Analysis and Interpretation of Financial Statements

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equity Income statement report on operating profit Balance sheet lists assets and indicates the parties who have a claim

1 Analysis and Interpretation of Financial Statements Prof Pieter Pelle INTRODUCTION Objective of financial reporting provide information for decision making Primary statements income statement, balance sheet and statement of changes in equity Income statement report on operating profit Balance sheet lists assets and indicates the parties who have a claim against those assets Financial analysis to gain further information not immediately apparent from reading the financial statements 1

2 OBJECTIVES OF ANALYSIS Financial analysis can be defined as knowing what to look for and how to interpret it The needs of the user will determine the objective TYPICAL NEEDS OF USERS ARE: Determine whether enterprise achieved its main objective maximisation of profit Determine whether enterprise can repay interest and long-term debt Determine whether enterprise can service its short-term debt from liquid funds Determine whether enterprise will be able to honour commitments to guarantee supplier To establish where the problem areas are for underperforming To establish if investments yield a fair return 2

3 NATURE AND SCOPE OF ANALYSIS The nature and scope of analysis will differ for each objective Determine who the user is Determine the purpose of information required STEPS IN FINANCIAL ANALYSIS Select Compare Evaluate Predict 3

4 SELECT What is the purpose of the analysis? What are the appropriate tools to use? With other companies COMPARE With previous years With the industry With budgets With ideal targets 4

5 EVALUATE Is it good or bad? Was the result expected? If bad, why? If good, maintainable? Who/what is responsible? PREDICT What is likely to happen if no action is taken? What improving action is possible? 5

6 ANALYSIS WITHIN THE ENVIRONMENT CONTEXT Numerous factors impact on the business operation of any company These factors include: Variables within the company itself Variables in the company environment (external variables) VARIABLES IN THE COMPANY S ENVIRONMENT (EXTERNAL VARIABLES) The global economy The national economy The industry 6

7 THE INDUSTRY Company operates within a broader industry e.g. - the retail industry Factors to be considered are: Type of operation Type of product Location Clientele Suppliers Competition ANALYSIS OF INTERNAL VARIABLES Once the entity profit has been completed, it is necessary to evaluate the prospects of the company Future outlook of the company The quality of management The future turnover 7

8 RATIO ANALYSIS Most popular of all analytical techniques Strengths and limitations must be explored There exists a plethora of possible ratios Objective of the analysis is the criteria used when deciding upon the relevant ratios to be selected The strength of ratio analysis lies in comparison with a benchmark APPLICATION OF STRUCTURE RATIO ANALYSIS Ratios are classified in accordance with selected criteria used Five major areas of interest to analyse have been identified: Profitability Liquidity Efficiency Financial leverage Market 8

9 Example Bon Jovi Limited A listed company in the retail sector Main business is to purchase CDs from manufacturers which are then sold in bulk to retail outlets Bon Jovi Limited Balance Sheet at 30 June EQUITY AND LIABILITIES Shareholder s equity Non-current loans Current liabilities Creditors Other ASSETS Non-current assets Tangible assets Investments Current assets Inventory Debtors Cash resources

10 Bon Jovi Limited Income statement for the year ended 30 June Sales (gross revenue) Cost of goods sold Gross margin Revenue from investments Expenses Operating expenses Selling expenses Depreciation Net operating profit Interest Net profit before tax Taxation Net profit attributable to ordinary shareholders Income statement continued Net profit attributable to ordinary shareholders Dividends Retained profit for the year (1 094) Retained profit at the beginning of the year Retained profit at the end of the year Earnings per share 23.29c 6.35c 27.25c 47.31c Dividends per share 12c 10c 12c 14c Quoted share price (JSE) Highest price of the year Lowest price of the year Closing price Additional information All sales and purchases are on credit Information for 20X0: Sales R ; share price on 1 July, 186 cents Issued capital comprises 30 million shares of R1 10

11 PROFITABILITY RATIOS We have selected five primary aspects of profitability which are commonly identified. They attempt to reflect the profit per rand of sales or the profit per rand of capital invested. They are: gross margin; net margin; return on assets before interest and tax; return on capital employed; return on equity GROSS MARGIN PERCENTAGE Gross margin 100 Gross margin = Sales x = x 1 = 16.3% GROSS MARGIN (GM) This ratio indicates the percentages by which the total selling price is greater than the cost price.a gross margin percentage of 16.3% indicates that for every R1 of sales, 16.3c was gross profit.the remaining 83.7c cents in each rand is the cost price of the goods. 11

12 NET MARGIN PERCENTAGE Net profit to ordinary shareholders 100 Net margin percentage = Sales x = x 1 = 5.2% NET MARGIN (NM) The net margin percentage of 5.2% indicates that for every R1 of goods sold, 5.2c eventually becomes profit attributable to the ordinary shareholders. If turnover increases, then each time R1 is received, 5.2c will accrue to ordinary shareholders as net profit. RETURN ON ASSETS BEFORE INTEREST AND TAX (ROABIT) Net operating profit 100 ROABIT = Total assets x = x 1 = 27.7% ROABIT 20.9% 6.7% 21.5% 27.7% This ratio indicates how well total assets have been used in earning profit, before any parties are rewarded by distribution of the profit, including the South African Revenue Service, in the form of tax and the providers of debt capital by way of interest. Every rand invested in total assets earned 27.7 cents. 12

13 RETURN ON CAPITAL EMPLOYED (ROCE) Net operating profit 100 ROCE = Shareholders equity + Long-term loans x = x = x 1 = 34.1% ROCE 23.8% 7.7% 26.0% 34.1% A return of 34.1% indicates that for every R1 of total long-term capital employed, 34.1c has been earned before tax. Thus 34.1c in every R1 is available to pay interest, tax and shareholders. RETURN ON EQUITY (ROE) Net operating profit to ordinary shareholders 100 ROE = Shareholders equity x = x 1 = 24.0% ROE 15.3% 4.3% 16.6% 24.0% The return on equity is the residual net profit which is available to ordinary shareholders. A return of 24% is likely to be considered as more than satisfactory by the shareholders. 13

14 OTHER FACTORS TO CONSIDER: RETURN ON ASSETS INVESTED IN OPERATIONS BEFORE INTEREST AND TAX Net operating profit investment revenue 100 ROA (operations) = Total assets investments x = x = x 1 = 28.4% RETURN ON ASSETS INVESTED OUTSIDE BUSINESS OPERATIONS Revenue from investments 100 ROA (in investments) = Investments x = x 1 = 16.0% ROA (operations) ROA (investments) 19.9% 24.8% 3.7% 20.0% 22.9% 10.2% 28.4% 16.0% Investment returns were higher than returns from operations between and. Revenue from investments in the last two years indicates a poor return. 14

15 LIQUIDITY RATIOS These ratios help to determine whether a company will be able to meet its financial obligations in the short term. Two ratios have been selected, both of which are frequently used by management. They are: current ratio; acid test ratio CURRENT RATIO Current assets Current ratio = Current liabilities = = 1.61 expressed as 1.61 : 1 Current ratio From a scrutiny of the balance sheet, it is apparent that the current liabilities have increased relatively more than the current assets over the four-year period. 15

16 ACID TEST RATIO (Current assets inventory) Acid test ratio = Current liabilities ( ) = = = 0.68 expressed as 0.68 : 1 Acid test ratio This ratio is the real test of liquidity, as it removes inventory, which is not easily converted into cash, from the calculation of current assets. In order to interpret this ratio, it may be said that the company has 68 cents in cash or near cash to meet every R1 which will require payment in the short term. EFFICIENCY RATIOS Five ratios have been selected to assess the efficiency of the company in managing its fixed and current assets. Assets are compared to turnover in order to see how the relative use of assets over the period has performed in generating sales rands. The three most important working capital items are also tested in order to determine whether they have been efficiently used. The five ratios which will be calculated are: fixed asset turnover (turnover is another word for sales or gross revenue); total asset turnover; days inventory; debtors collection period; creditors settlement period. 16

17 Turnover Fixed asset turnover = Fixed assets = = 4.31 times FIXED ASSETS TURNOVER Fixed assets turnover This ratio indicates the extent to which fixed assets have been efficient in generating sales. It indicates that for every R1 invested in fixed assets, R4.31 was generated in sales during. Turnover Total assets turnover = Total assets = = 2.78 times TOTAL ASSETS TURNOVER Total assets turnover 20x x x x This ratio measures the extent to which total assets have generated sales. 17

18 DAYS INVENTORY Inventory x 365 days Days inventory = Cost of sales x 365 days = = days Day s inventory Days inventory indicates the quantity of inventory on hand in relation to the quantity purchased each day. Inventory is clearly the most significant current asset. Changes in this ratio have an impact on the current ratio. DEBTORS COLLECTION PERIOD Debtors x 365 days Debtors collection period = Credit sales x 365 days = = days Debtors collection period The debtors collection period shows how long debtors take to pay their accounts, by measuring the number of days from the date of sale to the date of payment. 18

19 CREDITORS SETTLEMENT PERIOD To calculate the time taken to settle debts with creditors, the credit purchases must be known. Credit purchases are calculated as follows: Credit purchases = Cost of sales + closing inventory opening inventory Creditors x 365 days Creditors settlement period = Credit purchases x 365 days = = days Creditors settlement period This ratio measures how long it takes the firm to pay its creditors. FINANCIAL LEVERAGE RATIOS These ratios examine the financing structure of the business. They focus on the combination of owner s equity and outside financing (long and short-term) used by the company. Three ratios have been selected for this purpose as follows: debt ratio; debt to equity ratio; interest cover. 19

20 DEBT RATIO Total debt 100 Debt ratio = Total assets x = x 1 = 40.4% Debt ratio 23.4% 31.5% 35.8% 40.4% The debt ratio has been defined as total debt compared to total assets. The total debt includes long-term loans and current liabilities. The ratio of 40.4% indicates that for every R1 used to purchase total assets, 40.4 cents of the financing was provided by parties other than the ordinary shareholders. DEBT TO EQUITY Long- term loans 100 Debt to equity = Shareholders equity x = x 1 = 36.6% Debt to equity 14.7% 25.1% 29.1% 36.6% This ratio may be interpreted to mean that for every R1 of capital provided by ordinary shareholders, 36.6 cents was raised through long-term loans. 20

21 INTEREST COVER Net operating profit before interest and tax Interest cover = Interest = = 7.07 times Interest cover The interest cover ratio, often referred to as times interest earned ratio shows the number of times which the net profit is able to cover the interest which is due. MARKET RATIOS Market ratios use information from the published stock exchange prices. In some instances a market value is selected and related to a book value in order to calculate the ratio, while in others two market values are related. Only ratios where both values are market generated can be classified as true market value ratios: return to shareholder; dividend yield; earnings yield; price earnings ratio. 21

22 RETURN TO SHAREHOLDER (RTS) Share price (end) share price (beginning) + dividends 100 RTS = Share price at the beginning of the year x 1 ( ) 100 = 198 x 1 = 35.4% Return to shareholder (20.1%) (3.0%) 73.6% 35.4% The ratio relates the actual cash income which an investor could have realised had the shares been purchased at the beginning of the year and sold at the end of that year. DIVIDEND YIELD (DY) Dividends per share declared during the year 100 DY = Share price at the end of the year x = 254 x 1 = 5.5% Dividend yield 8.8% 8.3% 6.1% 5.5% This ratio relates the cash receivable from dividends to the cash which could be realised if the share is sold. 22

23 Earning per share 100 EY = Share price x = 254 x 1 = 18.6% EARNINGS YIELD (EY) Earnings yield 17.3% 5.2% 13.8% 18.6% The earnings yield ratio relates earnings per share to the share price. Price per share P/E = Earnings per share 254 = = 5.4 times PRICE EARNINGS RATIO (P/E) P/E This ratio compares the book figure for earnings with the market figure for share price. It shows how much investors are prepared to pay per rand of reported profits 23

CHAPTER - VI RATIO ANALYSIS 6.3 UTILITY OF RATIO ANALYSIS 6.4 LIMITATIONS OF RATIO ANALYSIS 6.5 RATIO TABLES, CHARTS, ANALYSIS AND

CHAPTER - VI RATIO ANALYSIS 6.1 INTRODUCTION 6.2 NATURE OF RATIO 6.3 UTILITY OF RATIO ANALYSIS 6.4 LIMITATIONS OF RATIO ANALYSIS 6.5 RATIO TABLES, CHARTS, ANALYSIS AND INTERPRETATION OF DIFFERENT RATIOS