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Briefing Note: 6
A Methodology for Analysing Company Statements
As UK financial reporting is currently under transition from UK GAAP to IFRS, some duplicate terminologies are used.
The numerical information contained in the Statement of Financial Position (SFP) / Balance Sheet and Income (Profit and Loss) Statement, can be subjected to:
In analysing a set of figures in an annual report, we are likely to be trying to establish:
Here is a suggested method of analysing the figures presented in a set of year-end financial statements. Wherever possible, UK and the terminology of other English-speaking IFRS jurisdictions has been used.
Ratio analysis enables an overview of the financial performance of a company and will highlight issues for further investigation within the financial statements, or through other sources;
Ratio analysis is a useful tool for ‘taking apart’ a set of financial statements and forming a view of the business which they represent. However, it is important to not be ‘blinded by the ratios’, but to retain overview and common sense. And…..always remember that the financial statements are historic, that things can change fast in the commercial world.
Also, remember that as an analyst, your job is not just to calculate ratios; it is to understand what they tell you about the business; how it is performing and what the management team are trying to achieve.
Turnover / total sales, summarises the normal operating income of the company.
(Year 2 t/o minus Year 1 t/o) as a percentage of Year 1 t/o
The fundamental measure of business performance is profitability, and the most important of all is net profit, the ‘bottom line’ (of the Income Statement) which essentially represents the surplus generated from it’s trading in a particular year (after tax).
Always remember that net profit is not the same as the surplus cash which the business generates in that year, because profit from trading has to finance other essential cash flows such as capital investment and debt repayment or any investment in an expansion of working capital.
Net Profit Margin
Net Profit (profit after tax), as a percentage of total sales (total revenue).
Net Profit %
The resulting percentage can be compared with that for similar companies. This works well when comparing businesses which are truly similar, such as large food retailers or airlines, but care has to be taken (as with all the ratios) when comparing companies which are diverse businesses in terms of their principal trading activities.
The net profit percentage should be analysed year-by-year in the company being examined. What is the trend of it’s profitability, and how does this compare with the trend of it’s overall revenue year-on-year? How does this compare with the overall track record of it’s industry sector, or with the economy as a whole?
Might anything unusual have influenced the net profit figure, such as a profit/loss on the sale of a fixed asset or subsidiary company? In 2016-17 Tesco was hit with unusual apparent costs when it had to make a provision for penalties incurred by what was held to fraudulent reporting of it’s revenue in previous years. The consequent loss of net profit masked the fact that the company was beginning to turn round it’s dismal trend of profitability under a new management team.
Profit margins can also be calculated at different stages of the development of the P&L, as;
Gross Profit %
Operating Profit %
Calculating these margins is particularly useful when comparing very similar businesses in the same industry sector.
Gross margin shows how efficient the relevant businesses are in producing / selling their product – care has to be taken here to identify that the Income /Profit and Loss statements for the companies reports set the same costs against income to achieve the gross profit line.
Operating margin enables comparison on how companies compare in the fundamental operation of the business; it excludes unusual income or costs which will affect the net margin.
For comparing the profitability of a business over time, or of different businesses operating in different jurisdictions, analysts often use the EBITDA margin, which copes with differences in taxes, interest rates and fixed asset bases. This therefore enables the comparisons of companies in different jurisdictions.
Earnings before interest, tax, depreciation and amortisation (EBITDA)
Total Sales (Revenue)
Return on Equity
Profit after Tax
Share Capital & Reserves
This measures the return on the shareholders’ capital: it includes reserves as theoretically the company could be voluntarily wound up and these paid to shareholders. On average, over longer periods, RoE for larger European companies is around 10-12%.
RoE for a company is dependent upon two factors: how efficiently it employs its assets to generate profit, and how much of its asset base is funded by shareholders’ investment.
RoE is sometimes known as Return on Net Assets (RoNA). Total equity is the balance sheet value of the business when debt is treated as a liability, which is, if you think about it, the same as the (balance sheet) value of net assets. Therefore RoE/RoNA shows the percentage return that net profit provides on the (balance sheet) value of the business.
Return on Capital Employed
Return on Capital Employed (ROCE) is the most used measure of a firm’s profitability.
When calculating, care should be taken to ensure that the SFS / Balance Sheet is of the form where total capital employed is set against net assets; rather than the form where all debt is netted off against assets to produce net assets against shareholders’ funds).
Total Capital Employed is therefore all debt plus shareholders’ funds (equity).
ROCE measures the return which is being generated on the funds which have been invested in the company, i.e. equity investment, retained profit and debt. Again, comparisons can be between similar companies or in the same company over time.
Earnings before interest and tax, depreciation and amortisation (EBITDA)
RoCE indicates how much profit is generated for each pound of assets invested.
Why do analysts use the EBITDA figure and not PAT? Well, tax rules can change from year to year, a company might benefit from tax allowances in a particular year, and any international comparisons between companies would be complicated by different tax structures.
Similarly, excluding depreciation and amortisations enables comparison between companies with different ages of asset base (some may have been fully depreciated) or different depreciation policies.
What does rising ROCE show? Well, profitability might have improved; and this should be signalled by a rise in Net Profit Margin. Improved ROCE might also have come through improvements in the efficiency with which assets are being used: after all, fixed assets and current assets are what our funds are invested in.
Therefore, we could be using our fixed assets more efficiently (perhaps reducing the level we need for the same scale of trade). We could be managing current assets better through better working capital control (clearing stock or work in progress, collecting debtors quicker) which will mean that less has to be invested in financing the working capital requirement.
Be aware that falling ROCE could be due to ‘notional’ adjustments to asset values. If a company revalues land/property fixed assets upwards, this will create a matching rise in the funds apparently funding the business through increasing the size of the revaluation reserve (part of ‘shareholders’ funds’). This is a notional transaction; it does not result in any more actual income for the company unless it elects to sell those properties. Thus our profit is now set against an increase of capital employed in the business; the denominator of our formula.
EBITDA / Enterprise Value
Total capital employed is sometimes alternatively expressed as Enterprise Value, with the difference that the equity component (the other being debt) is expressed as being valued at total market capitalisation rather than the equity value shown on the balance sheet. This figure, plus debt, is theoretically what it would cost an acquiror to buy the business and discharge the debts.
Therefore this alternative to ROCE, used by some analysts, divides Enterprise Value by EBITDA.
Dividend per Share
Total Shares in Issue
Provides a useful track of dividend paying behaviour over time. Companies do not necessarily specify the dividend payment at the bottom of the income statement, but it will be shown on the cash flow statement. The total number of shares in issue may be shown on the balance sheet; alternatively it should be specified in the notes to the accounts.
However, the amount of dividend paid from a year’s profit is a decision of the management team, (subject to ratification at the shareholders’ annual general meeting) and is influenced not only by the profit performance in that year, but by the needs of funding cash flows such as capital investment, debt repayment or expansions of working capital. A management team might alternatively want to build a cash reserve for a particular project, such as the purchase of another business.
Companies capable of fast growth may chose to not pay any dividend, instead investing all profit back into the business to fuel further growth. This means that shareholder value (the price of their shares in the stock market) should rise by a greater percentage than their dividend payment would otherwise have been (as a percentage of share price) if the management team had decided to pay out profit as dividend instead.
Earnings Per Share
Total Shares in Issue
Following the above discussion on management choice in paying a dividend, it is clear that Earning Per Share (EPS) is a more useful measure of how well shareholders are benefiting from their investment in a particular year.
What is the Right Level of Investor Return?
People sometimes say ‘that company is providing me with a good rate of return on my investment. It’s much better than I’d get if I invested money in a bank savings account’.
They are essentially saying ‘funds invested in that company generate a higher return than a safe investment.’ This is also how the stock market values shares; investors decide to buy shares because of the returns which shares can generate, and this demand/supply pull then impacts on share price in the market. The other component of the share buying decision is risk…therefore riskier businesses command a lower share price than low-risk businesses which are a more attractive investment.
So the benchmark minimum return on the funds invested in a business is dependent on the perceived riskiness of investing in that business. It is possible to calculate this level of benchmark return as every significant business has a risk factor calculated for it based on the historic volatility of it’s share price in the stock market. This factor, referred to as the ‘beta factor’, acts as a multiplier of a typical safe investment % return (such as on a current government bond), to generate a percentage return which is the minimum which shareholders should expect on their investment.
The level of Capital Employed in a business depends on the efficiency with which the assets that the capital is invested in, is being managed.
A company awash with Non-Current ( Fixed) and Current Assets may look healthy, but it also requires an unnecessarily high level of funding: the money which has paid for those assets must have come from somewhere! Using assets efficiently is key to generating a good return on the level of investment.
There are of course, two fundamental classes of assets; current assets which are those which convert to cash within a year, and non-current assets (or ‘fixed’ assets), which relate to its infrastructure.
Analysts review ‘working capital management’ to measure the speed with which a company turns its raw materials to cash.
Working Capital Management
Operating working capital = current assets – cash and marketable securities.
Operating Working Capital to Sales Ratio
Operating working capital
Which can be alternatively expressed as:
Operating Working Capital to Sales Turnover
Operating working capital
Stock Days ( ‘Inventory Turnover’)
Stock (‘inventory’) is valued on an FSP / Balance Sheet at cost, so the correct comparison is with the Income Statement (P&L) cost figure (if detailed). Multiplying by 365 converts the ratio into days.
Stock (Inventory) X 365 = Stock Days
Cost of Sales
Service-based businesses may show ‘Work-in-Progress’ instead of stock / inventory. If these are partnerships (and therefore not bound by accountants’ reporting rules) they generally show WIP at value, not cost. Otherwise, companies will value wip at cost.
Work-in-Progress X 365 = WIP Days
Debtor Days (‘Trade Receivables Days’)
Debtors or Receivables analysis is usually based on trade debtors/receivables.
Debtors /Recievables X 365 = Debtor / Receivables Days
This can alternatively be expressed as Debtors / Trade Receivables Turnover:
Debtors (‘Trade Receivables’)
Creditor (‘Trade Payables Days’)
Similarly, care has to be made with creditor / trade payables analysis. At the time that annual balance sheets are drawn up in published financial statements, companies often have unusual creditor / trade payables liabilities, most notably a provision for tax and another for dividend payment. It is normal practice for analysts to use the monies owed to trade suppliers as being the basis for calculating the creditor / payables ratios.
Creditors (‘Trade Payables’) X 365 = Creditor (Trade Payables) Days
Cost of Sales
This can alternatively be expressed as Creditors / Trade Payables Turnover:
Cost of Sales
Creditors (‘Trade Payables’)
I prefer analysing the efficiency of working capital management in terms of the days worth of stock (inventory), debtors (receivables) and creditors (payables) which a company has on its balance sheet, because set against costs on the Profit and Loss (Income) statement, you can calculate the working capital requirements of the business.
Working on a days basis is also useful for giving a detailed view of solvency.
Working Capital Requirement to Fund Operations:
(Stock(Inventory)days + Trade Debtors(Payables)days – Creditors(Payables)days)/365 X Cost of sales
Checks need to be made on what is included in the cost of sales figure on the profit and loss (income) statement.
Working Capital Requirement to Fund the Company’s Activities
(Stock(Inventory)days + Trade Debtors(Payables)days – Creditors(Payables)days)/365 X Total costs
Normally, analysts would exclude unusual Debtor(Receivables) or Creditor(Payables)items.
Fixed Asset (‘Non-Current Asset’) Management
Analysis of the efficiency with which fixed(non-current) assets are used can look at all of this class of asset, including tangibles, intangibles and goodwill, or can alternatively concentrate analysis on use of PP&E, (property, plant and equipment).
Analysts will normally subtract any non-interest bearing non-current liabilities to work from a net fixed(non-current) assets figure.
Fixed (Non-Current) Asset Turnover
Net Fixed (Non-Current) Assets
Check how this ratio changes over time. If declining, it could be because turnover is falling relative to fixed assets, but it could also be because fixed assets are increasing in value, either through capital investment, or through the revaluation of assets.
Property, Plant and Equipment Turnover
The most important Fixed (Non-Current) asset in a company’s balance sheet isnormally PP&E; property, plant and equipment.
Net property, plant and equipment
This measures the company’s typical cushion over its outflows of cash.
The ‘right’ score for a particular company will depend on the industry in is in. A heavy engineering company might need cover of 2.5, whereas a confectioner might be OK with 1.5. Supermarkets typically operate with cover of just 0.5.
Businesses with excess cover may look highly solvent, but this also highlights a possibly inefficient use of financial resources; perhaps through poor working capital management.
The current ratio is felt to be a rather blunt tool. More useful as a measure of solvency is the:
Acid Test (or ‘Quick Ratio’).
Liquid Assets (Generally debtors / receivables+ cash and marketable securities)
This measures the ability of a business to meet its short term cash commitments through assets which can be turned into cash relatively quickly.
The meaning of ‘liquid’ assets can vary from business to business.
In general….and it is something of a generalisation, analysts are happy to see a current ratio of better than one. However, some businesses have slow paying debtors, and if you are looking at their ability to meet the current months cash requirements, then their ability to raise sufficient cash may be scant.
On the other hand, if you acid test a big retailer such as Sainsbury’s, Tesco, Asda, they may appear insolvent, typically scoring less than a guideline 0.5 minimum, in other words only 50p exists for every £1 of trade creditor liability.
However, for these businesses, stock is also a liquid asset, as stocks are turned over within a few days. They have a negative working capital requirement, taking two months to pay suppliers, whereas cash comes into the business every day from sales of goods which have only been in stock for a couple of days.
The solvency tests for a business show us their ‘typical’ position based on a set of accounts. We can (and should) check on the solvency position over time.
As far as a true test of solvency, however, the fact is that businesses fail when their cash is inadequate at a specific point of time. An end of year balance sheet is unlikely to identify the period when the company is most vulnerable, and the document is also poor at indicating the current position. It might, after all, be 16 months old.
Debt is obviously of major importance in the financing of most large companies. Where growth prospects and margins are good, sensible use of debt will make for more profit and or growth than the cost of the debt financing.
However, high levels of debt restrict strategic options and mean that the lenders take a close interest in the business. Covenants will restrict the company’s ability to do things such as dispose of assets. High levels of debt also reduce the ‘cushion of safety’and add risk. Business failures tend to arise when overdrafts add to existing debt until the lenders close the business down.
The extent to which a company might resort to risk also depends on its risk profile. Companies which are stable and have predictable cash flows are likely to resort to debt. Companies which are riskier, with unpredictable cash flows and a higher degree of business uncertainty, will have to have to use a higher proportion of equity funding.
Debt can be attractive to companies;
Debt to Capital Employed Ratio
Short Term + Long Term Debt
Total Capital Employed
This is the traditional method of calculating gearing, and unless you have a reason to use one of the alternatives below, is the easiest to use and will mean that your review of different companies or the same company over time, is consistent.
Liabilities to Equity Ratio
This ratio is essentially the reciprocal of the assets to equity ratio.
Debt to Equity Ratio
This ratio shows how many pounds of debt financing the company is using for every pound of investment provided by the shareholders.
Short Term + Long Term Debt
Net Debt to Equity Ratio
The next two ratios measure debt as a proportion of total capital.
Short Term + Long Term Debt – Cash and Marketable Securities
Net Debt to Net Capital Ratio
Interest-bearing liabilities – Cash and marketable securities
Interest bearing liabilities – Cash and marketable securities + shareholders’ equity
Note that short term debt may be referred to as current debt, long term debt as non-current debt. Shareholders’ equity is alternatively known as shareholders’ funds, and includes all reserves such as retained profit as well as the actual equity funding of the business.
Interest Cover (Cash Flow Basis
Cash flow from operations + interest payable + tax payable
Debt analysis can go beyond mere ratios which help to understand the scale of debt and the safe cover of interest payments. The notes to the accounts will usually give a view of the kinds of debt which a company has, when its components fall due for settlement, the different costs of the different forms of debt, and possibly of how some of the debt is secured….at least of the primacy of a piece of debt (i.e. how high it ranks in the hierarchy of settlement in the event of business failure).
Note: A Complication
Under IFRS, companies are encouraged to capitalise any interest costs which clearly relate to the acquisition or creation of a fixed asset. This means that the interest charges shown in the Income statement may not be the total interest paid by the business.
As we are interested in knowing how able the company is to meet its total interest repayment obligation, we need to include such capitalised interest costs in our total.
Check the notes to the accounts for a section which explains borrowing costs in more detail. You can also refer to the Accounting Policies section of the Financial Statements to confirm that the company is capitalising relevant interest costs.
Future Impacts of Debt Repayment on Cash Flow
While the company may have good solvency in the year reported on, there may be an ‘elephant lurking in the cupboard’ with reference to future debt repayments. Positive cash flow this year, may preface high negative cash flow next year, because a major debt becomes due for repayment.
Analysis should therefore include a review of future debt repayment liabilities, and the consideration that these will have on future cash flows. Check the Notes to the Accounts for the Debt Schedule.
A prudent management will have built up a reserve to finance this, which will be part of the asset base of the business. Alternatively, they may be able to finance or part-finance the debt repayment through;
As the gearing ratios use shareholders’ funds (equity interest), the denominator will be affected by fixed asset revaluation. If you are comparing two companies, you may be comparing one with another which has a more recent asset revaluation, or you may be comparing with a company from a jurisdiction which does not allow asset revaluation. In these circumstances, remove the Revaluation Reserve from the Equity figure.
In some jurisdictions, companies are allowed to make substantial provisions at the discretion of management, as opposed to only where a clear obligation exists, as under IFRS and UK GAAP. If comparing companies with those in these jurisdictions, these provisions should be ‘added back’ if they are significant.
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