Interpretation of financial statements using Ratio Analysis. PDF

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Interpretation of financial statements using Ratio Analysis....

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Lecture 3 Interpretation of financial statements using Ratio Analysis. 1. Interpretation of financial statements.   

It is not easy to evaluate performance just by looking at an organisations financial statements Financial statements provide absolute figures which make meaningful comparison difficult For example a profit before tax of £100,000 might appear adequate but: - What does this represent as a percentage of revenue? - What percentage return does it represent to an investor? - Are resources being used efficiently? - How does performance compare with previous accounting periods / industry averages / competitors?

a) How are they doing?

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Compare the performance of NEXT plc and Tesco plc in the financial year ending in 2017. Which is more profitable? Which one is the more attractive investment prospect?

b) Interpretation  We can gain a better understanding of performance by examining financial statements using a range of techniques including: - Horizontal analysis - Trend analysis - Vertical analysis - Ratio analysis  However, it should be strongly noted that we shall only be focusing on the use of Ratio Analysis  These techniques look at the relationship between figures in an entity’s financial statements and allow us to make comparisons with: - previous accounting periods - similar businesses / industry averages  This allows us to: - Establish trends - Highlight significant differences in performance - Forecast future performance

2. Ratio Analysis. 

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In general ratios are broken into five groups dealing with: - Profitability - Efficiency - Liquidity - Capital structure (Gearing) - Investors Some overlap between these areas Note that in order to make use of ratios we must have something to compare them against

a) Interpretation technique - Suggest reasons why performance has improved or declined - Use ratios to support your analysis - Make use of financial statements provided as well as ratios – look at figures underlying the ratios - Examine contextual information in Annual Report to understand changes in figures - Make recommendations based on analysis - State any limitations or further information needed - It is not necessary to calculate every ratio

3. Profitability Ratios. a) NEXT plc

b) Gross profit margin (%)  Formula : =

Gross Profit x 100% Revenue

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Calculations :

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Comments - Only takes into account cost of goods sold - In 2016/17, for every £100 of sales, NEXT plc made a gross profit of £33.80 - Slight decline from 2015/16 - May be due to:  Decrease in selling prices  Change in sales mix  Slight increase in supplier prices hence increase in cost of sales  More items that are not sold at full price

c) Operating profit margin (%)  Formula : = Operating profit x 100% Revenue 

Calculations :

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Comments : - Takes into account cost of sales and all other operating expenses - In 2016/17, for every £100 of revenue, NEXT plc makes an operating profit of £20.20 - Slight deterioration from 2015/16 - Smaller than the decline in gross margin - Operating expenses have decreased slightly - No unrealised foreign exchange losses

d) Net profit margin (%)  Formula: = Net profit x 100% Revenue 

Calculation:

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Comments: -

Takes into account cost of sales and all other expenses including finance costs and tax In 2016/17, for every £100 of revenue, NEXT plc makes a net profit of £15.50 Slight deterioration from 2015/16

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Smaller than the decline in gross and operating margin Finance costs increased but tax decreased

e) Return on Capital employed (ROCE) (%)  Formula: =

Operating profit

x 100%

Capital employed Note: -

Capital employed = Shareholders’ funds (Total Equity)+ LT debt OR Total Assets – Total Current Liabilities Several different definitions of capital employed - be consistent

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Calculations :

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Comments : -

Indicates how efficiently an organisation utilises the long term funds at its disposal In 2016/17 for every £100 of long term funds invested, the business made a return of £49.30 Significant deterioration on 2015/16 Operating profit has fallen and both equity and long-term debt have increased Mainly due to retained earnings (equity) and corporate bond issue (long-term debt) Note that current liability for corporate bonds has been off  New bonds issued to pay off the old ones

f) Return on equity (ROE).  Formula : =

Profit after tax

x 100%

Shareholders’ equity 

Calculations :

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Comments : -

Indicates the return the company earns for shareholders on their invested capital In 2016/17 for every £100 of equity invested, the business made a return of £124.40 Significant deterioration on 2015/16 Profit after tax has fallen slightly Equity has increased due to retained earnings NEXT have not earned additional return on the profits shareholders have reinvested in the group What plans do management have to deliver higher profits?

Ratio analysis – Summary. 

From our brief ratio analysis for NEXT plc we can see that:

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Slight decline in the gross profit margin Slight decline in operating profit margin Further analysis of operating expenses is necessary to establish why the operating profit margin has improved Revenue generated by each FTE employee has fallen slightly, however there is need for more information in order to comment further

Recap. 

In general ratios are broken into five groups dealing with: - Profitability

 

- Efficiency - Liquidity - Capital structure (gearing) - Investors Some overlap between these areas Remember that in order to make use of ratios we must have something to compare them against

4. Liquidity ratios. a) NEXT plc

b) Current ratio.  Formula :

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Calculations :

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Comments : -

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At 28/01/17 for every £100 of current liabilities, NEXT plc has £229 of current assets  This is much higher than at 30/01/16 NEXT plc can easily pay current liabilities Current liabilities have reduced greatly  Reduction in corporate bonds  Reduction in overdraft  Dividends already paid Note – current assets earn low returns

c) Quick ratio.  Formula :

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Calculations :

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Comments : -

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At 28/01/17 for every £100 of current liabilities, NEXT plc has £167 of quick assets  This is much higher than at 30/01/16 NEXT plc can easily pay current liabilities, even if they cannot sell stock quickly How long does it take to sell stock? Note – current assets earn low returns

Liquidity ratios. 

Comments : -

NEXT plc appears to be holding too high a value of current assets Earning a low return on these assets Must carry a large value of inventory, but this is not the problem (balance has declined) Is trade receivables balance too high? Be careful of text book ‘recommended’ current ratio of 2:1  For instance McDonald’s, Tesco, Man Utd operate with 0.2:1

5. Efficiency ratios. a) NEXT plc

b) Asset Turnover.  Formula :

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Calculations :

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Comments : -

In 2016/17 for every £1 invested, the business makes £2.44 of revenue This is a significant decline on 2015/16 Reduction is mainly due to the increase in capital employed Investments could have been made close to the year-end

c) Inventory turnover period.  Formula : = Ave Inventory x 365 days Cost of Sales - Note: 

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Calculations :

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Comments : -

Use closing inventory if average not available (be consistent)

Indicates how long on average goods are held in inventory The inventory turnover period decreased from 65 to 61 days in 2017 This is desirable for NEXT plc as their inventory is seasonal, subject to fashion and easily damaged.

d) Average trade receivables collection period. • Formula

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Calculations :

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Comments : -

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Provides an indication of how quickly customers take to pay for credit sales Lengthy collection period might indicate:  Increased risk of bad debts  Potential cash flow problems NEXT plc’s period is long and getting longer Catalogue sales on credit terms Use quick rather than current ratio to assess liquidity

e) Payables payment period.  Formula :

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Calculations :

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Comments : -

Provides an indication of how quickly a business pays its trade payables / suppliers Taking too long will impact upon an organizations credit rating and cause supply problems A slight improvement on 2015/16 Due to reduction in trade payables balance...