Financial appraisal, using a range of financial performance and efficiency ratios

When considering the risk factors involved in trading with another organisation, it can be useful to review the other partys financial accounting reports. Ratio analysis can be applied to financial accounts to help identify where risks might exist, and to otherwise answer questions about the companys financial position:

Performance: How well is the business performing? How profitable is it? How well is it
controlling its costs? How does the business compare with its competitors? Is performance improving or deteriorating?

Financial status: How financially sound is the company? Is the company solvent? How liquid is
it?

Efficiency: How quickly does the company move its stock? How quickly does it collect payment
from customers? How quickly does it pay its bills?

When going through the measure we will apply them to the accounts set out below

Balance Sheets of The Regal Caf as at December 31st ASSETS Current Assets: Cash Short-term Investments Accounts Receivable Inventories Prepaid Expenses Total Current Assets Investments Fixed Assets: Land Buildings Furniture & Equipment Less: Accumulated Depreciation Operating Equipment Total Fixed Assets Total Assets LIABILITIES & OWNERS EQUITY Current Liabilities: Accounts Payable Accrued Income Taxes Accrued Expenses Current Portion of Long Term Debt Total Current Liabilities Long-Term Debt: Mortgage Payable Deferred Income Taxes Total Long-Term Debt Total Liabilities Owners Equity: Common Stock @ $0.20 per share N.V. Paid-in Capital in Excess of Par Retained Earnings Total Owners Equity Total Liabilities & Owners Equity 2008 $20,000 60,000 100,000 14,000 13,000 207,000 43,000 68,500 810,000 170,000 1,048,500 260,000 11,500 800,000 1,050,000 2009 $21,000 81,000 90,000 17,000 12,000 221,000 35,000 68,500 850,000 190,000 1,108,500 320,000 20,500 809,000 1,065,000 2010 $24,000 145,000 140,000 15,000 14,000 338,000 40,000 68,500 880,000 208,000 1,156,500 381,000 22,800 798,300 1,176,300

$60,000 30,000 70,000 25,000 185,000 425,000 40,000 465,000 650,000 55,000 110,000 235,000 400,000 1,050,000

$53,500 32,000 85,200 21,500 192,200 410,000 42,800 452,800 645,000 55,000 110,000 255,000 420,000 1.065,000

$71,000 34,000 85,000 24,000 214,000 400,000 45,000 445,000 659,000 55,000 110,000 352,300 517,300 1,176,300

Income Statements of The Regal Caf For the years ended December 31st Food & Beverage Sales Less: Cost of Sales Gross Profit Payroll & Related Costs Operating expenses Fixed Costs Operating Profit (PBIT) Interest Expense Income Before Income Taxes Income Taxes Net Income (PAT) Dividend for the year Retained profit Retained Earnings b/f 1/1 Retained Earnings c/f 31/12 2009 1,300,000 282,900 1,017,100 320,000 302,000 105,500 289,600 54,000 235,600 94,300 141,300 121,300 20,000 235,000 255,000 2010 1,352,000 288,500 1,063,500 335,500 312,500 111,000 304,500 60,000 244,500 97,800 146,700 49,400 97,300 255,000 352,300

Additional notes: 1. Credit sales are 70% of total food & beverage sales for each year. 2. Purchases: 2009 $285,900; 2010 $286,500 2009 $7.71 2010 $6.93

3. The average share price:

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5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Return on Equity Return on Assets (ROA) Net Profit Margin (NP%) Gross Profit Margin (GP%) Asset Turnover Fixed assets Turnover Working Capital Turnover Current ratio Acid test ratio Inventory Turnover Average Collection Period Average Payback Period EPS P/E Dividend Cover Dividend per share Dividend Yield Gearing ratio Debt ratio Interest cover

Ratio PBIT x100 Average Owners Equity PBIT x 100 Average Total Assets -CL PBIT x 100 Sales Gross Profit Sales x 100

Working

2009

Working

2010

Sales Average Total Assets - CL Sales Average Fixed assets Sales Average Working Capital Current Assets Current Liabilities CA (Inventory + Prepayments) Current Liabilities Average Inventory x 365 Cost of sales Average Accts. Rec. x 365 Credit sales Average Accts. Pay. x 365 Purchases Profit after tax No of Ordinary shares Share price EPS Profit after tax Ordinary Dividend Dividend Number of shares Divi. per share x 100 Share price Prior charge capital x 100 Total Owners Equity Total Liabilities x 100 Total Assets PBIT Interest

Return on Owners Equity

Net Income/Average Owners equity x 100

Return on capital employed (ROCE) or Return on Assets (ROA)

Operating profit (PBIT) / (Average Total assets current liabilities) x100.

Return on capital employed is one of several rate of return measures. It is usually measured using profit before interest and tax (that is, the operating profit) and expressing this figure as a percentage of all the long-term capital employed by the business. This latter figure would usually include the shareholders funds (including retained profits) as well as any long-term loans or bonds. What is an acceptable return? Much depends on the nature of the business. A company that is capital-intensive (such as many manufacturing businesses) is likely to have a lower return on capital than one with fewer tangible assets (such as a PR consultancy). In general terms, though, the ratio should over a period of time be higher than the companys cost of capital.

Net profit margin

Operating Profit/Sales or turnover (expressed as a percentage).

The profit margin also known as return on sales identifies how efficient the company is at converting sales into profit, it is a measure of how effective the company is at controlling expenses. What constitutes a high profit margin depends entirely on the industry in question. Generally speaking, increasing profit margins are good news for a business.

Asset turnover
Sales/Average Total assets - CL.
Asset turnover is a measure of efficiency in terms of the use of available capacity in other words, how well the company is using its assets to generate sales. If the figure declines, it might suggest a decline in efficiency for example an increase in assets not being matched by a proportionate increase in sales. However, an apparently improved ratio could be achieved if a company failed to keep its plant and machinery up to date by not replacing old fixed assets.

This ratio could be supported by calculating the Fixed asset turnover, and also the Working capital turnover. These calculations would identify the area of asset investment that is affecting the returns on capital employed

Financial status or liquidity ratios

Current ratio
Current assets/Current liabilities (expressed as a multiple or ratio, for example 2 or 2:1). The current ratio measures the extent to which short-term assets are adequate to cover shortterm liabilities. A normal figure (if such a thing exists) for the current ratio might be about 2:1. However, just as too low a figure raises questions about liquidity, too high a figure might prompt questions about how efficiently the company is being run. Money invested in current assets may tie up funds that could be better used elsewhere.

Acid test ratio

Liquid assets (current assets excluding stock)/Current liabilities (expressed as a multiple or ratio, for instance 2 or 2:1).

The acid test is a more rigorous test of liquidity than the current ratio, as it only uses what are known as liquid (or quick) assets. This refers to current assets which are quickly convertible into cash, and for this reason would normally exclude stocks which may not always be easily saleable. If this ratio comes out as above 1, this is normally considered a comfortable situation. For both the current ratio and the acid test, falling ratios are a sign of deteriorating liquidity. If we look at the relevant part of the balance sheet above we can work out the ratios

Working capital or efficiency ratios

When considering sources of finance we will look at working capital management as a means of generating internal finance. When appraising a supplier, we can consider similar issues and assess how well they are managing their own resources:

Stock turnover days

(Average stock/Cost of sales) x 365 (expressed as a number of days). Stock turnover measures how quickly goods move through the business usually the quicker the better. The stock figure used must be viewed with caution, particularly in a seasonal business.

Debtor days
(Average Trade debtors/Turnover) x 365 (expressed as a number of days). Debtor days shows how long, on average, it takes for the company to get paid for the goods it sells. Strictly speaking, only credit sales should be used for a company that sells some goods for cash.

Creditor days
(Average Trade creditors/Purchases (or cost of sales)) x 365 (expressed as a number of days). Creditor days measures how long the company is taking to pay its suppliers. An increase in the number of days could indicate some pressure, but might also mean simply that the company is

managing its cash flow better by delaying payment.

There are two main risks associated with working capital. First, there is the risk of overcapitalisation. This occurs when a business actually has more invested in working capital than it really needs. This could take the form of having too much stock, for example, or a disproportionately high level of debtors. Such a situation suggests inefficiency, and because it ties up capital that is of no real benefit has a financial price.

The second risk factor, though, concerns almost the opposite scenario. If company expands, but does not invest sufficiently in the extra working capital needs that go along with expansion, it may find itself what is known as overtrading. Here the risk is that cash flows coming into a business are insufficient to meet payment obligations when they arise. Gearing ratio The ratio between ordinary share capital and fixed interest-bearing securities is called financial gearing, or as it is termed in the USA, leverage. A company that is financed mainly by equity is said to be low geared. The higher the proportion of fixed interest capital, the higher the gearing. A high-geared company is one in which equity capital (including reserves) is less than fixed interest capital. The most commonly used measure of gearing is based on the balance sheet values of fixed interest and equity capital. Gearing = Prior charge capital Total Owners Equity x 100

The term prior charge capital refers to securities on which interest or dividends must be paid before arriving at the earnings for ordinary shareholders. It includes both preference shares and loans. The amount of gearing will influence the value of earnings attributable to ordinary shareholders. A company in high gear must earn sufficient profits to cover its interest charges before any is available to equity. A company is in low gear if the gearing ratio is less than 100%, and highly geared if the ratio is above 100% Interest cover = Operating Profit/Interest This gives a direct indication of the ability of the company to meet its interest commitments because it is the possibility of a company failing to pay interest that represents the greatest danger of high gearing When profit measures are calculated over several years, the results give a more dynamic picture of the effects of gearing. The balance sheet ratios are, on the other hand, static figures that may not change even when the companys true position is deteriorating. An interest cover of less than 3 is considered low, indicating that profitability is too low given the high gearing of the company. The Debt Ratio = Total Debt/Total Assets x 100 These are other measures of financial risk, 50% is considered as a safe limit of debt.

Employee ratios Other frequently used measures consider financial results compared with the number of employees in a business, for example: sales per employee operating profit per employee output per employee. These three measures are calculated simply by dividing the appropriate figure (e.g. sales) by the number of employees as disclosed in the financial accounts.

Growth ratios
Additionally, measures that reflect the growth of a business can often be useful. These are often referred to as growth ratios, and involve measuring the year-on-year growth of particular aspects of a business for example sales growth, profit growth and net asset growth.

Cash flow ratios

Most traditional ratios focus on the profit and loss account/balance sheet relationship, and pay
less attention the cash flow statement. There are, however, a number of ratios which have become more widely used in recent times and which bring cash flow figures into play.

Cash flow to current liabilities

(Net cash flow from operating activities/Average current liabilities) x 100. This measure considers how easily a business is able to meet its current liabilities out of the cash it generates from its operations an extension to the liquidity theme discussed above.

Cash flow per share

(Cash flow/Weighted average number of shares). This looks at how much cash is generated per share that exists in the company. An increase therefore suggests improvement. The cash flow figure used will depend on what is being examined for example, one could consider the total cash flow, but alternatively limit it to the cash flow generated from operations.

3.3 Investment ratios

Another category of ratios relate to share prices and are normally calculated with the shareholder and investors in mind. They will form a key part of an investors decision making whether to buy or sell shares in a particular company. They are also often good indicators of the overall financial status of a company. Some of the ratios reflect the markets view of a company, which can be a good indicator of future prospects. In looking at these measures, we will use data from Perco Plc, a fictitious UK listed company. Perco has recently announced its results. The following data is relevant: Perco made a profit after tax of 70 million. The average number of ordinary shares in the company over the last year was 500 million.

 The companys latest annual dividend is 8p per share. The latest share price is 1.60. There are no preference dividends.

Earnings per share

Earnings per share (EPS) is the profit attributable to shareholders divided by the number of ordinary shares in issue (expressed in cash amount). So, in the case of Perco, the EPS will be: 70 million/500 million shares = l4p. In other words, for every share that exists in the company, l4p profit has been earned. The earnings per share (EPS) figure is not itself a ratio, but it is a figure that is central to the next ratio we look at, the price/earnings ratio. EPS is a figure that is published as part of a companys annual results, and describes how much profit has been made by the company for each share it has issued. The profit element or earnings is the profit that is attributable to the ordinary shareholders of the company. Thus it is the profit that has been made after interest and tax have been deducted but also after any preference dividends, as they are not payable to the ordinary shareholders.

Price/earnings ratio
The price/earnings (P/E) ratio is the market price per share divided by the EPS (expressed as a multiple). The PIE ratio shows how much of a multiple of EPS one has to pay when acquiring shares in a particular company. In other words, how many years it will take to recoup (in the form of profits) the price paid for the shares assuming that future profitability remains the same. This ratio can be historic (based on the most recent published financial results) or prospective (based on expected future EPS). It is a useful measure of comparison between companies, and is often used to assess value in a share price. For example, if the PIE ratio is relatively low, the shares might represent value at the prevailing price. Interpretation of PIE ratios requires particular caution, however. A company with a high PIE ratio is not necessarily better than one with a low one. It simply means that the shares are more highly rated, based often on expectations of future growth. In the case of Perco, the following figures are relevant: Latest share price: 160p Latest EPS: l4p P/E ratio 160/14 = 11.4 times. In other words, somebody buying Perco shares at 160p is paying 11.4 times the amount of profit made for each share in the company. Put another way, each penny of Perco profits will cost a new shareholder 11.4p if buying the shares at this point in time. And, putting it another way still, it will take an investor 11.4 years to recoup the amount invested if future profits remain the same. The P/E ration may be used to value the shares of a target company, that is a company that is the subject of a possible takeover bid by another company, the bidding company. This is a common method of valuing a controlling interest in a company, where the owner can decide on dividend and retention policy. The EPS of the target company is multiplied by the bidding companys P/E ratio so as to value the target companys shares. The P/E ratio thus relates earnings per share to a shares value. P/E ratio = Market value of the share EPS

Market value per share = EPS x P/E ratio The EPS could be a historical EPS or a prospective future EPS. For a given EPS figure, a higher P/E ratio will result in a higher price. A bidder company may sometimes use their higher P/E ratio to value a target company. This assumes that the bidder can improve the targets business, which may be a dangerous assumption to make. It may be better to use an adjusted industry P/E ratio, or some other method. An adjusted industry P/E would normally be taken as 1/2 to 2/3 of the industry average. Example: application of the P/E ratio in valuing a target company Earth plc has earnings of 70 cents per share with a market value of $5.25 per share. Earth plc proposes a takeover bid for Wind Ltd. Wind Ltd has an EPS of 22 cents. Using the price/earnings method calculate the price per share that Earth plc would offer investors in Wind Ltd to complete the takeover. Answer: Earth plc P/E ratio = 5.25 0.70 = 7.5

Wind Ltd share value = P/E ratio x EPS = 7.5 x 0.22 = $1.65

Dividend yield
Dividend yield is the dividend per share divided by the market price per share (expressed as a percentage). So far we have looked at measures that consider the overall profit made for shareholders. We will now consider the part of that profit that is paid out to shareholders the dividend. This is the cash amount that is paid out to shareholders, and it represents that part of the profit that the company is distributing rather than retaining in the business. Dividend yield measures the percentage return on the market price of a share, in terms of the dividend paid. Whereas EPS looks at the profit made per share, this measure looks at the relationship between the latest dividend paid out per share, and the price of that share. A high dividend yield can represent an attractive investment but it may just reflect a falling share price. The falling share price in turn may suggest difficulties and possibly reduced dividends in the future. In the case of Perco, we are told that the dividend being paid is 8p per share. This needs to be compared to the latest share price: So, if an investor buys Perco shares at todays price of 160p, and future dividends stay at 8p, the cash return on the investment will be 5%.

Dividend Cover
Dividend cover indicates how well a dividend is covered by the companys earnings (that is, the profit attributable to shareholders). Where dividend cover is less than 1, dividends are being paid, at least partly, out of reserves (basically, profits made in previous years). Such an approach cannot continue indefinitely. The calculation works as follows: Earnings per share (EPS)/Dividend per share (expressed as a multiple). So, going back to Perco, the EPS was 14p and the dividend was 8p. Dividend cover is therefore: 14p/8p = 1.75 times

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Profit levels are sufficient to cover the dividend payout but less than half the profits made are being retained by the business.

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