1. EC7095 Financial Statement Analysis
Lecture 4

2. Recap – lecture 3
Profitability
ROCE
ROE
Profit Margins
Asset Turnover

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

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

5. 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

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

7. 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

8. 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?

9. 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

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

11. Next plc Balance Sheet as at 29 January 2011
ASSETS AND LIABILITIES
Non-current assets notes
£’m £’m
Property, plant & equipment
Intangible assets
Interests in associates
Other investments
Defined benefit pension surplus –
Other financial assets
Current assets
Inventories
Trade and other receivables
Other financial assets
Cash and short term deposits
1, ,041.2
Total assets , ,693.5

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

13. EQUITY
Share capital
Share premium account
Capital redemption reserve
ESOT reserve (138.6) (78.2)
Fair value reserve (3.2) 5.1
Foreign currency translation reserve
Other reserves (1,443.8) (1,443.8)
Retained earnings 1, ,615.2
Shareholders’ equity
Non-controlling interest (0.2)
Total equity

14. Next plc Income Statement for the year ended 29 January 2011
Notes £m £m
Revenue 1, 2 3, ,406.5
Cost of sales (2,445.0) (2,409.6)
Gross profit ,
Distribution costs (223.2) (232.1)
Administrative expenses (214.7) (236.6)
Other gains
Trading profit
Share of results of associates
Operating profit
Finance income
Finance costs (24.3) (25.3)
Profit before taxation
Taxation (150.5) (141.3)
Profit for the year

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

16. 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?

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

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

19. 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

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

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

22. 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?

23. 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?

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

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

26. 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

27. 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

28. 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?

29. 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

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

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

32. 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

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

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