Lecture 2 (PBB) Interpretation of Statements_1 (1)

8/3/2019 Lecture 2 (PBB) Interpretation of Statements_1 (1)

1/41

Click to edit Master title style

Click to edit Master subtitle style

30/04/2012

NX0441Ratio Analysis

Dr. Israel N. Davidson


2/41

Objectives

Discuss key performance measurementquestions in business and the role of ratio

analysis

Calculate important ratios for assessing thefinancial performance and position of an

organisation and explain the significance of

the ratios calculated


3/41

Organisation Performance(The Key Questions)

PROFITABILITY

Is the businessprofitable?

Note: Read the article

Why measure performance? by R.D Be


4/41


LIQUIDITY

Examples


5/41


STABILITY

Are company operations generatingsufficient resources to repay

long-term liabilities and reinvestin required new technologies?


6/41


INVESTMENT

RETURN


7/41


STRATEGIC PLANS:

HOW EFFECTIVE?


8/41

Answers to the key questions

1. Review of the Business: Chairman's and CEO's Review . Description of the business activities, objectives, developments a

competitive environment.

Political, environmental and macro-economic issues

2. A review of cash flow statement

3. Ratio and trend analysis P & L, B/Sheet4. Inter-firm comparison

5. Balanced Scorecard


9/41

Three Most Common Financial

Analysis Techniques

1. Ratios Profitability - depth of company profitability. Liquidity - financial strength to meet its obligations

they fall due.

Efficiency - utilisation of resources Stability - long-term financial prospects Investment return - investment performance

compared e.g. to other opportunities


10/41

Three Most Common Financial

Analysis Techniques2. Trend analysis Attempts to establish the organisation's

pattern of performance and how it compares from one perto the other.

3. Inter-firm comparison Measures how well an organisatis doing in comparison with others in the same industry.


11/41

1. Ratio Analysis

Ratios provide improved and relatively simple means of evaluatinthe financial health of a business.

However, ratios do not make much sense if not compared with astandard or yardstick e.g.

Prior expectations Budget

Previous performance

Industrial or wider economic averages


12/41

Profitability Ratios

These ratios inform whether a business is making profits -and if so whether at an acceptable rate.

The profitability ratios include:

gross profit margin,

operating profit margin

net profit margin

return on assets

return on capital employed (ROCE)

There are at least 5 steps to determining the depth of an

organisations profitability


13/41

Profitability Ratios

1. Measure the return on sales (i.e. gross profit margin):

Gross profitSales

x 100

From Incomestatement

From Incomestatement

This ratio focuses on the prime costs(i.e. direct costs of sales) and theselling price.

It is a measure of the efficiency with

which the prime costs are beingcontrolled.

It could also point to the pricing strategyof the business


14/41

Return on SalesExample

Budget 2011 2010

Net sales 3000 2,500 2,000

Cost of sales 1700 1,500 1,400

Gross profit 1,300 1,000 600

Gross profit margin ([GP/Sales] x 100) 43% 40% 30%

Note: The difference in gross profit margin could be a productof better/poor cost control, high pricing strategy, or both


15/41

Profitability Measures2. Examine the operating profit margin which measures

earnings before interest and tax. It assesses whether or nthe core business of a company is profitable.

= EBIT

SALES

x 100

Income

statement

Incomestatement

EBIT =Earnings before interest & tax


16/41

Profitability4. Review Return on Assets which reports on how well

management is performing on all resources in its care. It measure of how effectively the business assets are beingemployed to generate profit.


17/41

Profitability5. Evaluate Return on capital employed (ROCE). This rati

measures how much profit is made for every / $ of inves


18/41

Efficiency Ratios

These ratios give an insight into how efficiently a business iutilising those resources invested in fixed assets and workincapital.

A measure of total asset utilisation A measure of fixed asset capacity

Evaluation of efficiency with which stock in trade is managed Evaluation of efficiency with which debtors are managed

A measure of whether credit facilities are fully utilised


19/41

Efficiency Ratios

A measure of total asset utilisation

Note: Capital Employed = Total assets

current liabilities


20/41

Efficiency Ratios

A measure Fixed Asset Capacity


21/41

Efficiency Ratios A measure Efficiency with which debtors are managed.

debtors being allowed excessive credit?


22/41

Efficiency Ratios

A measure Credit taken from suppliers


23/41

How to use ratios

Calculate the ratios for the same company over several

successive years for evidence of:

Consistency of earning

Earning growth

or Earning decline.

Compare ratios with other companies in the sameindustry to ascertain the position of the company in theindustry.


24/41

Liquidity Ratio

Current Ratio A measure of a firm's ability to meet

its short-term financial obligations.


25/41

Liquidity Ratio

Acid test or Quick ratio


26/41

Stability Ratios

These ratios focus analysis on the long-term health of a business - especially th

effect of the capital or finance structure on the organisation.

Gearing Ratio

Interest Cover Ratio

Note: Highly geared = where the gearing ratio is more than 50%

Low geared = where the gearing ratio is below 50%


27/41

Stability Ratios(Gearing)

Gearing ("leverage") is a measure of the proportion of businessinvestment that is financed by borrowing. In theory, the higher thegearing the higher the risks to a business.

Note:Borrowing = Long-term debts + normal overdraft


28/41

Stability Ratios(Interest Cover)

A measure of the ability of a business organisation to service its debt. It seeks answer the question Is the profit sufficient to pay interest and other finance co


29/41

Other Ratios

Sales Mix: This is the composition of the total sales. Profits will be greater wh

high margin rather than low margin items constitute a relatively largeproportion of total sales.

Each product has different profit margin.

Therefore overall profit depends on well-balanced sales. It is important to keep a close watch on the sales mix and to mo

gross margin per product or service.


30/41

Sales Mix - Example

NED Hotels Limited

Services Sales Sales Mix Budget % %

Room hire (high margin service) 200,000 29 45

Food 300,000 43 25

Beverages 150,000 21 20Car hire 50,000 7 10

700,000 100 100

Profits will be greater where high margin rather than low margin items

constitute a relatively large proportion of total sales.


31/41

Reading List

Behn R.D. (2003) Why measure performance? Different purposesrequire different measures. Public Administration Review, Sept/O2003, Vol. 63, No.5


32/41

NOTES


33/41

Interpretation of Gross Margin

or return on sales

This ratio informs about the business's ability to consistently control its productioncosts or to manage the margins it makes on products bought and sold.

GM is the percentage of revenue remaining after deducting cost of sales

It is a good indicator of an organisations efficiency in production, purchasing anddistribution.

A business with GM ratio better than industrial average, budget and the previous is an indication of better production process, or purchasing and distribution strateor both.

Pricing policy or price war can have impact on this ratio

The example shows that the company was more efficient in the first year (40%) ththe second (20%).

Gross profit margin is often quite stable in percentage terms


34/41

Sources of Information(Company Performance)

1. Annual Report

Income Statement, balance sheet, statement of caflows, etc.)

Reports also contain:

Narrative information about the company Chairman and ChiefExecutives reviews

Footnotes to the financial statements A summary of the accounting principles used

Comparative financial data for a number of years

Dr. E. Davidson


35/41


2. Press releases - More timely information. Changes in personnel

Changes in dividends

Issuance or retirement of debt

Acquisition or sale of assets or business units

New products New orders

Changes in production plans

Financial results


36/41

3. Financial Press4. Internet - Websites

5. Pro forma statements from companies



37/41

Current Ratio

This measure estimates whether the business can pay debts due within one year from assets that it expects to tuinto cash within that period. A ratio of less than one should be of concern to the management, particularly if it persfor any length of time.

A ratio of at least 2 to 1 is considered the minimum evidence of liquidity.

A significantly higher ratio may suggest that the company is not using its funds efficiently. A satisfactory Current Rwill be within close range of the industry average.

It enables an informed opinion about a companys liquidity and the effectiveness with which the working capital is managed.

No hard and fast rule as to what constitutes acceptable liquidity ratio bearing in mind that the nature of the indushas bearing on the ratio.

Short-term creditors/suppliers and bankers have preference for a higher current ratio for it reduces their risk. Shareholders would prefer lower current ratio thus enabling more business assets to work and grow business an

profit.

A weakness of the current ratio is that the stock may include a high proportion of items that are difficult to liquidateurgently. They may also possess uncertain liquidation values. To overcome this criticism, quick or acid test ratio icalculated.


38/41

Quick or Acid Ratio

It is not easy to turn all assets into cash at short notice. Some - notably rawmaterials and other stocks - must first be converted into final product, then sold

and the cash collected from debtors.

For this reason, the Quick Ratio adjusts the Current Ratio to eliminate all assets

that are not already in cash (or "near-cash") form. A ratio of less than one shou

be of concern to the management.


39/41

Gearing Ratio

Gearing looks at the relationship between the long-term liabilities total capital employed in a busine

This relationship has be balance - the shareholders' funds should be significantly higher than the loterm liabilities (borrowings).

Shareholders would like to see the ratio in their favour for the following reasons:

Borrowed funds attract interest which must be paid even in poor performing years.

Shareholders expect to earn dividends yearly but in poor performing years this may not be

possible.

Shareholders have voting power to affect major business decisions.

Long-term liability holders (Lenders) do not have voting power but can override the wishes of

shareholders in situations where payment of interest or repayment of loan in trouble.

Note: gearing can be a financially sound part of a business's capital structure particularly if thbusiness has strong, predictable cash flows.


40/41

Profitability

The adequacy of a company's earnings can be measured in terms of:

(1) the rate earned on sales; (2) the rate earned on average total assets; (3) the rate earned on averagecommon stockholders' equity; and (4) the availability of earnings to common stockholders.

The most widely used profitability measurements are profit margin on sales, return-on-investment ratios, and earnings per share.

(http://www.va-interactive.com/inbusiness/editorial/finance/intemp/analyze.html#purpose)


41/41

Objective of Financial Statement Analysis

Equity investors and creditors use FSA to:

Predict expected return profitability and future share or security pr

Access the risks associated with the returns trends in past sales,operating expenses and net income give clues to future returns.

The management uses management accounting information for plannin

decision making and control.

Lecture 2 (PBB) Interpretation of Statements_1 (1)

Documents