1 Business analysis Concepts 2008 revision
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1
Business analysis
Concepts
2008 revision
2
References
Making the most of your tax accountsJohn Warrington Milk Development Council
Financial & Management AccountingPauline Weetman Financial Times/Pitman
Applied Farm ManagementJ Turner and M Taylor BSP
Business analysis with ExcelConrad Carlburg QUE
Using your accountsFamily Farm Series ATB
Financial Management for Farmers and Rural Managers Martin F Warren Stanley Thornes Interpreting Company Reports and Accounts G. Holmes and A. Sugden Prentice Hall
3
Comparative analysis
4
Comparative analysisTeam MT PTS TRS CON PEN DG YC RC
New Zealand 5 327 48 36 5 0 2 0
South Africa 7 278 33 25 21 0 3 0
France 7 227 27 19 18 0 2 0
Australia 5 225 31 20 8 2 2 0
Argentina 7 209 23 14 18 4 3 0
Wales 4 168 23 16 7 0 0 0
England 7 140 12 7 17 5 1 0
Fiji 5 134 16 12 10 0 3 0
Scotland 5 129 15 15 8 0 1 0
Tonga 4 89 9 7 10 0 3 1
Italy 4 85 8 6 11 0 3 0
Samoa 4 69 5 4 12 0 1 0
Ireland 4 64 9 5 2 1 2 0
Japan 4 64 7 4 7 0 0 0
USA 4 61 7 4 6 0 4 0
Canada 4 51 6 3 5 0 1 0
Georgia 4 50 5 5 5 0 2 0
Romania 4 40 5 3 3 0 1 0
Portugal 4 38 4 3 3 1 1 0
Namibia 4 30 3 3 2 1 0 1
http://www.rugbyworldcup.com/statistics/season=2007/type=Points/team=0/statistics/index.html
5
Comparative analysis
A comparison of results with other information sources
Internal previous years accounts current budgets
External Independent surveys
6
Comparative analysis
Comparison has to be on a “like for like” basis
Farm Income debt free tenant farmer without salaried
management Management and Investment Income Net Farm Income
7
Management and Investment Income
The reward for the farmer’s (and spouse) management and interest on the tenant’s capital employed on the farm
8
Management and Investment Income
+Overdraft interest
+Mortgage interest
+Management fee
-Notional rent
less
TPLA profit/loss
REVENUE
Closing valuation
EXPENDITURE
Opening valuation
MII
equals
Overdraft interest, Mortgage interest and Management fee will have been included in EXPENDITURE and are deductions which reduce Profit. By adding them back to profit the deduction is cancelled and has no effect on the measure of output (MII).
Notional rent is an additional deduction to convert all farms to a tenanted basis. This allows for ‘like for like’ comparisons
Deducting notional rent from profit reduces the measure of output (MII).
9
Management and Investment Income (example)
+Overdraft interest
+Mortgage interest
+Management fee
-Notional rent
less
TPLA profit/loss
REVENUE
Closing valuation
EXPENDITURE
Opening valuation
MII
equals
£20 000
£5 000
Includes £5 000 overdraft
£25 000
£100 000 £80 000
- £5 000
+ £5 000
Effect on MII is £ 0
10
Net Farm Income
The return to farmer and spouse on tenant type capital for their labour and management
Calculated as if all farms are tenanted
11
Overhead costs NFI vs MII vs Profit NFI MII Profit
Regular labour and NI Physical labour farmer and spouse Unpaid family labour Paid management Rent and rates Notional rent Machinery depreciation Machinery running and repairs Interest Miscellaneous (including office costs, accountant, telephone, insurance, membership fees)
12
Comparative analysis
Gross Margins Gross margin per head (GM per hd) Gross margin per hectare (GM per ha)
Overheads Overhead cost per hectare Overhead costs per £100 output Overhead costs as a proportion of gross
margin
13
Gross Margin per head to Gross Margin per hectare
Gross Margin per head (£/hd)
X
Stocking rate (no./ha)
=
Gross Margin per hectare (£/ha)
14
Proportional analysis
Assessment of technical and financial efficiency of the business
Costs are expressed as a % of total output
Commonly used for dairy herd analysis
15
Proportional analysis example
Your figures % Top 25%£ actual
Output 300,000 100% 100%
Variable costs 100,000 33% 34%GROSS MARGIN 200,000£ 67% 66%
Labour 55,000 18% 8%Power and machinery 15,000 5% 7%Property 22,000 7% 5%Sundries 23,000 8% 3%Interest 16,000 5% 5%Rent 5,000 2% 3%Depreciation 24,000 8% 7%TOTAL FIXED 160,000£ 53% 38%
PROFIT 40,000£ 13% 28%
16
Unit cost of production
Used when large proportion of output from one source
Dairy production Output and costs divided by total litres
produced Beef production
Output and costs divided by total kg meat produced
17
Unit cost of production (1)
Dairy gross margin (unit cost basis)
Yield (litres per cow) 6000Output £ per cow p per litre
Milk 1080 18.0Calf 50 0.8
Replacements -103 -1.7Total 1027 17.1Variable costs
Concentrate 173 2.9Sundries 140 2.3
Forage 84 1.4Total 397 6.6GROSS MARGIN 630 10.5
18
Reductionalist theory
Break down results into individual components
Allows physical and financial analysis to proceed
19
Sensitivity analysis
Analyse effect of change (in advance) on enterprise profitability
Sensitive items cause large changes e.g. commodity prices
Insensitive items cause small changes e.g. vet and med, sundries
sensitivity
resp
on
se
20
Sensitivity analysis
input
ou
tpu
t
less sensitive
more sensitive
response
21
Sensitivity analysis example
Cow yield 6000 litres Milk price 16 ppl 100 cows in herd Vet and Med £15 per cow
Assess the effect of 10% change in milk price vs Vet and Med
22
Sensitivity analysis – change in margins
Milk± 10% x 16ppl x 6000 litres x 100 cows
= ± £9600 Vet. and Med.
± 10% x £15 per hd x 100 cows
= ± £150
23
Business analysis
Methods
24
“….published accounts are utterly and absolutely useless….”
Clive JenkinsUnion Leader
Quote
25
Purpose of business analysis
Identify strengths and weaknesses Is the business sustainable?
Short term Cash flow, Operational requirements
Long term Profitability, Equity
26
Core analysis
Profit Capital Cash
27
Analysing profit
PROFIT
EXPENDITURE
REVENUE
OPENING VALUATION
CLOSING VALUATION
28
Why does a business need a profit?
Profit provides for:- Personal drawings Taxation Repayment of borrowed money Replacement of machines Investment or expansion purposes
29
Profit sufficiency
Profit requirements are specific to a business
A business with “profit sufficiency” provides adequate cover for personal and investment needs
30
Profit sufficiency example
PROFIT requirement remainder
Personal drawings 10 000 50 000
Taxation 5 000 40 000
Repayment of borrowed money 7 000 35 000
Replacement of machines 20 000 28 000
Investment or expansion purposes 3 000 8 000
PROFIT SUFFICIENCY 5 000
PROFIT
31
Analysing Profit
Have you a profit or a loss ? Is the profit sufficient ? Does profit cover private drawings ? How was the profit earned ? Are there extraordinary items ?
32
Profit does not cover private drawings
Private drawings and taxation Lifestyle?
33
How was profit earned ?
Sales Costs Valuations Depreciation
Level of investment
What are the main contributory elements?
34
Sales example
Item (Year 1) £
Finished lambs 35000
Store lambs 5000
Cull ewes 1800
Wool 500
Breeding stock 1200
TOTAL 43500
Item (Year 2) £
Finished lambs 27000
Store lambs 15000
Cull ewes 1500
Wool 700
Breeding stock 2400
TOTAL 46600
35
Analysis overall
salesin change % 100
£Year1
1Year 2Year
salesin increase %13.7100
43500£
43500£46600£
A negative value would indicate a decrease in sales
36
Individual component analysis
Year 1 Year 2 % changeFinished lambs 35000 27000 -22.9%
Store lambs 5000 15000 200.0%
Cull ewes 1800 1500 -16.7%
Wool 500 700 40.0%
Breeding stock 1200 2400 100.0%
TOTAL 43500 46600 7.13%
Is this misleading?
37
Proportional analysis of sales (Year 1)
Wool1%
Cull ewes4%
Breeding stock
3%
Finished lambs81%
Store lambs11%
Item £
Finished lambs 35000
Store lambs 5000
Cull ewes 1800
Wool 500
Breeding stock 1200
TOTAL 43500
38
Proportional analysis of sales (Year 2)
Wool2%
Cull ewes3%
Breeding stock
5%
Finished lambs58%
Store lambs32%
Item £
Finished lambs 27000
Store lambs 15000
Cull ewes 1500
Wool 700
Breeding stock 2400
TOTAL 46600
39
Sales and Costs
Breakdown into physical and financial aspects
How do they compare to last year? How do they compare to budget? How do they compare to others? What are the main contributory
elements?
40
Comparative time frame
Sales
Costs
currentaccounts budgets
-1-2-4 -3
Sales
Costs
Sales
Costs
Sales
Costs
Sales
Costs
Sales
Costs
Sales
Costs
Sales
Costs
more accurate
less accurate
more accurate
less accurate
41
Valuations
Are they realistic? Retained or unsold livestock increase
Closing Valuation and Profit Knock on effect for following year Valuations are an unsustainable
source of profit
42
Valuation as a source of Profit
Revenue 100 000 Expenditure 100 000
Closing valuation
35 000Opening valuation
25 000
Revenue - Expenditure 0
Change in valuation (CV-OV) + 10 000
PROFIT 10 000
43
Depreciation and investment (1)
Investing in machinery and buildings increases depreciation charge
High depreciation costs indicate high levels of investment
Low depreciation charges indicate low levels of investment
44
Depreciation and investment (2)
High depreciation could indicate over investment
High depreciation could indicate compensatory investment
Low depreciation might trigger compensatory investment in the future
45
Depreciation vs investment
time
£
Depreciation
Maintenance
Total
Total costs greater than original costs - reinvest
46
Are there extraordinary items?
Unexpected items of revenue Rare (windfall)
Unexpected items of expenditure Common
building repairs high replacement rate Labour
Likely to increase with uncertainty in weather patterns
47
Analysing gross margins
A measure of enterprise productivity Physical efficiency Financial efficiency
48
Relationship between Profit and Gross Margin
Profit
Gross Margin
Fixed Costs (Overheads)
Variable Costs
Enterprise Output
Other Enterprise Gross Margins
49
Physical and Financial analysis
Comparative Per ha Per £100 working capital Per 100 hours labour
Published information
50
Strengths of gross margins
Simple to construct and use Useful tool for business planning Indicates inter enterprise strength and
weakness
£100 GM per ha
£50 £25
51
Weaknesses of gross margins
Does not produce profit figure Overheads excluded
Gross margin must be interpreted in relation to overhead cost
Profit is not proportional to gross margin Does not allow for compensatory or
detrimental relationships between enterprises
52
Profit is not proportional to gross margin
Gross Margin
Fixed Costs
Profit
Lower Fixed Costs result in higher proportion of Gross Margin as Profit
Gross Margin
Fixed Costs Profit
Higher Fixed Costs result in lower proportion of Gross Margin as Profit
53
Scatter graph analysis
Total Overhead costs £ per ha
Gro
ss M
arg
in £
per
ha
HI
HI
LO
LO
Highly profitable business
Less efficient business
Efficient business
Loss making business
INTENSIV
E
EXTENSIVE
54
Dairy herds FBS 2003/04
AVG GM
AVG FC
PROFITABILITY
1000
1200
1400
1600
1800
2000
2200
1000 1100 1200 1300 1400 1500 1600 1700 1800 1900 2000
55
Constructing the breakeven line
Total Overhead costs £ per ha
Gro
ss M
arg
in £
per
ha
Breakeven line
where
Gross Margin=Overheads
(0,0)
(500,500)
(750,750)
56
GM >Overheads = PROFIT
Zone of profitability
Total Overhead costs £ per ha
Gro
ss M
arg
in £
per
ha
Breakeven line
where
Gross Margin=Overheads
Overheads >GM = LOSS
57
Breakeven does not usually pass through the averages
Overheads
Gro
ss M
argi
n
Overheads
Gro
ss M
argi
n
Overheads
Gro
ss M
argi
n
OverheadsG
ross
Mar
gin
Overheads
Gro
ss M
argi
n
Business results
GM per ha & Overheads per ha
58
Coping with uncertainty
normal distribution
increased variability
Less values near the mean
Greater proportion of distribution away from the mean
Unpredictable behaviour of biological, physical and financial systems
59
Analysing Capital
Capital is a resource The balance sheet provides a
snapshot of capital in a business Net worth is an indication of the size
the business and the amount of resource available
60
Establishing long term stability and viability
The potential to survive adverse trading conditions
Sufficient proprietor capital Potential to raise creditor finance
Solvency Favourable equity ratios
61
Establishing long term stability and viability (1)
The ability of a business to meet its trading commitments on time
Liquidity Capacity of the business to make an
adequate return on capital employed Return on capital
62
Establishing long term stability and viability (2)
The ability of a business to generate sufficient profits that cover personal drawings, loan repayment, reinvestment and taxation.
63
Solvency
The first indicator of balance sheet strength
Assets > Liabilities
64
Solvency (1)
A solvent and profitable business might not be healthy
Downturn in profits could erode low proprietor capital
65
Ratio analysis
Short term analysis Liquidity ratio Current ratio Equity ratios
66
Ratio analysis
Longer term analysis Liquidity ratio Current ratio Owner equity ratio Debt/Equity ratio
67
Liquidity ratio
The availability of cash in the near future i.e. can short term debts be covered without selling live or deadstock
cash + debtors : creditors + overdraft
ideal ratio 1 : 1
68
Current ratio
Similar to Liquidity ratio. Can current liabilities be met without selling fixed assets or raising long term loans?
Current assets : Current liabilities
ideal ratio 2 : 1
69
Current ratio (1)
Acceptable ratio dependent on composition of current assets
A lower ratio may be acceptable if you have a high proportion of cash and debtors (i.e. liquid assets) in current assets as opposed to high proportion of growing crops or stock (i.e. less liquid assets)
70
A lower Current ratio
Current assetsCash 15000
Debtors 12000Growing crops 5000
Beef cattle 2000Total 34000
Current liabilities 30000
Current ratio 1.1
79%
21%
Current assetsCash 4000
Debtors 3000Growing crops 15000
Beef cattle 12000Total 34000
Current liabilities 30000
Current ratio 1.1
21%
79%
Which is acceptable ?
71
Current ratio (2)
Low ratios may be acceptable if creditors are willing to wait for payment
Large quantities of underutilized cash sitting in a bank account produce high ratios and indicate poor cash management
72
Acid test
Highlights liquidity of current assets Might explain low current ratio Identifies the ratio of very high liquid
assets to current liabilities
73
Acid test (1)
sliabilitie Current
sale for Livestockcrops HarvestedDebtorsCashtest Acid
74
Acid test (2)
Which are the liquid assets? Some debtors excluded when extended
credit operative Unused overdraft can be considered a
liquid asset Guide ratio 1:1
75
Factors that affect liquidity
External factors Internal factors
Capital injectionIncrease in creditTax refundGovernment grants
Sale of fixed assetsProfit
LIQUIDITYReduction in credit facilitiesLossesRe-investment in fixed assetsInflation
Tax paymentsCredit repaymentDividendsDrawingsBonuses
+
-
76
Working capital ratio
Capital required to fund a production cycle
Ratio gives indication of amount of additional WC required to fund increase in sales
77
Working capital ratio (1)
Sales
sliabilitie Current-assets Current ratio WC
78
Working capital ratio example
Current assets £110,000 Current liabilities £60,000 Sales £250,000 projected to increase
by £75,000 Calculate change in working capital
79
Working capital example (1)
250,000
60,000-110,000 ratio WC
20% or 0.2250,000
50,000 ratio WC
Every £100 of additional sales will require £20 additional working capital therefore increasing sales by £75,000 increases working capital requirement by £15,000
80
Equity ratios
The proportion of a proprietors equity in a business
Exposure of a business to outside creditors
Traditionally high in the land based sector
81
Be careful with terms
Net Worth
≡
≡
Net Capital
Equity
82
Equity ratios (1)
Equity to total capital employed Owner equity ratio
Equity to equity plus long term debt Equity to long term debt
Gearing Total borrowing to equity
Debt/equity ratio
83
Owner equity ratio
assets total
worthnetratioequity Owner
• Proportion of capital supplied by the owner
• Can be expressed as a %
84
Owner equity ratio - example
assets total
net worthratioequity Owner
000 100
000 80ratioequity Owner = 80%
Net Worth Liabilities
£80 000 £20 000
Assets
85
Equity to equity plus long term debt
debt term long worthnet
worthnetratio
• Proportion of long term capital supplied by the owner
86
Gearing
100 worthnet
debt term long % Gearing
100assets
sliabilitie % Gearing
87
Gearing (1)
Measure of the drain on resources by long term debt
Normal <25% Critical 25-30% Trouble ahead >30%
88
Debt/Equity ratio
worthnet
sliabilitie totalratioy debt/equit
89
Performance ratios
A measure of the return on resource utilised by the business
90
Return on Capital
100capital
profitcapital on return %
100 worthnet
profitequity owner on return %
91
Return on Capital (1)
100assets
profitemployed capital on return %
100sales
profitmargin profit %
92
You can manipulate numbers
Profit = £10 000
Assets=£100 000
Liabilities = £20 000
100capital
profitcapitalon return %
100000 100
000 10capitalon return %
= 10%
100net worth
profitequityowner on return %
100000) 20-000 (100
000 10capitalon return %
= 12.5%
WHICH ONE DO YOU CHOOSE ?
93
You can manipulate numbers AGAIN
Profit = £10 000
Assets=£100 000
Liabilities = £50 000
100capital
profitcapitalon return %
100000 100
000 10capitalon return %
= 10%
100net worth
profitequityowner on return %
100000) 50-000 (100
000 10capitalon return %
= 20%
WHICH ONE DO YOU CHOOSE ?
94
Interpretation of ratios
Identify “unusual” information Identify reason for “unusual” information Identify trends Corroborate information by using other
sources Use ratio analysis as a tool for creating
questions (table 5.6 p70 Turner and Taylor)
95
Limits of ratio analysis
Ratios indicate trends away from expectation
No two businesses are alike Ratios are not an answer – they are a
platform on which to ask more questions
96
Business trends
Deriving conclusions about the health of a business from a single balance sheet or TPLA are difficult
Information is best from Studying a series of statements from the
business Investigating trends between statement
components
97
References on ratio analysis
Financial management for farmers and rural managers Martyn Warren Blackwell Science Chapter 3 pp 28-41
Applied Farm Management Turner and Taylor BSP Chapter 5 pp 52-78
98
Rental equivalents
The financial commitment of a business and the cost of owning or renting land
Rent and rates
+ Overdraft interest
+ Loan and mortgage interest
+ Capital repayments
+ Hire purchase and leasing charges
99
Rental equivalent measuresRental equivalent per ha
Farm type Average farm High performance farm
Dairy (rearing replacements) 150 270
Dairy (flying herd) 190 350
Cereals 95 200
Cereals / Dairy 140 220
Arable 180 350
Beef / Sheep 90 150
From Applied Farm Management Turner and Taylor p229-230
100
Disposal of funds statement
Traces flow of cash through business during year
Monitor of changes in assets and liabilities
Looks at sources and uses of cash
101
Disposal (Flow) of Funds Statement
Sources Net Profit (loss)
Depreciation (+)
Debtors (increase -, decrease +)
Creditors (increase +, decrease -)
Valuations (increase -, decrease +)
Benefits in kind (-)
CASH FROM TRADING
Add Capital introduced
Sale of land, property, investments
Increase in overdraft
Increase in loans
Reduction in Cash balances
CASH FROM OTHER SOURCES
TOTAL CASH AVAILABLE
Uses Commitments
Private drawings
Tax Payments
Reduction in loans
TOTAL COMMITMENTS
Add Purchase of of land, property, investments
Net purchase of buildings
Purchase of machinery
Less sale of machinery
Repayment of Overdraft
Increase in cash balances
TOTAL CASH USED
102
Sources of cash
Trading activities Profits
External sources Grants
Increase in liabilities More overdraft/loan cash available
Reduction in assets Realise asset into cash
103
Uses of cash
Losses Loss of wealth
External uses Removed from trading horizon
Reduction in liabilities Pay off debt
Increase in assets Make the business less liquid by investing
104
Using the disposal of funds statement
Significant increases in liabilities Growth of fixed assets at expense of
current assets Growth in fixed assets financed though
short term liabilities Excessive private drawings
105
Cash flow analysis
Cash is the most sensitive financial indicator
Warns of trading difficulties as they happen
Indicator of business liquidity
106
Cash flow analysisbudget
actual good
actual bad
time
107
Cash flow analysis – weak 1st 6 months
Net Cash Flow Cumulative
Jan -4420 -4420
Feb -2052 -6472
Mar 3309 -3163
Apr 2991 -172
May -3462 -3634
Jun -4434 -8068
Jul 20728 12660
Aug 13194 25854
Sep 16292 42146
Oct 14577 56723
Nov 10086 66809
Dec 23060 89869
Total 89869
-10000
0
10000
20000
30000
40000
50000
60000
70000
80000
90000
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Net Cash Flow Cumulative
108
Cash flow analysis – consistent cash flow
0
10000
20000
30000
40000
50000
60000
70000
80000
90000
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Net Cash Flow Cumulative
Net Cash Flow Cumulative
Jan 7000 7000
Feb 7000 14000
Mar 7000 21000
Apr 7000 28000
May 7000 35000
Jun 7000 42000
Jul 7000 49000
Aug 7000 56000
Sep 7000 63000
Oct 7000 70000
Nov 7000 77000
Dec 7000 84000
Total 84000
109
Cash flow analysis
Inconsistent cash flow usually leads to increased interest charges and lower profits
Limits ability to deal with uncertainty Limits capacity to plan capital
spending
110
Variance analysis
Measures discrepancies in cash flow between budgeted and actual
It accounts for VOLUME (size of enterprise) OUTPUT (yield) or INPUT per unit
volume PRICE per unit produced or consumed
111
Variance analysis (1)
Favourable variance Increase in output Decrease in input
Unfavourable variance Decrease in output Increase in input
112
Variance analysis (2)
Two way PRICE vs INPUT/OUTPUT
Three way PRICE vs INPUT/OUTPUT vs VOLUME
113
Two way analysis
Budget Cereal yield 8t/ha Cereal price £90/t
Actual Cereal yield 9t/ha Cereal price £85/t
t/ha
£/t
BUDGET
8
90
ACTUAL
9
85
Unfavourable variance due to price
Favou
rab
le
varia
nce d
ue to
q
uan
tity
114
Two way analysis (1)
Actual revenue = 9t/ha x £85/t = £765 Budget revenue = 8t/ha x £90/t = £720
Difference = +£45
115
Two way analysis (2)
price budgetquantity unit in differencequantity unit to due Variance
quantity actualprice in differenceprice to due Variance
Example
90££90/t1t/haquantity unit to due Variance
£45- 9t/ha-£5price to due Variance
Total variance = +£45
116
Three way analysis
price budget quantity budget volume in difference volume to due variance
price budget volume actual quantity in difference quantity to due variance
quantity actualvolume actual price in difference price to due variance
117
Three way analysis (1)
Budget Cereal yield 8t/ha Cereal price £90/t Cereal area 22 ha
Actual Cereal yield 9t/ha Cereal price £85/t Cereal area 25 ha
Calculate the variance
118
Limits of variance analysis
Time consuming and complicated OK if limit analysis to major items
Not suitable for inter farm comparisons Formula is imprecise
119
Favourable price and quantity variance
quantity
price
BUDGET
ACTUALfavourable variance due to price
favou
rab
le
varia
nce d
ue to
q
uan
tity
Interaction price x quantity
Attributed to price alone
120
Unfavourable price and quantity variance
quantity
price
BUDGET
ACTUAL
unfavourable variance due to price
un
favou
rab
le
varia
nce d
ue to
q
uan
tity
Interaction price x quantity
Attributed to quantity alone
121
Favourable quantity and unfavourable price variance
quantity
price
BUDGET
ACTUAL
Price variance = diff price x budget quantity
Quantity variance = diff
quantity x actual price
price budgetquantity in differencevariancequantity quantity actualprice in differencevariance price
Over estimation
122
A health warning
It is not always possible to calculate/construct every analysis technique.
Calculated analyses are often in conflict with each other
Interpretation is not always clear Always ask why and find an explanation Commonsense must prevail