Financial Analysis

2. Ratio Analysis

1
 Performance Review (1)

The main aims of a business performance review

are to provide an understanding of the business
and to provide an interpretation of the financial
results

Care must be taken in reviewing business

performance, primarily because of lack of
consistency in definitions; changes in economic
conditions and regional variations.

2
 Performance Review (2)
An important method used to analyse the financial
performance of a business is the use of ratio
analysis. The usual ratio categories are:

- profitability

- efficiency

- liquidity

- financial structure

- investment
3
The stages of a Performance review

4
 SWOT Analysis

Strengths Weaknesses

Opportunities Threats

5
 Potential Internal Strengths
• Many product lines?
• Manufacturing competence?
• R&D skills and leadership?
• Cost or differentiation advantage?
• New-venture management expertise?
• Appropriate management style?
• Appropriate control systems?
• Ability to manage strategic change?
6
 Potential Internal Weaknesses
• Obsolete, narrow product lines?
• Loss of customer goodwill?
• Inadequate information systems?
• Growth without direction?
• High conflict and politics?
• Industrial relations problems?

7
 Potential Environmental
Opportunities
• Expand core business?
• Exploit new market segments?
• Diversify into new growth businesses?
• Vertically integrate forwards or backwards?
• Overcome barriers to entry?

8
 Potential Environmental Threats

• Increases in domestic or foreign

competition?
• Rise in new or substitute products?
• Potential for take-over?
• Changes in demographic factors?
• Changes in economic factors?
• Rising labour costs?
9
An example of a SWOT analysis for an
airline company

10
PESTLE Analysis
 POLITICAL

 ECONOMIC

SOCIAL

 TECHNOLOGICAL

LEGAL

ENVIRONMENTAL
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 In search of Competitive
Advantage…..?
Porter’s Five Forces (1985) is an analytical model
which

allows competitive dynamics to be assessed with

regard to

the existing and future profitability of the firm.

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 Porter’s Five Forces
Threat of
New
Entrants

Bargaining Rivalry Bargaining

Power of Among Power of
Suppliers Existing Buyers
firms

Threat of
Substitute
Products
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 Scope of ratio analysis

Ratio analysis can be applied to financial

statements and similar data in order to:
• Assess performance of a company.
• Determine whether company is solvent and
financially healthy.
• Assess risk attached to its financial
structure.
• Analyse returns generated for shareholders
and other interested parties.
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 Ratio analysis
• Financial figures on their own are difficult to interpret.
• Need context

• Ratio analysis is the means of relating one figure appearing

in the FS to another, in the hope of drawing a meaningful
conclusion from the relationship
• Helps to examine and assess trends

• In examining ratios, ensure you are comparing ‘like’ with

‘like’. Comparison is only possible if an identical basis of
compilation is used and if there is uniformity in the
preparation of the financial statements.
• A Ratio on its own are meaningless….. Its value is as a
comparator

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 Evaluated against

Past periods

Similar businesses during the

same period

Industry norms

Budgets

Rules of thumb
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 Categorisation of ratios
Profitability ROCE, ROE,capital
Profits relative to Sales and turnover, ROA
investment. Can look at different levels Net & Gross margins
of profits (gross, operating, after tax)
Activity/Efficiency: Receivables, Inventory
The efficiency with which management and Payables days,
manage current assets Asset Turnover
Liquidity: Current & acid test
The ability to meet its short term cash
obligations
Financing: Gearing ratios, Debt to
The impact of company’s long term equity, Interest cover
financing structure
Investment: EPS, PE, Dividend
The return generated specifically to cover & yield
shareholders
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 Capital Employed
• The funds which company had at its disposal
 Definitions vary
 Equity Plus Long term loans
 Equity only
 Equity Plus Long term loans plus short term debt
(including trade creditors)
 Total assets (return on total assets)

 NB: Equity= share capital plus all the reserves

(ie share premium, revaluation reserve, retained
earnings etc)

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 Profitability ratios
Return on shareholders Funds (RoE)

× 100
Net profit after interest & tax
Total Equity
Return on capital employed

Operating profit × 100

Total equity+ Long-term debt
Operating profit margin

Operating net profit × 100

Sales

Gross profit margin

Gross profit × 100

Sales

Capital turnover= Sales = times

Capital employed
22
 Gross Margin and Net Margin
• GM Reflects a company’s trading policy and sector
• Reasons for change in GM over time
– Change in sales policy re selling price per unit or product mix
– Change in purchase cost per unit
– Theft, change in productivity, inventory write offs
– Manipulation: closing inventory, sales.

• Variation in Net margin

– Ability to control costs
– Exceptional costs
– Gross profit issue
• Analysis should include a review of all cost items to isolate
reason for variation
• Can use different profit levels (operating profit, profit
before interest and tac, profit after interest and tax etc.
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 Return on Capital Employed, Return on
Equity, Capital turnover
- ROCE Assesses how effectively have funds have been
deployed for all providers of finance
- ROE assesses the effectiveness specifically for
shareholders
- Useful to compare against:
A target return
The cost of borrowing or alternative investments

- Capital turnover looks at how effectively funds are being

deployed to generate sales.

Calculate the profitability ratios for C&C

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C&C Profitability ratios y.e. 28.02.2014 y.e. 28.02.2013
€ mill € mill
Gross Breakdown not given of Gross profit
margin

Op Operating profit 106.0 110.0

profit Net sales 620.2 17.09% 476.9 23.07%

PBIT Profit before interest& tax 106.0 110.0

Net sales 620.2 17.09% 476.9 23.07%

PBT net profit before tax. 95.5 105.1

Net sales 620.2 15.40% 476.9 22.04%

PAT net profit after tax. 83.3 89.4

Net sales 620.2 13.43% 476.9 18.75%

ROCE operating profit 106.0 110.0

debt + equity *1,199.5 8.84% 1,064.5 10.33%
* 852+_347.4
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C&C Profitability ratios y.e. 28.02.2014 y.e. 28.02.2013
€ mill € mill
ROE profit after tax 83.3 89.4
equity 852.1 9.78% 779.7 11.47%

Capital turnover
sales 620.2 476.9
Capital employed in year
(Debt + Equity) 1,199.5 0.52 1,064.5 0.45

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 Liquidity ratios

Formula

Current assets
Current ratio
Current liabilities

Acid test ratio Current assets –inventories

Current liabilities

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 Current Ratio and quick
• Benchmark-
– Current: 2:1 or 1.5: 1,
– Quick: 1:1 - 0.7:1
– but consider against industry norm

• Too low: inability to meet debts

• Too high: inefficient use of funds
• But care in interpreting: check the reasons behind it
• Calculate for C&C

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C&C Liquidity (Solvency) ratios

Current
ratio
current assets 375.8 267.7

current liabilities 181.0 2.08 135.8 1.97

Acid test
ratio
current assets -
inventories *303.6 218.8

current liabilities 181.0 1.68 135.8 1.61

*375-72.2=
303.6

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 Efficiency ratios

Formula

Inventories days Inventory (closing or average) × 365

Cost of sales

Trade receivable days Trade receivables × 365

Sales

Trade payable days Trade payables × 365

Purchases

Asset Turnover Sales revenue_______________

Totals assets

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 Inventory days, receivable days, payable
days
- Efficiency= Low inventory and receivable days; High
payable days…..but within limits…….
- If payable days are too high, supplier relationships can
be jeopardised.

- Reasons behind the ratios must be examined:

- High inventory days could indicate poor stock control, ;low
moving sales; deliberate stock piling
- High receivable days can indicate poor credit control, risk of
bad debt, overly generous credit policy
- All may be distorted by seasonality

Calculate for C&C

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C&C Activity ratios

Receivable
Days Days Days
Note 16 Tr. Rec'bl * 365 118.8 78
Net sales 620.2 69.92 476.9 59.70

Payables
Days
Note 17, 3 Tr. Pays * 365 74.5 42.6
cost of sales 279.3 97.36177.5 87.60

Inventories
Days
Note 15, 3 Stock x 365 72.2 48.9
cost of sales 279.3 94.35 177.5 100.55

Asset turn
over Net sales 620.2 476.9
Total assets 1380.5 0.451,200.3 0.40

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• Financial structures of firms vary

Financed by shareholders: Equity

Financed by outsiders requiring a fixed

rate of return: Debt
eg bank loans, Preference shares,
bonds and debentures

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• Gearing: the extent to which a business is financed
by debt.
• Also called financial leverage

High level Highly Higher

debt geared risk

• Benefits of debt Vs Risk

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 • Debt Repayable- interest & capital
Riskier • Debt repayment date scheduled
• Dividend at discretion of directors

•Debt Issue costs lower

Cheaper •Debt interest is tax deductible
•Debt more secure for lender thus
return expected lower than equity

No Dilution • Debt : No dilution of ownership

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 Gearing ratios

Formula
Non-current interest bearing debt (loans, bonds, pref shares)
Debt to Equity
equity

Non current interest bearing debt

Gearing Non current interest bearing debt
+ Equity

Interest Net profit before interest and tax

cover ratio Interest payable

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• The lower the level the greater the risk that company
will
– be unable to service its debt obligations
– dividends are at risk

• Rule of thumb- 5 prudent, <2 unsatisfactory

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Gearing and finance ratios C and C Group
28.02.2 28.02.
y.e. 014 y.e. 2013

Debt (Non-
Gearing Ratio current Liabs) 347.4 284.8
Debt +
Equity 1,199.5 28.96%1,064.5 26.75%

Debt / Equity Debt 347.4 284.8

Equity 852.1 40.77%779.7 36.53%

Interest Cover PBIT 106.0 110.1

Int 9.64 22.02
Payable 11.0 times5.0 times

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• Investments are made with a view to:
– Earnings….. dividends
– Capital appreciation…. Share price

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 Investment ratios

* Given in notes to FS Formula

Earnings per Net Profit after interest & tax

share* Number of ordinary shares in issue

Price/earnings Market price per share

ratio (P/E) Earnings per share

*EPS
Dividend cover * Dividend per share
ratio
*Dividend per share
Dividend yield Market price per share
ratio
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 Price Earnings ratio

• Measures the markets confidence in the future earning

power of the business. Forward looking.
Viewed as how quickly the market expects earnings to
grow- the higher the P/E the faster the expected growth
Also viewed as a multiple in terms of the number of years
earnings required to recoup the price paid for the share
(assuming all earnings are distributed)

Low PE High PE
Stage of development Established company Growth company
Potential Value for Cheap relative to EPS: Expensive. Possibly
money Possible Value stock over-priced
Market confidence Low High
exceptional current Exceptionally good Exceptionally poor
years performance years performance years performance
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 Basic
EPS profit after tax
number of ordinary
Note 10 shares in issue given 24.7c given 27.2c
Diluted
EPS given 24.3c given 26.6 c

Div / Sh given 9.05c 8.5c

Note 9

Div EPS 24.7 2.72 27.2 3.2

Cover dividend per share 9.05 times 8.5 times

Div Yield dividend per share 0.0905 0.085

share price 4.922 1.83%4.895 1.74%

P/E share price 4.922 4.895

Basic EPS 0.247 19.920.272 18.00

€4.9220 - 28.02.2014 Share prices obtained from SE listing

€4.8950 - 28.02.2013 45
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Problems with ratio analysis
• Financial position statement is a snapshot as it
relates to the company's position on one day
of the year.

• It can be difficult to find a similar company in

order to make intercompany comparisons.

• May be creative accounting, e.g. off-balance-

sheet financing, complex financial instruments.

• Ratio analysis should be seen as the start of

financial analysis, serving mainly to raise
questions which require deeper investigation.

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