KEY QUESTIONS

Users

Information
Shortcomings

Different techniques
USERS OF FINANCIAL
STATEMENTS
Share-
(5-9 to 5-11) holders

Credit
grantors

Customers Suppliers

Merger
Auditors
analysts

Manage- Govern-
Employees
ment ment
 WHAT?
SOURCES OF INFORMATION
(p5-2 to 5-9)

• Integrated report (Information systems / DLA 212; more

detail in PGDA)
- Organizational overview and external environment, Governance and remuneration,
Business model, Risks and opportunities, Strategy and resource allocation,
Performance, Outlook
• Published annual financial statements and interim
statements
- Statement of Comprehensive Income
- Statement of Financial Position
- Statement of Cash Flows
- Statement of Changes in Equity
- Directors’ report
- Auditors’ report
 WHAT?
SOURCES OF INFORMATION
(p5-2 to 5-9)

Documents made available to the Registrar of Companies

SENS information at the JSE

Statistics SA

Other publications e.g.

Business section of papers and magazines
Websites with investor information
 LIMITATIONS OF ACCOUNTING DATA
(p5-11 to 5-12)

Monetary expression

Simplification and summarisation

Estimations, subjectivity & changes in accounting policy

Inflation impairs comparison

 HOW?
VARIOUS TECHNIQUES
(p5-12 to 5-15)

1 Comparative financials and

Trend analysis
Compare over time. Direction, rate, amount

2 Index analysis Figures expressed i.t.o base year (100%).

3 Common size analysis Every year – Assets = 100%; Equity + Liabilities

= 100% (SFP); Sales = 100% (SCI). Be Careful!

4 Cash flow analysis Operating – Investment and Financing activities

What happens to the company’s money? How is
cash generated

5 Ratio analysis Relationship of one variable to another variable

1. COMPARATIVE ANALYSIS
Year-on year trend/change
e.g trend over 10 years
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Sales (in Rands) 40 000 50 000 150 000 155 000 85 000 60 000 70 000 80 000 75 000 85 000 77 000 90 000
% Change (Sales) 25% 200% 3% -45% -29% 17% 14% -6% 13% -9% 17%

Sales (in Rands)

180,000

160,000

140,000

120,000

100,000

80,000

60,000

40,000

20,000

-
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
2. INDEX ANALYSIS

3 573 / 2 320

Typical Limited

Statement of Comprehensive Income 2016 2015 2016 2015

Rm Rm
Income Statement

Sales revenue 3 573 2 320 154% 100%

Cost of sales -2 036 -1 206 169% 100%
Gross Profit 1 537 1 114 138% 100%
Sales and marketing expenses -679 -394 172% 100%
Admin and general expenses -322 -186 173% 100%
Other expenses -254 -116 219% 100%
Profit before interest and tax 282 418 67% 100%
Finance costs -100 -80 125% 100%
Profit before tax 182 338 54% 100%
Income tax expense -54 -101 53% 100%
Profit for the year for continuing operations 128 237 54% 100%
Dividends -53 -99 54% 100%
Retained earnings for the year 75 138 54% 100%
 3. COMMON SIZE ANALYSIS

Express line items as % of assets or sales 2 036 / 3 573 x 100

Typical Limited

Statement of Comprehensive Income 2016 2015 2016 2015

Rm Rm
Income Statement

100% Sales revenue 3 573 2 320 100.0% 100.0%

Cost of sales -2 036 -1 206 57.0% 52.0%
Gross Profit 1 537 1 114 43.0% 48.0%
Sales and marketing expenses -679 -394 19.0% 17.0%
Admin and general expenses -322 -186 9.0% 8.0%
Other expenses -254 -116 7.1% 5.0%
Profit before interest and tax 282 418 7.9% 18.0%
Finance costs -100 -80 2.8% 3.4%
Profit before tax 182 338 5.1% 14.6%
Income tax expense -54 -101 1.5% 4.4%
Profit for the year for continuing operations 128 237 3.6% 10.2%
Dividends -53 -99 1.5% 4.3%
Retained earnings for the year 75 138 2.1% 5.9%
4. CASH FLOW ANALYSIS
o t in
N reia
r
Co
 Cash flow analysis
1. Compare profit before tax and interest, with cash from operations
- Is sufficient cash generated by the business?

Cash conversion rate = Cash flow / profit

This can be measured at different levels, however the cash flow and profit
information must be comparable, e.g.: cash flow from operations and
EBITDA. The ratio measures the proportion of profit that is changed into
cash.

2. Operating activities continued

Financing costs:
- Movement in loans
- Change in interest rates

Tax: Difference of paid and payable (what caused increase and difference)

Dividends - From what was it paid?

 Cash flow analysis
Movement in statement of cash flows or
difference between balances in statement of
3. Working capital changes financial position.

Compare growth in sales to change in working capital:

Increase in accounts receivable Growth in sales? Change in

credit policy? Poor management? Problems with collection?
Interaction with
Increase in inventory Decrease in sales? Old inventories? asset
Price increases? Shortages or surpluses in manufacturing? management
ratios?
Decrease in accounts payable Pressure to pay? Alternative
financing source? Increase  Not able to pay

4. Investing activities

Acquisition of equipment – replacement or expansion? Compare replacement

with depreciation over period. Was there a similar increase in profits?
 Cash flow analysis
5. Financing activities

What type of financing?

What was the purpose?

Loans that are not repaid – reason? Is there a deviation from the contract
stipulations?

What was the movement in cash / bank overdraft?

Isn’t the bank overdraft rather part of permanent financing?

What was the cash used for; or what was the source of the increase?

6. Conclusion
 5. RATIO ANALYSIS (p5-15 to 5-
26)

1. Market value ratios Later – Covered in Valuations and Mergers and Acquisitions

2. Debt management ratios

3. Asset management ratios Covered in Working Capital and Cost of Capital (278)

4. Liquidity ratios Covered previously

5. Profitability ratios
6. Cash flow ratios
Refer to Financial Statements of
Typical Limited on Sunlearn or
p.5-6 to p. 5-9 in Correia
 PE-ratio
Dividend payout ratio
Market value ratios Dividend yield
Earnings yield
Later in the year Dividend cover

Interest cover
Debt management ratios Debt to equity
Debt ratio

Asset turnover
Asset management ratios Debtors collection period
Inventory turnover
Working capital management
Financial ratio
analysis
Liquidity ratios Current ratio
Quick ratio

Growth in sales
Gross profit margin
Profitability Operating profit margin
Statement of Comprehensive Net profit margin
Income Return on total assets (ROA)
Return on equity (ROE)
EPS

Cash flow Profit vs cash?

Statement of cash flows Cash flow to total debt
 Debt
management
ratios
 Interest cover
EBIT / Interest

2016 2015
282/100 418/80
= 2.82 times 5.23 times

EBITDA coverage
EBITDA / Interest
 Debt ratio
Total debt / Total assets
Or Debt to Equity

2016 2015
520/ 1435 480/1320
= 36.24% 36.36%

Total assets = total debt + total equity

 Debt to equity ratio
IB debt / Total equity
Interest
Bearing Or I/B Debt / Total Assets
2016 2015
(400 + 22) / 915 (380 +12)
= 46.12% = 46.67%

Interest bearing debt (LT & ST) is a source of

financing from return-seeking investors 
not part of recurring operating cycle  not
part of working capital
 PE-ratio
Dividend payout ratio
Market value ratios Dividend yield
Earnings yield
Later in the year Dividend cover

Interest cover
Debt management ratios Debt to equity
Debt ratio

Asset turnover
Asset management ratios Debtors collection period
Inventory turnover
Working capital management
Financial ratio
analysis
Liquidity ratios Current ratio
Quick ratio

Growth in sales
Gross profit margin
Profitability Operating profit margin
Statement of Comprehensive Net profit margin
Income Return on total assets (ROA)
Return on equity (ROE)
EPS

Cash flow Profit vs cash?

Statement of cash flows Cash flow to total debt
 Asset
management
ratios
Inventory turnover
COS / Inventory

2016 2015
2036/65 1206/60
31.3 times 20.1 times
Debtor’s collection period
Trade receivables / credit sales x 365

2016 2015
122 / 3573 x 365 108 / 2320 x 365
= 12.46 =16.99
Fixed asset turnover
Sales / fixed assets

2016 2015
 Asset turnover
Sales / Assets

2016 2015
 Change in working capital
[Raw material days + WIP days + Finished goods days] + Debtors days –
Creditors days
= Inventory days + Debtors days – Creditors days

Increase WCC: Inv days Deb days Cred days

Utilises cash

Decrease WCC: Inv days Deb days Cred days

Generates cash

Optimal WC policy = balance risk & return

Application of ratio analysis: Asset Management ratios
Refer to – Working Capital lectures

Working capital ratios

Working capital ratio: Current assets: Current liabilities

Quick ratio: Norm depends on

(Current assets – Inventory) : Current liabilities industry, history etc…

Debtors collection period:

Trade debtors / Credit sales x 365

Creditors payment period:

Trade creditors / Credit purchases x 365

Inventory days:
Inventory / Cost of sales x 365
 PE-ratio
Dividend payout ratio
Market value ratios Dividend yield
Earnings yield
Later in the year Dividend cover

Interest cover
Debt management ratios Debt to equity
Debt ratio

Asset turnover
Asset management ratios Debtors collection period
Inventory turnover
Working capital management
Financial ratio
analysis
Liquidity ratios Current ratio
Quick ratio

Growth in sales
Gross profit margin
Profitability Operating profit margin
Statement of Comprehensive Net profit margin
Income Return on total assets (ROA)
Return on equity (ROE)
EPS

Cash flow Profit vs cash?

Statement of cash flows Cash flow to total debt
Liquidity
ratios
 Current ratio

2016 2015
 Quick ratio

2016 2015
 PE-ratio
Dividend payout ratio
Market value ratios Dividend yield
Earnings yield
Later in the year Dividend cover

Interest cover
Debt management ratios Debt to equity
Debt ratio

Asset turnover
Asset management ratios Debtors collection period
Inventory turnover
Working capital management
Financial ratio
analysis
Liquidity ratios Current ratio
Quick ratio

Growth in sales
Gross profit margin
Profitability Operating profit margin
Statement of Comprehensive Net profit margin
Income Return on total assets (ROA)
Return on equity (ROE)
EPS

Cash flow Profit vs cash?

Statement of cash flows Cash flow to total debt
Profitability
ratios
Gross profit margin
Gross profit / Sales

2016 2015
Operating profit margin
EBIT / Sales

2016 2015
Net profit margin
Net profit / Sales

2016 2015
 Return on total assets
EBIAT (or NOPAT) / Total assets
Conceptually most correct!

2016 2015

2016 2015
EBIT 19.65% 31.67%
EAIT 8.92% 17.95%
Earnings before interest after tax (EBIAT)

EBIAT can be calculated in one of two ways:

1. Net profit plus after-tax interest

Net Profit 128
Interest 100
Add back:
Tax on interest (28)
After-tax interest 72
= EBIAT 200

2. EBIT x 72%
EBIT 282
This will only work where
X 72%
there is NO deferred tax
=EBIAT 203 or permanent differences

ALWAYS USE METHOD ONE TO BE SAFE

 Return on net assets (RONA)
NOPAT / Net operating assets
Also called
ROCE or Conceptually most correct!
ROIC
2016 2015
128 + (100 x 0.72) / 1 337 237 + (80 x 0.72) / 1 232
= 14.96% = 23.91%

Net assets (or net operating assets) 2016 2015

Total assets – current liabilities (1 435 – 98) 1 337 1 232
Non-current assets + NWC (1 227 + (208-98) 1 337 1 232
 Return on equity
Net profit / Shareholder funds

2016 2015
Leverage – impact on earnings
Refer to ManAcc 278 – Capital structure (Chapter 14)

What is impact of debt on shareholder earnings (ROE)?

Example 14.1 (Correia p.14-4)

 Companies A and B are identical, except for their

financing

 A: All equity company

 B: Leveraged capital structure

Debt ratio of 40%
Interest of 11% pa
Tax = 28%
 Assets = R1 000m
 Operating profit = R400m

Compare the ROA and ROE of the two companies.

Leverage – impact on earnings
Example 14.1

256.3 +(44 x 72%) / 1000 = 256.3 / 600 = 42.7%

28.8%
COMPANY A COMPANY B
Equity R1,000 Equity R600
Debt - Debt R400

EBIT R400 EBIT R400

Interest R0 Interest (R44)
Tax (R112) Tax (R99.70)
Net profit Net profit
R288 R256.30

Return on equity 28.8% Return on equity 42.7%

Return on assets 28.8% Return on assets 28.8%

Return on equity = Net profit/ Equity

Return on assets = NOPAT or EBIAT / Assets

Positive leverage:
When after-tax cost of debt ((11% x 0.72)=7.92%) is lower than the return on assets,
(28.8%), it will increase shareholders' return (42.7%).
Leverage – impact on earnings

Unfavourable effect of leverage

Example 14.2

 Companies A and B are identical, except for their

financing

 A: All equity company

 B: Leveraged capital structure

Debt ratio of 40%
Interest of 11% pa
Tax = 28%
 Assets = R1 000m
 Operating profit = R42.5m

Compare the ROA and ROE of the two companies.

 Leverage – impact on earnings
Example 14.2
(42.5 x 72%) / 1000 =
3.06%
-1.5 / 600 = -0.25%%
COMPANY A COMPANY B
Equity R1,000 Equity R600
Debt - Debt R400

EBIT R42.5 EBIT R42.5

Interest R0 Interest (R44)
Tax (R11.9) Tax ( 0 )
Net profit Net profit
R30.6 (R1.5)
Return on equity -0.25%
Return on equity 3.06% Return on assets 3.06%
Return on assets 3.06%

Cost of debt (11x0.72=7.92)> Return on assets (3.06%)

Negative leverage:
When after-tax cost of debt ((11% x 0.72)=7.92%) is higher than the return on assets,
(3.06%), it will decrease shareholders' return (-0.25%).
 PE-ratio
Dividend payout ratio
Market value ratios Dividend yield
Earnings yield
Later in the year Dividend cover

Interest cover
Debt management ratios Debt to equity
Debt ratio

Asset turnover
Asset management ratios Debtors collection period
Inventory turnover
Working capital management
Financial ratio
analysis
Liquidity ratios Current ratio
Quick ratio

Growth in sales
Gross profit margin
Profitability Operating profit margin
Statement of Comprehensive Net profit margin
Income Return on total assets (ROA)
Return on equity (ROE)
EPS

Cash flow Profit vs cash?

Statement of cash flows Cash flow to total debt
Cash flow
ratios
 Cash flow to total debt
Cash flow from operations /
Total debt
Interest Bearing Debt
…. Why?

2016 2015
N/A
 PE-ratio
Dividend payout ratio
Market value ratios Dividend yield
Earnings yield
Later in the year Dividend cover

Interest cover
Debt management ratios Debt to equity
Debt ratio

Asset turnover
Asset management ratios Debtors collection period
Inventory turnover
Working capital management
Financial ratio
analysis
Liquidity ratios Current ratio
Quick ratio

Growth in sales
Gross profit margin
Profitability Operating profit margin
Statement of Comprehensive Net profit margin
Income Return on total assets (ROA)
Return on equity (ROE)
EPS

Cash flow Profit vs cash?

Statement of cash flows Cash flow to total debt
Bringing it all together

2016 2015
Interest cover 2.82 5.23
Debt ratio 36.24% 36.36%
Debt equity ratio 46.12% 46.67%
Gross profit margin 43.02% 48.02%
Net profit margin 3.58% 10.22%
Return on total assets 13.94% 22.32%
Return on equity 13.99% 28.21%

Look at all previously calculated ratios in example together.

Tell the story of this company

Good exam technique:

- Interpretation of comparison to benchmark, using info in scenario
- Interpretation in relation to another relevant other ratio, using info in
scenario
F.S analysis based on context; industry norms- bigger picture Example

Italtile Integrated Annual Report 2019 p.72

Market value ratios- Example
covered later

Italtile Integrated Annual Report 2019 p.72

 LIMITATIONS OF RATIO ANALYSIS p5-29

 Diversified into different industries?

 Leader or average?

 Different accounting policies

 “Window-dressing”

 Subjective assessment of good or bad

 Change in type of business

 Very old assets

 OTHER FINANCIAL STATEMENT
CONSIDERATIONS

• Structured analysis: Du Pont Covered at PGDA level

• Economic Value Added (EVA)

• What’s behind the numbers

• Failure prediction Refer to Businesses in

Financial Distress
 Performance measures
MDC
Examples of financial measures: Performance
o Return on investment (ROI) Measurement – Part 1
= Return / Investment

o Residual income (RI) (sometimes also called Economic Profit)

= Return – (Investment x Required rate of return)
What is meant
o Economic value added (EVA™) by ‘adjusted’?
= Adjusted EBIAT – (Adjusted invested capital x WACC)

Before interest, but

Total assets less non-interestbearing short term liabilities
After tax
OR
Non-current assets plus net working capital
 MDC
EVA TM Performance
Measurement – Part 1

• EVATM (Economic value added) is a specific form of RI that is

patented by the consulting firm Stern Stewart.

• There are more than 170 possible adjustments that should,

according to Stern Stewart, be made to ‘return’ and ‘investment’.
Most adjustments revolve around the fact that items that are treated
as accounting expenses in a given period but in fact render long-
term benefits (e.g. marketing and advertising, research and
development), are capitalised and amortised.

• According to Joel Stern only 10 to 20 of these possible adjustments

may apply to any single average organisation.
 ECONOMIC VALUE ADDED (EVA)

When is wealth created or destroyed?

NOPAT Equity + Interest-bearing liabilities

EVA = Return – (WACC x invested capital)

Please note: We will only do unadjusted EVA – which

then is effectively the same as Residual Income (RI).
EVA is also used in some valuation methods, which will
be covered in the second semester.
 ECONOMIC VALUE ADDED (EVA)

CLASS EXERCISE
• Calculate Typical Limited’s EVA. Assume cost of capital
is 16% and tax is 28%.

• Compare EVA to ROE.

 ECONOMIC VALUE ADDED (EVA)

2016 Rm

Invested capital 1 337

Cost of Capital (required return) 16%

214

NOPAT 200

EVA (14)
 WHAT’S BEHIND THE NUMBERS?

Understand……

→ The business and industry sector

→ Business and financial risks

→ Key drivers

→ Management’s motives for selecting accounting policies

→ Accounting policy with flexibility

 UNDERSTAND THE WARNING SIGNS
• Increase in accounts receivable that exceeds the increase in sales.
• Increase in inventory that exceeds the increase in sales.
• Restructuring, non-recurring charges and asset write-downs or
sales
• Accounting income and tax losses.
• Accounting income and a negative operating cash flow
• Complex company structures and related party transactions.
• Accounting policies in relation to research and development,
depreciation and leasing.
• Accounting practices that are at variance with the norm for the
industry sector.
• Lack of corporate governance.
• Changes in auditors, Qualified opinions or published disagreement
with the auditor.
• Changes in revenue recognition policies.
• Vendor financing and financing structures.
• Changes to provisions and reserves.
 FURTHER FACTORS TO CONSIDER

Are the directors selling their shares Are there rumors w.r.t. product
in co? quality?
Is the co aggressive wrt recognizing Does the co have strong brands?
revenue on LT contracts?
Is the co aggressive about Communication with s-holders and
acquisitions? analysts
Are the customers of the co Is management incentivized to
performing well? focus on shareholders interests?
Is the co subject to litigation? Is the quality of management better
than that of rest of the industry?
Is the company subject to significant Does the co make optimal use of IT
operational risks? Do they have
insurance?
Does the company have Does the co have valuable
environmental liabilities? intangible assets
 Analysis of information
How to decide the scope of what to discuss / exam technique
• Don't jump in and start discussing – plan carefully what you will include!
• Scope will be determined by:

Required part
Mark allocation Specific areas for
Distribute the discussion / specific 50 mark
marks over audience question
different
subcategory 15 mark
question
Availability of
Company's comparative
position information
Apparent problem In most cases,
areas? Context? ratios can only be
Other information interpreted with a
in scenario? comparative