Lecture 5

Fundamentals of Accounting:
Interpretation of Financial
Statements

Chapter 7

Malcolm Anderson
Cardiff Business School
 Overview

Objectives of analysis
Types of ratio
Uses and limitations
Corporate failure prediction
Example Fred's Pizzas
 Objectives of analysis
To understand a business better by a
systematic review of its financial
statements
To compare a business performance and
position over time - against itself and/or
against those of other businesses
To interpret the results of these
comparisons
 What to compare with?
Internal budgets and plans
Past periods (time series analysis)
Other companies (cross-sectional analysis
- comparison with one or more companies in
the same sector)
Industry or sector data (another version of
cross-sectional analysis - comparison with
published averages for the industry/sector)
 Types of Ratio

There are 6 main lenses through which we

can view a company:
Liquidity
Profitability
Efficiency
Gearing
Investor
Cash based ratios
 What the terms mean
Liquidity: can the firm pay its way in the short-term?
Profitability: is the business making a profit? How good is
the profit? Is it a good return for the shareholders?
Efficiency: is the firm using its resources effectively?
Gearing: is the financial structure sensible? Is the firm
making appropriate use of borrowings? Has it struck the
right balance between equity and loan finance?
Investor: is it attractive to a potential shareholder?
Cash ratios: is a good profit performance matched by
robust cash generation and long-term solvency?
 Factors To Consider

Information needs of the user

Dont overdo the calculation of ratios
Consider the relationships between the
ratios you calculate
What can be done to improve the situation?
Uses of Ratio Analysis
Summarising complex accounting information into a
small number of key indicators
Internal management purposes: comparing position
and performance against a pre-set budget or an
external benchmark
Making comparisons over time and between firms
Identifying relative efficiencies by linking
performance to size prevents distortions of scale
Communicating complex ideas (e.g. sales per square
foot, banks income to expenses ratio) to external
users of financial information
 Limitations of Ratios
Lack of standard definitions
Unrepresentative SOFP figures (historic cost or revaluation?)
Accounting is not uniform: comparisons may be distorted
(e.g. by depreciation/asset replacement policies or by
creative accounting)
Dont provide answers just raise questions
Perverse incentive effects (e.g. under-invest to improve
short-term profitability)
SOFP snapshot may be misleading (e.g. year-end inventory
may not reflect average levels)
 Prediction of Failure
Strong evidence of the success of ratios in this area
Beaver (matched pairs of failed and non-failed businesses)
found predictive differences up to 5 years ahead (best results
from cash flow:total debt ratio)
Zmijewski (sample of 3,600+ businesses over 6 years) found
predictive effects in several areas (but not liquidity)
Altman (1968, 2000) and Argenti (1976) developed multivariate
techniques - the latter using qualitative assessments as well as
calculations in his A-score model
Taffler (1977 and later) developed the Altman Z-score for
different UK industry sectors.
 Freds Commercial Pizza Supplies:
Income Statement (000)
Revenue: 10,000
Cost of sales: 5,000
Gross profit 5,000
Operating expenses: wages 1,000
other costs 2,000 3,000
Profit from Operations 2,000
Interest payable 300
Profit before tax 1,700
Tax payable 400
Profit after Tax 1,300

Additional Information:
Dividends paid 300
Retained profit 1,000
 Freds Commercial Pizza Supplies:
SOFP (000)
Non current assets (cost 4,500 less deprn 500) 4,000
Current assets: Inventory 1,000
Trade Receivables 900
Cash 1,000
2,900
Total assets 6,900
Share capital 2,600
Retained profit 1,000
Shareholders equity 3,600
Long term loan 2,000
Current liabilities: 1,300
Total equity & liabilities 6,900
 Further information about FCPS

Average number of employees: 100

Cash flow details (000):

Cash received from customers 9,100
Net operating cash flows 1,500

Current liabilities analysis (000):

Trade payables 900
Tax payable 400
1,300
 Liquidity ratios
Can the firm pay its obligations in the short-term?

Current Current assets 2,900 = 2.23

Ratio Current liabs. 1,300

Quick Monetary assets (2,900-1,000)

Ratio Current liabs. 1,300
= 1.46
(monetary assets = Current assets less inventory)
 Profitability Ratios
Is the business making a profit?
How good is the profit in relation to the
investment made in the business? [return on
investment]
Return on Capital Employed (ROCE)
Return on Total Assets (ROTA)
How good is the profit in relation to the sales
made? [margin]
Gross profit margin
Net profit margin
Return on Capital Employed
(ROCE)
Operating profit (PBIT) 2,000 x100%
Equity + Long term Loans 3,600 + 2,000
= 35.7%
ROCE measures the return achieved on ALL long-term
funding (equity and debt) employed.
Equity includes all the retained profit and reserves of
a business.
PBIT = Profit Before Interest and Tax
 Return on Total Assets (ROTA)
Operating profit (PBIT) x 100%
non current assets + current assets
2,000 x 100% = 29.0%
4,000 + 2,900
measures the return achieved by the firm on all its
asset base, however the assets are funded.
allows us to compare different funding structures (e.g.
one firm with long-term borrowings and another with
short-term funding on a consistent basis - using the
ROCE formula mechanically would not achieve this.
 Gross Profit Margin
Gross (Trading) Profit 5,000 x 100% = 50.0%
Sales Revenue 10,000

Measures profit generated from sales

difference between the cost of production and
what the product sells for.
However, some firms with very high margin
products may also incur very high running
expenses - you dont sell Porsches in Tesco.
 Net Profit Margin
Operating profit (PBIT) 2,000 x 100% = 20.0%
Sales Revenue 10,000
measures operating profit (after taking account of
running costs) as a % return on the firms sales.
shows not just the margins earned on sales but also the
firms ability to control its operating costs.
A low cost operator may be able to undercut
competitors prices because it can run its business
much more cost-effectively.
Also known as Return on Sales or ROS
 Efficiency Ratios

Long-term (use of the asset base to generate sales)

Capital turnover ratio (CAT)
Non current asset turnover ratio (NAT)
Total asset turnover ratio (TAT)
Short-term (effective management of working capital)
Average receivable (debtor) collection period
Inventory conversion period
Average payable (creditor) payment period
 Capital Turnover
Sales Revenue 10,000 = 1.79x
Capital Employed 5,600

A measure of how effectively the firm is using its

funding base to generate sales.
Broadly speaking, the higher the ratio, the better, but a
very high ratio may suggest under-capitalisation
Sometimes called asset turnover ratio - based on
total assets less current liabilities, which is an
alternative definition of capital employed.
Non-current Asset Turnover
Ratio
Sales Revenue 10,000 = 2.5x
Non-Current Assets 4,000
A measure of how effectively the firm is using its
long-term asset base to generate sales.
May be of particular relevance in comparing the
performance of, for example, retailers (whose major
asset is usually the selling space) or high-tech
manufacturers
BUT may be distorted by failure to replace assets
Total Asset Turnover Ratio
Sales Revenue 10,000 = 1.45x
Non current + Current Assets 6,900

A measure of how effectively the firm is using its

entire asset base to generate sales.
If a firm is fixed-asset-heavy or carries high
levels of stock then a low ratio may suggest lack
of efficiency
Useful for comparisons between firms with
different funding bases
 Asset Age

Net book value 4,000 x 100% = 89%

Asset Cost 4,500

89% of the assets cost remains undepreciated

at the year-end
A measure of the age of non-current assets
Provides a guide as to the amount of asset un-
depreciated.
Average (Debtor) Collection
Period
Trade Receivables 900 x 365 days
Credit Sales 10,000
= 33 days

Measures the average time taken to collect money

from receivables
May be distorted by seasonal factors or by major
upturns in sales activity
Inventory Turnover Period
Inventory 1,000 x 365 days
Cost of Sales 5,000
= 73 days
Measures the average time taken to turn inventory into
sales (or the average length of time inventory is held
for)
May be distorted by seasonal factors or by major
upturns in sales activity
uses Cost of Sales and not sales
Payables (Creditor) Payment
Period
Trade Payables = 900 x 365 days
Cost of Sales 5,000
= 65.7 days
Measures the average time taken to pay suppliers
May be distorted by special treatment of a few large
suppliers
cost of sales acts as a reasonable proxy for
purchases on credit (which is what gives rise to
trade payables)
 Working Capital Efficiency
Money owed by customers or tied up in stocks is a quasi-
investment of company funds; money owed to suppliers is
an informal borrowing.
Most firms try to manage working capital to reduce the
amounts involved: faster payment by debtors reduce the
default risk and increases a firms own liquidity; holding
the minimum safe level of stock saves on storage,
obsolescence risk, insurance etc.
Making creditors wait too long for payment may incur
legal penalties, affects supplier relationships and makes for
a poor credit history - to be practised with caution!
Other efficiency measures
Sales per employee: Sales 10m
Average employees 100
= 100,000 per head

(Higher sales/employee implies higher productivity)

Average wage: Wages 1,000k

Average employees 100
= 10,000 per year each
(A high average wage may imply a more motivated and
skilled workforce)
Gearing (Financial structure)
Posh PLC has share capital of 1m and long term loans of
1m, borrowed at 10% interest. It pays no tax.
(000) 2012 2013 2014
PBIT 200 300 500
(% increase) +50% +67%

Interest charges 100 100 100

Available for shareholders 100 200 400
(% increase) +100% +100%

The effect of fixed borrowings is to gear up (or leverage)

the return to ordinary shareholders - provided that the good
times keep rolling!
 Gearing (Financial structure)

Scary PLC has share capital of 1m and long term loans of

1m, borrowed at 10% interest. It pays no tax.
(000) 2012 2013 2014
PBIT 200 220 180
(% increase) +10% -18%
Interest charges 100 100 100
Available for shareholders 100 120 80
(% increase) +20% -33%
The gearing effect works both ways: when profits fall, the
return to shareholders falls more sharply.
Gearing is a measure of financial risk, because lenders
have first call on profits and must be paid first.
Debt : Capital Employed Ratio

borrowings as a % of long-term funding.

Higher gearing makes the returns to shareholders more
volatile (more risky).
Long-term debt 2,000 x 100% = 35.7%
Capital employed 5,600

no hard-and-fast rule about what is an appropriate level of

gearing - varies from industry to industry
Gearing by itself may also be misleading: 36% gearing
may appear much more risky when interest rates are high
compared to times of low interest rates.
 Interest Cover Ratio

PBIT (Operating Profit) 2,000 = 6.7x

Interest Payable 300

indicates how well the interest bill can be afforded: how

safely can the business service its debt from PBIT?
High levels of interest cover suggest that the lenders
repayments are reasonably secure.
High cover may also suggest that a firm is UNDER-
borrowed: if FCPS can borrow at 15% and earn a return of
35% on the funds, the return to shareholders would be
boosted by higher borrowings to fund further expansion.
 Total Owing: Total Assets Ratio

Current Liabilities + Long-term debt 3,300 x100%

Non-current Assets + Current Assets 6,900
= 48% or 0.48 : 1
If the firm went bust and secured lenders were repaid first,
how much might the rump of the firm be worth in a fire
sale?
What risks does a supplier run by trading with the firm?
Suggests that liabilities are > 2x covered by asset values.
Implies that the firm can go bust (& have its assets sold off at
anything up to a 50% discount) without the unsecured
creditors losing out on what is owed to them.
 Assumptions

We are given the following information:

FCPS has been floated on the stock market. Its
2.6m ordinary shares were issued at a price of 1
each.
The shares would now cost 5.00 each to buy on
the stock market
The average dividend yield in FCPS market
sector is 3.5%
The average Price/Earnings Ratio is 7x
 Dividend yield
Dividend per share (300/2,600) x 100%
Price per share 5.00
= 2.31%
what return would I earn if I invested now?
Dividend per share is calculated by dividing the
total annual dividend by the total number of shares
in issue (most companies disclose the rate of
dividend per share in their reports anyway)
 Earnings per share (EPS)

Shareholders profit (PAT) 1,300,000 =0.50

Total shares in issue 2,600,000

how much profit does investing in 1 share buy?

(NB strictly, this calculation is based on the
AVERAGE shares in issue)
NB shares dont have to have a 1 par value -
they might be 5p or 10p shares and so the number
of shares will be proportionately larger - and the
EPS proportionately smaller.
 Dividend Cover
Shareholders profit OR Earnings per share
Dividends payable Dividend per share
1,300,000 50.00p
300,000 11.54p = 4.3 x
very like interest cover: how affordable is the dividend?
Expanding companies with new projects to invest in
may pay out proportionally less in dividends; mature
cash cows proportionally more
Either way, the safety of future dividends may depend
on a relatively cautious payout now!
 Price/Earnings Ratio
Current share price 5.00 = 10x
Earnings per share 0.50
Someone buying a share in FCPS has to pay 10 times
current earnings as against a sector average of 7x earnings
a measure of market expectations: a highly regarded firm
has a high P/E since its future earnings prospects are
regarded as good enough to warrant paying more for the
shares
This might reflect prospects for business growth,
perceptions of management quality, market leadership (or
even flavour of the month in market fashions)
 Market Capitalisation
Current share price x Shares in issue = Market Cap
5.00 x 2.6m =13.0m
Total stock market value of the firm (this compares
with a net asset value of 3.6m or 1.38 per share)
Capitalisation varies daily with share price movements
Passing a certain threshold for capitalisation may
enhance the status of a share (e.g. if it qualifies for
membership of a representative index FTSE100,
many index-tracking funds MUST therefore invest in
 Cash Based Ratios

Cash flow is an objective measure not subject to

accounting assumptions and allocations
Cash flow ratios may provide a useful control when
assessing accounting-based performance
Over the medium term, one would expect a firms
operating cash flow to cover all its ongoing
obligations (debt servicing, dividend payments, tax
payments) and investment needs (replacement of the
fixed asset base), although major expansions such as
new projects or takeovers might still need to be
funded externally
 Cash Based Ratios :
Quality of Earnings
Net operating cash flow 1,500 x 100% = 75%
Operating profit 2,000

What proportion of profit is represented by cash

flows?
Unless a firm has consistent, rapid expansion over
several years (therefore increased non-cash
depreciation) the two bases should grow closely
together.
 Cash Based Ratios:
Quality of Sales

Cash from customers 9,100 x 100% = 91%

Sales revenue 10,000

Measures what proportion of reported sales

revenue is represented by cash generation
Cash Based Ratios:
Cash Generation v Obligations Maturing
Cash generated from operations to maturing obligations ratio

Net cash flow from operating activities = 1,500 = 1.15

Current Liabilities 1,300

The higher the ratio, the better for the liquidity of the
company
Using operating cash flows rather than current assets is often
seen to be a more reliable guide to liquidity
Here, the company generates 1.15x the operating cash flows
for the year compared to the current liabilities owed at the
year-end