1. Managing Finance and Budgets Lecture 4 Financial Statements (3)

2. Session 4 - Financial Statements (3)  Learning outcomes: Understand the role and limitations of financial statements in relation to SMEs, VCOs and large organisations Manipulate and use financial statements to inform decision-making in situations typically found in SMEs and VCOs  Key concepts: Analysing accounts Ratios

3. Session 4 - Financial Statements (3) Content:  A: Analysing Accounts  B: The different types of Ratio  1.Profitability Ratios  2.Liquidity Ratios  3.Financing Ratios (Gearing)  4.Efficiency Ratios  5.Investment Ratios  C: Example of Analysis

4. A: Analysing Accounts

5. Analysing Accounts - Key Points When making an analysis of a business through its accounts, we should take into consideration:  The nature of the business  Changes in the nature of the business over time  Comparisons to similar businesses  The management of the business - marketing, operations, personnel, finance  The interpretation and presentation of figures  Other non-financial information, such as seasonal and other trends, the weather, political climate etc.

6. Factors affecting analysis Our analysis may be affected by some or all of the following:  Incomplete or imperfect information  Subject to distortion by individual events  Changes or differences in accounting policies  Inflation  Window dressing and manipulation  Snapshot nature of the Balance Sheet  Investment in business compared to returns to shareholders and/or directors  Conglomeration of different types of activity in one set of figures

7. The Use of Ratios (1)  Ratios are analytical tools designed to provide a single summary figure which gives a snapshot of a particular type of activity or answers a particular question.  Normally, a ratio compares one figure with another, or gives a percentage.  Most ratios are straightforward, easy to understand with names which convey what they actually do, for example, one of the ratios from last week was: Average Stockholding Period = Average stock level x 365 Cost of Sales

8. The Use of Ratios (2) Ratios:  Can be used as basis of comparison - e.g. other companies, other periods, targets or forecasts  Allow comparisons between and within firms  Enable trends to be identified  Enable comparisons to be made where scale is different

9. Sample Ratios  Retail Sales per square metre  Sales Cost per £1000 loaned  Food cost per patient  % Bed Occupancy  % of sales spent on advertising (or anything)  Cost of water (electricity) per kilo manufactured  Average number of students per class  Expenditure on books per student  Cost per outcome for different departments

10. Activity One Discuss the following:  Imagine you are the proprietor of a hotel and restaurant. Identify a series of key ratios which would help you to monitor on a day to day basis how well the hotel is performing.

11. Activity One - Solutions Key ratios to monitor how well a hotel is performing. These might include:  % Room occupancy  Average customer payment  Reservations as a % of total occupancy  Cleaning Costs per room  Average direct cost per room occupancy  Total Overheads bill per day’s operation  Total Salaries as a percentage of turnover  % food wastage per day … and many more!

12. The Use of Ratios (3) When using a Ratio:  Identify users Who wants to know the information?  identify information required What is it that they need to know?  Select and calculate ratios, Which is the best tool for the job?  Interpret. What does the number tell you?

13. The Use of Ratios (4) When using a Ratio:  Use standard cross-sector ratios, industry-specific ratios or, if necessary, create your own  Be aware of variation in definitions - be consistent  Use more than one ratio – a single ratio is just a starting point

14. B: The Different Types of Ratio

15. The Different types of Ratio  We will look at five different categories of Ratio used in Financial Analysis: 1. Profitability How successful is the business? 2. Efficiency How is the business using its resources? 3. Liquidity Is the flow of cash sufficient to meet obligations? 4. Financing What is the source of financing for the business? 5. Investment Does the company represent a good investment for shareholders?

16. The Different Types of Ratio 1. Profitability

17. Profitability Ratios  The first set of ratios we will look at, attempt to measure profitability; that is, whether or not the business is financially successful.  Note that just looking at the the amount of of profit made by a company in a particular year may give a distorted picture of the company’s position.  A £1.5m profit generated on a turnover of £10m, can look very good. The same profit on a turnover of £100m looks poor.  However there may be reasons why the first company has generated so much profit; there could be a one-off sale of assets, for example, which have increased in value.

18. Four Profitability Ratios There are four important ratios: ______________________________________________________________________________________________________________________________________________  Gross Margin% = Gross Profit x 100 Sales ______________________________________________________________________________________________________________________________________________  Net Margin% = Net Profit before tax & interest x 100 Sales ______________________________________________________________________________________________________________________________________________  Return on Ordinary Shareholders Funds (ROSF) = Net Profit after tax and preference dividends x100 (Share Capital + Reserves) ______________________________________________________________________________________________________________________________________________  Return on Capital Employed (ROCE) = Net Profit before tax and interest x100 (Share Capital + Reserves+ LT Loans)

19. Activity Two Calculate and comment on profitability ratios for the two years shown: YEAR 1 YEAR 2 SALES2,240,0002,681,200 COST OF SALES1,745,4002,072,000 OVERHEADS 252,000 362,800 INTEREST 24,000 6,200 TAX 60,200 76,000 DIVIDENDS 40,200 60,000 SHARE CAPITAL 300,000 334,100 RESERVES 198,300 302,500 LONG TERM LOANS 200,000 60,000

20. Activity Two – Example Spreadsheet  The Spreadsheet mfb4.exe gives the full set of examples and the details of the calculations carried out.  We will look at one example of each type of calculation

21. Activity Two Solutions Gross Margin% In the spreadsheet:

22. Gross Margin% The P & L Account Shows:  Sales£2,240,000  Gross Profit£494,600 (NBGross Profit = Turnover – Cost of Sales) Gross Margin%= 494600 x 100= 22.1% 2240000 The company makes 22p for every £1 it brings in. This can be used to pay overheads etc.

23. Activity Two Solutions Net Margin% In the spreadsheet:

24. Net Margin% The P & L Account Shows:  Sales£2,240,000  Net Profit after Tax and Dividends£118,200 (NB Net Profit = Turnover – Cost of Sales- Overheads) Net Margin%= 118200 x 100= 10.8% 2240000 After paying all outstanding costs, the company makes 11p for every £1 it brings in.

25. Activity Two Solutions ROSF% In the spreadsheet:

26. ROSF% The P & L Account Shows:  Net Profit after Tax and Dividends£118,200  Share Capital £300,000  Reserves£197,500 £497,500 ROSF%= 118200 x 100= 31.8% 497500 The company is making 32p for every £1 invested by shareholders.

27. Activity Two Solutions ROCE% In the spreadsheet:

28. ROCE% The P & L Account Shows:  Net Profit (before Tax & Interest)£242,600  Share Capital £300,000  Reserves£197,500  LT Loans£200,000 £697,500 ROCE%= 242600 x 100= 34.8% 697500 Including loans, the company makes 35p for every £1 invested in the business.

29. The Different Types of Ratio 2. Liquidity

30. Liquidity Ratios  These Ratios seek to answer the question: ‘Can the business pay its way?’  All of these ratios look at the flow of cash in the company, and try to determine whether or not, at a particular point in time, the business has enough cash to pay what it owes.  Liquidity = amount of stock, debt etc., which can be easily converted into cash

31. Ratios - Liquidity We look at three ratios: ______________________________________________________________________________________________________________________________________________  Current ratio = Current Assets (Over 1 for solvency) Current Liabilities e.g. Current ratio of 1.5 = £1.50 owned for every £1 owed ______________________________________________________________________________________________________________________________________________  Acid test = Current Assets excluding stock Current Liabilities ______________________________________________________________________________________________________________________________________________  Operating Cash Flow to Maturing Obligations = Operating Cash Flows Current Liabilities

32. Activity Three Calculate and comment on liquidity ratios for the two years shown: YEAR 1YEAR 2 DEBTORS240,800210,200 BANK ACCOUNT 33,500 41,000 OPENING STOCK 241,000300,000 CLOSING STOCK300,000370,800 TRADE CREDITORS 221,400228,800 DIVIDENDS OWING 40,200 60,000 CORPORATION TAX OWING 60,200 76,000 CASHFLOW FROM OPERATIONS 231,000251,400

33. Activity Three The ratios in this section refer to the items in the second part of the spreadsheet mfb4.exe

34. Activity Three In the spreadsheet:

35. Current Ratio Current Assets :  Trade Debtors£240,800  Bank Account £33,500  Closing Stock Value£300,000 £574,300 Current Liabilities:  Trade Creditors £221,400  Dividends Owing £40,200  Corporation Tax Owing £60,200 £321,800 Current Ratio= 574300= 1.8 321800 The business owns almost twice as much as it owes

36. Acid Test Ratio In the spreadsheet:

37. Acid Test Ratio Current Assets excluding Stock :  Trade Debtors£240,800  Bank Account £33,500 £274,300 Current Liabilities:  Trade Creditors £221,400  Dividends Owing £40,200  Corporation Tax Owing £60,200 £321,800 Acid Test Ratio= 274300 = 0.9 321800 Excluding stock, the business owns almost as much as it owes..

38. Cash-Flow to Obligations Ratio In the spreadsheet:

39. Cash-Flow to Obligations Ratio  Net Cash-Flow from Operations£231,000 Current Liabilities:  Trade Creditors £221,400  Dividends Owing £40,200  Corporation Tax Owing £60,200 £321,800 Cash-Flow to Obligations = 231,000 = 0.7 Ratio321800 The currently available cash in circulation is about three-quarters of what is needed to pay current debts

40. The Different Types of Ratio 3. Financing

41. Financing Ratios Organisations use external funding because:  It may be beneficial tax-wise  They may have insufficient funds themselves  The return may be higher than the cost of the funding

42. Financing Ratios  We look at two ratios which analyse the position of the business in relation to external funding : Gearing = ______Long-term Loans x 100__ Share Capital + Reserves + LT Loans Interest Cover = Profit before interest & tax Interest due

43. Activity Four Use the figures shown in Activity Two to calculate and comment on financing ratios for the two years shown.

44. Gearing In the spreadsheet: Note: ‘Long Term Loans’ appears in both the Numerator and the Denominator of the Ratio Note: ‘Long Term Loans’ appears in both the Numerator and the Denominator of the Ratio

45. Gearing  Long Term Loans:£200,000  Share Capital £300,000  Reserves£197,500  LT Loans£200,000 £697,500 Gearing% = 200000 x 100 = 28.7% 697500 Just over a quarter of the company’s financing comes through loans

46. What is gearing?  Financial Gearing occurs when a business is financed in part by outside parties.  This is normally in the form of a long-term loan or overdraft.  The level of gearing is crucial: under healthy trading conditions, companies which have higher gearing give greater returns for shareholders. …see next slide…

47. Effect of gearing: Normal Conditions Company A Company B Equity100 10 Loans - 90 Sales100100 Direct Costs 40 40 Gross Profit 60 60 Indirect Costs 50 50 Net Profit 10 10 Interest @7% - 6.30 Tax 3 1.11 Profit after tax/int 7 2.59 ROSF 7% 26% Company A has no gearing; Company B has high levels of gearing Both companies have the same levels of profitability and costs. Company B pays out interest on loans, but Company A does not. This is the crucial point: compare the Return on Shareholdings: Although A makes more profit, B is working on lower levels of capital, and so its ROSF is proportionately much higher(26%) than for A (7%) This is the crucial point: compare the Return on Shareholdings: Although A makes more profit, B is working on lower levels of capital, and so its ROSF is proportionately much higher(26%) than for A (7%)

48. Effect of gearing: Poor Trading Conditions ------ Sales drop by 10% ------ Company A Company B Equity 100 10 Loans -90 Sales 9090 Direct Costs 3636 Gross Profit 5454 Indirect Costs 5050 Net Profit 4 4 Interest @7% - 6.30 Tax 1.20 - Profit after tax/int 2.80 2.30- ROSF 2.8% - Company A have the same levels of gearing as before. A downturn in sales means that each company now has a net profit of only £4 After B has paid interest on the loan, the company is in deficit. In this case, A is still trading but showing a reduced profit to shareholders, but B is now in dire circumstances, and needs to find additional finance to continue trading.

49. Interest Cover In the spreadsheet:

50. Interest Cover  Net Profit:£242,600  Interest due£24,000 Interest Cover = 242600 = 10.1 24000 The company makes 10 times as much as it needs to service its loans

51. The Different Types of Ratio 4. Efficiency

52. Efficiency Ratios  These ratios are concerned with the way that assets are used in an organisation.  Some of these are useful financial management tools that we have met previously, for example the average stock turnover and the average credit period. As we have already seen, these can be very useful in controlling the flow of cash in an organisation.  Others are concerned with the use of resources, both human and otherwise.

53. Efficiency Ratios Stock turnover (days) = Average Stock Value x 365 Cost of Sales _____________________________________________________________________________________________________________________________________________ Debtors (days) = Total Debtors x 365 Total Credit Sales _____________________________________________________________________________________________________________________________________________ Creditors (days) = Total Creditors x 365 Credit Purchases _____________________________________________________________________________________________________________________________________________ Sales to Capital Employed = _________Total Sales________ Share Capital + Reserves + LTL _____________________________________________________________________________________________________________________________________________ Sales per employee = ____Total Sales___ No of employees

54. Activity Five Use the figures shown in Activities Two and Three and the additional figures shown below to calculate and comment on efficiency ratios for the last two years: YEAR 1YEAR 2 CREDIT PURCHASES1,804,4002,142,800 NUMBER OF EMPLOYEES 14 18

55. Stock Turnover Period In the spreadsheets:

56. Stock Turnover Period  Opening Stock Value£241,000  Closing Stock Value£300,000  Cost of Sales £1,745,400 Stock Turnover (Days) = (241000+300000)/2 x 365 1745400 = 56.7 days Stock is held on average for 57 days

57. Average Settlement period for Debtors In the spreadsheets: We assume here that all the sales were on credit.

58. Average Settlement period for Debtors  Trade Debtors£240,800  Total Sales £2,240,000 Average Settlement Period = 240800 x 365 2240000 = 39.2 days Debtors take 39 days on average to pay the money.

59. Average Settlement period for Creditors In the spreadsheets:

60. Average Settlement period for Creditors  Trade Creditors£221,400  Total Sales £1,804,400 Average Settlement Period = 221400 x 365 1804400 = 44.7 days The company takes 45 days on average to pay its bills.

61. Sales to Capital Employed In the spreadsheets:

62. Sales to Capital Employed  Total Sales£2,240,000  Share Capital £300,000  Reserves£197,500  LT Loans£200,000 £697,500 Sales to Capital Employed = 2240000 697500 = 3.2 The turnover of the business is three times the total capital invested in it.

63. Sales per Employee In the spreadsheets:

64. Sales per Employee  Total Sales£2,240,000  Number of Employees 14 Sales per Employee = 2240000 14 = £160,000 Each employee brings in £160,000 worth of business.

65. The Different Types of Ratio 5. Investment

66. Investment Ratios  These ratios all seek to measure the value of the shareholder’s investment in the company, and the return on that investment.  It should be noted that the money the shareholder may have paid for the shares, may not reflect either their current market value, or the actual stake it represents in the company.  For example, shares in TSB were originally sold at £1.00 each in the 1980s. This represents the capital invested in the company. If you had bought these shares in 1996 you would have paid around £11.00 per share. Currently they are trading at around £6.00 per share.

67. Investment Ratios - Shareholder Value Dividend per share = _Dividends announced__ Number of issued shares _____________________________________________________________________________________________________________________________________________ Dividend payout = Dividends announced x 100. Net profit after interest/tax/pref.dividends _____________________________________________________________________________________________________________________________________________ Dividend Yield = Dividend per share/(1-tax rate) x 100 Market value per share _____________________________________________________________________________________________________________________________________________ Earnings per share = Net profit after interest/tax/pref.dividends Number of issued shares _____________________________________________________________________________________________________________________________________________ Cash-Flow per share = Operating Cash-Flow - pref.dividends Number of issued shares _____________________________________________________________________________________________________________________________________________ Price/earnings ratio = Market price per share Earnings per share

68. Activity Six Using the figures given in Activities 2 and 3, and the additional figures below, calculate and comment on shareholder value for the two years shown: YEAR 1YEAR 2 Number of Ordinary Shares600,000668,200 Preference Dividends/Shares NIL NIL Market Price Per Share 2.50 3.50

69. Dividend per Share From the spreadsheets:

70. Dividend per Share  Dividends Announced £40,200  Number of Shares 600,000 Dividend per Share = 40200 600000 = £0.067 Each shareholder gets 6.7p for each share they own.

71. Dividend Payout From the spreadsheets: Here we are assuming that these are ordinary, rather than preferential dividends

72. Dividend Payout  Net Profit £242,600  Interest - £24,000  Tax - £60,200  Net profit after interest/tax £158,400  Dividends Announced £40,200 Dividend Payout = 40200 x 100 158400 = 25.4% One quarter of the total profit is paid out in dividends to shareholders.

73. Dividend Yield From the spreadsheet and the first example in this section:  Dividends Announced £40,200  Number of Shares 600,000 Dividend per Share = 40200 600000 = £0.067 In addition, we will be assuming a tax rate of 20%

74. Dividend Yield  Dividend per share £0.067  Market Price per Share £2.50  Tax Rate20% Dividend Yield = 0.067/(1 – 0.2) x 100 2.50 = 3.35% NB: 20% = 0.2 Shareholders are currently getting a rate of return of 3.35% on their investment at market value (compare Inflation ~ 2%)

75. Earnings per Share From the spreadsheets: Here we are again assuming that these are ordinary, rather than preferential dividends

76. Earnings per Share  Net Profit £242,600  Interest - £24,000  Tax - £60,200  Net profit after interest/tax £158,400  Number of shares issued: 600,000 Earnings per Share: = 158400 600000 = £0.264 The company is making about 26p for every share that is held.

77. Cash-Flow per Share From the spreadsheets: Here we are again assuming that these are no preferential dividends

78. Cash-Flow per Share  Operating Cash-Flow £231,000  Number of shares issued: 600,000 Cash-Flow per Share: = 231000 600000 = £0.385 There is about 40p for every share in current circulation within the company.

79. Price/Earnings Ratio From the spreadsheet, and the 4 th ratio in this set:  Net Profit £242,600  Interest - £24,000  Tax - £60,200  Net profit after interest/tax £158,400  Number of shares issued: 600,000 Earnings per Share: = 158400 600000 = £0.264

80. Price/Earnings Ratio  Market Price per share: £2.50  Earnings per share: £0.264 Price/Earnings Ratio: = 2.50 0.264 = 9.45 The market price of a share is about 10 times the profit made by the share. (may be better the other way round – each share earns about one-tenth of its current market value in a year)

81. Comparison of Ratios Share Price P/EShare Price P/E 2/8/00 22/9/01 SAFEWAY 283.517.531914 SAINSBURY 32217.632718.2 TESCO 22121.9238 19.6 MAN UTD. 32154.412220.3

82. C: Example of Analysis

83. Analysing a Company’s Performance  The next slide shows five different ratios calculated from the published accounts of J. Sainsbury PLC, summarising the company’s performance over the five-year period 1996-2000  As you look through these figures, you should ask yourself:  What trends can be detected?  Is the company improving its performance?  Would you consider investing in the company?

84. Ratio Analysis - J Sainsbury Plc 1996 1997 1998 1999 2000 TURNOVER (£ million)13,49913,31215,49616,37817,414 PROFIT BEFORE TAX 764 651 728 755 580 NET MARGIN (%) 5.6% 4.6% 4.7% 4.6% 3.3% EARNINGS PER SHARE 26.8p 22.0p 25.1p 29.2p 18.3p DIVIDEND PER SHARE 12.1p 12.3p 13.9p 14.32p 14.32p DIVIDEND COVER 2.21 1.78 1.8 2.03 1.27 Figures taken from J Sainsbury Plc Website - 2 August 2000 Dividend cover is the reciprocal form of the Dividend Payout Ratio

85. Ratio Analysis - J Sainsbury Plc Axis scales have been modified to enable comparisons to be made:

86. Comparison of ratios  It can be noted from the previous slides that while the turnover has increased steadily over the five-year period, the profit before tax, fluctuates somewhat, with a sharp downturn in 2000.  The downward trend is even more evident from the net margin, which has down a steady reduction over the 5 years.  On the other hand, the dividend per share rose steadily over the first 4 years, and maintaining this level in 2000. However, the earnings per share shows a much less impressive performance.

87. The Limitations of Ratios Analyses which only use ratios only give a limited vision:  The quality of base data in financial statements may be suspect.  Ratios can measure relative performance, but do not allow for scale (see Sainsbury example).  They give only a basis for comparison – we need to compare like with like.  Some ratios ( balance sheet - e.g.) measuring at a single point in time, and not over a period.  One off events such as disposal of assets can give rise to major distortions.

88. Activity Seven Discuss the following: If a business is “overtrading”, do you think the following ratios would be higher or lower than normally expected? (a)Current ratio (b)Average stock turnover period (c)Average settlement period for debtors (d)Average settlement period for creditors

89. Activity Seven In an ‘overtrading’ position, these ratios would be: (a)Current ratio: Lower (Liabilities would increase) (b)Average stock turnover period Lower (Stock run-outs occur) (c)Average settlement period for debtors Higher (if inability to supply means total sales lower) orLower (if business chases debt due to shortage of cash) (d)Average settlement period for creditors Higher (shortage of cash makes it difficult to pay creditors)

90. Seminar Four - Activities  Preparation: read Chapter 7 (M & A 2 nd Edition) Or Chapter 6 (M & A 1 st Edition)  Describe key concepts: Analysing accounts Ratios Exercises:  M & A (2 nd Ed.) Exercise 7.3 (pages 239-240) and Exercise 7.5 (pages 241-242)  Or M & A (1st Ed.) Exercise 6.3 (pages 215-216) and Exercise 6.5 (pages 217-218)