Unit 2.

4: Performance evaluation

Limitations of Accounting Information

There are a number of problems with financial statements:

1. The first issue is that financial statements are simply a set of

financial facts broken down into various line items, e.g., the revenue
generated, the salaries expense, or the historic purchase price of a
particular piece of PPE. But the financial statements don't tell us
much about what any of that means and is limited in helping us
contextualise the information.

2. Financial statements also contain a huge volume of information that

can be very overwhelming without further work to understand the
relationship between the factual information given in the financial
statements.

Further Limitations of Accounting Information

Financial statements comprise largely accounting information. Outlined

below is a list of the major limitations of accounting information:

 Exclusion of non-monetary items:

o Only items that have a rand value can be included.

o Value of management team, brand value, customer loyalty,

etc. is not included.

 Simplification/summarisation:

o Recording complex and varied economic events require some

level of simplifying or summarising.

o High-level summaries are provided of items accounted for

e.g., all fixed assets, major customers, material adjusting
journals, etc. are not all listed in the financial statements.

 Accounting policies:

o Choices are allowed in accounting which can make companies

incomparable e.g., cost model vs revaluation model for PPE.

o Accounting requires estimation and judgement which could

differ between entities e.g., depreciation arising from the
estimated useful life of assets.
  Inflation:

o Distorts comparison of figures over time e.g., the cost of a

machine 20 years ago on the cost model has no real relevance
today.

 Market information:

o Does not include market perceptions of the future, such as

expected growth, expected industry downturn, expected
labour unrest.

At this point, it should be clear that accounting information may be

relatively limited, and that financial statement analysis can be a way of
helping us better understand that information. However, different users of
financial statements may require different information from performing
their analysis. Thus, it is not only the context of the business that shapes
the analysis, but also the context of the users.

Context of the Stakeholders and Users of Financial Statements

Hopefully, you managed to identify some of the common users of financial

statements outlined below:

 Investors (debt and equity) and analysts

 Management

 Employees and labour unions

 Suppliers

 State and statutory bodies

Equity investors and analysts

Equity investors are the last in line to be repaid – either as dividends or in

the form of a return of their original share capital if the company winds up.
Debt investors receive interest and capital before equity investors. This
exposes equity investors to significantly higher risk; their informational
needs are, therefore, typically greater than the needs of debt investors.
They need to ensure that the company generates a sufficiently high return
on their investment and that it, at the same time, ensures capital
preservation.
Analysts analyse the same to determine whether equity investors should
invest in listed companies and also use reported financial information to
value companies.

Debt investors

Debt investors have a slightly different focus to that of equity investors.

They are concerned with whether they will be repaid their interest and
capital. They are less concerned with the profits and returns over and
above the interest. Since they will not participate in any amount above
the interest, they are less concerned with maximising returns and more
concerned with minimising risk. In the short term, they are concerned that
the company has sufficient cash to cover interest payments and over the
long term, that it has sufficient cash to cover interest and repay capital.

Management

Management places greater emphasis on information necessary for

decision-making and control over the operations and investments of the
business. They often require granular details about products and their
costs, and therefore rely on management information systems, which are
more detailed, rather than financial statements. However, management
bonuses may be linked to figures reported in the audited financial
statements or there may be another reason for management to pay
particular interest to figures reported in the financials.

Employees and labour unions

These stakeholders are concerned with job security and salary

negotiations. They may look to financial statements to provide information
on the risks that the business is taking, it’s long-term stability as well as
whether company profitability supports requested salary increases. They
also concentrate on changes in salaries and, in particular, salaries as a
proportion of revenue and in relation to other expenses.

Suppliers

Suppliers often grant credit to their customers and will therefore want to
know whether the company is able to pay for goods and services supplied.
Therefore, financials are generally requested by suppliers when a
company applies for credit.

State and statutory bodies

SARS and auditors often rely on analytical procedures to detect changes

and abnormalities in financial statements which may reflect certain risks –
for SARS, whether taxable income is misstated, and for auditors, material
mistakes. SARS can use ratio analyses to determine whether a company is
underpaying tax. Auditors use ratio analyses, especially trend analysis, to
identify reported figures that may possibly be misstated and require
additional audit work.

Based on their needs, opportunities, and risks, the different stakeholders

outlined above may focus on different aspects of the financial statements
and may be more concerned with particular ratios instead of all/others.

Approach reflects business process

1. Maximising profit. How?

a. Grow revenue
b. Cost efficiency and operating leverage
i. Profitability ratios
ii. i.e., operations
c. generate as much revenue as possible of existing assets
i. asset utilisation and efficiency ratios
ii. working capital ratios
iii. i.e., investments
d. Return ratios (return on assets)
2. Add financial leverage to enhance returns to equity hodlers
a. Relationship between financial and operating leverage
b. Return ratios (return equity)
c. I.e., financing
3. Without increasing short term risk
a. Liquidity ratios
4. Without increasing long-term risk
a. Solvency/debt management ratios

Categories of ratios

- Performance ratios
o Profitability ratios
o Return ratios
o Asset management ratios
 Asset utilization/efficiency
 Working capital management
- Position ratios
o Liquidity ratios (short term solvency)
o Solvency ratios (debt management)
- Other
o Cash flow ratios
 o Market ratios

From the video, it should be clear that a traditional goal of a business is to

maximise profits and, ultimately, maximise shareholder returns. Based on
this, we can trace through a logical set of steps that a business should
follow to optimise its returns. By drawing on various ratios that tell us how
well these steps have been performed we can assess the business’
performance.

Typically, a business seeks to maximise profits in one of three ways:

1. Growing revenue

2. Reducing costs

3. Managing and utilising assets efficiently

The business can also enhance returns to equity holders through

an appropriate capital structure: optimising the debt-to-equity ratio of
the company. However, at the same time, it also needs to balance this
against the potential increased risk that arises from adding debt to the
business.

The different types of financial statement analysis typically analyses the

logical steps to optimise returns. Over the course of the next lessons, we
will look at the various types of analyses and ratios that can be performed
to provide more information about each of the steps in the business
process.
Lesson 2: Business performance measures
After having watched the above video, you should be comfortable with the
following:

 One of the most important return measures is return on assets

(ROA). This may also be referred to as return on investment (ROI) or
return on capital employed (ROCE). It is a measure of the return for
each rand of assets invested in.

o We calculate ROA as operating profit before interest over

assets.

o The operating profit figure can be before or after tax but what
is essential is that it excludes interest (and the tax deductions
on the interest, if we are using an after tax earnings – EBIAT).

o The asset figure can be total assets but is ideally net assets.
We calculate net assets as total assets less working capital
liabilities, or as a shortcut less current liabilities.

o What is essential is that, for the purpose of comparison, the

respective ROA ratios of any industry or competitor must be
calculated in the same way, i.e., compare apples with apples.

 Another very widely calculated return measure is return on equity,

ROE, which reflects the return to equity holders in proportion to the
amount they have invested.

o We therefore need to look at what is returned to the equity

investors only, i.e., the net profit (after interest and tax)
relative to what they have invested – the equity balance.

 It is conceptually wrong to calculate ROA using a net profit figure.

We are trying to assess the return on our investment; we therefore
need to look at a return that excludes the effects of the financing
decision i.e., interest. Furthermore, since assets are funded by both
debt and equity holders, we must use a return against which both
debt and equity holders have a claim.

Once you are comfortable with the key return measures, we can go into
more detail to better understand how efficiently we have used our assets
by using the asset efficiency and utilisation ratios.
In the video below, some of the key working capital ratios are covered:

 Inventory turnover

 Inventory, debtor and creditor days

 The working capital or operating cycle days

 1. Maximising the profit. How?

o Grow revenue

o Cost efficiency and operating leverage

 Profitability ratios

 i.e. operations

o Generate as much revenue as possible of existing assets

 Asset utilisation and efficiency ratios

 Working capital ratios

 i.e. investments

o Return ratios (return on assets)

2. Add financial leverage to enhance returns to equity holders

o Relationship between financial leverage and operating

leverage

o Return ratios (return on equity)

o i.e. financing

2.1 with minimising the increase in short-term risk

 Liquidity ratios

2.2 with minimising the increase in long-term risk


 o

 Solvency/debt management ratios

Lesson 3: Debt management

What Counts as “Debt” versus “a Liability”?

This is a good question...

But before you read below and we unpack this question, give some
thought to what you think the meaning of "debt" is within the context of
ratio analysis in MAF compared to the broader understanding of what is
generally classified as "a liability".

Permanent sources of funding (debt) and liabilities per IFRS

In MAF we make a distinction between permanent sources of funding and

liabilities. Liabilities per IFRS are simply put any future obligation BUT not
all future obligations are necessarily sources of funding that we have
specifically raised to fund our business e.g., pension fund obligations and
deferred tax balances are liabilities but not a source of funding like a bank
loan.

There is a more complicated argument that all liabilities (future

obligations) do indirectly provide funding in that we have to pay them in
the future but because we do not have to pay them right now that means
we have cash available that we otherwise would not have had BUT they
are still then conceptually very different from specifically going out and
raising money for the purchase of operating assets.

Permanent sources of funding (debt) vs. current/non-current

classification for IFRS

There is also a difference between PERMANENT sources of funding in MAF

and non-current (long-term) and current (short-term) liabilities as per IFRS.
Current and non-current refers to the repayment timelines and not
whether this will always be a part of the funding structure of a company.
For example, bank overdrafts are typically settled within the short-term
but once repaid a company often immediately utilises the available
overdraft again, therefore making them a permanent part of the
company's funding structure. So even though such a bank overdraft is
reported as a current liability, it is still a permanent source of funding.
Similarly, the current portion of a long-term loan which, although it will be
repaid within 12-months, is a permanent source of funding.

Now that we have looked at solvency ratios and considered the above, the
next aspect of assessing a company's debt management and the risk of
debt is to look at its liquidity situation.

Liquidity Ratios

'Liquidity' refers to a company's ability in the short term to meet its

various obligations. For example, will it be able to pay its suppliers for the
inventory that it ordered? Or does it have sufficient inventory that it can
sell to pay its staff at the end of the month? These ratios are concerned
with the short term and, often, the operational obligations of a business.
Very often businesses might be able to repay their long-term debt
obligations, given a period of years to build up its operations and generate
profits. However, they often fail because they can’t meet their short-term
obligations, such as paying their monthly interest, staff and/or suppliers.

The liquidity ratios help us to assess this risk. The two key ratios that we
use for this are the current ratio and the quick ratio. Investopedia has
two very good articles on each of these ratios; their links are provided
below.

Current ratio

Read this article on the current ratio.Links to an external site. You should
have noticed from the article that one of the problems with the current
ratio is that it includes all assets as part of current assets. The current
ratio is a ratio that helps us to assess the risk of a business. But one of the
reasons why a business may be in distress is because it is unable to sell
its inventory. For example, suppose the business bought inventory that
people didn't want because it was of poor quality, was out of fashion or
was mispriced in comparison to the prices of competitors. Including this
inventory as part of current assets which could be sold to pay current
liabilities does not make sense. From a risk point of view, there is a chance
that this inventory may never be sold! Therefore, we often use an
additional ratio known as the 'quick ratio' or the 'acid test ratio' to help us
address this risk.

Quick ratio

Read this article on the quick ratio.Links to an external site. The quick
ratio provides a test on the company's ability to repay its short-term debts
under tough trading conditions. (The word 'quick' is an old-fashioned
English term for 'living', and the phrase 'acid test' comes from testing
under tough or difficult circumstances.) This does not mean that the quick
ratio is a better than the current ratio. It is a ratio that is used in addition
to the current ratio to simulate tough trading conditions. It is not meant to
provide insight into the company under normal trading conditions.
Lesson 4: Operating and financial leverage

Welcome to the lesson on financial leverage and operating leverage. Let's

start by considering what operating leverage and financial leverage are at
a high-level:

 Operating leverage refers to the extent to which a company’s

costs are fixed in nature rather than variable in nature.

 Financial leverage refers to the extent to which assets are funded

by debt rather than equity.

These two concepts both have a significant impact on levering up returns

to stakeholders. Although they are conceptually separate issues, there is
an important interplay between them that is highlighted in this lesson.

'Operating leverage' and 'financial leverage' are also separate topics from
'financial statement analysis', but we will use ratio analysis to help us
analyse them.

Furthermore, since this module focuses on evaluating a business’s

performance, operations, and financial position, this is an opportunity to
illustrate how these concepts lever up returns to stakeholders but also
how they increase risk at the same time, and need to be considered when
we are evaluating the capital structure of a company.
You should have noted the following in this video:

 Operating leverage refers to the proportion or percentage of costs

that are fixed costs relative to the proportion of variable costs.

 High operating leverage occurs when there is a high proportion of

fixed to variable costs and, vice versa, low operating leverage
occurs where there are low levels of fixed costs relative to variable
costs.

 High levels of operating leverage allow us to enhance (or amplify or

lever or increase) our profits and, ultimately, our returns. As a result
of operating leverage, we can achieve greater percentage increases
in profits than the percentage increase in sales, i.e., the profit % is
levered up.
  Operating leverage can enhance the return on assets (ROA). BUT
the opposite is also true when sales decreases, and this therefore
links with business risk (simply put: the higher a company's fixed
costs, the higher its business risk and the higher potential for
increased returns - linking with the risk-return relationship covered
in previous modules).

You should also have noted that:

 Financial leverage refers to the proportion of assets that are

funded by debt rather than equity.

 High financial leverage occurs when a greater percentage of the

assets are funded by debt, i.e., we have a high debt ratio, a high
debt to equity ratio, and a low equity ratio.

 Low financial leverage occurs when a lower proportion of assets are

funded by debt than equity, i.e., we have a low debt ratio, a low
debt to equity ratio, and a high equity ratio.

 Financial leverage can be used to enhance the returns on equity

(ROE) but has no effect on the return on assets (ROA). The opposite
is however also true, as the return on equity (ROE) can decrease
when debt funding is used and the cost of debt funding (Kd)
exceeds the return on assets (ROA), which links
with financial risk (simply put: the higher a company's debt
obligations, the higher its financial risk and the higher potential for
increased shareholder returns - linking with the risk-return
relationship covered in previous modules).
Example 1
Example 2

Comment
Notice that revenue has increased by 100% while the operating profit has
increased by 133%. The return on assets has increased from 30% to 35%
due to the operating leverage.

Net profit has increased from R300 to R600. Thus, at a cost of only R100
in interest charges, the company has increased it operating profit by R400
(and net profit by R300), i.e., it doubled its net profit, with no additional
investment required by the shareholders.

As a result of the amplifying effects of both operating and financial

leverage, the ROE has increased from 30% to 60%. (In the previous
example, Company Delta only had financial leverage and the increase in
ROE was from 30% to 50%.) Thus, the combined effects are now even
more pronounced.

Many companies are cautious to combine financial leverage and operating

leverage as it increases the company's overall risk significantly.

Lesson 5: The sustainable growth rate

You should now be able to recognise that the growth of a business will
ultimately depend on its ability to grow and expand its assets. Funding
any additional growth in assets, without raising more equity from
shareholders, is then dependent on the return (or profits) we generate on
our existing assets, and how much of that profit we retain to buy
additional assets. It is also dependent on our target capital structure; we
should raise additional finance to match the funding from retained
earnings (internally generated equity funding) in order to ensure that we
maintain our target capital structure. The funding raised from debt and
invested into assets will generate the normal return on assets, but will
also attract an interest charge; hence the return on the assets funded by
debt will be the ROA less the interest (Kd). This gives us our formula:

SGR = (ROA)(p) + (D/E)(p)(ROA – i)

Where:

ROA = Return on assets, after tax (%)

p = Retention rate (%), where Retention rate = 1 - Payout ratio

D/E = Debt/equity ratio (%)

i = Interest rate (cost of debt), after tax (%)

Example

Zalkon (Pty) Ltd is in an industry in which the typical growth rate averages
12% per annum. The expected ROA over the long term is 15%. The D/E
ratio is 1:3. The marginal cost of debt is 10%. The company has a policy to
pay out 70% of its profits as dividends.

Ignore tax.

Required

Calculate the sustainable growth rate for Zalkon (Pty) Ltd.

SGR = (ROA)(p) + (D/E)(p)(ROA – i)

SGR = (15%)(30%) + (1/3)(30%)(15% – 10%)

SGR = 5%

Take note of the fact that it is the retention ratio, not the payout ratio, that
we need. If the company is paying out 70% of its profits as dividends it
must have a 30% retention ratio.

Completing the Analysis

It is not just enough to mechanically substitute numbers from the financial

statements into formulae. You also need to:

 Understand the business context:

o Company strategy

o Micro and macro factors

 Understand the key drivers of value:

o Certain ratios are critical to a specific industry

 o For example, the operating margin in the retail industry

 Understand the accounting issues:

o Which accounting policies are flexible

o Accounting (non-cash flow) adjusts that may be material e.g.,

impairment of PPE

 Include non-financial analysis:

o Integrated reporting information – the number of deliveries

and new markets, etc.

o Think of balanced scorecard measures (previously covered in

Strategy)