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M17EFA–FinancialStatementAnalysisandValuationInterpretationoffinancialstatementsusingratioanalysisLearningobjectivesBytheendofthissessionstudentsshouldbeableto:Calculateaccountingratiosforprofitability,liquidity,efficiency,capitalstructureandinvestorsUsetheseratiostoassesstheperformanceofacompanyovertimeCategoriesofratioIngeneralratiosarebrokenintofivegroupsdealingwith:ProfitabilityEfficiencyLiquidityCapitalstructure(gearing)InvestorsSomeoverlapbetweentheseareasRememberthatinordertomakeuseofratioswemusthavesomethingtocomparethemagainstLimitationsofratioanalysisFinancialstatementsarehistoricinnature(backwardratherthanforwardlooking/outofdate)Comparisonofresultsmadedifficultby:UseofdifferentaccountingpoliciesOneoffitemsthatdistortresults(eg:largebaddebt,restructure,redundancy)Definitionused(eg:ROCE,Gearing,capitalemployed)Yearendbalancesnotalwaysrepresentativeofperiodasawhole(eg:highinventorylevelsbeforeXmas)Ratioanalysismayindicateproblems,itwon’tnecessarilyrecommendsolutionsInterpretationtechniqueSuggestreasonswhyperformancehasimproved/declinedUseratiostosupportyouranalysisMakeuseoffinancialstatementsprovidedaswellasratios(eg:makeupofCurrentassets/liabilitiesisoftenmoreusefulthanthecurrentratio/acidtest)MakerecommendationsbasedonyouranalysisStateanylimitations/furtherinformationneededItisnotnecessarytocalculateeveryratioInterpretationoffinancialstatementsusingratioanalysisDetailedexample-ContinentalRestaurantsplcAnnual%changeinrevenue-FormulaRevenuein20X5–Revenuein20X4x100Revenuein20X4
Annual%changeinrevenue-Calculation20X47,026,484–6,566,805 x 100 = 7.0% 6,566,80520X58,422,157–7,026,484 x 100 = 19.9% 7,026,484Annual%changeinrevenue-CommentsRevenueduring20X5was19.9%higherthan20X4Growthdueto:OpeningoftwonewrestaurantsExistingrestaurantsbecomingestablishedandgainingloyalcustomerbaseProfitabilityratiosGrossprofitmargin(%)
-Formula
= GrossProfit x100% RevenueGrossprofitmargin(%)
-Calculation20X4= 4,279,904 x 100% = 60.9% 7,026,484 20X5= 5,211,238 x 100% = 61.9% 8,422,157 Grossprofitmargin(%)
-CommentsOnlytakesintoaccountcostofsales(eg:foodcosts)In20X5,forevery£100ofsales,thecompanymakesagrossprofitof£61.90Significantimprovementon20X4Maybedueto:LoyalcustomerbasehasallowedrestaurantstoincreasepricesChangeinsalesmixIncreaseinsizeallowscompanytonegotiateimproveddiscountsfromsuppliersMoreexperiencedstaffresultinginbetterportioncontrolandlesswasteProfitfromoperations(%)-Formula= Profitfromoperations x 100% RevenueProfitfromoperations(%)-Calculation20X4= 1,260,216 x 100% = 17.9% 7,026,484 20X5= 1,513,358 x 100% = 18.0% 8,422,157 Profitfromoperations(%)-CommentsTakesintoaccountcostofsalesandallotheroperatingexpensesIn20X5,forevery£100ofsales,thecompanymakesaprofitfromoperationsof£18.00Alternativelyforevery£100ofsales,£82coversfoodcosts,wagesandotherexpenses,thebalanceisprofitfromoperationsNosignificantimprovementon20X4despiteimprovementingrossprofitmarginMaybedueto:FailuretocontrolbusinessexpensesasnumberofrestaurantsexpandsImpactofoneoffcosts(eg:settingupnewrestaurants)BreakdownofexpensesrequiredControlofstaffcosts
-Formula= Staffcosts x100% RevenueControlofstaffcosts
-Calculation20X4= 1,150,639 x 100% = 16.4% 7,026,484 20X5= 1,460,166 x 100% = 17.3% 8,422,157Controlofstaffcosts
-CommentsIndicateshowwellthecompanyiscontrollingemployeecostsIn20X5forevery£100ofsales,£17.30wasspentonwagesandsalariesIncreaseonpreviousyear,andthishasalmostwipedoutgainsarisingfromimprovementingrossprofitmarginMaybedueto:ShortageofskilledlabourLocationofnewrestaurantsReturnonCapitalemployed(ROCE)(%)-Formula= Profitfromoperations x100% CapitalemployedNote:Capitalemployed=shareholders’fundsandLTdebtSeveraldifferentdefinitionsofcapitalemployed-beconsistentROCE(%)-Calculations20X4=
1,260,216 x100% =21.6% 5,078,210+750,000 20X5=
1,513,358 x100% =22.7% 5,914,134+750,000 ROCE(%)-CommentsIndicateshowefficientlyanorganisationutilisesthelongtermfundsatitsdisposalIn20X5forevery£100oflongtermfundsinvested,thebusinessmadeareturnof£22.70Significantimprovementon20X4Comparewith:InterestrateReturnsavailableelsewhereLiquidityratiosCurrentratio-Formula
= CurrentAssets CurrentLiabilities
Currentratio–Calculations20X4= 2,954,210 = 7.6 388,364 20X5= 2,416,669 = 9.2 263,911Quickratio-Formula= CurrentAssets-Inventory CurrentLiabilities
Quickratio-Calculations20X4= 2,954,210–37,625 = 7.5 388,364 20X5= 2,416,669–61,579 = 8.9 263,911Liquidityratios-CommentsWhencommentingonliquidityalwaysconsiderthemakeupofcurrentassets(toomuchinventory/receivables?)
In20X5,forevery£1ofshorttermliabilities,thebusinesshad:£9.20ofcurrentassets£8.90ofquickassets
Liquidityratios-CommentsWithover£2millionincashthebusinesscurrentlyhasnoliquidityproblems
Howeverholdingsuchhugeamountsofcashfortoolongmayindicateaninefficientuseofbusinessresources
Becarefuloftextbook‘recommended’currentratioof2:1McDonald’s,Tesco,ManUtdoperatewith0.2:1
Useofassets/efficiencyratios
AssetTurnover-Formula
= Revenue. Capitalemployed
Assetturnover-Calculations
20X4= 7,026,484 = 1.21 5,078,210+750,000
20X5= 8,422,157 = 1.26 5,914,134+750,000Assetturnover-CommentsIn20X5forevery£1invested,thebusinessmakes£1.30ofrevenue
Thisisaslightimprovementon20X4andisdespiteopeningtwonewrestaurantsduring20X5Inventoryturnoverperiod-Formula= AveInventoryx365days CostofSales
Note:Useclosinginventoryisaveragenotavailable(beconsistent)Inventoryturnoverperiod-Calculations20X4= 37,625 x365days= 5days 2,746,58020X5= 61,579 x365days= 7days 3,210,919Inventoryturnoverperiod-CommentsIndicateshowlongonaveragegoodsareheldininventory
Freshfoodshouldbeheldfornomorethanafewdays.BWSmaybeheldlonger
NomajorproblemswithinventorycontrolpolicyAveragetradereceivablescollectionperiod-formula= Tradereceivablesx365days CreditsalesorRevenueAveragetradereceivablescollectionperiod-Calculations20X4= 206,777x365days = 11days 7,026,484
20X5= 256,729x365days = 11days 8,422,157 Averagetradereceivablescollectionperiod-CommentsProvidesanindicationofhowquicklycustomerstaketopayforcreditsales
UKaverageis30days
Lengthycollectionperiodmightindicate:IncreasedriskofbaddebtsPotentialcashflowproblemsPayablespaymentperiod-Formula = TradePayables.x365days Purchases(ORCOS)
Payablespaymentperiod-Calculations20X4= 388,364 x365days = 52days 2,746,580
20X5= 263,911 x365days = 30days 3,210,919
Payablespaymentperiod-CommentsProvidesanindicationofhowquicklyabusinesspaysitstradepayables/suppliersTakingtoolongwillimpactuponanorganisationscreditratingandmightmeanthatitmissesoutondiscountsforpromptpayment30daysisinlinewithUKaverageandrepresentsasignificantimprovementon20X4DuPontanalysisROCEProfitfromoperations%AssetturnoverDuPontanalysisProfitfromoperations/CapitalemployedProfitfromoperations/RevenueRevenue/capitalemployedDuPontanalysis–20X4ROCE=AssetturnoverXProfitonoperations%=£7,026,484X£1,260,216£5,828,210£7,026,484=1.2X17.9%=21.48%DuPontanalysis–20X5ROCE=AssetturnoverXProfitonoperations%=£8,422,157X£1,513,358£6,664,134£8,422,157=1.26X18%=22.7%DuPontanalysisLinksprofitabilityandefficiencyratiosSplittingtheROCEintothese2componentscangivefurtherinformationaboutperformanceForexamplemaybeabletoimproveprofitsthroughmakingbetteruseofresources(efficiency)CapitalstructureGearingratio-Formula Nonequityfunds x 100Nonequityfunds+ShareholdersFunds Note:Severaldefinitionsofcapitalemployed(beconsistent)
Gearingratio-Calculations20X4
750,000x 100 = 12.9% 750,000+5,078,210
20X5
750,000x 100 = 11.3% 750,000+5,914,134Gearingratio-CommentsIndicatesbusinessesrelianceonlongtermdebt
In20X5forevery£100oflong-termfunds:£11.30isintheformoflong-termdebtBalance(£88.70)isprovidedbyshareholders
Oncegearingcreepsabove50%:ProfitmaynotcompletelycoverinterestpaymentsLongtermlendershaveinvestedmoreinthebusinessthanshareholdersandhavemoretoloseintheeventofbusinessfailureBusinessesareseenasariskierinvestmentInvestorratiosOrdinarydividendcover-Formula
= Profitattributabletoordinaryshareholders OrdinaryDividend
Ordinarydividendcover-Calculations20X4= 863,957 = 3.0times 286,454
20X5= 1,179,669 = 3.4times 343,745Ordinarydividendcover-CommentsIn20X5thecompanyhassufficientprofitstopayitsordinarydividend3.4timesSufficientfundstopaydividendandretainsomeprofitstofundfuturegrowthofthebusinessDividendpershare(pence)-Formula Dividends(equity)
Numberofsharesinissue
Dividendpershare(pence)-Calculations20X4= 286,454 = £0.03 = 3.0p 9,548,470
20X5= 343,745 = £0.036 = 3.6p 9,548,470Dividendpershare(pence)-CommentsIn20X5foreachshareowned,ashareholderwillreceiveadividendof3.6pence.Slightincreaseon20X4Dividendyield(%)-FormulaDividendpershare(equity) x 100Marketvaluepershare
Dividendyield(%)-Calculations20X4 = 3.0 x 100 = 2.9% 105.0
20X5 = 3.6 x 100 = 2.7% 135.0
Dividendyield(%)-CommentsIn20X5foreachshareowned,ashareholderreceivedadividendthatrepresentsareturnof2.7%whencomparedwiththemarketvalueofoneshare
Althoughthedividendpersharehasincreased,dividendyieldhasfallenslightlysince20X4Earningspershare-FormulaProfitattributabletoordinaryshareholdersNumberofordinarysharesinissue
Earningspershare-Calculat
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