Financial Analysis - Ratios 1 24 October

Warwick Business School 24 October, 2016
Analysing the accounts
• A key objective of the module
• What can the financial reports tell us
• How do we make sense of the information
Warwick Business School

Reasons for Analysis
 Different Questions
 Should we trade with them?
○ Will they go bust before they pay?
 Should we lend them money?
 Where will they be in ten years time
 What can we learn and apply to ourselves?
 Is it a good investment? Should we acquire them?
Done for a purpose
 Questions will always attempt to be “realistic”
 Real companies with possible real situations

Who is asking the question?
 Different Users
 Suppliers
 Banks
 Customers
 Competitors
 Shareholders

All about numbers?
 Numbers are meaningless without
 An understanding of the background
 Interpretation
 Some textbooks are naïve and misleading
 Financial analysis is a “real life skill”
○ Not a set of simple formulae to apply mindlessly
○ Answers often not obvious
 Good industry and company knowledge matters more than
mathematical technique
○ Much of the literature would give you the impression that the
opposite were true
○ Balancing simplicity and complexity
Example difficult questions
We will work out some basic ratios today, but
interpreting “reality” can’t be reduced to a few
small equations
 Are current liabilities a source of finance?
 Should you include them in a debt ratio?
 Should we treat pension deficit as debt?
 Are preference shares debt?
 UK GAAP (pre 2005) treated them more like equity
 IFRS treats them more like debt
 Answer?
How to answer the question(s)?
 Know about the industry and company first
 Variety of techniques
 Ratios
○ Not the only tool!
 Common size analysis (express IS items as a % of sales
or SFP items as % of equity)
 Comparative techniques
 eg balanced scorecard, regression etc
 Credit rating methods

Where to get information?
 Government statistics
 Industry sources
 Company sources
 Report and Accounts
 Other publications e.g.
○ Datastream,
○ FAME,
○ Trade sources
○ FT.com

Presentation techniques
 In Annual Reports
 Annual reports tell a story, hence interpret with care.
 Use the group (consolidated) accounts
 Also note
○ the “Comprehensive income statement”
○ the Statement of Changes in Equity
 There are no standards governing graphical presentation.
 Words will be selective
 Pictures potentially more so
 However
 The analyst should use their own words, graphs and pictures
○ Has more meaning than a string of numbers
○ Trends are highlighted.
○ Aids understanding
A framework for analysis
Don’t dive into

the numbers
without thinking!

Detach the last page!
 Some numbers for us to use
 M&S
 Last two financial years
 (Slightly) simplified set of numbers

A structure for appraisal
1) Why am I doing it – what is the question?
2) Understanding the industry and the company
Context  Porter's 5 forces, value chain,....
 Positioning of each company in the industry
 How the company “works”
Overview
3) Overview
 A “big picture” of the numbers
4) Data issues
 Accounting policy choice and effect on numbers
Ratios 5)
 Exchange rates, year end dates, inflation rates
Compute ratios
Evaluation
6) Analyse ratios - what is the answer?
7) Conclusion/Recommendations

A framework for analysis
Company’s financial performance
Company’s strategy and vision
Company’s internal context
Industry/external context
Global environment
The Past and Present
The Future

ontext
 External
 Economy, markets, competitors,
 PEST. PESTLE, ESTEMPLE etc..
 Internal
 Who owns the shares?
 Experience and quality of management
 Corporate governance
 Corporate structure
 Business Model? E.g. franchise/non-franchise, Lease/own,
Make/buy in, Vertical Integration? etc.

Keep a broad mind
• Strategy and marketing provide the backdrop for financial
analysis
• There are lots of models, but using your brain is the most
important part
– All situations are a little different
– Models and diagrams provide useful starting points
– As a minimum we need to know enough to understand
what the business is and how it works

 The big picture
 Main Trends?
 What’s changed?
 Up / down?
 Better / worse?

Caveats for published accounts
 Normally use published accounts

 Limited information
 "Snapshot", not necessarily (usually?) typical
 No allowance for inflation
 But might use a database eg FAME, Datastream etc
 Read less into a number than a trend
 There are few ratios with universal benchmark levels
 A trend can reveal the speed of change
 What is best comparison?
Caveats for published accounts (ii)
 Problems for Comparison and Assessment

 Seasonal factors and year end dates
 Accounting Policy Choice
○ Degree of "creativity"
○ Cross Border Comparisons
 Exchange Rates?
 Companies can go bust quickly!
 If you have "power" in a corporate relationship,
ask for regular management accounts

Key things to remember
 We are always trying to learn

 We don’t just produce numbers for their own
sake
 Analysis is flexible
 Do what is appropriate
 What are you trying to find
 What is best number for that
 A brain exercise more than a calculator exercise!

Overview M&S
2015 2014
Turnover 10,311 10,309
% increase 0.0% 2.8%
Operating profit 680 646
% increase 5.3% -5.8%
EBITDA 1,251 1,199
% increase 4.3% -1.7%
Profit for the year (earnings) 482 506
% increase -4.7% 13.7%
Operating cash flow 1,278 1,130
% increase 13.1% -0.9%
Capital and Acq expenditure 700 642
% increase 9.0% -22.7%
Total debt -2,025 -2,104
% increase -3.8% -192.0%

Hit the numbers

Key problem in analysis
 We are trying to advise on decisions
 The future is what matters
 All we have is information (however good) on
the past
 This is a foundation for us to build a forecast on or to
base a decision on.
 The TV quiz question
○ “What happens next?”
 What is a good performance anyway?
Ratio Categories
 Performance
 Profits
 Use of Assets
 Sales
 Productivity
 Working Capital
 Inventory, Debtor and Creditor control
 Financial Status
 Liquidity (short term)
 Solvency (long term)
 Investment Ratios (lesson 9)
Key performance questions
 Return
 Management performance
○ Use of capital in generating profits
 Shareholder performance
○ Profit for shareholders from their investment
 See later lessons
 Margin
 % of sales price that becomes profit
 Productivity
 Good use of assets
 Good use of people
Start with ……….
Return
What is it?

Return on Return on Equity
Capital Employed (ROE or ROSF)
(ROCE)
Profit before interest and tax Profit after tax
Total assets less current liabs Equity
(or Long term funds )
• ROCE is a key driver of ROE

Return on Capital Employed
 Sometimes called the "Key Ratio".
 Gives the % return on the long term funds tied up in the
business.
 Answers the question "How have management performed with the
funds available?”
 Have management made a better ROCE than their Cost of Capital?
 The higher the risk, the higher the required return.
 Do not confuse this with Return on Equity (RoE)

 This is Profit after tax (dealt with in more detail in lesson 8)
Equity

Return on Capital Employed (1)
Profit before interest and tax
Total assets less current liabilities
M&S
2016 2015
584/6,371 701/6,084
Return on Capital
= =
Employed 9.2% 11.5%

Return on Capital Employed (2)
Underlying PBIT
Total assets less current liabilities
M&S
2016 2015
Underlying Return on 784/6,371 782/6,084
Capital Employed = =
12.3% 12.5%
Which one to use?

Du Pont analysis
ROCE = Asset Turnover x Sales Margin
PBIT = Sales x PBIT

CE CE Sales
Sales
margin

Return on Equity
• Also called Return on Shareholders’ funds
• Defined as Profit after tax

Equity
M&S
2016 2015
573/3,445 541/3,200
Return on Equity
= =
(underlying)
16.6% 16.9%
• Wow!! Shareholders get better return than ROCE

• More in lesson 8
Asset turnover
Turnover
Capital employed
M&S
2016 2015
10,555/6,371 10,311/6,084
Asset turnover = =
1.66 times 1.69 times

Asset turnover
 Expressed as a multiple.
 Shows the number of times the capital "turns over"
in a year or how many £'s of sales is generated by
every £ invested in the business in a year.
 Capital Intensive companies have a low turnover,
however companies using heavily depreciated
equipment can have quite high multiples. Retailers
can have high multiples.

Sales margin (Net margin)
PBIT
Turnover
M&S
2016 2015
584/10,555 701/10,311
Sales margin = =
5.5% 6.8%
784/10,555 762/10,311
Sales margin (underlying)
= =
7.4% 7.4%

Sales Margin (Net margin)
 Expressed as a percentage, the margin means how
many pence in each £ of sales is profit.
 Note how underlying gives a very different picture
 The trend over time would show whether the sales
price has been increased more or less than costs.
 Different Industries will have very different ratios.
 Gross margin refers to gross profit (after only
allowing for certain direct costs) divided by sales.

Typical Levels for ROE, Net Margin and ATO (Asset Turnover)
Source: Standard & Poor’s ROE(%) ROCE(%) Net Margin (%) ATO
Restaurants 15.6 14.2 5.0 2.83
Printing and publishing 14.6 14.3 6.5 2.20
Business services 14.6 15.3 5.2 2.95
Chemicals 14.3 13.6 7.1 1.91
Food stores 13.8 12.6 1.7 7.39
Road Transport 13.8 10.9 3.8 2.88
Food products 13.7 12.1 4.4 2.74
Communications 13.4 9.5 12.5 0.76
General stores 13.2 12.4 3.5 3.55
Petroleum refining 12.6 11.8 6.0 1.96
Transportation equipment 12.5 11.1 4.5 2.47
Airlines 12.4 8.6 4.3 1.99
Utilities 12.4 8.5 14.5 0.59
Wholesalers, non-durable 12.2 8.6 2.3 3.72
goods
15%
ROCE

Gross margin
Gross Profit
Turnover
M&S
2016 2015
4,128/10,555 3,985/10,311
Gross margin = =
39.1% 38.6%
How reliable is cost of

sales figure?

Gross margin
• Note 4 shows that inventory element of cost of sales is
• £5,779 (£5,746)
• These figures would make gross profit relating to
the goods only £4,776 (£4,565)
M&S
2015 2014
4,776/10,555 4,505/10,309
Gross margin using
= =
adjusted cost of sales
45.3% 44.3%

Expenses / Sales
We could (should?) drill deeper and look at

expenses in relation to sales

Comparisons
Glaxo Next Easyjet
2013 2014 2014
Return on Shareholders Funds (%) 95.00 242.82 26.75

Return on Capital Employed (%) 23.67 56.07 18.97
Profit margin (%) 25.08 18.59 12.83
Gross margin (%) 67.61 33.16 0.00
Net Assets Turnover (x) 0.94 3.02 1.48

Working Capital
 A key area of management performance.
 Companies go bust because they run out of
cash.
 Companies often run out of cash because of poor
working capital control.
 How much working capital do you want?
As little as possible!
 What is possible?
 Liquidity ratios are also working capital ratios.

Inventory ratios
 Expressed as number of days of inventory held.
Multiplying by 52 instead would give inventory
weeks.
 An alternative is the number of times the stock
turns over in a year: this is "cost of
sales/inventory".
 Includes raw materials, w.i.p. and finished goods. If
this information is available, then analyzing these
individually may be interesting too.
Inventory x 365
Cost of sales
Working capital ratios
M&S
2016 2015
800 x 365 798 X 365
Inventory days 6427 6326
= 45.4 days = 46.0 days
Can we find a
better figure?? What would be a
good number?

M&S
2016 2015
800 x 365 798 X 365
Inventory days 6,427 6,326
= 45.4 days = 46.0 days
Inventory days 798 x 365
using inventory
800 x365
recognised as 5,779 5,746
expense (note 4)
=50.5 days = 50.7 days

Debtor ratios
 Expressed as days outstanding.
 Ideally will use trade receivables not total receivables eg
prepayments
 A long debtor ratio may be due to long payment terms (e.g.
export sales) or to poor collection.
 A falling ratio is usually a sign of improving financial
management, but it might also imply a shortage of cash with
discounts being offered for early payment.
 Debtor payment periods are part of the pricing negotiation.
Debtors x 365
(Credit) Sales (turnover)

M&S
2016 2015
800 x 365 798 X 365
= 45.4 days = 46.0 days
116x 365 123 x 365
Debtor days 10,555 10,311
=4.0 days = 4.4 days
Is this a meaningful
figure???
What might we
typically expect??
Creditor ratios
 Expressed as the number of days between the receipt of
goods and payment for them.
 The ratio should only include those elements of current
liabilities where the company has some control over the
timing of payment.
 This may mean considering the current liability note rather than
taking the balance sheet figure.
 If “purchases” is not available use cost of sales.
 Consider including admin. costs
 A rising ratio may imply a cash shortage. There is an obvious
cash advantage to late payment , but there are also
downsides.....
Creditors x 365
Cost of purchases
M&S
2016 2015
800 x 365 798 X 365
= 45.4 days = 46.0 days
116x 365 123 x 365
Debtor days 10,555 10,311
=4.0 days = 4.4 days
1,022x 365 968 x 365
6427 6,326
Trade creditor days
= 58.0 days = 55.8 days
Working Capital Days -8.6 days -5.4 days

Working Capital Days
• The time it takes to go through the system
• Inventory days + Debtor Days- Creditor Days
• 45.4 + 4.0 – 58.0 = - 8.6 days
• M&S get the money in before they have to pay suppliers!

• Typical of retailers –particularly food etc. retailers
• Implies Working Capital is negative (Net Current Liabilities)
• The lower the better

Comparisons
Glaxo Next Easyjet
2013 2014 2014
Inventory days 53.6 37.6 0.0
Debtor Collection (days) 54.6 68.6 4.6
Creditors Payment (days) 37.7 19.0 10.8
Working capital days 70.5 87.2 -6.1

Liquidity and solvency
 The issue of liquidity is crucial.
 Liquidity trends and inter-company comparisons can
highlight a deteriorating cash position.
 Solvency looks longer term at debt and its effect on
profit.

Liquidity - current ratio
Current assets
Current liabilities
M&S
2016 2015
1461 = 0.69 1,455 = 0.68
Current ratio 2105 2,112

Liquidity - current ratio
 Answers the question "Can the company meet all
current liabilities with its current assets ?"
 Obviously a ratio of 1 would satisfy this, but whether
1 is too low or too high will depend on the industry.
A food retailer may have a ratio of 0.3 but more likely
in the range 0.5-0.9.
 The liquidity of the current assets is a key question.
That is, how fast can they be turned into cash.

Liquidity - acid test
Current assets less inventory

Current liabilities
M&S
2016 2015
661 = 0.31 657 = 0.31
Acid test (quick ratio)
2105 2,112

Liquidity – acid test
 As Current ratio, but the stocks are assumed to
be too illiquid to be included in the current
assets figure.
 Also called the "Quick ratio or Liquid ratio".
 The type of activity will affect the point at which
concern might be expressed. The better
approach would be to examine the trend over
time.

1.8
1.6
1.4
1.2
0.8
0.6
0.4 Current ratio

0.2 Acid test ratio
0

Solvency – interest cover
Profit before interest and tax

Interest payable
M&S
2016 2015
584 = 5.03 times 701 = 5.99 times
116 117
Interest cover
(Underlying cover
784/116 = 6.75 times)

Solvency – interest cover
 Expressed as a multiple measuring the number of times
interest payable is covered by profit.
 Gives the degree to which the company is vulnerable to being
unable to meet interest payments from profit.
 Interest payable is better than net interest
 The greater the proportion of capital from debt, the lower the
ratio.
 Consider whether preference dividends (often termed non-
equity) should be treated as interest.

Solvency - gearing
 A ratio of 1 would imply capital employed being equally
sourced from loans and shareholders.
 There are a number of alternative methods of calculation (e.g.
debt/(debt + shareholders' funds).
 What is debt? LT loans? LT + ST Loans? Interest bearing debt?
 A low ratio would imply a company could easily borrow funds
if required and therefore have more options available to it.
 Gearing is not necessarily bad

Lots of other
definitions !! E.g.
Solvency - gearing Debt
(Debt+ Equity)
Total debt (i.e. interest bearing)

Shareholders' funds
M&S
2016 2015
2073= 0.60 2025 = 0.63
Gearing 3443 3199

Gearing / leverage
 Change in risk level for the shareholders
 Change in reward level as debt increases
 Amplified
 The good times get better…
 The bad times get worse
 Interest payments stay constant however good
or bad the performance level
 Shareholders take the gain or loss

Comparisons
Glaxo Next Easyjet
2013 2014 2014
Current ratio (x) 1.11 1.76 0.89

Liquidity ratio (x) 0.83 1.30 0.89
Gearing (%) 261 281 18
Interest Cover (x) 9.67 25.57 53.82

The bigger picture
• A bigger pyramid in lesson 8
• Focused on the shareholder
ROCE • Same idea as ROCE = SM * AT
Sales Margin x Asset Turnover
Gross Expenses
Margin - Sales Sales/NCA Sales/CA
NCA = Non Current Assets ie Fixed assets
valuation
 Weigh up the evidence
 Look at Chairman and CEO statements and
Financial review
 answer the question!

valuation
 Interpret ratios in context
 Quality of earnings
 Exceptionals/ underlying profit trend?
 Take account of key events and changes
 Make appropriate comparisons
 Ensure questions raised have been covered
 Bring the analysis together
 Report findings & conclude
Use Ratio Analysis with care:
 Use of historical figures!
 Check on discretionary expenditure, E.g:
 Development expenditure
 Brands, Goodwill, Quality, etc.
 Must use same definitions for comparison
 Inflation distorts comparison over time
 Ratios ignore many factors not in accounts:
 Post balance sheet events
 Personnel changes
 Quality of management
 Skilled labour force ………..
Don’t forget Cash Flow Statement!
• Can be a useful source of information on future viability
• Is company generating enough cash for its needs???

B
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a
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k

B
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Marks and Spencer data
(Simplified and Summarised!!)
Tear off the

sheet

Marks and Spencer
2016 2015
53 weeks 52 weeks
Income statement ending 2 April ending 28 March
2016 2015
Underlying Non-Underlying Total Underlying Non-Underlying Total
£m £m £m £m £m £m
Turnover 10,555 10,555 10,311 10,311
Cost of Sales (6,427) (6,427) (6,326) (6,326)
Gross Profit 4,128 4,128 3,985 3,985
Selling and Admin
Expenses (3,413) (3,413) (3,305) (3,305)
Other operating income 69 69 82 82
Operating Profit 784 (200) 584 762 (61) 701
Interest Receivable 21 21 16 16
Interest Payable (116) (116) (117) (117)
Profit before tax 689 689 661 (61) 600
Tax (118) 34 (84) (125) 7 (118)
Profit for year 571 (166) 405 536 (54) 482
Attributable to:
Owners of the parent 573 (166) 407 541 (54) 487
Non-controlling interests (2) (2) (5) (5)
571 (166) 405 536 (54) 482
M&S Balance Sheet 2016 (£m) 2015 (£m)
Non-current Assets
Intangible Assets 802 858
Tangible Assets 5,027 5,031
Investments and other 1,186 852
Total Non-current Assets 7,015 6,741
Current Assets
Inventories 800 798
Trade and other Receivables 321 322
Cash 248 206
Other CA 92 129
Current Assets 1,461 1,455
Total Assets 8,476 8,196
Current Liabilities
Trade and other payables 1,618 1,642
ST Debt 298 279
Other 189 191
Current Liabilities 2,105 2,112
Non-Current Liabilities
LT Debt 1,775 1,746
Other LT Liabs 1,153 1,139
Total Non-Current Liabilities 2,928 2,885
Total Liabilities 5,033 4,997
Net Assets 3,443 3,199
Equity
Share capital 406 412
Reserves 3,039 2,788
Total Shareholders Equity 3,445 3,200
Minority Interests in Subsidiaries (2) (1)
Total Equity 3,443 3,199

M&S
Other data 2016 2015
Inventory recognised as expense 5,779 5,746
Trade receivables included in Trade and other receivables
figure 116 124
Trade payables included in Trade and other payables figure 1,022 968
Net Cash Flow from operating activities 1,212 1,278
Capital expenditure (from cash flow statement) 550 700
No of Shares (million) 1,623 1,648
Published eps pence 24.9 29.7
Interim divi for year (pence per share) 6.8 6.4
Proposed final Dividend for year (pence per share) 11.9 11.6
Depreciation and Amortisation(from cash flow statement) 577 550
Floor area mill sqm 2.15 2.12
Employees (FTE) 52,388 52,247

Financial Analysis - Ratios 1 24 October

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Warwick Business School 24 October, 2016

Analysing the accounts

• A key objective of the module

• What can the financial reports tell us

• How do we make sense of the information

Warwick Business School

Warwick Business School

Warwick Business School

Warwick Business School

Warwick Business School

Don’t dive into

Warwick Business School

 (Slightly) simplified set of numbers

Warwick Business School 24 October, 2016

Warwick Business School

The Past and Present

Warwick Business School

Warwick Business School

Warwick Business School

Warwick Business School

 Normally use published accounts

 Problems for Comparison and Assessment

Warwick Business School

 We are always trying to learn

Warwick Business School

Warwick Business School

Warwick Business School

Warwick Business School

• ROCE is a key driver of ROE

Warwick Business School

 The higher the risk, the higher the required return.

 Do not confuse this with Return on Equity (RoE)

Warwick Business School

Warwick Business School

Which one to use?

Warwick Business School

ROCE = Asset Turnover x Sales Margin

PBIT = Sales x PBIT

Warwick Business School

• Defined as Profit after tax

• Wow!! Shareholders get better return than ROCE

Warwick Business School

Warwick Business School

Warwick Business School

Warwick Business School

Warwick Business School

How reliable is cost of

Warwick Business School

Warwick Business School

We could (should?) drill deeper and look at

Warwick Business School

Return on Shareholders Funds (%) 95.00 242.82 26.75

Warwick Business School

Warwick Business School

Warwick Business School

Warwick Business School

Warwick Business School

Working Capital Days -8.6 days -5.4 days

• Inventory days + Debtor Days- Creditor Days

• 45.4 + 4.0 – 58.0 = - 8.6 days

• M&S get the money in before they have to pay suppliers!

Warwick Business School