Learning Resources Corner

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1 Professional Development Programme on Enriching Knowledge of the Business, Accounting and Financial Studies (BAFS) Curriculum Learning Resources Corner Course 1: Contemporary Perspectives on Accounting Unit 4: Financial Analysis Financial statements report both on a firm s financial position at a point in time and on its financial performance over some time. However, the real value of financial statements lies in the fact that they can be used to help predict the firm s future earnings and dividends. From an investor s standpoint, predicting the future is what financial statement analysis is all about, while from management s standpoint, financial statement analysis is useful both to help anticipate future conditions and, more importantly, as a starting point for planning actions that will influence the future course of events. Scenario: Anson Ltd and Johnson Ltd operate in the business of electrical appliances trading. The following are the financial statements of Anson Ltd and Johnson Ltd for the year ended 31 December Balance sheets as at 31 December 2006 Anson Ltd Johnson Ltd $ 000 $ 000 Non-current assets Property, plant and equipment 50,000 15,000 Current assets Inventory 10,000 4,000 Accounts receivable 9,500 5,000 Bank and cash 1,500 2,500 21,000 11,500 Current liabilities Accounts payable 10,800 6,200 Current tax payable 1, ,000 7,000 Net current assets 9,000 4,500 Total assets less current liabilities 59,000 19,500 Long-term liabilities Bank loan (repayable on 31 December 2010) 16,000 6,000 Net assets 43,000 13,500 1 of 10 Learning Resources Corner

2 Capital and reserves Ordinary share capital, $1 each 8,000 5,000 8% Preference shares 4,000 2,000 Share premium 7,500 4,000 Retained profit 23,500 2,500 43,000 13,500 Income statements for the year ended 31 December 2006 Anson Ltd Johnson Ltd $ 000 $ 000 $ 000 $ 000 Sales 80,000 55,000 Less: Cost of goods sold Opening inventories 5,000 3,500 Add: Purchases 45,000 25,500 Less: Closing inventories 10,000 4,000 40,000 25,000 Gross profit 40,000 30,000 Less: Expenses Administrative expenses 4,500 2,900 Distribution costs 1,000 3,800 Interest expenses Depreciation 3,500 2,500 Other operating expenses 3,500 9,500 13,000 19,100 Profit before tax 27,000 10,900 Tax 3,000 1,500 Profit after tax 24,000 9,400 Dividend ordinary shares 1,000 1,000 Dividend preference shares Retained profit for the year 22,680 8,240 The market prices per share of Anson Ltd and Johnson Ltd on 31 December 2006 were $54 and $16 respectively. All the sales and purchases are on credit basis. 2 of 10 Learning Resources Corner

3 Question: How do we use different types of ratios to compare and comment on the (i) profitability, (ii) shortterm liquidity, (iii) long-term solvency and (iv) quality of an investment, of both companies for the year ended 31 December 2006 and determine whether it is worthwhile to invest in either company or both? Firstly, we may calculate the following ratios for the year ended 31 December 2006: (i) gross profit ratio; (ii) net profit ratio (before interest and tax); (iii) return on owner s equity (before tax); (iv) return on capital employed (before tax); (v) assets turnover; (vi) current ratio; (vii) liquid ratio; (viii) inventory turnover (in times) (based on average inventory); (ix) inventory holding period (in days) (based on average inventory); (x) accounts receivable turnover (in days); (xi) accounts payable turnover (in days); (xii) gearing ratio; (xiii) interest cover; (xiv) debt to equity ratio; (xv) earnings per share (EPS); (xvi) dividend cover; (xvii) dividend yield; and (xviii) price earnings (P/E) ratio. 3 of 10 Learning Resources Corner

4 Computation of ratios: Anson Ltd Johnson Ltd (i) Gross profit ratio Gross profit x 100% $40,000,000 x 100% $30,000,000 x 100% Sales $80,000,000 $55,000,000 = 50.00% = 54.55% (ii) Net profit ratio (before interest and tax) Profit before interest and tax x 100% ($27,000,000 + $500,000) x 100% ($10,900,000 + $400,000) x 100% Sales $80,000,000 $55,000,000 = 34.38% = 20.55% (iii) Return on owners equity (before tax) Profit before tax x 100% $27,000,000 x 100% $10,900,000 x 100% Owners equity (ordinary share capital + reserves) ($8,000,000 + $7,500,000 + $23,500,000) ($5,000,000 + $4,000,000 + $2,500,000) = 69.23% = 94.78% (iv) Return on capital employed (before tax) Profit before tax x 100% $27,000,000 x 100% $10,900,000 x 100% Owners equity + preference share capital + long-term liabilities [($8,000,000 + $7,500,000 + $23,500,000) + $4,000, ,000,000)] [($5,000,000 + $4,000,000 + $2,500,000) + $2,000,000 + $6,000,000] = 45.76% = 55.90% (v) Assets turnover Sales $80,000,000 $55,000,000 Total assets less current liabilities ($50,000,000 + $21,000,000 $12,000,000) ($15,000,000 + $11,500,000 $7,000,000) = 1.36 times = 2.82 times (vi) Current ratio Current assets $21,000,000 $11,500,000 Current liabilities $12,000,000 $7,000,000 = 1.75 = of 10 Learning Resources Corner

5 (vii) Liquid ratio Current assets less inventory $21,000,000 - $10,000,000 $11,500,000 - $4,000,000 Current liabilities $12,000,000 $7,000,000 = 0.92 = 1.07 (viii) Inventory turnover (in times) Cost of goods sold $40,000,000 $25,000,000 Average inventory ($5,000,000+$10,000,000)/2 ($3,500,000 + $ 4,000,000) / 2 = 5.33 times = 6.67 times (ix) Inventory holding period (in days) Average inventory x 365 days ($5,000,000+$10,000,000)/2 x 365 days ($3,500,000 + $ 4,000,000) / 2 x 365 days Cost of goods sold $40,000,000 $25,000,000 = days (say 69 days) = days (say 55 days) (x) Accounts receivable turnover (in days) Accounts receivable x 365 days $9,500,000 x 365 days $5,000,000 x 365 days Credit sales $80,000,000 $55,000,000 = days (say 44 days) = days (say 34 days) (xi) Accounts payable turnover (in days) Accounts payable x 365 days $10,800,000 x 365 days $6,200,000 x 365 days Credit purchases $45,000,000 $25,500,000 = days (say 88 days) = days (say 89 days) (xii) Gearing ratio (Long-term liabilities + preference share capital) x 100% (Owners equity + preference share capital + long-term liabilities) ($16,000,000 + $4,000,000) x 100% [($8,000,000 + $7,500,000 + $23,500,000) + $4,000, ,000,000] ($6,000,000 + $2,000,000) x 100% [($5,000,000 + $4,000,000 + $2,500,000) + $2,000,000 + $6,000,000] = 33.90% = 41.03% (xiii) Interest cover Profit before interest and tax ($27,000,000 + $500,000) ($10,900,000 + $400,000) Interest $500,000 $400,000 = times = times 5 of 10 Learning Resources Corner

6 (xiv) Debt to equity ratio Total debts (Long-term liabilities + current liabilities) x 100% Owners equity ($16,000,000 + $12,000,000) x 100% ($8,000,000 + $7,500,000 + $23,500,000) ($6,000,000 + $7,000,000) x 100% ($5,000,000 + $4,000,000 + $2,500,000) = 71.79% = % (xv) Earnings per share (EPS) Profit after tax - preference dividends $24,000,000 $320,000 $9,400,000 - $160,000 Weighted average number of ordinary shares outstanding 8,000,000 5,000,000 = $2.96 / share = $1.85 / share (xvi) Dividend cover Profit after tax - preference dividends $24,000,000 - $320,000 $9,400,000 - $160,000 Ordinary dividends $1,000,000 $1,000,000 = times = 9.24 times (xvii) Dividend yield Ordinary dividends per share x 100% ($1,000,000 / 8,000,000 x 100%) ($1,000,000 / 5,000,000 x 100%) Market price per share $54 $16 = 0.23% = 1.25% (xviii) Price earnings (P/E) ratio Current market price per share $54 $16 Earnings per share $2.96 $1.85 = times = 8.65 times 6 of 10 Learning Resources Corner

7 Interpretation of ratios: We can now use the above ratios to compare and comment on the (i) profitability, (ii) short-term liquidity, (iii) long-term solvency and (iv) quality of an investment, of both companies for the year ended 31 December It is important to note that there is no set solution for ratio interpretation. Users of financial statements may analyse and interpret the companies in different ways, dependent on their experience on financial analysis and their particular interests. Below we produce some relevant points that are probably to be covered for the interpretation of ratios. (i) Profitability Johnson Ltd achieved a slightly higher gross profit ratio of 55% as compared with 50% of Anson Ltd. It shows that Johnson Ltd has the ability to increase selling price and to reduce the cost of goods sold in order to attain a higher gross profit than Anson Ltd. Despite a lower gross profit ratio, Anson Ltd achieved a net profit ratio of 34%, significantly higher than the ratio of 14% for Johnson Ltd. This was mainly because of comparatively lower operating expenses incurred by Anson Ltd. However, Johnson Ltd was more efficient in utilising the owners equity and capital employed to generate profit in that its return on owners equity was 95% as compared to the ratio of 69% for Anson Ltd and its return on capital employed was 56% as compared to the ratio of 46% for Anson Ltd. Johnson Ltd was also more efficient in utilising its assets to generate sales as its assets turnover was 2.8 times as compared to 1.4 times for Anson Ltd. Since Johnson Ltd has higher gross profit ratio, return on owners equity, return on capital employed and assets turnover, we may conclude that Johnson Ltd performed better in terms of profitability. (ii) Short-term liquidity Both the current ratio (1.67) and liquid ratio (1.07) of Johnson Ltd indicate that the company has better short-term liquidity than Anson Ltd. Anson Ltd s corresponding ratios of 1.75 and 0.92 indicate that it might have liquidity problem in settling short-term liabilities, as the liquid ratio was below the yardstick of 1. The lower inventory turnover and higher inventory holding period of 5.3 times and 69 days respectively indicate that Anson Ltd holds greater level of inventories than Johnson Ltd and thus funds were tied up that could be invested elsewhere for a return. The ratios may also suggest that Anson Ltd had certain inventories that were slow moving or obsolete. The accounts receivable turnover for Anson Ltd was 44 days while for Johnson Ltd was 34 days. Anson Ltd might have granted a longer credit period to customers than Johnson Ltd in order to boost a higher level of sales. The accounts payable turnover for Anson Ltd and Johnson Ltd are nearly the same. Since Johnson Ltd has higher current ratio, liquid ratio, inventory turnover and accounts payable turnover, we may conclude that Johnson Ltd performed better in terms of short-term liquidity. 7 of 10 Learning Resources Corner

8 (iii) Long-term solvency Johnson Ltd s gearing is higher than that of Anson Ltd as meausured by both gearing ratio and debt to equity ratio. This is partly because Johnson Ltd has a large proportion of preference share capital and long-term bank loan. High gearing indicates a high financial risk that may lead to potential financial distress of a company. Both gearing ratios of Anson Ltd and Johnson Ltd (34% and 41% respectively) are considered acceptable. The interest cover* of Anson Ltd (55 times) and Johnson Ltd (28 times) was both high. There is no doubt on the ability of both companies to repay interest out of its profit. We may conclude that Anson Ltd s ability to meet its long-term obligations was better than Johnson Ltd. *Readers may note that dividend payments on preference shares classified as liabilities are recognised as interest expenses in accordance with HKAS 32 Financial Instruments: Presentation. If the reclassification is made, the interest-related ratios (including interest cover) will be affected. (iv) Quality of an investment The EPS of Anson Ltd was $2.96 per share, that was higher than $1.85 per share of Johnson Ltd. EPS indicates what the earnings are for each ordinary share held and is a traditional measure of the company s financial performance. The dividend cover of Anson Ltd was 23.7 times, that was higher than 9.2 times of Johnson Ltd. Dividend cover indicates the number of times the ordinary dividends are covered by the profit available for distribution. In this case, it seems that larger proportion of profits were retained by Anson Ltd for future investment opportunities to achieve earnings growth in the future. The dividend yield of Anson Ltd was 0.23%, which was lower than 1.25% of Johnson Ltd. Investors presumably would prefer to invest in Johnson Ltd if they invest primarily to receive a stream of dividend. The P/E ratio of Anson Ltd was 18.2 times, which was higher than 8.7 times of Johnson Ltd. The value of the P/E ratio reflects the market s appraisal of the ordinary share s future prospects. The higher P/E ratio of Anson Ltd implies that investors would reasonably expect its earnings to increase faster than those of Johnson Ltd. Conclusion The profitability and short-term liquidity measures of Johnson Ltd were better than Anson Ltd. The long-term solvency ratios, however, reveal that Anson Ltd appears to have better ability to meet the long-term debt obligations. Anson Ltd has retained profit and cash for future investment to generate earnings growth. As reflected in the high P/E ratio, investors are confident in the management and long-term prospects of Anson Ltd and it is expected that the market value of Anson Ltd s ordinary shares will likely to rise. In conclusion, we would prefer to invest in Anson Ltd s ordinary shares. 8 of 10 Learning Resources Corner

9 An integrated analysis of ratios: The ratios stated in the power point measure such diverse aspect of the company s profitability, short-term liquidity and efficiency, long-term solvency and investment ratios. The discussion has focused on the characteristics of individual ratios. Comprehensive financial analysis requires a review of three interrelationships among ratios: Economics relationships. Interdependent changes in various components of the financial statements stem from underlying economic relationships. For example, higher sales are generally associated with higher investment in working capital components such as receivables and inventory. Ratios comprising these elements should be correlated. Overlaping of components. The components of many ratios overlap due to the inclusion of an identical term in the numerator or denominator, or because a term in one ratio is a subset or component of another ratio. Change in one of these identical term will change a number of ratios in the same direction. Similarly, ratios that aggregate other ratios can be expected to follow patterns overtime consistent with those of their components. For example, the current ratio is essentially a aggregation of the individual current assets. Trend in this ratio will mirror those observed in liquid ratio, inventory turnover ratio and accounts receivable turnover ratio. Ratios as composites of other ratios. Some ratios are related to other ratios across categories. For example, the return on capital employed (ROC) before interest and tax is a combination of two profitability ratios: 1. Assets turnover 2. Net profit ratio (before interest and tax (EBIT)) Sales EBIT ROC = X Total Assets less current liabilities Sales A change of either of the ratios on the right-hand side will change the return on assets as well. The interrelationships among ratios have important implications for financial analysis. Disaggreation of a ratio into its component elements allows us to gain insight into factors affecting a firm s performance; for example, significant changes in ROA may be best understood through an analysis of its components. Further, ratio differences can highlight the economic characteristics and strategies of: The same firm over time; Firms in the same industry; Firms in different industries; Firms in different countries. These relationships among ratios imply that one might be able to ignore some component ratios and use a composite or representative ratio to capture the information contained in other ratios. 9 of 10 Learning Resources Corner

10 Readings & References Andy TM Li, Patrick PH Ng (2005) Introduction to Financial Statement Analysis, Financial Accounting, pp Linda WW Yau, Richard CK Yau (2001) Accounting Ratio Calculation and Interpretation, Bookkeeping and accounts, pp Geoffrey Holmes, Alan Sugden and Paul Gee (2005) Historical summaries, ratios and trends, Interpreting Company Reports and Accounts, pp Spiceland, Sepe, Tomassini (2007) The Balance Sheet and Financial Disclosures, Intermediate Accounting, pp Bodie, Kane, Marcus (2005) Macroeconomics and Industry Analysis, Investments, pp Bodie, Kane, Marcus (2005) Financial Statement Analysis, Investments, pp of 10 Learning Resources Corner

ARCUS Spółka Akcyjna

ARCUS Spółka Akcyjna www.arcus.pl Consolidated financial statement of Arcus S.A. Capital Group for the financial 31 December 2015 Warsaw, 21 March 2016 1 1 Data regarding the annual financial statement