P14B28

International Accounting
Lecture 3 & 4
Financial Statement Analysis

Group Assignment Membership Form

International Accounting P14B28
Semester 1 2014/15
Module Convenor: Rob Nieschwietz
Notes:
1. The Group Leader should submit the completed
membership form to the Faculty Office (AB 348) by 4pm
October 9th, 2014.
2. The group leader will be responsible for submitting the
electronic copy of the completed assignment on Turnitin.
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5.
6.

Group size: FIVE students

Please list the Group Leader first
Each group should submit only one completed form
List your Nottingham mail (no gmail or hotmail please!!)

Nottingham email ID

Signature

1.

@nottingham.edu.cn

2.

@nottingham.edu.cn

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@nottingham.edu.cn

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Leader

Last lecture a recap:

Principal financial statements
Balance sheet, or statement of financial
position (SOFP)

Profit and loss (P/L), or Income statement (I/S), or

Statement of financial performance (SOFP)

Cash flow statement or Statement of cash

flow (SOCF)

Now lets have a look at the extracts from Ted

Baker Group Accounts 2011
3

Leaning Objectives for Lecture 3&4

Explain and evaluate measures of a
companys performance ratio analysis
Critically apply ratio analysis, bearing in
mind its strengths and limitations

Why do we need ratios?

1. Comparisons between entities which of
the following companies is the most
profitable?

Profit
Net assets
Return
5

Co. A
000
200
500

Co. B
000
1,000
10,000

40%

10%

2. Comparisons over time has there been an increase or

decrease in profitability from one year to the next?
Previous
Current
year
year
000
000
Profit
900
1,000
Net assets
8,000
10,000
Return

11.25%

10%

In both cases a comparison of the absolute profits would give a misleading evaluation

The Functions of Ratio Analysis

The main function of ratio analysis is to enable
users of published financial statements to evaluate
the financial performance and financial position of
the reporting entity for the purpose of making
economic decisions (buy/sell/hold decision for
example). This usually takes the form of:
1. Comparisons with other entities (inter-firm);
and/or
2. Comparisons over time (time series analysis).
7

Warning!
Before you calculate ratios:
Understand the industry, the economy, the
management, the governance, the products,
the competitors, the value drivers (see next
slide), major risks (see later slide) etc.
Look for trends in the data
Look for keep performance indicators (KPIs)
including non financial data e.g. Sales per
square metre
Calculate percentage changes
8

Value Drivers
Business Type

Value Driver

Example

Merchant

Product / price differentials

M&S plc

Service

Exploit assets, e.g. knowledge

KPMG

Manufacturing

Transform bought-in goods and

services

Rolls Royce plc

Extractive

Exploit natural resources

BP

Banking

Differentials in price of money

HSBC

Measuring Risk
Financial risk: the risk that a firm will have insufficient funds to pay
interest or repay capital on its borrowing and hence default against its
lenders.
Business risk: the risk of failure in the product or supply markets and
hence a failure of its return-generating power; business risk also
includes risk brought about by technological change.
Regulatory risk: the risk that a firms products market or critical
supply markets may be subjected to adverse regulation which
diminishes its ability to earn revenue. The recognition in the 1980s
that asbestos was a principal cause of lung disease led to a ban on its
use as a building material; principal asbestos manufacturers were
forced out of business.
Market risk: the risk of variability in the firms share price and in the
price of its other traded financial securities.
10

CORE ANALYSIS (Moon and Bates 1993)

Establishing and understanding the
context within which the firm has
been operating, externally and
internally.

Focuses on the financial statements

themselves (together with any other
available information), trends in
sales, profits, and asset and liability
movements.

Calculation of financial ratios.

Interpret the ratios calculated and

evaluate the performance of the firm.
11

Context and Overview

What is the organisation? What does it do?
Differentiated/customised products or commodities?
How does it add value via its business processes?
What are its assets & liabilities?
Capital intensity?
Intangibles?

How do its customers pay? Cash or credit?

External environment PESTLE

SWOT

Corporate strategy
Critical success factors
12

Financial ratio classification

Categories

Profitability

Efficiency

Liquidity

Financial gearing

Investment
13

MAIN RATIOS

PROFITABILITY

ROCE
ROE
Capital turnover
Operating profit
margin
Gross profit
margin
Net profit margin

LIQUIDITY AND
EFFICIENCY

Acid test
Current ratio
Inventory
holding period
Trade receivable
collection period
Trade payable
payment period

FINANCIAL
GEARING

Debt/equity
ratio
Interest cover

INVESTMENT

Dividend yield
EPS
DPS
P/E ratio

Collis et al. (2012, p 216)

14

Main users of financial information relating to a business

Owners

Customers

Competitors

Employees
and their
representatives

Managers

Business
organisation
Lenders

Suppliers

Government

Investment
analysts

Community
representatives
15

Class Activity In pairs

How can ratios help users of accounts?
Select 3 user groups from the previous slide.
Think about what ratios they would be
particularly interested in and why.

16

Profitability Ratios
Re turn on equity ( ROE )

Pr ofit for ordinary shareholders

100%
Equity

Re turn on capital employed ( ROCE )

Capital turnover

Operating Pr ofit
100%
Equity Non - current Liabilities

Re venue
Equity Non - current liabilities

Operating profit
Operating profit m arg in
100%
Re venue
Gross profit m arg in

Gross profit
100%
Re venue
17

Return on Equity (ROE)

Re turn on equity ( ROE )

Pr ofit for ordinary shareholders

100%
Equity

TB 2010 / 2011
ROE

17, 280
100% 22.73%
76, 024

TB 2009 / 2010
ROE

13,527
100% 20.42%
66, 230

Focuses on the profit generated on the investment of shareholders

funds
Return is defined as the profit for ordinary shareholders profit after
interest and tax
Equity is the total equity
Benchmark?
18

- ROE behavior is
dependent on both
earnings and the
asset base.
- Patterns tend to
be mean-reverting.

19
Extracts from Business Analysis and Valuation (Palepu et al. 2010. p278-279)

Effect of Gearing on ROE

100% Equit y

50% equit y

10% equit y

50% debt

90% debt

Capital employed

100,000

100,000

100,000

Equity

100,000

50,000

10,000

50,000

90,000

20,000

20,000

20,000

5,000

9,000

20,000

15,000

11,000

6,000

4,500

3,300

14,000

10,500

7,700

14%

21%

77%

Debt
Operating profit before I and T
Interest @ 10% on debt
Profit after interest
Tax @ 30%
PAT
Return on Equity

20

Return on Capital Employed (ROCE)

Re turn on capital employed ( ROCE )

Operating Pr ofit
100%
Equity Non - current Liabilities

TB 2010 / 2011
24,132
ROCE
100% 31.11%
77,571
TB 2009 / 2010
ROCE

19, 782
100% 29.29%
67,546

Working 1

2010/2011

2009/2010

000

000

Equity

76,024

66,230

Non-current liabilities

1,547

1,316

Capital employed

77,571

67,546

ROCE measures the percentage return on the total investment of funds in the
business.
Capital employed include the shareholders fund and all sources of long-term
finance
ROE is a more modest return measure than ROCE
21

Capital employed: Long-term Funding (SOFP)

ASSETS

Non-current
assets

Current assets

CLAIMS
Shareholders
equity
Long -term
debt

Long term
funding

Current
liabilities

22

Capital Turnover
Capital turnover

Re venue
Equity Non - current liabilities

TB 2010 / 2011
187, 700
Capital Turnover
2.42 times
77,571
TB 2009 / 2010
Capital Turnover

163,586
2.42 times
67,546

As high as possible higher level of turnover for lower level of

investment
2.42 times indicates that the capital have been turned-over 2.42
times during the year. Or every 1 invested in the capital employed
generates 2.42 of sales revenue.
23

Operating Profit Margin

Operating profit
Operating profit m arg in
100%
Re venue
TB 2010 / 2011
24,132
Operating Profit Margin
100% 12.86%
187, 700
TB 2009 / 2010
Operating Profit Margin

19, 782
100% 12.09%
163,586

TB is making an operating profit of slightly over 12 on every 100 of

revenue.
Improve the ratio by increasing selling price, if possible, or cutting costs.
ROCE = Capital Turnover x Operating Profit Margin

24

Gross Profit Margin

Gross profit
Gross profit m arg in
100%
Re venue
TB 2010 / 2011
Gross Profit Margin

115, 777
100% 61.68%
187, 700

TB 2009 / 2010
99,927
Gross Profit Margin
100% 61.09%
163,586
The relationship between production/purchasing costs and sales revenues. The
gross margin needs to be high enough to cover all other costs incurred by the
company.
Net profit margin (%) = PAT/Revenue
25

Typical margin loss in different businesses

26

Considerations when calculating

RETURN RATIOS
There are no standard formulae - What is
appropriate in the particular circumstances?
1 Match asset base with relevant income
2 Does the profit figure gross / net /
operating - need adjustment?
3 Before or after tax ?
4 The averaging of balance sheet items
5 The effect of gearing
27

Class Activity - how choosing a different asset

(capital) base produces different rates of return?

Preference shares
Have a fixed dividend.
Must be paid before ordinary dividend for the year.
Arrears must be paid before ordinary dividend (cumulative preference shares).
Generally have priority on winding up.
Do not have right to residual profits on winding up.
Not technically equity.

28

29

Asset/Capital
base

Income
matched

Return
(%)

a Equity (excl preference shares)

190,000

40,000

21.1

b Share capital plus loans

300,000

72,000

24.0

c Share capital + loans

investments

250,000

67,000

26.8

30

Using average figures

If we are making profits, equity is bigger at the end of the year than
the beginning. In fact, it is growing through the year.

opening
capital

average
capital

If we are comparing income statement (period) figures with

balance sheet ones, it may be appropriate to use an average
balance sheet figure. Calculate the best average you can using
the information available.

closing
capital

31

Liquidity and Efficiency Ratios

Liquidity :
Current ratio

Current assets
Current liabilities

Current assets Inventories

Acid test
Current liabilities
Efficiency :
Inventory holding period

Inventory
12 months [or 365 days ]
Cost of sales

Trade receivables
12 months [or 365 days ]
Re venue
Trade payables
Trade payable payment period
12 months [or 365 days ]
Cost of sales
Trade receivable collection period

32

Liquidity and Efficiency

Liquidity ratios reflect the health or otherwise of the cash position of

the business and its ability to meet its short-term obligations.

Efficiency ratios reflect how effectively business transactions are being
converted into cash.
What if a company have bad liquidity/efficiency ratios?
Their profit margins may be eroded by the financing costs of funding
overdue accounts
Cash flow shortfalls maybe put pressure on their ability to meet their
day-to-day obligations to pay employees, replenish stocks, etc
Limitations:
Snapshot only, trend may be more important.
No standard ideal result, need comparisons.

33

Current Ratio and Acid Test

Current ratio
Acid test

Current assets
Current liabilities

Current assets Inventories

Current liabilities

TB 2010 / 2011

TB 2009 / 2010

83,800
Current ratio
2.14 :1
39,186
83,800 42, 492
Acid test
1.05 :1
39,186

67,387
2.36 :1
28,594
67,387 33, 450
1.19 :1
28,594

Current ratio =2.14:1, ie. for every 1 of current liabilities there is 2.14 of current
assets with which to meet these commitments.

Usually current ratio should be larger than 1. The company should have enough
assets to cover its liabilities.

This ratio is unhelpful if inventory is not able to be sold quickly acid test
34

Current Ratio and Acid Test

Acid test is also called Quick Ratio or Liquid Ratio

Acid test

Current assets Inventories

Current liabilities

Limitations: this ratio assumed current assets are quickly turned into cash
and current liabilities are quickly payable, which is not valid in real life.
Defensive interval

Quick assets
Average daily cash from operations

Quick assets current assets inventory

Average daily cash from operation

opening debtors + sales - closing debtors

365

Defensive interval shows how many days a company could survive at its
present level of operating activity if no inflow of cash were received from
sales or other sources.
eg. TB 2009/10 Defensive interval = 79 days

35

Efficiency
Inventory holding period

Inventory
12 months [or 365 days ]
Cost of sales

Trade receivables
12 months [or 365 days]
Re venue
Trade payables
Trade payable payment period
12 months [or 365 days]
Cost of sales
Trade receivable collection period

TB 2010 / 2011

TB 2009 / 2010

42, 492
12 7.09 months
71,923
18,182
Trade receivables collection period
12 1.16 months
187, 700
18,888
Trade payables payment period
12 3.15 months
71,923

33, 450
12 6.31 months
63, 659
14, 436
12 1.06 months
163,586
10,392
12 1.96 months
63, 659

Inventory holding period

Trade receivable collection period (debtor days) indicates the average time taken,

in calendar months/days, to receive payment from credit customers.

Trade payable payment period (creditor days) indicates the average time taken,
in calendar days/months, to pay for suppliers received on credit.
Management should take the maximum time allowed to pay trade creditors,
whilst collecting payment from trade debtors as quickly as possible.
36

Efficiency
Usually we will use average inventory to calculate the
inventory turnover. But if a figure for opening stock is not
provided, we can use closing stock as a proxy.
opening inventory clo sin g inventory
Average inventory
2

Caveat: No standard period inventory levels will vary

depending on the business activities and the time of year.
Again, trends are more helpful than snapshot
Ideally we should use purchases to calculate Trade Payables
Payment Period, but if the figure for purchase is not available,
we could also use cost of sales
If a breakdown of debtors/creditors is not given, it is likely
that the figures are in the notes to the accounts.
37

Operating Cash Cycle/Cash Operating Cycle

The time between buying inventory and receiving cash from customers.

OCC Average inventory holding period

Average trade receivable collection period
Average payable payment period

Typical operating cycle for a retailer

OCC

A longer operating cash cycle means more money is tied up in working capital. A
shorter operating cycle is therefore preferable.

38

Gearing Ratios
Non current liabilities
Debt / equity ratio
100%
Equity
Operating profit
Interest cov er
100%
Interest payable
Generally concerned with the relationship between debt and equity capital,
the financial structure of an organization.
Used by investors and lenders to assess financial risk when a business has an
obligation to service and repay long-term debts.
The higher the gearing, the higher the risk that the business will be unable to
pay the interest on its loans or make repayment in times of economic
recession.
On the other hand, the higher the gearing, the higher the returns to
shareholders will be in strong economic conditions.
39

Gearing Ratio
TB 2010 / 2011
1,547
Debt / equity ratio
2.03%
76, 024
24,132
Interest cov er
371.26 times
65
TB 2009 / 2010
1,316
1.99%
66, 230
19, 782
Interest cov er
133.66 times
148
Debt / equity ratio

These ratios describe the relative proportions of debt and equity used to
finance a business.
Interest cover calculates the number of times the interest payable is
covered by profits available for such payments and assesses the relative
safety of interest payments.
40

Investment Ratios
Dividend per share

Dividends
Number of ordinary share

Dividend per share

Dividend yield
Average share price
Earnings per share

Pr ofit for ordinary shareholders

Number of ordinary share

Share price
Pr ice / earnings ratio ( PE )
Earnings per share
Investment ratios generally indicate the extent to which the business is

undertaking capital expenditure to ensure its survival, and stability and its
ability to sustain current revenues and generate future increased revenues.
It is also used by investors, analysts and financial journalists to evaluate the
shareholders return and aid investment decisions.
41

Dividend per share and Dividend yield

Dividend per share
Dividend yield

Dividends
Number of ordinary share

Dividend per share

Average share price

TB 2010 / 2011

TB 2009 / 2010

8,574
Dividend per share
100 20.52 pence
41, 786
20.52 p
Dividend yield
4.65%
441.40 p

7,138
100 17.15 pence
41, 623
17.15 p
3.91%
439.10 p

Dividend per share (Dividend net) is the total amount declared as dividends
per each ordinary share in issue.
Dividend yield shows how much a company pays out in dividends each year
relative to its share price
If average share price is not available, you can also use the FYE date share
price.
If two companies both pay annual dividends of 1 per share, but company A
is trading at 20 while company B is trading at 40, then A has a dividend
yield of 5% while B is only yielding 2.5%. Thus, assuming all other factors are
equivalent, which stock would an investor prefer?
42

Earnings per share (EPS) and P/E ratio

Earnings per share

Pr ofit for ordinary shareholders

Number of ordinary share

Pr ice / earnings ratio ( PE )

Share price
Earnings per share
TB 2009 / 2010

TB 2010 / 2011
Earnings per share
P/E

17, 280
100 20.52 pence
41, 786

441.40 p
10.67 years
41.35 p

13,527
100 32.50 pence
41, 623
439.10 p
13.51years
32.50 p

EPS measures the total return per share of earnings available to

shareholders.
P/E ratio reflects the stock markets view on how long the current level of
EPS will be sustained. OR how many years it would take to recover the
market price paid for the shares out of the earnings. The higher the P/E ratio
the better, as it reflects the stock markets confidence in the companys
financial prospects.
Dividend cover = EPS / DPS - It shows the number of times the profits
attributable to equity shareholders cover the dividends payable for the
period.

43

2
4.30

2.18

4.25

2.81
2.65

4.14

2.96

Average for all SE

listed businesses

Beverages

Life insurance/
assurance

Electricity

Food and Drug

retailers

Media

Travel and leisure

Tobacco

Pharmaceuticals and
biotechnology

Industrial
engineering

Chemicals

Construction and
materials

Oil and gas

Average dividend yield ratios for businesses

in a range of industries

5.22

4.45

4.23

3
3.12

2.62

2.19

0
Constructed from data appearing in The Financial Times, 3/4 April 2010
44

25.0

5.0

Chemicals

30.0

Construction
and materials

Oil and gas

times

28. 79

15.0

10.0
12.77

20.0

15.58

12.31
17.34
17.17
17.20

21.78

Average for all SE

listed businesses

Beverages

Life insurance/
assurance

Electricity

Food and Drug

retailers

Media

Travel and leisure

Tobacco

Pharmaceuticals and
Biotechnology

Industrial
engineering

Average price/earnings ratios for businesses

in a range of industries

19.07
17.73

15.11

14.10
11.31

Constructed from data appearing in The Financial Times, 3/4 April 2010
45

Effect of Gearing on EPS

Two companies, identical operating profit and capital employed

Year
Operating profit
Interest
EPS

Year
Operating profit
Interest
EPS

1
k
200
0
200
0.20

Company A
2
3
4
k
k
k
300
200
40
0
0
0
300
200
40
0.30 0.20 0.04

1
k
200
50
150
0.30

Company B
2
3
4
k
k
k
300
200
40
50
50
50
250
150
-10
0.50 0.30 -0.02

5
k
200
0
200
0.20

5
k
200
50
150
0.30

Company A
Capital employed
Shareholders funds
Loans
Capital employed
Capital gearing

k
1000
0
1000
0%

Company B
Capital employed
Shareholders funds
Loans
Capital employed
Capital gearing

k
500
500
1000
100%

Assume 1 shares in issue

46

Effect of Gearing on EPS

0.60
0.50

EPS

0.40
0.30

Company A

0.20

Company B

0.10
0.00
-0.10

Year
47

Limitations of ratio analysis

Data unavailable or unsynchronised

Non-standardised accounting
Do not take account of non-financial factors
May be misleading
Summarised data, limited segmental analysis

Conclusion:
Ratio analysis can only support decisions and
encourage further enquiry.
It is important to note that ratios are not standard
but can be calculated in different ways.
Consistency and interpretation are what matters!
48

Tips for your group project 1

Read Moon & Bates 1993
Obtain Annual Report for your chosen company
Undertake qualitative analysis on nature of
business/strategy etc and decide what impact
this might have on the results you will get from
your ratio analysis
Data source
Financial statements
Datastream (Electronic database in school)
49

Tips for your group project 2

Use the best available information, which may not be
ideal information that we have seen with averaging
balance sheet values, applies to other information
available to us.
eg. Debtor collection period relate to credit sales. Cash sales
produce no debtors! You might have to assume there are no
cash sales.

So ratios and averages are simplifications, intended to

give a broad view.
If other credit balances are long term items, we could
treat them as part of capital for the purposes of ratio
analysis.
50

Tips for your group project 3

The simplified balance sheets from the examples
show basic categories.
Published accounts often show other items, which
may be difficult to interpret, even with the help of
the notes.
Such items may include various provisions,
including provisions relating to pensions, or
deferred tax assets and liabilities.
Judgement is needed to decide what to include in
ratio analysis.
51

PRACTICE QUESTIONS on Ratio Analysis

in Collis et al. (2nd)
P236 Q1 Q3 Q4
Solutions to practice questions can be
downloaded from Moodle

52