Chapter 27/28

Financial analysis

The need for accounting ratios

Accounting ratios are used to enable us to analyze and interpret accounting statements. Mark-up and margin
The purchase cost, gross profit and selling price of goods or services may be shown as: When shown as a fraction or percentage of the cost price, the gross profit is known as the mark-up.
Cost Price + Gross Profit = Selling Price

When shown as a fraction or percentage of the selling price, gross profit is known as the margin.

Mark-up =Gross Profit/Cost Price, as a fraction, or if required as a percentage, multiply by 100. Margin =Gross Profit/Selling Price as a fraction, or if required as a percentage, multiply by 100.

Managers commission
Managers of businesses are very often remunerated by a basic salary plus a percentage of profits. It is quite common to find the percentage expressed not as a percentage of profits before such commission has been deducted, but as a percentage of the amount remaining after deduction of the commission. The formula to be used to arrive at the correct answer is:
Percentage commission/100 + Percentage commission x Profit before commission

Commonly used accounting ratios

There are some ratios that are in common use for the purpose of comparing one periods results against those of a previous period. Two of those most in use are the ratio of gross profit to sales, and the rate of stock turnover or stock turn. Gross profit as percentage of sales The basic formula is:
Gross profit x 100= gross profit as a percentage of sales Sales 1

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Stock turnover The quicker we sell our stock (we could say the quicker we turn over our stock) the more the profit we will make, if our gross profit percentage stays the same. To check on how quickly we are turning over our stock we can use the formula:
Cost of goods sold = no. of times stock turn over a period Average stock

The need for ratios

Without ratios, financial statements would be largely uninformative to all but the very skilled. With ratios, financial statements can be interpreted and usefully applied to satisfy the needs of the reader.

Users of ratios
there are vast number of parties interested in analyzing financial statements, including shareholders, lenders, customers, suppliers, employees, government agencies and competitors. Yet, in many respects, they will be interested in different things. There is not, therefore, any definitive, all-encompassing list of points for analysis that would be useful to all these stakeholder groups. it is possible to construct a series of ratios that together will provide all of them with something that they will find relevant and from which they can investigate further if necessary. Ratio analysis is a first step in assessing an entity. It removes some of the mystique surrounding the financial statements and makes it easier to pinpoint items which it would be interesting to investigate further.

Categories of ratio
Profitability ratios 1 Return on capital employed (ROCE) ; This is one of the most important profitability ratios, as it encompasses all the other ratios, and because an adequate return on capital employed is why people invest their money in a business in the first place. (a) Sole traders; we will use the average of the capital account as the figure for capital employed, i.e. (opening balance + closing balance) 2. (b) Limited companies; There is no universally agreed definition of return on capital employed for companies. The main ones used are: (i) return on capital employed sourced from ordinary shareholders (ii) return on capital employed sourced from all long-term suppliers of capital.

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i) In a limited company this is known as Return on Owners Equity (ROOE) or, more commonly, Return on Shareholders Funds (ROSF). From now on, we shall use the second of these terms, Return on Shareholders Funds, but you will need to remember that when you see Return on Owners Equity, it is the same as ROSF. The Return is the net profit for the period. The term Shareholders Funds means the book value of all things in the balance sheet that describe the owners capital and reserves. Owners are the holders of the ordinary share capital. This is calculated: Ordinary Share Capital + all Reserves including Profit and Loss Account.

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(ii) This is often known simply as Return on Capital Employed (ROCE). The word Return in this case means net profit + any preference share dividends + debenture and long-term loan interest. The word Capital means Ordinary Share Capital + Reserves including Profit and Loss Account + Preference Shares + Debentures and Long-term Loans.

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2 Gross profit as percentage of sales
The formula is:

gross profit x 100 sales 3 Net profit as a percentage of sales

The formula is: net profit x 100 sales

Liquidity ratios
the ratio called return on capital employed is used to provide an overall picture of profitability. It cannot always be assumed, however, that profitability is everything that is desirable. It must be stressed that accounting is used, not just to calculate profitability, but also to provide information that indicates whether or not the business will be able to pay its creditors, expenses, loans falling due, etc. at the correct times. Failure to ensure that these payments are covered effectively could mean that the business would have to be closed down. Being able to pay ones debts as they fall due is known as being liquid. It is also essential that a business is aware if a customer or borrower is at risk of not repaying the amount due. New customers are usually vetted prior to being allowed to trade on credit rather than by cash. For private individuals, there are credit rating agencies with extensive records of the credit histories of many individuals. For a small fee, a company can receive a report indicating whether a new customer might be a credit risk. Similarly, information can be purchased concerning companies that indicates their solvency, i.e. whether they are liable to be bad credit risks. The difference between these two sources of information is that, while the information on private individuals is based on their previous credit record, that of the companies is generally based on a ratio analysis of their financial statements. When it comes to the liquidity of a business, both its own ability to pay its debts when due and the ability of its debtors to pay the amount they owe to the business are of great importance. Ratio analysis that focuses upon liquidity (or solvency) of the business generally starts with a look at two ratios (liquidity ratios) that are affected most by these two aspects of liquidity, the current ratio and the acid test ratio.

1 Current ratio
This compares assets which will become liquid within approximately twelve months (i.e. total current assets) with liabilities which will be due for payment in the same period (i.e. total current liabilities) and is intended to indicate whether there are sufficient short-term assets to meet the short-term liabilities. current ratios = current asset current liability When calculated, the ratio may be expressed as either a ratio to 1, with current liabilities being set to 1, or as a number of times, representing the relative size of the amount of total current assets compared with total current liabilities.

Acid test ratio

This shows that, provided creditors and debtors are paid at approximately the same time, a view might be made as to whether the business has sufficient liquid resources to meet its current liabilities. Acid test ration= current asset stock current liabilities

Efficiency ratios
1 Stock turnover; Stock turnover measures how efficient a business is at maintaining an appropriate level of stock. When it is not being as efficient as it used to be, or is being less efficient than its competitors, this may indicate that control over stock levels is being undermined. A reduction in stock turnover can mean that the business is slowing down. Stocks may be piling up and not being sold. This could lead to a liquidity crisis, as money may be being taken out of the bank simply to increase stocks which are not then sold quickly enough. Note: we are classifying stock turnover as an efficiency ratio. It is often also classified as a liquidity ratio.

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2 Debtor/sales ratio The resources tied up in debtors is an important ratio subject. Money tied up unnecessarily in debtors is unproductive money. Note; we are classifying debtors/sales as an efficiency ratio. Like stock turnover, it is often also classified as a liquidity ratio, as it can reveal both efficiency and liquidity issues. The next ratio, creditors/purchases, also provides this double aspect view.

Shareholder ratios
These will include the following ratios. Note that price means the price of the shares on the Stock Exchange.
1 Earnings per share (EPS)
The formula is; Earnings per share=

Net profit after interest and tax and preference dividends Number of ordinary shares issued This gives the shareholder (or prospective shareholder) a chance to compare one years earnings with another in terms easily understood. Many people consider EPS to be the most important ratio that can be calculated from the financial statements.

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2 Price/earnings ratio (P/E)
The formula is: Price/earnings ratio = Market price per share

Earnings per share This puts the price into context as a multiple of the earnings. The greater the P/E ratio, the greater the demand for the shares.
3 Dividend yield
This is found by the formula:

Dividend yield = Gross dividend per share Market price per share

This measures the real rate of return by comparing the dividend paid to the market price of a share.

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4 Dividend cover
This is found by the formula: Dividend cover = Net profit after tax and preference dividends Ordinary dividends paid and proposed This gives the shareholder some idea as to the proportion that the ordinary dividends bear to the amount available for distribution to ordinary shareholders. Usually, the dividend is described as being so many times covered by profits made. If, therefore, the dividend is said to be three times covered, it means that one-third of the available profits is being distributed as dividends.

Capital structure ratios

Gearing ; The relationship of equity shares (ordinary shares) to other forms of long-term financing (long term loans plus preference shares) can be extremely important. Analysts are, therefore, keen to ascertain a ratio to express this relationship. There is more than one way of calculating gearing. The most widely used method is as follows: = Long-term loans + Preference shares x100
Ordinary share capital + Reserves + Preference shares + Long-term liabilities

This formula is sometimes abbreviated to: Prior charge capital x 100 Total capital
which is exactly the same. Long-term loans include debentures. Total capital includes preference shares and ordinary shares, all the reserves and long-term loans.

Changing the gearing of a company

The management might decide that for various reasons it would like to change the gearing of the company. It can do this as follows:
To reduce gearing 1 By issuing new ordinary shares 2 By redeeming debentures 3 By retaining profits

To increase gearing 1 By issuing debentures 2 By buying back ordinary shares in issue 3 By issuing new preference shares Such changes will be influenced by what kinds of investors the company wishes to attract. A highly geared company will attract risk-taking buyers of ordinary shares, whilst a low geared company will be more attractive to potential ordinary shareholders who wish to minimise risk.

Other ratios
There are a large number of other ratios which could be used, far more than can be mentioned in a textbook such as this. It will depend on the type of company exactly which ratios are the most important and it is difficult to generalise too much. Different users of the accounts will want to use the ratio analysis which is of vital concern to them. If we can take as an example a bank which lends money to a company, it will want to ensure two things: (a) that the company will be able to pay interest on the loan as it falls due; and (b) that it will be able to repay the loan on the agreed date. The bank is therefore interested in: (a) short-term liquidity, concerning payment of loan interest; and (b) long-term solvency for eventual repayment of the loan. Possible ratios for each of these could be: (a) Short-term liquidity ratios, mainly the acid test ratio and the current ratio, already described. (b) Long-term solvency ratios, which might include: (i) Operating profit/loan interest. This indicates how much of the profits are taken up by paying loan interest. Too great a proportion would mean that the company was borrowing more than was sensible, as a small fall in profits could mean the company operating at a loss with the consequent effect upon longterm solvency. (ii) Total external liabilities/shareholders funds. This ratio measures how much financing is done via share capital and retained profits, and how much is from external sources. Too high a proportion of external liabilities could bring about long-term solvency problems if the companys profit-making capacity falls by a relatively small amount, as outside liabilities still have to be met. (iii) Shareholders funds/total assets (excluding intangibles). This highlights the proportion of assets financed by the companys own funds. Large falls in this ratio will tend to show a difficulty with long-term solvency. Similarly, investors will want to see ratios suitable for their purposes, which are not the same as those for the bank. These will not only be used on a single company comparison, but probably with the average of the same type of ratios for other companies in the same industry.

The investor: choosing between shares and debentures

The choice of an investor will always be related to the amount of acceptable risk. We can list the possible investments under the headings of risk. Lowest risk Debenture holders have their interest paid to them whether or not profits are made. This contrasts with shares, both preference and ordinary, where there have to be profits available for distribution as dividends. In addition, should there be insufficient cash funds available to pay debenture dividends, many debentures give their holders the right to sell off some or all of the assets of the company, and to recoup the amount of their debentures before anyone else has a claim. Such an investment does not have as much security as, say, government stocks, but it certainly ranks above the shares of that same company.

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Medium risk Preference shareholders have their dividends paid after the debenture interest has been paid, but before the ordinary shareholders. They still are dependent upon profits being available for distribution. If they are of the cumulative variety then any shortfall can be carried forward to future years and paid before any ordinary dividends are taken.

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Highest risk Ordinary shareholders have the highest risk. They must give way to both debenture holders and to preference shares for interest and dividends. However, should the remaining profits for distribution be very high then they may get a high return on their money.

Fixed and variable costs

Some costs will remain constant whether activity increases or falls, at least within a given range of change of activity. These costs are called fixed costs. Variable costs on the other hand will change with swings in activity.

Limitations of accounting statements

Financial statements are only partial information. They show the reader of them, in financial terms, what has happened in the past. This is better than having no information at all, but much more information is needed to fully understand the present situation. First, it is impossible to sensibly compare two businesses which are completely unlike one another. Second, there are a whole lot of factors that the pastfocused financial statements do not disclose.

introduction
Ratio analysis is, therefore, a first step in assessing the performance and financial position of an entity. It removes some of the mystique surrounding the financial statements and makes it easier to pinpoint items which would be interesting to investigate further.

Profitability
These measures indicate whether the company is performing satisfactorily. They are used, among other things, to measure the performance of management, to identify whether a company may be a worthwhile investment opportunity, and to determine a companys performance relative to its competitors. There are a large number of these ratios. You will recall that we covered three in Business Accounting 1 gross profit : sales, net profit : sales and return on capital employed. We shall review them once more and add some others that are commonly used.

Solvency
Being solvent means having sufficient resources to meet your debts when due. Your resources must be sufficiently liquid to do so, hence the frequent use of the term liquidity when referring to this group of ratios. As you learnt in Business Accounting 1, the solvency of individuals is often performed through credit checks undertaken by credit rating agencies. Many lenders, such as banks, use a checklist of questions concerning financial status before they will lend or grant credit to a private individual. For companies, information can be purchased that indicates their solvency, i.e. whether they are liable to be bad credit risks. Such information is usually based, at least in part, upon ratio analysis of their financial statements. When it comes to the solvency of a business, both its own ability to pay its debts when due and the ability of its debtors to pay the amount they owe to the business are of great importance. Ratio analysis that focuses upon solvency (or liquidity) of the business generally starts with a look at two ratios that are affected most by these two aspects of liquidity: the current ratio and the acid test ratio.

Efficiency ratios
Profitability is affected by the way that the assets of a business are used. If plant and machinery are used for only a few hours a day, the business is probably failing to utilise these assets efficiently. This may be because there is limited demand for the product produced. It could be due to the business restricting supply to maximise profitability per item produced. On the other hand, it could be that there is a shortage of skilled labour and that there is no one to operate the plant and machinery the rest of the time. Alternatively, it could be that the plant and machinery is unreliable, breaking down a lot, and that the limited level of use is a precautionary measure designed to ensure that production targets are met. In common with all accounting ratios, it is important that the results of efficiency ratio computations are not treated as definitively good or bad. They must be investigated further through consideration both of the underlying variables in the ratios, and of the broader context of the business and its relation to the industrial sector in which it operates.

Shareholder ratios are those most commonly used by anyone interested in an investment in a company. They indicate how well a company is performing in relation to the price of its shares and other related items including dividends and the number of shares in issue. Dividend yield Dividend yield measures the real rate of return by comparing the dividend paid to the market price of a share. It is calculated as: Gross dividend per share/Market price per share Earnings per share (EPS) EPS is the most frequently used of all the accounting ratios and is generally felt to give the best view of performance. It indicates how much of a companys profit can be attributed to each ordinary share in the company. FRS 14: Earnings per share provides the formula to be used when calculating this ratio: Net profit or loss attributable to ordinary shareholders/The weighted average number of ordinary shares outstanding during the period Dividend cover Dividend cover compares the amount of profit earned per ordinary share with the amount of dividend paid, thereby showing the proportion of profits that could have been distributed and were. It differs from EPS only in having a different denominator. The formula is: Net profit or loss attributable to ordinary shareholders /Net dividend on ordinary shares Price earnings (P/E) ratio The P/E ratio relates the earnings per share to the market price of the shares. It is calculated as: Market price/Earnings per share and is a useful indicator of how the stock market assesses the company. It is also very useful when a company proposes an issue of new shares, in that it enables potential investors to better assess whether the expected future earnings make the share a worthwhile investment.

Shareholder ratios

Capital structure
There are a number of ratios that can be used to assess the way in which a company finances its activities. One, creditor days, was referred to in the last section. The ratios discussed in this section differ in that they are longer-term in nature, being concerned more with the strategic rather than with the operational level of corporate decision making.
Net worth : Total assets; This ratio indicates the proportion of fixed and current assets that are financed by net worth (the total of shareholders funds, i.e. share capital plus reserves). Fixed assets : Net worth ; This ratio focuses on the longer-term aspects of the net worth: total assets ratio. By matching long-term investment with longterm finance it is possible to determine whether borrowing has been used to finance some long-term investment in assets. Where this has occurred, there may be a problem when the borrowing is to be repaid (as the fixed assets it was used to acquire cannot be readily converted into cash). Again, this ratio is of most use when the trend over time is analysed. Fixed assets : Net worth + long-term liabilities ; This ratio focuses on whether sufficient long-term finance has been obtained to meet the investment in fixed assets. Debt ratio ; This ratio compares the total debts to total assets and is concerned with whether the company has sufficient assets to meet all its liabilities when due. Capital gearing ratio; This ratio provides the proportion of a companys total capital that has a prior claim to profits over those of ordinary shareholders.

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Debt : Equity ratio ; This is the ratio of prior charge capital to ordinary share capital and reserves. Borrowing : Net worth; This ratio indicates the proportion that borrowing represents of a companys net worth. Interest cover;This ratio shows whether enough profits are being earned to meet interest payments when due. It is calculated by dividing profit before interest and tax by the interest charges.

Overtrading
A very high proportion of new businesses fail within the first two years of trading. This can occur because there was insufficient demand for the goods or services provided, because of poor management, or for any of a number of other reasons of which possibly the most common to arise is overtrading. However, unlike the other common causes of business failure, overtrading often arises when a business is performing profitably. Furthermore, overtrading can just as easily affect established businesses as new businesses. Overtrading occurs when poor control over working capital results in there being insufficient liquid funds to meet the demands of creditors. As the cash dries up, so do the sources of supply of raw materials and other essential inputs suppliers will not continue to supply a business that fails to settle its bills when due. Overtrading is generally the result of sales growth being at too fast a rate in relation to the level of trade debtors, trade creditors and stock.

chapter 28
Interpretation of financial statements

Background
When shareholders receive the financial statements of the company they have invested in, many simply look to see whether the business has made a profit, and then put the document away. (This is one reason why the introduction of an option to send shareholders abbreviated financial statements, rather than the far more costly to produce full set of financial statements, was introduced a few years ago.) They are aware of only one thing that the company made a profit of x. They do not know if it was a good profit. Nor do they know whether it was any different from the profit earned in previous years. (Even if they had noticed the previous periods profit figure in the comparative column, they would be unaware of the equivalent figures for the periods that preceded it.) In addition, they would have no perception of how the performance compared with that of other companies operating in the same sector.

Sector relevance
Analysis and interpretation of any phenomenon is all very well if conducted in isolation from the rest of the world. However, it can be of only limited use without comparitors with which to develop an understanding of what is being examined. Even when this is done, it is important that the comparitors are valid there is not much point in comparing the performance of a Rolls- Royce with that of a bicycle. Like must be compared with like. Racing bike to racing bike, mountain bike to mountain bike, Premiership football team to Premiership football team, and so on. For companies, the easiest way to ensure that like is being compared with like is to compare companies that operate in the same business sector. The importance of ensuring that any comparison undertaken between companies involves companies in the same sector can best be illustrated through an extreme example: that of the contrast between service companies and manufacturing companies.

Pyramid of ratios
Once ratios have been analysed and compared, explanations must be sought for the results obtained. Sometimes it will be obvious why a certain result was obtained for example, if a company has moved from traditional stock-keeping to a just-in-time system during the period, its stock turnover will bear no resemblance to that which it had in the previous period. For those inside the company its directors and management the management accounting records are available to assist in finding explanations, as are the companys staff. Outsiders shareholders, analysts, lenders, suppliers, customers, etc. do not have access to all this internal information (though some of these user groups will have access to more internal information than others banks. One source of additional information available to everyone is a result of the fact that most ratios can be further subdivided into secondary ratios which, themselves, can also be subdivided, so building into a pyramid of ratios. By following through the pyramid of a given ratio, the source of the original ratio can often be isolated, enabling a far more focused investigation than would otherwise be possible.