Analysis of Published Accounts & Investment Analysis  We know who the main users of accounts are  We know what’s involved in published accounts  But can we use them better ?

Analysis of Published Accounts & Investment Analysis  We know who the main users of accounts are  We know what’s involved in published accounts  But can we use them better ?  YES

Analysis of Published Accounts & Investment Analysis  To do so we use several ratios, all of which are for different information purposes.  You HAVE to know and remember how they are calculated and WHY they are calculated.  Nearly always part of the exams are – explaining ways in which a business can improve on disappointing performance based on ratio results.

Analysis of Published Accounts & Investment Analysis  What is ratio analysis ?  Accounting data, no matter how manipulated and interpreted, cannot solve problems and answer all questions on the business, as business behaviour cannot all be quantified.  Not always easy to use accounting data to asses performance.  Example:  Gale LTD$50 m  Higgins LTD$500 m  At first glance what can you see ?  Is Higgins more successful than Gale ?  Are the managers of Gale less effective ?  Are they becoming more profitable and good investments ?  Are Higgins employing better strategies ?

Analysis of Published Accounts & Investment Analysis  What is ratio analysis ?  Accounting data, no matter how manipulated and interpreted, cannot solve problems and answer all questions on the business, as business behaviour cannot all be quantified.  Not always easy to use accounting data to asses performance.  Example:  Gale LTD$50 m  Higgins LTD$500 m  At first glance what can you see ?  Is Higgins more successful than Gale ?  Are the managers of Gale less effective ?  Are they becoming more profitable and good investments ?  Are Higgins employing better strategies ?  ANSWER – cant tell from the limited info

Analysis of Published Accounts & Investment Analysis  If we look at a little bit more:  Gale LTD $250 m turnover, $400 m capital employed  Higgins LTD $3.2 Billion and $5 billion capital employed  We can now start to get a more detailed picture of performance, especially if you compare against earlier results.

Analysis of Published Accounts & Investment Analysis  The two types of ratios that will be required at AS level are Liquidity ratios and Profitability ratios.  Liquidity ratio

Analysis of Published Accounts & Investment Analysis  The two types of ratios that will be required at AS level are Liquidity ratios and Profitability ratios.  Liquidity ratio  How quickly can a business meet its short term debts or liabilities.  Profitability ratio  Compare the profits of the business with sales, assets and the capital employed in the business.

Analysis of Published Accounts & Investment Analysis  Profitability ratio  How successful is the management of the business at earning profits from sales and assets employed.  These are widely used to measure the performance of a company – and by association the managers too.  Gross profit margin  Measures gross profit with sales turnover  Gross profit margin % = Gross Profit / sales turnover X 100  Gale LTD 2002 GP 125m2002 STO 250m  Higgins LTD2002 GP 800m2002 STO 3,2oom

Analysis of Published Accounts & Investment Analysis  Gross profit margin for both:

Analysis of Published Accounts & Investment Analysis  Gross profit margin for both:  Gale LTD 125/250 X100 = 50 %  Higgins LTD 800/3,200X 100 = 25%  Key notes  Higgins GP margin could be lower because ?

Analysis of Published Accounts & Investment Analysis  Gross profit margin for both:  Gale LTD 125/250 X100 = 50 %  Higgins LTD 800/3,200X 100 = 25%  Key notes  Higgins GP margin could be lower because ?  Using a low price strategy to increase sales  How could Higgins increase its ratio ?

Analysis of Published Accounts & Investment Analysis  Gross profit margin for both:  Gale LTD 125/250 X100 = 50 %  Higgins LTD 800/3,200X 100 = 25%  Key notes  Higgins GP margin could be lower because ?  Using a low price strategy to increase sales  How could Higgins increase its ratio ?  By reducing Cost Of Sales – using a cheaper supplier  GP margin is a good indicator of how much value has been added by mangers to the cost Of Sales  Very difficult to compare ratios of businesses in different industries.

Analysis of Published Accounts & Investment Analysis  Net Profit margin  Compares net profit with sales  Net Profit margin % = NP / Sales Turnover X 100  Gale LTD NP $50m, STO $250m  Higgins LTDNP $500m, STO $3,200m  Net Profit margin:

Analysis of Published Accounts & Investment Analysis  Net Profit margin  Compares net profit with sales  Net Profit margin % = NP / Sales Turnover X 100  Gale LTD NP $50m, STO $250m  Higgins LTDNP $500m, STO $3,200m  Net Profit margin:  Gale LTD 50 / 250 X 100 = 20%  Higgins LTD 500 / 3,200 X 100 = 15.6%

Analysis of Published Accounts & Investment Analysis  Key points to remember here:  The difference between the two companies, in terms of profitability, is not as big as first suggested.  Gale LTD has relatively high overheads compared to sales possibly  Higgins could narrow the group more by reducing expenses and keeping turnover high – easier said than done.

Analysis of Published Accounts & Investment Analysis  Return On Capital Employed (ROCE)  Most commonly used one in assessing profitability  Compares profit with the capital which has been invested in the business  ROCE = NP / CE X 100  So.....  Gale LTD NP $50m, CE $400m  Higgins LTDNP$500m, CE $5b

Analysis of Published Accounts & Investment Analysis  Return On Capital Employed (ROCE)  Most commonly used one in assessing profitability  Compares profit with the capital which has been invested in the business  ROCE = NP / CE X 100  So.....  Gale LTD NP $50m, CE $400m  Higgins LTDNP$500m, CE $5b  Gale 50 / 400 X 100 = 12.5%  Higgins500 / 5,000 X 100 = 10%

Analysis of Published Accounts & Investment Analysis  Key points  The higher the value the better return you are getting  The result can be compared with the return from interest accounts – could the capital be invested in a bank at a higher rate of interest ?  ROCE can only be increased by increasing the profitable and efficient use of an asset.  The method for calculating this ratio is not universally agreed upon because of the different industries  ROCE is not related to the risks involved within business.  A high rate of return maybe because the business has undergone a successful risk taking exercise that has paid off rather than become more efficient.

Analysis of Published Accounts & Investment Analysis  Liquidity ratios  These asses how well a business can pay its short term debts.  Important measure of short term health of the business.  Not concerned with profits but more with the Working capital of the business.  If there is not enough working capital it can cause problems and if there is too much then what about opportunity cost ?!

Analysis of Published Accounts & Investment Analysis  Current ratio  Current assets / current liabilities  Gale LTD CA $60m, CL $30m  Higgins LTDCA $240m CL $240m

Analysis of Published Accounts & Investment Analysis  Current ratio  Current assets / current liabilities  Gale LTD CA $60m, CL $30m  Higgins LTDCA $240m CL $240m  Gale LTD60 / 30 = 2:1  Higgins LTD240 / 240 = 1:1

Analysis of Published Accounts & Investment Analysis  Key Points  Gale LTD is more liquid than Higgins LTD. For every $1 of Gales short term debt he has $2 to pay for it !  The general agreed best place to be is 1.5:1 or 2:1  Higgins could be in trouble with his current state of $1 of assets to pay every $1 of liabilities.  A low ratio may not be unusual for businesses like a supermarket who have very regular cash inflows  A high ratio suggests that the business is not wisely using its funds and could possibly get better return on parts of it if placed somewhere else.  If there is a low one a business may sell some assets in order to inject some cash into the business

Analysis of Published Accounts & Investment Analysis  Acid Test (quick ratio)  A sterner ratio test  Ignores stock as a current asset, because how can u guarantee u will sell it ?  By taking these out of the equation Accountants are giving a clearer picture of what’s what !  Liquid assets = current assets – stocks  ACID test = liquid assets / current liabilities

Analysis of Published Accounts & Investment Analysis  Key points  Anything below 1 is dangerous as it means that the business has less than $1 to pay off any $1 of debt  However, you NEED to compare against previous years before condemning any sort of result. For example 0.6:1 is not great but maybe better than a previous year which could have been 0.4:1  Firms with high stock levels will have very different results for both the acid test and the current ratio test. Not a problem if stocks are always high due to type of industry like a furniture store but if you were a computer store it maybe a problem.  Selling stocks for cash will not improve current ratio but will the acid test as cash is a liquid asset.

Analysis of Published Accounts & Investment Analysis  What is investment ?  All businesses take investment decisions and some involve big strategic issues like relocation or moving towards a heavier capital intensive work force.  Some investment details wont be analysed such as replacing the coffee machine.

Analysis of Published Accounts & Investment Analysis  So what is investment appraisal ?

Analysis of Published Accounts & Investment Analysis  So what is investment appraisal ?  Evaluating the desirability or profitability of an opportunity or project.  Done by quantitative techniques that asses financial feasibility  Non financial issues can be important though so qualitative techniques maybe called up on.  Some businesses don’t bother with any of the above and do it all on a hunch !  Who does this ?

Analysis of Published Accounts & Investment Analysis  So what is investment appraisal ?  Evaluating the desirability or profitability of an opportunity or project.  Done by quantitative techniques that asses financial feasibility  Non financial issues can be important though so qualitative techniques maybe called up on.  Some businesses don’t bother with any of the above and do it all on a hunch !  Who does this ?  Businesses that still have the found entrepreneur dominating proceedings like Richard Branson

Analysis of Published Accounts & Investment Analysis  All investment involves an outlay of cash – this is done because the person or business doing so expects a return !  Quantitative methods of appraisal (ratio analysis) make comparisons between the outflow and inflow of cash

Analysis of Published Accounts & Investment Analysis  Investment appraisal – what do you need ?

Analysis of Published Accounts & Investment Analysis  Investment appraisal – what do you need ?  To be able to judge the profitability of any investment project using quantitative methods you need what information ?

Analysis of Published Accounts & Investment Analysis  Investment appraisal – what do you need ?  To be able to judge the profitability of any investment project using quantitative methods you need what information ?  Initial cost of investment, including any installation costs (if its equipment)  Estimated life expectancy  Residual value  Forecasted net returns or net cash inflows from the project. The expected return on the asset minus the cost of running it.

Analysis of Published Accounts & Investment Analysis  What do you know or notice about the kind of information required ?

Analysis of Published Accounts & Investment Analysis  What do you know or notice about the kind of information required ?  Its all based on estimates and forecasts !

Analysis of Published Accounts & Investment Analysis  Forecasting in an uncertain time  All techniques to appraise investment projects require forecasts on future cash flows.  Referred to as net cash flows using:  Forecasted net cash flow = forecasted cash inflow – forecasted outflow  These can then be compared against other projects and the initial investment.  Its not easy and wont be 100% accurate.  The longer the forecast the more things can ‘crop up’ in the mean time.

Analysis of Published Accounts & Investment Analysis  Some projects require forecasts for next couple of years.  Think of the construction of a new airport.  What might happen here ?

Analysis of Published Accounts & Investment Analysis  Some projects require forecasts for next couple of years.  Think of the construction of a new airport.  What might happen here ?  Recession may hit  Improved rail system might encourage people to use that form of transport  Increase in oil prices leading to higher flight prices.

Analysis of Published Accounts & Investment Analysis  All investments therefore hold risk  Some obviously more than others  You can’t get away from this fact  And this will always be in managers minds when producing forecasts – well it should be if it isn’t !

Analysis of Published Accounts & Investment Analysis  Quantitative techniques  Payback method

Analysis of Published Accounts & Investment Analysis  Quantitative techniques  Payback method  The length of time the inflow will payback the original investment.  The time at which the investment is made can or is referred to as yr 0.  This has a negative cash flow.

Analysis of Published Accounts & Investment Analysis  Example  When is pay back period, assuming cash flows are received evenly throughout the yr ? YearAnnual Net Cash FlowCumulative cash flow 0(500,000) 1300,000(200,000) 2150,000(50,000) 3150,000100, ,000 (inc residual value) 200,000

Analysis of Published Accounts & Investment Analysis  The end of the 4 th month.  Yr 3 we needed $50,000 and was expecting $150,000 in yr 4.  $50,000 is 1/3 of $150,000 and 1/3 of a year is end of 4 months.  Additional cash inflow needed / annual cash flow X 12  50,000 / 150,000 X 12 = 0.04

Analysis of Published Accounts & Investment Analysis  Why is this analysis important ?

Analysis of Published Accounts & Investment Analysis  Why is this analysis important ?  Helps us look at possible other investments and helps us choose the best one for our needs.  Some businesses will not accept an investment if the payback period is going to be over a certain time

Analysis of Published Accounts & Investment Analysis  What other reasons can we think of for payback period analysis being important ?

Analysis of Published Accounts & Investment Analysis  What other reasons can we think of for payback period analysis being important ?  Business may have took out a loan and the longer the payback period the more interest to pay.  Opportunity cost of the capital to be used.  Some managers don’t like taking any risks  Long forecast periods can mean un planned circumstances arise  Future cash flow figures have actual lower real value on the day of realisation.

Analysis of Published Accounts & Investment Analysis  Advantages to payback ?

Analysis of Published Accounts & Investment Analysis  Advantages to payback ?  Quick and easy to calculate  Easy to understand  Emphasis on speed of return on cash flows gives the benefit of concentrating on the more accurate short term forecasts of the profitability  Helps eliminate projects that would not be good for the business  Some business hold liquidity more significantly than profitablity

Analysis of Published Accounts & Investment Analysis  disadvantages

Analysis of Published Accounts & Investment Analysis  Disadvantages  Doesn’t actually take into account the entire profitability of a project - only up until payback is complete  The concentration on the short term may lead them to neglect some very profitable long term investments just because they may take a bit of time to payback.  Does not take into consideration timing of the inflows during payback.

Analysis of Published Accounts & Investment Analysis