Ratio Analysis – main strength

Ratios: direct the user’s focus of attention identify and highlight areas of good and bad

performance identify areas of significant change.

Compare like with like

Comparing current financial ratios with: financial ratios for a preceding period budgeted financial ratios for the current period financial ratios for other profit centres within the company financial ratios for other companies within the same sector.

Importance of uniformity

Comparison is possible only if there is Uniformity in the preparation of accounts An awareness of any differences in international

accounting policies.

Need to understand how ratios are defined

Implications of any given ratio requires a clear definition of its constituent parts. Definitions of ratios may vary from source to source e.g. concepts and terminology are not universally defined.

Awareness of underlying trends ROCE remains a constant 10% over the years 20X1–20X3 Net profit increased by 50% in both 20X2 and 20X3 This trend is not ascertainable in the ROCE ratio.

Return on

Net profit Capital employed capital employed

£ £

20X1 100,000 1,000,000 10%

20X2 150,000 1,500,000 10%

20X3 225,000 2,250,000 10%

Review of ratio analysis

• Six Primary ratios

– Investment ratios

– Operating ratios

– Liquidity ratios

2007 2006EBIT 1,230 1,889Shareholders' Funds 3,549 2,725Capital Employed 4,579 3,715Sales 7,435 7,156

Rolls Royce Group figures in £millions

Primary investment level ratios

Primary investment ratio (operating return on equity)

Earnings before interest and tax

Shareholders’ funds

2007 20061,230/3,549 1,889/2,7250.347 0.69334.7% 69.3%

Primary investment level ratios

• Primary financing ratio (Financial leverage multiplier)

Capital employed Shareholders’ funds

• Effect on profit of assets funded by other sources.

2007 20064,579/3,549 3,715/2,7251.290 1.363129% 136%

Primary operating level ratios

Return on capital employed

Earnings before interest and tax Capital employed

• No single definition of capital employed• Use for strategic planning.

2007 20061,230/4,579 1,889/3,7150.269 0.50826.9% 50.8%

Primary operating level ratios

Primary utilisation ratio (asset turnover)

Sales Capital employed

Sales increasing

Assets decreasing

• Fixed asset replaced?

• Inventory falling? 2007 20067,435/4,579 7,156/3,7151.624 1.926162.4% 192.6%

Can be based purely on assets

Primary operating level ratios

Primary efficiency ratio

Earnings before interest and taxSales

• Company pricing policy

• Type of industry

• High volume/low profits?2007 20061,230/7,435 1,889/7,1560.165 0.26416.5% 26.4%

Why Pyramid of ratios?

EBIT/Shareholders' funds = 0.347 = CE/Shareholders funds X EBIT/CE = 1.290 X 0.269 = 0.347 AND EBIT/CE = 0.269 = Sales/CE X EBIT/Sales = 1.624 X 0.165 = 0.269

0.347

1.290 X 0.269

1.624 X 0.165

Primary liquidity ratio

Current ratio

Current assets Current liabilities

Current ratio

What if Current ratio increases?

Growth: inventory buildup expecting sales growth Decline: inventory buildup result of falling sales Expansion: permanent increase in scale Inefficiency: poor control over working capital.

Subsidiary ratios

Gearing ratios (Financial Risk ratios)

Liquidity ratios

Asset utilization ratios (Efficiency ratios)

Investment ratios

Profitability ratios.

Subsidiary ratios – gearing

Subsidiary ratios – liquidity

Quick ratio – identify the company norm

The following is an extract from the 2003 Annual Report of Barloworld:

2003 2002 2001 2000 1999 1998 1997

Quick ratio 0.8 0.7 0.8 0.9 1.1 0.7 0.8

Subsidiary ratios – Investment

Earnings per share – usein strategic planning

The 2002 Annual Report of Gamma Holding NV states:

Gamma Holding aims to maximize shareholder value, taking into account the interests of the employees and other stakeholders in the company.

In doing so, Gamma Holding strives to offer its shareholders an attractive return based on continuous growth of earnings per share of an average 10% over a number of years whilst maintaining healthy balance sheet ratios and generating positive cash flows.

Furthermore, the company aims to achieve an average return on capital employed (including goodwill) of 15%.

PE – a measure of market confidence

Market price also takes into account anticipated changes in the earnings arising from their assessment of macro events such as

political factors, e.g. imposition of trade embargoes and sanctions

economic factors, e.g. the downturn in manufacturing activity company related events, e.g. possibility of organic or acquired

growth and the implication of financial indicators for future cash flow estimates.

VT Group plc P/E ratios

Market price & EPS in pence

2007 2006 2005 2004Market Price 491.50 451.50 317.00 262.00EPS 24.81 23.59 18.27 9.00

P/E ratio 19.81 19.14 17.35 29.11

PE ratio – implication of financial indicators

Balance sheet: change in debt/equity ratio in relation to prior periods new borrowings to finance expansion debt restructuring following inability to meet current repayment terms; adequacy of working capital low acid test (quick) ratio in relation to prior periods indicating liquidity

difficulties change in current ratio in relation to prior periods, i.e. higher

indicating a build-up of slow-moving inventory and lower possible inventory-outs

contingent liabilities that could be damaging if they crystallize non-current assets being increased or not being replaced.

PE ratio – implicationof financial indicators

Income statement: change in sales trend limited product range, products moving out of patent protection period expanding product range changes in technology beneficial or otherwise to company; high or low capital expenditure/depreciation ratio indicating that

productive capacity is not being maintained loss of key suppliers/customers, e.g. loss of longstanding Marks &

Spencer contracts change in ratio of R&D to sales

In short

Many factors can impact on P/E ratio. Overconfident management Over ambitious forecasts can impact on P/E

Capital Radio plc Example2000EPS = 26.3pMarket Price of Ordinary Shares at Balance Sheet date = £14.382001EPS = 23.8pMarket Price of Ordinary Shares at Balance Sheet date = £5.20P/E Ratio200014.38 / 0.263 = 54.7 times20015.20 / 0.238 = 21.8 times

Subsidiary ratios – asset utilization

7,435/4,206 = 1.77

7,435/7,253 = 1.03

7,435/2,499 = 2.98

6,003/2,203 = 2.72

7,435/889 = 8.36

6,003/778 = 7.72

Debtors (receivables) – note 12Creditors (payables) – note 15

Rolls Royce figures 2007 2006

1.98

0.99

2.63

3.02

8.28

8.51

Focussing on key industry ratios

Somerfield Stock & Cost of Sales Stock in Balance Sheet 2000 – 372.6 2001 – 329.9

Cost of Sales from P&L 2000 – 5415.5 2001 – 4523.5

Applying the ratios

2001 4523.5 = 13.7 times in the year 329.9 2000 5415.5 = 14.5 times in the year 372.6

Diagnosis? – what might be going wrong & why?

Prognosis

Stock availability

When basic items are not available on the shelves, it is frustrating for any shopper. For Kwik Save’s target market, who keep relatively small stocks at home, it is particularly frustrating and encourages them to shop elsewhere. We have sharply increased the availability of everyday and promotional items through improvements in distribution and stores’ internal replenishment procedures.

During October, we reappraised the frozen food lines that we stock, simplifying the offer to ensure high availability and good presentation for the most popular products. This worked well, and we are now applying the same principles elsewhere in the store – making ranges simpler and more disciplined while still providing the choice that today’s consumers require.

We are also increasing the focus on brands, taking Kwik Save back to its roots by offering the biggest brands at lowest prices.

To give customers a lower-cost choice we have been offering Somerfield own-label products, but this has confused many customers. We are phasing this policy out, replacing all Somerfield lines with value alternatives by this Autumn.

Prognosis

Investing behind the scenes We are investing in our IT and distribution systems to achieve higher

availability and service to stores at lower cost.

Our IT strategy is to simplify and clarify our systems – focusing investment initially on updating our distribution and Kwik Save store systems. By June this year, all Kwik Save units were linked into our store IT system.

During the year we opened a completely rebuilt and enlarged distribution depot near York. The depot is over 500,000 sq ft in size and handles ambient, chilled and frozen products. It is operated by an outsourced logistics specialist. The new year will see the increasing use of multi-temperature vehicles, significantly increasing both depot and store productivity. In the South West we outsourced some of our logistics operations, ensuring that staff transferred to the outsourcing organisations on equivalent terms.

Did it work?

Calculating ratios for the next 2 years

2002 report – 13.9 times per year 2003 report – 15.6 times per year

Moral:

Identify ratios important to your industry.

Ensure they do not deteriorate.

If they do – It will be noticed!

Subsidiary ratios – profitability

Industry specific metrics

To remain competitive you will need to continually re-invest in R&D and Product Development

For high tech businesses the spend range is between 5% and 10% of revenues

Early on you will be much closer to 10% This is why you need healthy gross margins

R&D spending

R&D as percentage of Sales

0.00

5.00

10.00

15.00

20.00

25.00

2003 2004 2005 2006 2007

Percentage

BAE

Meggitt

RR

VT

Smiths

2003 2004 2005 2006 2007BAE 20.42 18.91 13.15 10.12 10.20Meggitt 4.97 5.78 3.86 8.59 7.97RR 4.98 4.85 4.27 5.17 5.12VT 0.40 0.21 0.14 0.15 0.04Smiths 4.24 5.00 4.76 3.08 2.42

Impact on Profit margins?

Profit Margins

-5.00

0.00

5.00

10.00

15.00

20.00

25.00

2003 2004 2005 2006 2007

Per

cen

tag

e

BAE

Meggitt

RR

VT

Smiths

2003 2004 2005 2006 2007BAE 2.78 -2.55 6.32 6.97 8.63Meggitt 10.44 11.81 14.30 19.39 12.00RR 3.19 5.15 7.22 19.44 9.86VT 2.42 4.87 7.12 7.82 6.31Smiths 7.11 10.98 10.27 3.76 11.85

Segmental AnalysisImplication for future cash flows

Illustration from Royal Ten Cate NV

Implication for future cash flows

• Illustration from Royal Ten Cate NV (contd.)

RevenuesOperating resultReturn oncapital employed (%)

Segmental analysis – geographical segments

Factors to consider

Political conditions Economic conditions Exchange control regulations Currency risks.

Implication for share valuation

Different risks

Problems for conglomerates

Differential PE for different segments.

Selected share movement

Share Price Movement

0100200300400500600700800

Dat

e

30/0

9/20

04

31/0

1/20

05

31/0

5/20

05

30/0

9/20

05

31/0

1/20

06

31/0

5/20

06

29/0

9/20

06

31/0

1/20

07

30/0

5/20

07

28/0

9/20

07

31/0

1/20

08

30/0

5/20

08

Pen

ce

BAE

Meggitt

RR

QQ

VT

Implication for share valuation

Non-financial ratios

Operational statistics

Trend Analysis

Consideration will be given to the following: Horizontal analysis between two periods Trend analysis over a series of periods Historical summaries Vertical analysis – common size statements.

Horizontal analysis

Trend Analysis

Trend analysis series of periods

Trend Analysis

Vertical analysis – Income Statement

Vertical analysis – Balance Sheet

Multivariate analysis – Altman’s Z-score

Less than 1.8: Bankruptcy risk is highBetween 1.8 and 2.7: Bankruptcy risk is fairBetween 2.7 and 3.0: Bankruptcy risk is possible, but

not likely in the near-futureHigher than 3.0: Bankruptcy risk is low

Tesco Group plc

Application of Altman’s Z Score Z-Score Data

£millions(A) PBIT 2,869(B) Total Assets 24,807(C) Net Sales 42,641(D) MV of Equity (shares X MV) 35,445(E) Total Liabilities 14,301(F) Working Capital -3,576(G) Retained Earnings 5,693

Note: No of shares at 2007 = 7,947,349,558

A/B X 3.3 0.382C/B X 0.999 1.717D/E X 0.6 1.487F/B X 1.2 -0.173G/B X 1.4 0.321

Z Score = 3.734

Bankruptcy risk is LOW

Who’d have predicted that!