes Ratio analysis should be used with care. It does not provide the answers to all the questions that the analyst will have. Instead, ratio analysis will highlight the areas that require further investigation. When using ratios to analyse the financial performance of an organisation it is very important that you are aware of their limitations. These limitations should always be taken into consideration when making use of ratio analysis: Ratios do not provide an accurate picture of financial performance, they are only useful guidelines; Ratios are calculated using statement of financial position information that is only applicable to one day in the year; seasonal variations may be missed altogether; The financial statements from which ratios are calculated contain assumptions and estimates which can be very subjective; Ratios are calculated using information that is historic. Inflationary effects may need to be taken into account; Organisations can adjust their payment patterns towards their year-end to improve the appearance of their ratios; Computation of certain ratios and their comparison can be complicated by the treatment of corporate taxation and VAT; It can be difficult to access sufficient information to calculate meaningful ratios as such information tends to be summarised and selective; When analysing the ratios of different companies, the companies must be comparable, for example it would be pointless to compare certain ratios of, say Marks and Spencer with Reuters as they operate in different industries. Also, it would be pointless to compare certain ratios of Marks and Spencer with those from a small corner shop as they will have significantly different bargaining power with their suppliers; When comparing the ratios of different organisations you must allow for different accounting policies; When comparing the ratios of organisations you need to be aware of any difference in the categorisation of costs. For example, one organisation may include a particular cost within cost of sales whereas another may include the same cost within operating costs; The introduction of new accounting standards can make the comparison with previous periods ratios difficult without recalculating the previous periods ratios; When interpreting ratios you must take all other relevant factors into account. For example, if the organisation has been the subject of a recent takeover, a reduction in costs may be a result of the takeover rather than an improvement in the efficiency of management of the existing business; and It can be very difficult to produce a meaningful analysis of consolidated financial statements using ratio analysis if the group includes companies from a variety TPS Advanced Finance Module 10 23