Ratio Analysis - ACCA SBR notes PDF

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ACCA SBR notes...

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Ratio Analysis Users and their information needs: The old IASB Framework outlined seven different groups of users of financial statements. Each user group has different information needs, but as a general rule financial statements prepared in accordance with IFRSs should provide all user groups with most of their needs. The table below lists the user groups, indicates the information that they require from published reports and accounts, and suggests which items in the financial statements will be of most interest to each group. User Investors/ potential investors

Information needs • Risks and returns relating to their investment • Security of dividend payments • Information to make decisions about buying, selling or holding shares • Future growth prospects.

Employees

• Stability of the company (job security and job prospects) • Information about the company’s ability to pay bonuses or higher salaries. • Whether the entity has sufficient cash flow to repay loans • The entity’s ability to pay interest • The adequacy of collateral/ security for loans and bonds

Lenders (banks, bondholders)

Suppliers

Customers Government

General public

• The entity’s ability to settle its liabilities • The entity’s ability to survive and continue as a customer • The entity’s ability to survive and continue as a supplier • The entity’s contribution to the economy • Regulation of activities • Taxation • Obtaining government statistics • Environmental and social awareness • Contributions to the local economy

Items of interest • Trend analysis: changes in revenue, costs and profits over the past few years • Dividend cover • Events and announcements after the reporting period • Share price • Corporate governance reports. Narrative business review. • Profitability and cash position • Increases in salaries (%) relative to increases in profit and dividends • Directors’ remuneration • Cash flow • Total borrowing by the entity: financial gearing • Interest cover • New charges created over the entity’s assets • Net current assets • Growth record • Growth record • Cash flow • Revenue and profit • Market share

• Environmental and social reports • Directors’ report • Narrative business review Note: Management are not included as a user group because they should have access to much more detailed information about the company’s financial position and performance, from internal reports and budgets.

Financial measures of performance Categories of financial ratios: The basic financial ratios should already be familiar to you. Ratios can be divided into five categories:

The main ratios will be considered in more detail. For the purpose of your examination, you need to know how to calculate each ratio, but you must also understand why each ratio, or each category of ratios, might be of particular interest to a specific user group. An examination question may ask you to provide an analysis of financial statements for a particular user. It will not tell you which ratios to calculate. Instead, you will have to decide for yourself which ratios may provide useful information for that user. Therefore you should learn to identify and select the appropriate ratios for each user group, and then analyse what the ratio appears to show, from the point of view of that user. Profitability ratios: This category of ratios measures the performance of the company in terms of the return (profit) earned on the capital employed in the business. These ratios are relevant for measuring the success of management in using the resources under their control. They also allow customers and suppliers to assess whether the company has the ability to continue operating successfully in the future. Gross profit margin:

Gross profit Revenue

× 100%

Analysing the gross profit margin can often provide useful information for users of financial statements.

• This ratio should normally remain fairly constant from one year to the next. Even a fairly small change in the ratio might indicate that something of significance has happened. • Variations between years may be attributable to     

A change in sales prices A change in sales mix A change in purchase/production costs An exceptional write-off of inventory Exceptional expenses or lost revenues (such as the consequences of a strike by employees).

Operating profit margin:

Operating profit Revenue

× 100%

Operating profit margin is affected by more factors than gross profit margin. Many operating costs are fixed and therefore do not necessarily increase or decrease with revenue. This means that operating profit margin may be more volatile year-on-year than gross profit margin. Be aware that many operating costs, such as depreciation and impairment losses, are heavily reliant on management judgement. This may hinder the ability to compare the operating profit margin of one company with another company. Return on capital employed (ROCE)/ Return on (total) capital employed (ROCE):

Operating profit Profit before interest ∧tax × 100% or Capital employed Share capital+reserves+debt capital

× 100%

Capital employed is equity plus interest bearing finance. ROCE is a measure of how efficiently an entity is using its resources. It should be compared to: • Previous years' figures • The target ROCE • The ROCE of competitors • The cost of borrowing. Return on shareholders’ funds (ROSF): The return on shareholders’ funds (ROSF) or return on shareholders’ capital (ROSC) measures the return on the capital invested by shareholders. It measures how efficiently the company is using the capital that only shareholders have provided, to obtain profits. In a company with no preference shares and no non-controlling interests, this ratio is calculated as follows:

Profit before tax × 100% Share capital reserves

When a company has non-controlling interests or preference shares, you need to decide on the most suitable method of calculating the ratio. Remember that the figure above the line must be comparable with the figure below the line. For example, if you are measuring the return on capital for equity shareholders in the parent company, the most suitable ratio would be:

Profit after tax attributable Share capital+reserves attributable × ¿ equity shareholders∈the parent company ¿ equity shareholders of the parent company ¿ ¿ 100% Using ROCE or ROSF • It is not necessary to calculate both these ratios. The ratio that you calculate should be the ratio that is of the greatest interest to the particular user or user group. For example, management may be most interested in ROCE, but an equity investor would be interested in ROSF. • ROCE or ROSF could be compared to real interest rates that are currently available to investors in the market. For example, if a company has a ROCE of 3% when interest rates of 5% are available in the bond markets, a shareholder might be advised to consider selling his shares. However, it is important to remember that bond yields are returns calculated from the market price of bonds; whereas ROCE and ROSF are calculated from financial statements and are not market rates of return. • Bank overdrafts might be included as part of capital employed in the ROCE ratio, because many companies ‘roll over’ their overdraft facility and use it as long-term funding. When a bank overdraft is large, the interest cost of the overdraft might be high, and it would therefore be appropriate to include the bank overdraft ‘below the line’ in capital employed, because the overdraft interest is included ‘above the line’ in profit before interest and tax. • A company may be able to ‘manipulate’ its ROCE or ROSF ratios by using accounting policies or financing strategies, such as:  Choosing to re-value non-current assets or choosing the historical cost model  Timing the acquisition of non-current assets or the timing of new financing so as to have the minimal adverse impact on ROCE. Overhead percentage: Overhead percentage ratios measure the ratio of overhead costs to sales revenue. The main overhead costs are administrative expenses and sales and distribution costs.

Overheads Sales

× 100%

Even when the gross profit margin is constant, the net profit margin may be affected by changes in the overhead cost ratios. • An analysis of overhead costs is more meaningful if total overhead costs can be analysed into variable overheads and fixed overheads • The ratio of variable overhead costs to sales revenue should remain constant from one year to the next, unless something of significance happens (such as a major increase in variable overhead costs)

• The ratio of fixed overhead costs to sales revenue should decrease as the company grows and increases its annual revenue. However, when a company grows, fixed cost spending also increases, so the decline in the fixed costs/sales ratio might not be ‘dramatic’ and substantial. • The overhead costs to sales ratios are affected by exceptional items, such as company reorganisation and the cost of settlement of lawsuits/ legal disputes.

Efficiency ratios: Cash flow is the lifeblood of an entity. Cash is needed to maintain operations by paying suppliers and employees, and to allow the company to grow. Cash income and spending can be controlled to some extent through management of the cash operating cycle (management of ‘working capital’). The operating cycle (also called the cash cycle) refers to the continuous cycle of business activities, whereby an entity spends cash to acquire materials, labour and other resources, and eventually recovers its cash (with a profit) by selling goods or services to customers and collecting payment. For a manufacturing entity, the operating cycle begins when the entity buys raw materials on credit and turns the materials into finished goods. The finished goods are then sold on credit, generating trade receivables. The entity then collects the cash from the customers. The cash cycle is the average length of time between paying cash to suppliers and receiving cash from customers. Problems arise when cash income is not being generated by operations quickly enough. When this happens, the entity may have difficulty with paying cash to its suppliers. Alternatively, it needs to set aside much more capital than necessary for working capital. Poor working capital management and an inefficient cash cycle mean inadequate cash flows. Examples of poor management include: • Holding excessive levels of inventory

Liquidity and working capital

Current ratio:

Current assets Current liabilities

:1

The current ratio measures whether an entity has sufficient current assets to meet its short-term obligations. The higher the ratio, the more financially secure the entity is. However, if the ratio is too high then it may suggest inefficiencies in working capital management. Inventory turnover period:

Inventories Cost of sales

× 365 days

A high inventory turnover period may suggest: • Lack of demand for the entity's goods • Poor inventory control. Receivables collection period:

Trade receivables Credit sales

× 365 days

An increase in the receivables collection period may suggest a lack of credit control, which could lead to irrecoverable debts. Payables payment period:

Trade payables Credit purchases

× 365 days

This represents the credit period taken by the company from its suppliers. A long credit period can be a good sign because it is a free source of finance. However, if an entity is taking too long to pay its suppliers then there is a risk that credit facilities could be reduced or withdrawn.

Long-term financial stability Gearing:

Debt Equity

Or

Debt Debt +equity

Gearing indicates the risk attached to the entity's finance. Highly geared entities have a greater risk of insolvency. Interest cover:

Operating profit Finance costs

Interest cover indicates the ability of an entity to pay interest out of the profits generated. A low interest cover suggests that an entity may have difficulty financing its debts if profits fall.

Investor ratios P/E ratio:

Current share price EPS The P/E ratio represents the market's view of the future prospects of an entity's shares. A high P/E ratio suggests that growth is expected.

Limitations of financial information: Ratio analysis generally relies on the published financial statements of an entity. However, many user groups have become increasingly aware of the limitations of traditional financial reporting. Historical information: Published accounts are historical in nature, and report the past performance of the company. Past performance does not guarantee future performance. However, there is very little information in the audited financial statements about the future prospects of the company. A Chairman’s statement, a directors’ report and a business review or Operating and Financial Review are produced by companies in some countries. These narrative reports often include information about changes to the business and the outlook for the next few years. However, these often provide insufficient information and cannot always be relied on to provide an ‘unbiased’ view of the company’s future prospects. Users of financial statements, particularly shareholders and other investors, may use trend analysis to analyse a company’s performance over the past few years, and predict future performance from past trends. Stock market announcements by a company and press releases by the company to the media, together with general economic information, can also be used to try to predict future performance. The effect of inflation: Inflation affects the information in financial statements prepared under the historical cost convention. When the rate of inflation is fairly high, information in the financial statements may be unreliable. • For many companies, many of the assets in the statement of financial position are undervalued because in a period of fairly high inflation the replacement cost of the assets will be substantially higher than their carrying values (at net book value, based on historical cost). • IAS 16 and IFRS 9 allow certain assets to be re-valued in the statement of financial position whilst others are carried at historical cost.

In a period of inflation, the reported profit is also misleading when the historical cost convention is applied. The reported profit does not take account of the higher cost of replacing inventory that has been sold or non-current assets that have reached the end of their useful life. Access to information: Most users will not have access to the forecasts and projections produced by management as part of their monthly management accounts. This information would be invaluable to investors who want to assess the future prospects of the company. Some users of financial information may be in a position to ask a company to provide this information. For example: • A bank will want to see the cash flow forecasts and business plans of a company before agreeing to lend it money • The government may have a statutory right to demand detailed financial information from a company, for example about its sales, in order to compile national statistics. Insufficient detail: IFRSs specify the disclosures of information that entities should provide in their financial statements. Much of the detailed information is aggregated into a total figure, and companies generally provide only the minimum level of disclosure required by IFRSs. Some international accounting standards require the disclosure of details, such as IFRS 5 Non-current assets held for sale and discontinued operations. These help with the interpretation of performance, but the disclosures are still not given in sufficient detail to satisfy the needs of all users. Some standards include voluntary disclosure requirements. For example, IAS 7 recommends analysis of operating cash flows under the direct method. However, most companies choose not to provide any more information than is absolutely necessary, and most use the indirect method. Creative accounting: Over recent years, the rules in the IFRS accounting framework have been strengthened, and the opportunities for ‘window dressing’ of the financial statements have been reduced. Even so, there are still some opportunities for companies to ‘manipulate’ the figures in their financial statements, to improve their reported position and their financial ratios. This is known as creative accounting. For example, some accounting standards still allow a choice of accounting treatment. For example, IAS 16 allows the use of the cost model or revaluation model for non-current assets. A company will be tempted to select the policy that shows the ‘best’ results. There are also a number of areas where accounting standards provide no rules or where the rules on the accounting treatment of an item are unclear. This allows companies to design their own accounting treatment, until such time as rules are introduced or strengthened. Even when standards do exist, the management of entities may be allowed to use their judgement when applying an accounting policy or making an estimate. For example, judgement is needed to decide whether the conditions have been met for capitalisation of development costs (IAS 38). Scope of the audit: In addition to the financial statements, the annual report and accounts published by companies include other information that may be of relevance to users. This information may include:

• An operating and financial review, or a business review • A Chairman’s statement • A directors’ report • A corporate social responsibility report (or social and environmental report). However, many companies publish an annual corporate social responsibility report as a separate document. The company itself is able to decide the content of these reports and the amount of detail that they provide. As a general rule, a company will only want to publish positive news and not the ‘bad news’. The information in these reports is not subject to a full audit and so the audit opinion does not extend to them. (Auditors are required to read the content of the reports, to ensure that it does not undermine the credibility of the financial statements. If problems are found, the auditors will seek adjustment from management but if this is refused there is generally little that the auditor can do.) Note: In the EU, the recent EU accounts modernisation directive introduced a requirement for listed companies to produce an annual business review. National governments will give guidance or establish rules about what this review should contain, but it will not be subject to audit. The information needs of management: The management of a company needs much more information about the financial performance and position of their company than other user groups. They need reports more regularly, and often they need access to information immediately through on-line IT systems. They also need information in sufficient detail and suitably analysed. Management have access to this amount of information and detail through the reporting systems of the company, and in budgets, forecasts, business plans, strategy documents and monthly management accounts. Detailed reports on inventory levels, slow-moving items and the ageing of outstanding receivables should also be available from the management information systems of the company. However, the quality of the management information is only as good as the system that provides it. Poor management information (information that is inaccurate and unreliable, provided too late or irrelevant) can lead to wrong decisions being made by management. The management of an entity may also have access to information about competitors, such as market share statistics (if these are collected by industry regulato...