UNIT SIX

INTERPRETATION OF FINANCIAL STATEMENTS

1.0 INTRODUCTION Financial statements are a product of facts and personal judgements. The accounting conventions and standards applied affect the contents and presentation of financial statements. It is therefore important to appreciate the underlying weaknesses of the various conventions and standards employed. In analysing financial statements the accountant tries to explain the relative importance and relationships behind the figures presented in the financial statements. In carrying out the analysis ratios are among some of the common tools employed in financial analysis. Basically ratio analysis seeks to answer the following questions: a) How profitable is the firm? b) Is the firm solvent? c) What is the ownership structure of the firm? d) What is the financial strength of the firm? e) Is the firm growing? f) How secure are the investments in the firm? OBJECTIVES OF THE UNIT The objectives of the unit are: To enable the calculation and analysis of useful financial ratios. To use ratios to assess a firms performance is comparison with its previous periods performance, similar firms and industry performance. To discuss the role of ratio analysis in predicting company performance. To discuss the limitations of ratio analysis. To outline the main uses of ratios. TYPES OF RATIOS Various ratios may be computed from financial statements. It must be mentioned at the onset that no single ratio taken in isolation will explain the performance of a firm. A rather wholistic picture is often arrived from analysing a group of ratios. Even then a group of ratios should not be taken as conclusive other items of information are relevant to give a fuller picture viz: a) b) c) d) The age and nature of the firms assets. Current and future developments in the companys markets, size etc. Extraordinary items in the income statement. Any other information contained in the financial reports such as chairmans report, directors report, auditors report etc. (BPP.2005:490).

1.1

2.0

This unit focuses on common ratios that will help answer the six basic questions outlined in 1.0 above. The ratios are divided in to five broad categories as shown below: a) b) c) d) e) 2.1 Profitability and return. Long term solvency and stability. Short term solvency and liquidity. Efficiency (activity ratios) Shareholders investment ratios.

PROFITABILITY AND RETURN RATIOS The financial performance of a firm can be assessed by reference to its ability to generate profit as well as its performance vis a viz the investment injected by investors. It follows that the ratios concentrate on the relationship between profit and sales, profits and assets employed as well as earnings per share, divided yield and price earnings. 1

2.1.1

RETURN ON CAPITAL EMPLOYED (ROCE) This ratio reveals the return on capital employed and shows the efficiency with which management would have employed funds placed at their disposal by shareholders and other financiers. The ratio is often expressed as a percentage. a) Net Profit (after interest and tax) Shareholders equity Shareholders equity is made up of share capital and reserves. It thus measures profitability in relation to what the legal owners of the firm have contributed. The obvious limitation of such an approach is, its failure to fully reflect managerial efficiency. b) Net Profit (before interest and tax) Net Capital Employed In the above approach current liabilities are deducted from total assets to get the net capital employed. The drawback of such an approach is current liabilities which an important source of capital employed are ignored. c) Net Profit (after interest and tax) Gross Capital Employed The ratio is all encompassing in that it shows what management have produced given all assets at their disposal. For the ratio to be fully reflective assets should be fairly stated as is now required by international financial reporting standards. An in depth understanding or analysis of return on equity is achieved by looking at secondary ratios. The ratios are: net profit to sales sales to total assets. If the net profit to sales ratio is unsatisfactory this can be attributable to a number of factors. It could be the pricing policy of the firm which may be resulting in insufficient mark up or alternatively the cost structure. On the other hand if the gross profit ratio is good a bad net profit to sales ratio may be a result of expenses which may be unnecessarily too high. This can happen in situations where a firm operates below capacity, say due to a shortage of raw materials but still maintains the same work force. The ROCE is often expressed as:
Sales Capital Employed x Net Pr ofit Sales

x 100

The return on capital employed is useful in making comparisons over time between firms in different industries or economies. Several disadvantages can be cited in using ROCE as a measure of managerial efficiency (Pizzey A; 2001:240). It is misleading if all capital employed is not included and if profits are computed at current prices while capital employed is stated at book value on historical costs. The risk taken with the investment must be established to ascertain whether the ROCE is adequate to compensate investors for that risk. Factors beyond management control must be defined and their effect noted before ROCE can be used to measure managerial performance. ROCE only shows results of one year yet investment is a long term operation. Not all firms seek to maximise their profits, for example, an institution like Zimbabwe Open University. There is no single agreed definition of capital employed. a) The return on capital employed can be compared from three perspectives. Change in ROCE from one year to the next. 2

b) c) 2.1.2

ROCE being earned by other companies. ROCE versus current market borrowings. RETURN ON EQUITY (ROE) It is based on the same principles as ROCE and is expressed as: ROE Profit (after tax and preference dividend) Ordinary share capital and other equity

The ratio takes a very limited view in that it is based on profit after tax and preference dividends. This is not a widely used ratio. 2.2.0 SHORT - TERM SOLVENCY AND LIQUIDITY The ratios are used to measure a firms ability to remain solvent in the event of adversities, by measuring its ability to meet short - term financial commitments or obligations. A firm that is facing difficulties is highly unlikely to get credit whether long or short - term. In most instances once there are tell tale signs of problems short term creditors are likely to take action on the firm thus precipitating insolvency. Indicators of short term stability are measured by two classes of ratios, that is: a) those which relate current assets to current liabilities, thus indicating an imbalance between the burden of immediate debts in relation to the firms ability to meet such debts; and b) those ratios that indicate the rate at which short term assets are utilised, thereby affording a measure of the firms liquidity. THE CURRENT RATIO It is the ratio of current assets to current liabilities, and shows the number of times current assets cover current liabilities. In other words the ratio shows the amount of the firms own funds used to finance short term assets. The ratio is also used to assess the risk of lending to a firm. The amount of funds available to fund current operations are also ascertained from this ratio. The ratio is expressed as follows: = Current assets Current liabilities In using the current ratio as a predictor of financial viability a number of problems arise. To begin with current assets include inventory, trade and other receivables, cash and cash equivalents. Inventory valuation as learnt from IAS2, 11 and other related standards is not easy and straight forward. The mere fact that different valuation bases can be used for inventory, and that bad debts are based on judgement introduces a measurable degree of subjectivity. It is also possible to reduce inventory and trade receivables without affecting a firms financial stability. On the other hand a firm with a high current ratio represented by high levels of inventory trade receivables and cash may be very inefficient. The nature or type of inventories may be important in that show moving inventory for example is risky compared to fast moving. The trade receivable portfolio, its nature and composition can be a factor affecting the current ratio. For example, if Agribank has a trade receivables portfolio consisting of communal farmers, A1 farmers (subsistence farmers) A2 farmers (commercial) the risk profiles are quite different. 2.2.2 ACID TEST RATIO (Quick ratio) Given the inherent weaknesses of the current ratio discussed above the quick ratio becomes a more accurate guide to a firms liquidity. The ratio excludes inventory and is expressed as: Current Assets Inventory Current liabilities Inventory is excluded on the basis that at times it is slow moving and therefore cannot be easily turned into cash. A ratio of at least 1 is recommended for firms with slow moving 3

2.2.1

inventory, while anything slightly less than 1 may be comfortable for firms with fast moving inventory. While both the current ratio and quick ratio offer an indication of a firms liquidity position the ratios should be interpreted taking cognisance of industry and firm peculiarities. It is also important to mention that a firm may have ratios which are unnecessarily high than expected and this is also an indication of some problems. The quick ratio also suffers from similar disadvantages as the current ratio. 2.2.3 TRADE RECEIVABLES COLLECTION PERIOD The ratio shows the time it takes for the firms debtors to pay their accounts. It is the time between sale of goods on account and the actual receipt of payment by the firm selling the goods. The trade receivables collection period is calculated as: Trade receivables x 365 days Sales (credit) The sales figure is the one reflected in the income statement, whereas, trade receivables should be from the list of trade receivables. As a rough guide the collection period should not excessively exceed the normal payment period. Some analysts have suggested a maximum of one and half times the net credit period. This means that if the net credit period is 30 days the collection period should not exceed 45 days. Should the collection period show an increase over time, this indicative of poor credit control within the firm. 2.2.4 INVENTORY TURNOVER This is also an estimated figure obtainable from published financial reports, and is expressed as Inventory x 365 days Cost of Sales The ratio measures how a business is trading. If the ratio is increasing over time this may be an indication of a shown down in trading or a build up of inventory, suggesting an excessive investment in inventories. A higher inventory turnover is preferable but pay special attention to: a) lead times b) season variations or fluctuations in trade c) operating costs of the firm (purchasing, ordering storage etc) d) alternative use of warehouse space. e) risk of perishing or obsolescence of inventory. f) availability or otherwise of finance. Thus the trade receivables and inventory turnover ratios give an indication of how soon a firm is able to obtain hard cash from its products and services. Where credit sales cannot be ascertained the total sales figures as reflected in the income statement are used. In situations where seasonal variations in sales are common monthly averages may be more useful than the balance sheet figure. 2.2.5 TRADE RECEIVABLES AGING ANALYSIS Accounts are categorised according to their billings to their customers. Percentages are calculated in relation to the overall total receivables. A good accounts receivable policy should have a large proportion of the receivables lying within the current and credit terms period. All those accounts falling outside should be a cause for concern for management and may be indicative of collection problems.

2.2.6

ACCOUNTS PAYABLE PAYMENT PERIOD The ratio shows the average time it takes a firm to pay its trade payables. Purchases are not normally disclosed in the accounts and hence the cost of sales can be used as a proxy. If there is an increase in the ratio over time this may be indicative of liquidity problems within the firm. The ratio is calculated thus: Trade accounts payable x 365 Purchases

2.3.0

LONG TERM SOLVENCY AND STABILITY Long term financial stability of a firm cash be defined as its ability to meet all its liabilities, both current and non current. The ratio is this class try to assess how much the firm owes in relation to its size. It is important for a firm to keep its liabilities under scrutiny for the following reasons. a) b) Existing and potential lenders may not be willing to advance more funds to a firm which appears outstretched. A low level of profit before interest and taxes is highly sensitive to upward changes in interest rates which may result in interest charges exceeding the profit before interest and taxes of the firm.

2.3.1

RATIO This is the ratio of a firms total assets to its total debts. It is simply: Total debts Total assets There is no maximum safe debt ratio, though 50% is normally considered safe. It must be emphasized that some firms may operate with a ratio of more than 50%, and henceforth trend analysis becomes useful.

2.3.1

LEVERAGE AND GEARING RATIO a) Capital / gearing The ratio explains the relationship between the non current liabilities of a firm and its shareholders equity. It is expressed as follows: Total non current liabilities (long term debt) term debt Shareholders equity + non current liabilities term debt Prior charges capital such preferred shares and debentures are included in long term debt. b) Leverage It measures the proportion of total assets financed by equity and thus expressed
Shareholde rs equity Shareholde rs equity + total long term debt term debt

OR
Shareholde rs equity Total assets current liabilitie s

No absolute limit can be placed on the capital gearing ratio, though 50% is generally considered about right. Since the two ratios try to quantify the risk involved in holding equity shares in a firm, it can be said that the more highly geared a firm the greater the risk that ordinary shareholders may get little or no dividends. Gearing or leverage also affects the solvency of a firm due to the effect of interest payments and their variability. 5

2.3.3

INTEREST COVER The interest cover ratio shows whether a firm is earning enough profits before interest and tax to pay its interest. Generally an interest cover of more than 3 is considered considerable. The ratio is calculated as shown below: Profit before interest and taxes Interest charges

2.3.4

CASH FLOW RATIO One of the short comings of the interest cover is that a firms ability to service debts is related to both interest and principal payments and these are met out of cash are opposed to profits per se. Henceforth the cash flow ratio seeks to relate the cash flow of the firm to the sum of interest and principal payments. The cash flow ratio is expressed as
1 Pr ofit (before int erest & taxes ) + Depreciati on 1 t 1 Interest + Pr incipal payments 1 t

2.4.0

where t = tax rate SHAREHOLDERS INVESTMENT RATIOS When an investor buys shares of a particular firm the objective is to make the best allocation of available funds which will result in the investor maximising his / her utility. Shareholders both potential and existing use certain ratios to assess the value and quality of an investment in the ordinary shares of a company / firm. EARNINGS PER SHARE (EPS) This is the return on each ordinary share in a firm in a given period. Thus earnings per share is the amount of the net profit for the period that is attributable to each ordinary share which is outstanding during al or part of the period. IAS # 33 requires all companies with (potential) ordinary shares which are publicly traded to present EPS, other companies are also encouraged though not obliged. a) Basic EPS These are calculated as follows:
Net Pr ofit attributab le to ordinary shareholde rs average number of ordinary shares outs tan ding during during the period

2.4.1

= Weighted b) =

Dilicted EPS This is expressed as follows:

N e tP ro fita ttrib u ta bto o rd in a ry a re h o ld e le sh rs W e ig h tea v e ra gn u m b eo f o rd in a ry a re o u tsta nd in gd u rin g e p e rio d+ d e r sh s th

Weighted number of ordinary shares dilutive shares The earnings per share has a significant effect on the firms share price. A share price may fall if the market anticipates a fall in EPS, but this is not very rational given the often subjective assumptions underlying the preparation of accounts. EPS has been used as a means of assessing managerial performance. 2.4.2 DIVIDEND COVER The ratio indicates the proportion of earnings / profits retained by the firm and the level of risk in future years, should profits decline, for the firm to be able to maintain the same dividends payments. Dividend cover in other words is the proportion of profit on ordinary 6

activities for the year that is available for distribution to shareholders that has been paid and what proportion will be retained in the business to finance future growth. Significant changes in dividend cover from one year to the next should be analysed. The cover is calculated as:
Net dividend EPS per (ordinary ) share

2.4.3

PRICE EARNINGS RATIO (P/E) The ratio indicates the number of years it would take to recover the share price out of current earnings of the firm. It is the ratio of the firms share price to the earnings per share and calculated as shown below:
Share price EPS

A high P/E ratio is a sign of strong shareholder confidence in the firm and its future and the converse is true. 2.4.4 DIVIDEND YIELD This ratio focuses on the value of the declared dividends to the investor. In other words if the return a shareholder is currently expecting on the shares of a firm. The formula is:
Current Dividend per ordinary share x 100% market value per ordinary share (ex dar )

2.5.0

PREDICTIVE POWER OF FINANCIAL RATIOS Reliance on ratio depends on one perception of their predictive power relative to the problem at hand. The perception may be subjective as based on empirical analysis. A number of empirical studies have tested the predictive power of ratios. WILLIAM H. BEAVERS STUDIES (1966) He tested the predictive power of 30 financial ratios comparing failed firms with those that did not fail are a five - year period prior to the failure. The mean ratios of the failed firms was found to significantly lower and to deteriorate markedly as failure approached. Many of the ratios showed excellent predictive power. EDWARD I. ALTMAN (1968) This study was similar to the one carried out by Beaver W H (1966), the only various being the us of multiple discrimant analysis to predict bankruptcy. The study started with 22 ratios which were later reduced to five that had a high predictive ability. The study resulted in the Z score model as shown below: Z Where X1 X2 X3 X4 X5 = = = = = = 1.2X1 + 1.4X2 + 3.3X3 + 6X4 + 1.0X5 working capita to total assets cumulative retained earnings to total assets earning before interest and taxes to total assets market value of equity to book value of total liabilities sales to total assets

2.5.1

2.5.2

The Z ratio is the overall index of the multiple discrimant function. The predictive value of the Z Model declined with the increase in years prior to bankruptcy, but the model was able to forecast failure very well up to 2 years before bankruptcy. 2.5.3 ZETA MODEL (1983) This was an improvement on the Z Model, and included capitalisation of leases. The model could predict bankruptcy up to five years prior to failure. The model is protected by copyright and the coefficients are only available to subscribers. When the model was tested on 64 firms Altmen E. I et al found that 96% of the failures could have been predicted on 7

the basis of financial statements information 1 year before and 63% on the basis of the same information 5 years before. 2.5.4 CASH FLOW BASED MODEL (1989) The model made use of the components of the cash flow statement viz, operating, investing, financing and changes in working capital. A 92% accuracy for 1 year prior to the event declining to 72% 5 years before was recorded for the model. LIMITATIONS OF RATIO ANALYSIS A number of accounting scandals such that of Enron are enough evidence that financial statements may be manipulated limiting the usefulness of any ratio calculated therefrom. Limitations of ratio analysis can be summarised as follows: Availability of comparable information for example what comparable information can be used by the Zimbabwe Defence Industries gives its unique nature? Financial statements report on what has transpired and history is not always a good predictor of the future. Ratios are not definitive, they act as mere guides. Interpretation needs careful analysis and should not be considered in isolation, other factors also need to be taken aboard. Ratio analysis is a subjective exercise, for example, different definition of capital employed may be used. Ratios may be manipulation in as much as the financial reports from which they are based can also be manipulated. Ratios are not defined in a standard from except EPS governed by IAS # 33, even then different interpretations can still emerge. One cannot predict corporate failure on the basis of ratios alone. If financial reports are not adjusted for the effects of inflation ratios calculated during periods of inflation may be misleading. 2.7.1 HORIZONTAL & VERTICAL ANALYSIS HORIZONTAL ANALYSIS A firms performance from year to year is analysed over time. The absolute changes are divided by the base years data obtain percentage changes. The analysis is significant in that it can show trends over time. The advantages and disadvantages of the approach are summarised below: Advantages i. Percentage changes of important items are shown, for example, trade receivable, revenue, expenses etc. ii. The analysis draws attention to significant changes which may require further probing or examination. Growth patterns over the years for a firm can be determined. iv. Performance of a pattern is assessed in light of previous years performances. Disadvantages i. Selection of the base year to benchmark the trend analysis may give biased results, for example in a hyper inflationary period. ii. Financial information presented in historic terms during a period of inflation may be misleading. iii. Changes in accounting estimates as per IAS # 8 may not be taken into account. iv. One off events like the 2006 World Cup, Solar Eclipse may lead to a boom in one year and this may not be fully explained in horizontal analysis. VERTICAL ANALYSIS 8

2.6.0

2.7.0

a)

iii.

b)

2.7.2

This involves analysis of a firm financial statement for a single period using ratios discussed in section 2.2 above. 2.8.0 USES OF ACCOUNTING RATIOS Ratios can be used in the following situations: a) Investment decisions, when and where to invest and disinvest. b) Comparison of a firms performance with those of similar firms, to assist in predicting the future. c) Summarise the financial position of a firm and highlight the interplay of factors between the balance sheet and the income statement. d) Assess the performance of a firms management, in terms of how well they have deployed the resources at their disposal. UNIT SUMMARY Ratio analysis helps provide more insight into financial reports presented to aid in decision making. Ratio can be categorised into profitability leverage liquidity shareholder investment ratios Ratio provide information through comparison, that is; trends from one year to the other standards or norms industry or other similar firms.

2.9.0

Ratios are not definitive, and should be considered together with other factors, in other words they have limitations. must be used with caution. 2.10 Some models have been developed to predict firm failure, but these

ACTIVITIES 1. The owner of the St Johns Printers, a small printing firm, has read about a scheme whereby significant accounting ratios are prepared in an average basis for the industry as a whole, and published as a yardstick against which individual firms can gauge their own performance and efficiency. He has acquired a set of ratios for firms in the class appropriate to his own, and now seeks to make a comparison, with your assistance. He provides you with the following information: Significant accounting ratios for a printing business with a Turnover in the range appropriate: Return on capital employed 14% Gearing ratio 20% Turnover ratio 2 times Current ratio 1:6:1 Acid test ratio 1:1:1 Gross profit ratio 14% Net profit ratio 7% Inventory turnover period 30 days Trade receivables collection period 30 days Trade payables payment period 60 days

Sales (80% on credit) Opening inventory Purchases Closing stock Labour Factory overheads GROSS PROFIT Expenses Finance charges NET PROFIT

St Johns Income Statements 2004 2005 $000 $000 2 880 416 4 200 000 (168 271) (220 412) (1 804 630) (2 706 000) 220 412 252 000 (502 641) (753 000) (371 240) (557 000) 254 046 215 888 (180 731) (150 000) 73 315 65 588 30 000 20 000 43 315 45 588

ST JOHNS BALANCE SHEETS 2004 2005 $000 $000 EQUITY & LIABILITIES Share Capital 250 000 250 000 General Reserve 296 000 296 000 Retained Earnings 4 692 50 280 550 692 596 280 NON CURRENT LIABILITIES Long term loan CURRENT LIABILITIES Trade and other payables Taxation ASSETS NON CURRENT ASSETS Property Plant & Equipment CURRENT ASSETS Inventory Trade and other receivable Cash and cash equivalents 300 000 150 385 50 000 1 051 077 200 000 120 000 40 000 956 280

468 207 220 412 357 620 4 838 1 051 077

421 000 252 000 250 000 33 280 956 280

a) b)

Required Compute the ratios for St Johns for 2004 and 2005. Comment on the performance of St Johns for the two years. a) Suggested Solution Activity 1 St Johns Printers COMPARATIVE RATIOS RATIO ST JOHNS 2005 2004 6% 5% 25% 35% 5.27 times 3.4 times 10 INDUSTRY 14% 20% 2 times

ROCE Gearing Turnover

Current ratio Acid Test Gross Profit Net Profit to sales Inventory turnover ratio Trade receivables collection Trade payables payment b)

3.35:1 1.77:1 5.14% 1.08% 34 days 21.72 days 16.17 days

2.9:1 1.8:1 8.8% 1.5% 44.5 days 45 days 30 days

1.6:1 1.1;1 14% 7% 30 days 30 days 60 days

Comments on performance St Johns is less profitable because its gross profit ratio is way below the industry average of 14% for both years. There is a marked decline in the ratio from 8.8% in 2004 to 5.14% in 2005. If the selling price of St Johns products are competitive and comparable on the market then it should aim towards reducing its cost of sales. Cheaper alternative sources of raw materials, if need be should be found. The turnover ratio indicates that the assets are working harder than other firms in the industry, 3.4 times in 2004 and 5.27 times in 2005. The current ratios for both years a much larger investment in working capital than with other companies in the industry. In 2004 this is evidence by a longer inventory holding period of 44.5 days as opposed to 30 days for the industry; a one and half times longer credit period and fast settlement of trade payables. In 2005 the inventory turnover is closer to the industry average a factor explained by a decrease in debtors and increase in sales revenue. The cash holding of the company improved in 2005 compared to 2004, but there is still room for further improvement. St Johns should look for suppliers who are willing to give credit terms which are closer to industry norms and improve on its inventory management in general. Other costs related to production should be examined, especially labour and factory overheads. The low level of investment in PPE may mean that St Johns is not using up to date technology and machinery. The high overheads may be a result of constant breakdowns of the plant. There is need to revisit the labour force in terms of numbers. St Johns should be commended for a good trade receivable management policy which is better than the industry norms. There is a slight improvement in the ROCE by 1% but this is still less than the industry average of 14%. The gearing ratio for 2004 is a cause for concern being 15% above industry average and is a sign of indebtness. However St Johns took a bold step in reducing its long term debt by a third and this reduced the gearing ratio by 10% in 2005 to close at 25%.

2.

You are the Financial Director of Parirenyatwa Group of Hospitals (PGH). The Chief Executive Officer is anxious to compare the performance of PGH with that of United Bulawayo Hospital (UBH) for the year ended 31 December 2005. You are provided with the following data: INCOME & EXPENDITURE ACCOUNTS FOR THE YEAR ENDED 31 DEC 2005 PGH UBH
$BILLIONS $BILLIONS $BILLIONS $BILLIONS

Operating Income Health grant (MOGCW) Hospital fees Education, training and research Other income (Note 1) Operating Expenditure Employment costs

36.217 2.032 .79 1.668 40.707 26.664

37.651 2.321 1.594 5.886 47.452 30.204

11

Drug supplies and related services Services from other state health institutions Premises maintenance Depreciation Other expenditure Finance Costs Surplus for the year

5.190 2.152 1.937 1.000 1.673 1.400

(40.016) .691

6.833 1.761 2.801 1.650 1.996 1.100

(46.345) 1.107

BALANCE SHEETS PGH

$BILLIONS Equity and Capital Capital and Reserves Non Current Liabilities Long term Loans Current Liabilities Trade and other payables Tax and NSSA Assets Non Current Assets Property, Plant and Equipment Current Assets Inventory Trade and other receivables Cash and cash equivalents 16.127 16.077 3.84 (note 2) .788 3.982 36.186 33.726 .743 1.398 .319 .979 .980 .402 2.653 0.718

UBH
30.951 15.339 3.371 49.551 47.300

$BILLIONS $BILLIONS $BILLIONS

2.460 36.186

2.361 49.661

CASH FLOR STATEMENTS FOR THE YEAR ENDED 31 DEC 2005 PGH $billions Cash flows from operating activities Net cash flow from operating activities Cash flow from investing activities Returns on investment and serving of debt Purchase of PPE Cash flow from financing activities Capital injections from Central Government New long term loans Repayment of long term loans Increase cash and cash equivalents Cash and cash equivalents at the beginning Cash and cash equivalents at year end 3.316 (1.682) (1.032) .089 (.378) .313 .006 .319 UBH $billions 4.214 (1.652) (4.786) 2.028 1.044 (.448) .400 .002 .402

OTHER INFORMATION Note 1 Other income mainly includes the provision to other government hospitals of specialist services, medical staff, laundry autoclaving, charges to staff for accommodation, etc. Note 2 Includes Loan creditors Dividends payables PGH $millions 790 358 12 UBH $millions 492 330

SUGGESTED SOLUTION ACTIVITY 2 INTERNAL MEMORANDUM TO FROM DATE SUBJECT : : : : The Chief Executive Officer The Finance Director 28 February, 2006 COMPARISON OF FINANCIAL PERFORMANCE OF PARIRENYATWA GROUPS OF HOSPITALS (PGH) AND UNITED BULAWAYO HOSPITAL (UBH) ($billions)

In terms of profitability, the ratio of operating surplus to equity and long term loans shows PGH with a return of 6.49% and UBH with 4.76%. Operating profit to income is 5.1% and 4.6% for PGH and UBH respectively. The activity ratio of income to capital is 1.26 times for PGH and 1.03 times for UBH. Thus PGH is more profitable than UBH because it has a slightly higher profit margin on its activities, and PGH works its capital employed harder. UBH has 16.5% more income than PGH, twice as much activity in education, training and research, and 3 times more income in the other income category. The staff of UBH earn $1.57 of income per $1 of staff costs, whereas the ratio for PGH is only $1.52. The cost relationships in table 1 below show that UBH spends more per $1.00 of income on supplies, premises, depreciation and other costs, whereas PGH spends more per $1 on staff and services from other state health institutions. This may reflect different methods adopted by the 2 entities, but PGH earns 5.1 cents of operating surplus per $1 of income against a 4.6 cents per $1 earned by UBH. Once the operating profit is earned, PGH applies it by paying considerably more in interest charges ($300m more). UBH remains with a sizeable surplus to help finance future activities. This reflects the capital structure of the two entities, whereby PGH has borrowed a larger proportion of the funds applied to its operations. Gearing ratio Debt to equity PGH 49.9% 1.24:1 UBH 33.1% 0.6:1

PGH is moving to redress the unhealthy situation since, in cash terms, it repaid a net of $289 million of long terms loans during the year, whereas UBH raised an extra net $596 million of long term loan. UBH has considerably more funds invested in PPE than PGH ($13.574 billion more), which may explain why its costs for premises and depreciation are higher. During the year UBH spent $4.786 billion on new PPE (PGH $1.032 billion), and financed the purchase by net cash flow of $2.562 billion, government capital of $2.028 billion (PGH raised no funds from this source) and net borrowings of $596 million. PGH has $13.7 PPE for every $1 of current assets but the ratio for UBH is 20:1. Both entities have a negative working capital PGH 0.61:1 and UBH 0.7:1. Table 2 below shows that UBH collects its debts much faster than PGH, but that on average it pays 20 days sooner than PGH. The validity of this comment of course depends on the relationship of the costs shown in the income statements to current liabilities. Both entities have the same inventory holding period of 52 days. SIGNED FINANCE DIRECTOR

13

Table 1 Cost per $1 of income Staff Supplies and services Services from other state health bodies Premises Depreciation Other Table 2 Trade receivable collection period PGH = 1398 X 365 = 12.5 days 40 707 PGH cents 65.5 12.7 5.3 4.8 2.46 4.11 UBH cents 63.5 14.39 3.7 5.9 3.48 4.21

UBH =

980 X 365 = 7.5 days 47 452

Trade payables payment period PGH = 2 046*1 X 365 = 85 days 8 713*2 Inventory PGH = 743 X 365 = 52 days 5 190

UBH =

1 831 X 365 = 65 days 10 290 979 X 365 = 52 days 6 833

UBH =

*1 Note 2 should be considered, that is, deduct the amounts from trade payables. *2 Denominator is sum of supplies, services from other state institutions and other expenditure. 3. Reported earnings per share is a very important indicator of performance for a quoted company Why do you think that this is, and do you agree? SUGGESTED SOLUTION TO ACTIVITY 3 EPS is one of the most frequently quoted statistics in financial analysis. Because of the widespread use of P/E ratio as a yardstick for investment decisions, it became increasingly important. It would seem the reported and forecast EPS of a firm have a significant effect on its share price. Thus, a share price might fall if expected EPS is going to be low. This is not very rational as EPS can be influenced many factors, some of which are the assumptions underlying historic accounts. There is no direct relationship between a firms value or its shares and the EPS. However it is a fact that the market is sensitive to EPS. EPS can also be used to measure managerial performance. In certain instances remuneration is linked to an EPS growth. This has the effect of putting pressure on management to produce results favourable to EPS, and may consequently lead to creative accounting. EPS is useful as a means of comparing financial performance of different firms and this is guided by IAS # 33. 4. Pondombiri Ltd has produced the following net profit figures. $billions 2003 1.5 14

2004 2.0 2005 2.5 On 1 January 2004, the number of shares outstanding was 500 000. During 2004, the company announced a rights issue with the following details: Rights: 1 new share for each 5 outstanding (100 000 new shares in total) Exercise price: $500 Last date to exercise rights: 1 March 2004. The market value of one share in Pondombiri immediately prior to exercise on 1 March 2004 is $ 1 100. REQUIRED Calculate the EPS for 2003, 2004 and 2005. SUGGESTED SOLUTION TO ACTIVITY 4 Calculation of theoretical ex-rights price. = Fair value of all outstanding share + total received from exercise of rights No. of shares outstanding prior to exercise + No. of shares issued in exercise = ($1 100 X 500 000) + ($500 X 100 000) 500 000 + 100 000

= $1 000 Calculation of EPS 2003 $ 2003 EPS as originally reported 1 500 000 000 500 000 2003 EPS restated for rights issue 1 500 000 000 X 1000 500 000 1100 2004 EPS including effects of rights issue
2 000 000 000 1100 (500 000 X 2 X ) + (600 X 10 ) 12 12 1000

2004 $

2005 $

3 000

2 727

3 380

2005 5.

EPS = 2 500 000 000 4 167 600 000 000 The following information has been extracted from the recent accounts of Vadzimba Ltd. Extracts from the Income Statements 2006 2005 2004 $000 $000 $000 Sales 11 200 000 9 750 000 8 000 000 Cost of Sales 8 460 000 6 825 000 5 500 000 Net profit before tax 465 000 320 000 280 000 This is after charging Depreciation 360 000 280 000 280 000 Debenture interest 80 000 60 000 50 000 Interest on bank overdraft 15 000 9 000 Audit fees 12 000 10 000 8 000 15

BALANCE SHEETS AS AT 31 DECEMBER

$m ASSETS Non current assets
PPE Current Assets Inventory Trade receivables Cash & cash equivalents Total assets EQUITY & LIABILITIES Capital & Reserves Ordinary share capital Reserves Non current liabilities 10% Debentures Current Liabilities Bank overdraft Trade payables Taxation Dividends 1 850 000 640 000 1 230 000 80 000 1 950 000 3 800 000 800 000 1 245 000 2 045 000 800 000 110 000 750 000 30 000 65 000 80 000 690 000 20 000 55 000 490 000 1 080 000 120 000 1 690 000 3 120 000 800 000 875 000 1 675 000 600 000 695 000 15 000 40 000 1 430 000 500 000 900 000 100 000 1 500 000 3 000 000 800 000 850 000 1 650 000 600 000 1 500 000

2006 $m

2005 $m $m $m

2004 $m

955 000 3 800 000

845 000 3 120 000

750 000 3 000 000

The industry average ratio are given below: ROCE (capital employed = equity + debentures Asset turnover Current ratio Quick ratio Gross margin Trade receivable collection period Trade payables payment period Inventory turnover Gearing Industry Average 18.50% 4.73% 3.91% 1.90 35.23% 52 days 49 days 18.3 32.71%

Required a) Calculate comparable ratio for Vadzimba for the 3 years ending 31 December 2004, 2005, and 2006. b) Write a report to your board of directors analysing the performance of Vadzimba for the 3 years comparing the year to year results and against the industry average given above. Note no solution is provided for activity 5.

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