Managing Finance and Budgets

1
Managing Finance and Budgets

• Lecture 4
• Financial Statements (3)

2
Session 4 - Financial Statements (3)

• Learning outcomes
• Understand the role and limitations of financial
  statements in relation to SMEs, VCOs and large
  organisations
• Manipulate and use financial statements to
  inform decision-making in situations typically
  found in SMEs and VCOs
• Key concepts
• Analysing accounts
• Ratios

3
Session 4 - Financial Statements (3)

• Content
• A Analysing Accounts
• B The different types of Ratio
• 1. Profitability Ratios
• 2. Liquidity Ratios
• 3. Financing Ratios (Gearing)
• 4. Efficiency Ratios
• 5. Investment Ratios
• C Example of Analysis

4
A Analysing Accounts
5
Analysing Accounts - Key Points

• When making an analysis of a business through
  its accounts, we should take into consideration
• The nature of the business
• Changes in the nature of the business over time
• Comparisons to similar businesses
• The management of the business - marketing,
  operations, personnel, finance
• The interpretation and presentation of figures
• Other non-financial information, such as seasonal
  and other trends, the weather, political climate
  etc.

6
Factors affecting analysis

• Our analysis may be affected by some or all of
  the following
• Incomplete or imperfect information
• Subject to distortion by individual events
• Changes or differences in accounting policies
• Inflation
• Window dressing and manipulation
• Snapshot nature of the Balance Sheet
• Investment in business compared to returns to
  shareholders and/or directors
• Conglomeration of different types of activity in
  one set of figures

7
The Use of Ratios (1)

• Ratios are analytical tools designed to provide a
  single summary figure which gives a snapshot of a
  particular type of activity or answers a
  particular question.
• Normally, a ratio compares one figure with
  another, or gives a percentage.
• Most ratios are straightforward, easy to
  understand with names which convey what they
  actually do,
• for example, one of the ratios from last week
  was
• Average Stockholding Period Average stock
  level x 365
• Cost of Sales

8
The Use of Ratios (2)

• Ratios
• Can be used as basis of comparison - e.g. other
  companies, other periods, targets or forecasts
• Allow comparisons between and within firms
• Enable trends to be identified
• Enable comparisons to be made where scale is
  different

9
Sample Ratios

• Retail Sales per square metre
• Sales Cost per 1000 loaned
• Food cost per patient
• Bed Occupancy
• of sales spent on advertising (or anything)
• Cost of water (electricity) per kilo manufactured
• Average number of students per class
• Expenditure on books per student
• Cost per outcome for different departments

10
Activity One

• Discuss the following
• Imagine you are the proprietor of a hotel and
  restaurant. Identify a series of key ratios which
  would help you to monitor on a day to day basis
  how well the hotel is performing.

11
Activity One - Solutions

• Key ratios to monitor how well a hotel is
  performing.
• These might include
• Room occupancy
• Average customer payment
• Reservations as a of total occupancy
• Cleaning Costs per room
• Average direct cost per room occupancy
• Total Overheads bill per days operation
• Total Salaries as a percentage of turnover
• food wastage per day
• and many more!

12
The Use of Ratios (3)

• When using a Ratio
• Identify users
• Who wants to know the information?
• identify information required
• What is it that they need to know?
• Select and calculate ratios,
• Which is the best tool for the job?
• Interpret.
• What does the number tell you?

13
The Use of Ratios (4)

• When using a Ratio
• Use standard cross-sector ratios,
  industry-specific ratios or, if necessary, create
  your own
• Be aware of variation in definitions - be
  consistent
• Use more than one ratio a single ratio is just
  a starting point

14
B The Different Types of Ratio
15
The Different types of Ratio

• We will look at five different categories of
  Ratio used in Financial Analysis
• 1. Profitability
• How successful is the business?
• 2. Efficiency
• How is the business using its resources?
• 3. Liquidity
• Is the flow of cash sufficient to meet
  obligations?
• 4. Financing
• What is the source of financing for the business?
• 5. Investment
• Does the company represent a good investment for
  shareholders?

16
The Different Types of Ratio

• 1. Profitability

17
Profitability Ratios

• The first set of ratios we will look at, attempt
  to measure profitability that is, whether or
  not the business is financially successful.
• Note that just looking at the the amount of of
  profit made by a company in a particular year may
  give a distorted picture of the companys
  position.
• A 1.5m profit generated on a turnover of 10m,
  can look very good. The same profit on a
  turnover of 100m looks poor.
• However there may be reasons why the first
  company has generated so much profit there could
  be a one-off sale of assets, for example, which
  have increased in value.

18
Four Profitability Ratios

• There are four important ratios
• __________________________________________________
  __________________________________________________
  __________________________________________
• Gross Margin Gross Profit x 100
• Sales
• __________________________________________________
  __________________________________________________
  __________________________________________
• Net Margin Net Profit before tax interest x
  100
• Sales
• __________________________________________________
  __________________________________________________
  __________________________________________
• Return on Ordinary Shareholders Funds (ROSF)
• Net Profit after tax and preference dividends
  x100
• (Share Capital Reserves)
• __________________________________________________
  __________________________________________________
  __________________________________________
• Return on Capital Employed (ROCE)
• Net Profit before tax and interest x100
• (Share Capital Reserves LT Loans)

19
Activity Two

• Calculate and comment on profitability ratios
  for the two years shown
• YEAR 1 YEAR 2
• SALES 2,240,000 2,681,200
• COST OF SALES 1,745,400 2,072,000
• OVERHEADS 252,000 362,800
• INTEREST 24,000 6,200
• TAX 60,200 76,000
• DIVIDENDS 40,200 60,000
• SHARE CAPITAL 300,000 334,100
• RESERVES 198,300 302,500
• LONG TERM LOANS 200,000 60,000

20
Activity Two Example Spreadsheet

• The Spreadsheet mfb4.exe gives the full set of
  examples and the details of the calculations
  carried out.
• We will look at one example of each type of
  calculation

21
Activity Two SolutionsGross Margin

• In the spreadsheet

22
Gross Margin

• The P L Account Shows
• Sales 2,240,000
• Gross Profit 494,600
• (NB Gross Profit Turnover Cost of Sales)
• Gross Margin 494600 x 100 22.1
• 2240000

The company makes 22p for every 1 it brings in.
This can be used to pay overheads etc.
23
Activity Two SolutionsNet Margin

• In the spreadsheet

24
Net Margin

• The P L Account Shows
• Sales 2,240,000
• Net Profit after Tax and Dividends 118,200
• (NB
• Net Profit Turnover Cost of Sales-
  Overheads)
• Net Margin 118200 x 100 10.8
• 2240000

After paying all outstanding costs, the company
makes 11p for every 1 it brings in.
25
Activity Two SolutionsROSF

• In the spreadsheet

26
ROSF

• The P L Account Shows
• Net Profit after Tax and Dividends 118,200
• Share Capital 300,000
• Reserves 197,500
• 497,500
• ROSF 118200 x 100 31.8
• 497500

The company is making 32p for every 1 invested
by shareholders.
27
Activity Two SolutionsROCE

• In the spreadsheet

28
ROCE

• The P L Account Shows
• Net Profit (before Tax Interest) 242,600
• Share Capital 300,000
• Reserves 197,500
• LT Loans 200,000
• 697,500
• ROCE 242600 x 100 34.8
• 697500

Including loans, the company makes 35p for every
1 invested in the business.
29
The Different Types of Ratio

• 2. Liquidity

30
Liquidity Ratios

• These Ratios seek to answer the question Can
  the business pay its way?
• All of these ratios look at the flow of cash in
  the company, and try to determine whether or not,
  at a particular point in time, the business has
  enough cash to pay what it owes.
• Liquidity amount of stock, debt etc., which can
  be easily converted into cash

31
Ratios - Liquidity

• We look at three ratios
• __________________________________________________
  __________________________________________________
  __________________________________________
• Current ratio Current Assets (Over 1 for
  solvency)
• Current Liabilities
• e.g. Current ratio of 1.5 1.50 owned for
  every 1 owed
• __________________________________________________
  __________________________________________________
  __________________________________________
• Acid test Current Assets excluding stock
• Current Liabilities
• __________________________________________________
  __________________________________________________
  __________________________________________
• Operating Cash Flow to Maturing Obligations
• Operating Cash Flows
• Current Liabilities

32
Activity Three

• Calculate and comment on liquidity ratios for
  the two years shown
• YEAR 1 YEAR 2
• DEBTORS 240,800 210,200
• BANK ACCOUNT 33,500 41,000
• OPENING STOCK 241,000 300,000
• CLOSING STOCK 300,000 370,800
• TRADE CREDITORS 221,400 228,800
• DIVIDENDS OWING 40,200 60,000
• CORPORATION TAX OWING 60,200 76,000
• CASHFLOW FROM OPERATIONS 231,000 251,400

33
Activity Three

• The ratios in this section refer to the items in
  the second part of the spreadsheet mfb4.exe

34
Activity Three

• In the spreadsheet

35
Current Ratio

• Current Assets
• Trade Debtors 240,800
• Bank Account 33,500
• Closing Stock Value 300,000
• 574,300
• Current Liabilities
• Trade Creditors 221,400
• Dividends Owing 40,200
• Corporation Tax Owing 60,200
• 321,800
• Current Ratio 574300 1.8
• 321800

The business owns almost twice as much as it owes
36
Acid Test Ratio

• In the spreadsheet

37
Acid Test Ratio

• Current Assets excluding Stock
• Trade Debtors 240,800
• Bank Account 33,500
• 274,300
• Current Liabilities
• Trade Creditors 221,400
• Dividends Owing 40,200
• Corporation Tax Owing 60,200
• 321,800
• Acid Test Ratio 274300 0.9
• 321800

Excluding stock, the business owns almost as much
as it owes..
38
Cash-Flow to Obligations Ratio

• In the spreadsheet

39
Cash-Flow to Obligations Ratio

• Net Cash-Flow from Operations 231,000
• Current Liabilities
• Trade Creditors 221,400
• Dividends Owing 40,200
• Corporation Tax Owing 60,200
• 321,800
• Cash-Flow to Obligations 231,000 0.7
• Ratio 321800

The currently available cash in circulation is
about three-quarters of what is needed to pay
current debts
40
The Different Types of Ratio

• 3. Financing

41
Financing Ratios

• Organisations use external funding because
• It may be beneficial tax-wise
• They may have insufficient funds themselves
• The return may be higher than the cost of the
  funding

42
Financing Ratios

• We look at two ratios which analyse the position
  of the business in relation to external funding
• Gearing ______Long-term Loans x 100__
  
• Share Capital Reserves LT Loans
• Interest Cover Profit before interest
  tax
• 
  Interest due

43
Activity Four

• Use the figures shown in Activity Two to
  calculate and comment on financing ratios for the
  two years shown.

44
Gearing

• In the spreadsheet

Note Long Term Loans appears in both the
Numerator and the Denominator of the Ratio
45
Gearing

• Long Term Loans 200,000
• Share Capital 300,000
• Reserves 197,500
• LT Loans 200,000
• 697,500
• Gearing 200000 x 100 28.7
• 697500

Just over a quarter of the companys financing
comes through loans
46
What is gearing?

• Financial Gearing occurs when a business is
  financed in part by outside parties.
• This is normally in the form of a long-term loan
  or overdraft.
• The level of gearing is crucial under healthy
  trading conditions, companies which have higher
  gearing give greater returns for shareholders.
• see next slide

47
Effect of gearing Normal Conditions

• Company A Company B
• Equity 100 10
• Loans - 90
• Sales 100 100
• Direct Costs 40 40
• Gross Profit 60 60
• Indirect Costs 50 50
• Net Profit 10 10
• Interest _at_7 - 6.30
• Tax 3 1.11
• Profit after tax/int 7
  2.59
• ROSF 7
  26

Company A has no gearing Company B has high
levels of gearing
Both companies have the same levels of
profitability and costs.
Company B pays out interest on loans, but Company
A does not.
This is the crucial point compare the Return on
Shareholdings Although A makes more profit, B is
working on lower levels of capital, and so its
ROSF is proportionately much higher(26) than
for A (7)
48
Effect of gearing Poor Trading Conditions

• ------ Sales drop by 10 ------
• Company A Company B
• Equity 100 10
• Loans - 90
• Sales 90 90
• Direct Costs 36 36
• Gross Profit 54 54
• Indirect Costs 50 50
• Net Profit 4 4
• Interest _at_7 - 6.30
• Tax 1.20 -
• Profit after tax/int 2.80
  2.30-
• ROSF 2.8
  -

Company A have the same levels of gearing as
before.
A downturn in sales means that each company now
has a net profit of only 4
After B has paid interest on the loan, the
company is in deficit.
In this case, A is still trading but showing a
reduced profit to shareholders, but B is now in
dire circumstances, and needs to find additional
finance to continue trading.
49
Interest Cover

• In the spreadsheet

50
Interest Cover

• Net Profit 242,600
• Interest due 24,000
• Interest Cover 242600 10.1
• 24000

The company makes 10 times as much as it needs to
service its loans
51
The Different Types of Ratio

• 4. Efficiency

52
Efficiency Ratios

• These ratios are concerned with the way that
  assets are used in an organisation.
• Some of these are useful financial management
  tools that we have met previously, for example
  the average stock turnover and the average credit
  period. As we have already seen, these can be
  very useful in controlling the flow of cash in an
  organisation.
• Others are concerned with the use of resources,
  both human and otherwise.

53
Efficiency Ratios

• Stock turnover (days) Average Stock Value x
  365
• 
  Cost of Sales
• __________________________________________________
  __________________________________________________
  _________________________________________
• Debtors (days) Total Debtors x 365
• Total Credit Sales
• __________________________________________________
  __________________________________________________
  _________________________________________
• Creditors (days) Total Creditors x 365
• Credit Purchases
• __________________________________________________
  __________________________________________________
  _________________________________________
• Sales to Capital Employed _________Total
  Sales________
• Share Capital Reserves LTL
• __________________________________________________
  __________________________________________________
  _________________________________________
• Sales per employee ____Total
  Sales___
• No of employees

54
Activity Five

• Use the figures shown in Activities Two and
  Three and the additional figures shown below to
  calculate and comment on efficiency ratios for
  the last two years
• YEAR 1 YEAR 2
• CREDIT PURCHASES 1,804,400 2,142,800
• NUMBER OF EMPLOYEES 14 18

55
Stock Turnover Period

• In the spreadsheets

56
Stock Turnover Period

• Opening Stock Value 241,000
• Closing Stock Value 300,000
• Cost of Sales 1,745,400
• Stock Turnover (Days)
• (241000300000)/2 x 365
• 1745400
• 56.7 days

Stock is held on average for 57 days
57
Average Settlement period for Debtors

• In the spreadsheets

We assume here that all the sales were on credit.
58
Average Settlement period for Debtors

• Trade Debtors 240,800
• Total Sales 2,240,000
• Average Settlement Period
• 240800 x 365
• 2240000
• 39.2 days

Debtors take 39 days on average to pay the money.
59
Average Settlement period for Creditors

• In the spreadsheets

60
Average Settlement period for Creditors

• Trade Creditors 221,400
• Total Sales 1,804,400
• Average Settlement Period
• 221400 x 365
• 1804400
• 44.7 days

The company takes 45 days on average to pay its
bills.
61
Sales to Capital Employed

• In the spreadsheets

62
Sales to Capital Employed

• Total Sales 2,240,000
• Share Capital 300,000
• Reserves 197,500
• LT Loans 200,000
• 697,500
• Sales to Capital Employed
• 2240000 697500
• 3.2

The turnover of the business is three times the
total capital invested in it.
63
Sales per Employee

• In the spreadsheets

64
Sales per Employee

• Total Sales 2,240,000
• Number of Employees 14
• Sales per Employee 2240000 14
• 160,000

Each employee brings in 160,000 worth of
business.
65
The Different Types of Ratio

• 5. Investment

66
Investment Ratios

• These ratios all seek to measure the value of the
  shareholders investment in the company, and the
  return on that investment.
• It should be noted that the money the shareholder
  may have paid for the shares, may not reflect
  either their current market value, or the actual
  stake it represents in the company.
• For example, shares in TSB were originally sold
  at 1.00 each in the 1980s. This represents the
  capital invested in the company. If you had
  bought these shares in 1996 you would have paid
  around 11.00 per share. Currently they are
  trading at around 6.00 per share.

67
Investment Ratios - Shareholder Value

• Dividend per share _Dividends announced__
• Number of issued shares
• __________________________________________________
  __________________________________________________
  _________________________________________
• Dividend payout Dividends
  announced x 100 .
• Net profit after interest/tax/pref.d
  ividends
• __________________________________________________
  __________________________________________________
  _________________________________________
• Dividend Yield Dividend per share/(1-tax
  rate) x 100
• Market value per share
• __________________________________________________
  __________________________________________________
  _________________________________________
• Earnings per share Net profit after
  interest/tax/pref.dividends
• Number of issued shares
• __________________________________________________
  __________________________________________________
  _________________________________________
• Cash-Flow per share Operating Cash-Flow -
  pref.dividends
• Number of issued shares
• __________________________________________________
  __________________________________________________
  _________________________________________
• Price/earnings ratio Market price per
  share
• 
  Earnings per share

68
Activity Six

• Using the figures given in Activities 2 and 3,
  and the additional figures below, calculate and
  comment on shareholder value for the two years
  shown
• YEAR 1 YEAR 2
• Number of Ordinary Shares 600,000 668,200
• Preference Dividends/Shares NIL
  NIL
• Market Price Per Share 2.50
  3.50

69
Dividend per Share

• From the spreadsheets

70
Dividend per Share

• Dividends Announced 40,200
• Number of Shares 600,000
• Dividend per Share 40200 600000
• 0.067

Each shareholder gets 6.7p for each share they
own.
71
Dividend Payout

• From the spreadsheets

Here we are assuming that these are ordinary,
rather than preferential dividends
72
Dividend Payout

• Net Profit 242,600
• Interest - 24,000
• Tax - 60,200
• Net profit after interest/tax 158,400
• Dividends Announced 40,200
• Dividend Payout 40200 x 100
  158400
• 25.4

One quarter of the total profit is paid out in
dividends to shareholders.
73
Dividend Yield

• From the spreadsheet and the first example in
  this section

• Dividends Announced 40,200
• Number of Shares 600,000
• Dividend per Share 40200
  600000
• 0.067

In addition, we will be assuming a tax rate of
20
74
Dividend Yield

• Dividend per share 0.067
• Market Price per Share 2.50
• Tax Rate 20
• Dividend Yield 0.067/(1 0.2) x 100
  2.50
• 3.35

NB 20 0.2
Shareholders are currently getting a rate of
return of 3.35 on their investment at market
value (compare Inflation 2)
75
Earnings per Share

• From the spreadsheets

Here we are again assuming that these are
ordinary, rather than preferential dividends
76
Earnings per Share

• Net Profit 242,600
• Interest - 24,000
• Tax - 60,200
• Net profit after interest/tax 158,400
• Number of shares issued 600,000
• Earnings per Share 158400
  600000
• 0.264

The company is making about 26p for every share
that is held.
77
Cash-Flow per Share

• From the spreadsheets

Here we are again assuming that these are no
preferential dividends
78
Cash-Flow per Share

• Operating Cash-Flow 231,000
• Number of shares issued 600,000
• Cash-Flow per Share 231000
  600000
• 0.385

There is about 40p for every share in current
circulation within the company.
79
Price/Earnings Ratio

• From the spreadsheet, and the 4th ratio in this
  set

• Net Profit 242,600
• Interest - 24,000
• Tax - 60,200
• Net profit after interest/tax 158,400
• Number of shares issued 600,000
• Earnings per Share 158400
  600000
• 0.264

80
Price/Earnings Ratio

• Market Price per share 2.50
• Earnings per share 0.264
• Price/Earnings Ratio 2.50
  0.264
• 9.45

The market price of a share is about 10 times the
profit made by the share. (may be better the
other way round each share earns about
one-tenth of its current market value in a year)
81
Comparison of Ratios
82
C Example of Analysis
83
Analysing a Companys Performance

• The next slide shows five different ratios
  calculated from the published accounts of J.
  Sainsbury PLC, summarising the companys
  performance over the five-year period 1996-2000
• As you look through these figures, you should ask
  yourself
• What trends can be detected?
• Is the company improving its performance?
• Would you consider investing in the company?

84
Ratio Analysis - J Sainsbury Plc
1996 1997 1998 1999 2000 TURNOVER (
million) 13,499 13,312 15,496 16,378 17,414 PROFI
T BEFORE TAX 764 651 728
755 580 NET MARGIN () 5.6 4.6
4.7 4.6 3.3 EARNINGS PER SHARE
26.8p 22.0p 25.1p 29.2p 18.3p DIVIDEND
PER SHARE 12.1p 12.3p 13.9p 14.32p
14.32p DIVIDEND COVER 2.21 1.78 1.8
2.03 1.27 Figures taken from J Sainsbury Plc
Website - 2 August 2000
Dividend cover is the reciprocal form of the
Dividend Payout Ratio
85
Ratio Analysis - J Sainsbury Plc
Axis scales have been modified to enable
comparisons to be made
86
Comparison of ratios

• It can be noted from the previous slides that
  while the turnover has increased steadily over
  the five-year period, the profit before tax,
  fluctuates somewhat, with a sharp downturn in
  2000.
• The downward trend is even more evident from the
  net margin, which has down a steady reduction
  over the 5 years.
• On the other hand, the dividend per share rose
  steadily over the first 4 years, and maintaining
  this level in 2000. However, the earnings per
  share shows a much less impressive performance.

87
The Limitations of Ratios

• Analyses which only use ratios only give a
  limited vision
• The quality of base data in financial statements
  may be suspect.
• Ratios can measure relative performance, but do
  not allow for scale (see Sainsbury example).
• They give only a basis for comparison we need
  to compare like with like.
• Some ratios ( balance sheet - e.g.) measuring at
  a single point in time, and not over a period.
• One off events such as disposal of assets can
  give rise to major distortions.

88
Activity Seven

• Discuss the following
• If a business is overtrading, do you think the
  following ratios would be higher or lower than
  normally expected?
• (a) Current ratio
• (b) Average stock turnover period
• (c) Average settlement period for debtors
• (d) Average settlement period for creditors

89
Activity Seven

• In an overtrading position, these ratios would
  be
• (a) Current ratio
• Lower (Liabilities would increase)
• (b) Average stock turnover period
• Lower (Stock run-outs occur)
• (c) Average settlement period for debtors
• Higher (if inability to supply means total
  sales lower)
• or Lower (if business chases debt due to
  shortage of cash)
• (d) Average settlement period for creditors
• Higher (shortage of cash makes it difficult to
  pay creditors)

90
Seminar Four - Activities

• Preparation read
• Chapter 7 (M A 2nd Edition)
• Or Chapter 6 (M A 1st Edition)
• Describe key concepts
• Analysing accounts
• Ratios
• Exercises
• M A (2nd Ed.) Exercise 7.3 (pages 239-240)
  and Exercise 7.5 (pages 241-242)
• Or M A (1st Ed.) Exercise 6.3 (pages 215-216)
  and Exercise 6.5 (pages 217-218)