EC7095 Financial Statement Analysis Lecture 4

Recap – lecture 3 Profitability ROCE ROE Profit Margins Asset Turnover

Liquidity (Solvency) The ability to pay debts………

Liquidity (Solvency) The ability to pay debts as they fall due Importance of cash flow Liquidation/Bankruptcy Liquidity v Profitability “Working Capital”

Working Capital Working capital = Current assets – current liabilities Current assets includes: Inventory (stock), Receivables (debtors) and cash Current liabilities includes: Payables (creditors) and bank overdrafts Aim is to convert inventory into receivables and then receivables into cash in time to meet payments to payables

Current Ratio Current ratio = Current Assets : Current Liabilities What is a good ratio? Should it be 2:1? Liquidity problems or efficient!

Current Ratio 2009 2010 Inventory 2m Receivables 2m Cash 1m Total 5m Payables 2.5m Current Ratio = 2 Inventory 1m Receivables 1m Cash 0.5m Total 2.5m Payables 5m Current Ratio = 0.5

Current Ratio Are they being inefficient? 2009 2010 Inventory 2m Receivables 2m Cash 1m Total 5m Payables 2.5m Current Ratio = 2 Inventory 4m Receivables 4m Cash 1m Total 9m Payables 1.5m Current Ratio = 6 Are they being inefficient?

Current Ratio – Generating cash 2009 2010 Inventory 4m Receivables 4m Cash 1m Total 9m Payables 1.5m Current Ratio = 6 Inventory 2m Receivables 2m Cash 6m Total 10m Payables 2.5m Current Ratio = 4

Current Ratio Trends 2 – 1.8 – 1.5 – 1.2 Is it good or bad?

Next plc Balance Sheet as at 29 January 2011 ASSETS AND LIABILITIES Non-current assets notes 2011 2010 £’m £’m Property, plant & equipment 9 592.4 577.2 Intangible assets 10 46.5 47.4 Interests in associates 11 5.1 4.0 Other investments 12 1.0 1.0 Defined benefit pension surplus 21 55.7 – Other financial assets 15 24.3 22.7 725.0 652.3 Current assets Inventories 13 368.3 309.0 Trade and other receivables 14 645.6 616.6 Other financial assets 15 4.1 8.6 Cash and short term deposits 16 49.3 107.0 1,067.3 1,041.2 Total assets 1,792.3 1,693.5

Current liabilities Bank overdrafts 17 (10.2) (4.7) Unsecured bank loans 17 (115.0) – Trade and other payables 18 (544.6) (550.3) Other financial liabilities 19 (54.7) (93.6) Current tax liabilities (108.4) (109.5) (832.9) (758.1) Non-current liabilities Corporate bonds 20 (471.2) (520.9) Defined benefit pension deficit 21 – (49.5) Provisions 22 (13.3) (13.4) Deferred tax liabilities 6 (23.4) (3.7) Other financial liabilities 19 (2.6) (4.4) Other liabilities 23 (216.5) (210.1) (727.0) (802.0) Total liabilities (1,559.9) (1,560.1) Net assets 232.4 133.4

EQUITY Share capital 24 18.1 19.1 Share premium account 0.8 0.7 Capital redemption reserve 11.8 10.8 ESOT reserve (138.6) (78.2) Fair value reserve (3.2) 5.1 Foreign currency translation reserve 4.6 4.7 Other reserves 25 (1,443.8) (1,443.8) Retained earnings 1,782.6 1,615.2 Shareholders’ equity 232.3 133.6 Non-controlling interest 0.1 (0.2) Total equity 232.4 133.4

Next plc Income Statement for the year ended 29 January 2011 2011 2010 Notes £m £m Revenue 1, 2 3,453.7 3,406.5 Cost of sales (2,445.0) (2,409.6) Gross profit 1,008.7 996.9 Distribution costs (223.2) (232.1) Administrative expenses (214.7) (236.6) Other gains 2 2.2 0.7 Trading profit 573.0 528.9 Share of results of associates 11 1.8 0.9 Operating profit 3 574.8 529.8 Finance income 5 0.9 0.8 Finance costs 5 (24.3) (25.3) Profit before taxation 551.4 505.3 Taxation 6 (150.5) (141.3) Profit for the year 400.9 364.0

Next plc – Current Ratio 2011: 1067/833 = 1.28 2010: 1041/758 = 1.37 2009: 1074/714 = 1.50

Quick Ratio Considers only those current assets that can be turned into cash “quickly” Also known as “acid test” ratio = Current assets – Inventory : Current Liabilities Should it be 1:1?

Next plc – Quick Ratio 2011: (1067 – 368)/833 = 0.84 2010: 0.97 2009: 1.06

Inventory (Stock) How much should be held? What are the costs and benefits? What will happen if we run out?

Costs of holding inventory Space (e.g. rent) Insurance Pilferage Obsolescence ( Next had to reduce some inventory to below cost in 2011 costing them £89.1m (2010 £78.9m )) Capital tied up Uses up cash Staff/system costs

Benefits of holding inventory Satisfy more customers Satisfy customers quicker Avoid “stock-outs” Discounts for bulk buying “Holding” gains

Cost of a “stock-out” Lost profit on a sale Lost profit on future sales Lost goodwill

Inventory Ratios Inventory turnover Number of times = Cost of sales/Inventory Time to turnover = Inventory/cost of sales x 365 (days) Average or closing inventory?

Next plc – Inventory Turnover 2011: 2445/368 = 6.6 times 368/2445 x 365 = 55 days 2010: 2410/309 = 7.8 times 309/2410 x 365 = 47 days 2009: 2363/319 = 7.4 times 319/2363 x 365 = 49 days Or?

Receivables (Debtors) Giving credit – do we have to? Who do we give it to? Managing receivables Giving longer credit – costs and benefits Factoring

Receivables (Debtors) Key “ratio” is time taken to collect = Receivables/relevant sales x 365

Next plc - Receivables 2011: Directory sales = £936m Total receivable = £642m = 250 days Excluding doubtful debts £533m = 208 days 2010: Directory sales = £873m Total receivable = £643m = 269 days Excluding doubtful debts £520m = 217 days 2009: Directory sales = £816m Total receivable = £610m = 273 days Excluding doubtful debts £493m = 221 days

Payables (Creditors) Free? Trade and non trade Important to look at when each group needs to be paid – e.g. tax due 9 months after year end but trade payables may be due in 30 days or less. Time to pay = Trade Payables/Relevant purchases x 365

Next plc - Payables 2011: Trade Payables = £196m Cost of Sales = £2445m Time to pay = (196/2445) x 365 = 29 days 2010: Trade payables = £175m Cost of Sales = £2410m Time to pay = (175/2410) x 365 = 27 days 2009: Trade payables = £205m Cost of Sales = £2363m Time to pay = (205/2363) x 365 = 32 days Or?

Working Capital Cycle How long will it be between paying for goods and services receiving the cash from customers? = Time goods spend in stock + time taken by customers to pay – time taken to pay suppliers

Working Capital – Cash operating cycle Cash inflow RM stock WIP stock FG stock Credit sales Purchases Cash operating cycle Cash outflow

Overtrading Insolvency through being too successful! Growing too fast Common in new businesses Can be prevented through good planning

Symptoms of overtrading Rapid increase in turnover Rapid increase in volume of current assets Inventory turnover falls Receivable days grows Payable days grow Cash falls Current and quick ratios fall Debt levels increase

Overtrading – Balance Sheet Year 1 Year 2 Non current assets 160 Inventory 60 Receivables 64 Cash 1 125 Bank 25 Payables 50 75 50 210 Share Capital 10 Retained profit 200 Non current assets 210 Inventory 150 Receivables 135 Cash - 285 Bank 80 Payables 200 280 5 215 Share Capital 10 Retained profit 205

Overtrading – Income statement Year 1 Year 2 Sales 1000 Gross profit 200 Net Profit 50 Sales 2000 Gross profit 300 Net Profit 20