Ian McIsaac

Tailored and Public Courses

4

FINANCIAL ANALYSIS

4.1

Overview

Balance Sheet strength
Liquidity: The short run financial capacity to meet obligations and move opportunistically.

Leverage: The balance of debt and equity for long run risk/return tradeoffs.

Operating Performance: The ability to generate returns from the efficient employment of assets and capital.

Cashflow Strength: The ability to service debt, pay dividends and taxes and to make discretionary expenditures (such as capital expenditure).

4.2

Financial Ratios

4.2.1

Ratio Comparisons

a) Historic

This is where we need to compare the company against its own past record. Ratios can be used to assess previous performance by looking at trends over a number of periods (this involves looking at the ratios horizontally). Such an exercise will give us a good idea of what is changing, or indeed not changing. To ensure meaningful analysis of ratios, a minimum of three years financial information is required.

b) Industry

We can carry out a peer group analysis i.e. information we can obtain about the industry. Certain ratios can be “standard” across an industry. However, if you are comparing different business within the same industry, take care to think about:

• the size of the company
• accounting procedures
• product mix
• geographical spread

There is one further comparison which we have not yet mentioned and that is the vertical comparison i.e. if one ratio is increasing what impact can this have on another ratio? It is important to understand the impact that a change in one ratio has on another. If there are contradictory movements in related ratios, this should lead you to question and to investigate why, to understand how the risk in the business is changing.
For example, a decrease in the gross profit margin could have a knock on effect to:

• the net profit margin
• an increase in gearing caused by increased borrowings to compensate for lower profitability.

If the reverse was the case, it could mean higher contribution from sales to cover overheads leading to an improvement in the net profit margin and perhaps a decrease in borrowing.

Conclusion
Ratio comparison is essential to gauge the financial effect of the management decisions. Also look at the vertical connections to see whether the changes that are occurring do fit with what we know about the business.

Do not forget, comparing figures will in itself prove nothing but should raise questions in our minds which we need to direct towards the management of the business.

4.3

Ratio Analysis

4.3.1

Section C - Cashflow

• A broad measure of the business’s ability to meet all of its short-term financial obligations from core cash flow.

• Indicates the ability to service total interest commitments from cash generated from operations.
• Compared to Interest Cover in Section S (stake) this ratio gives a far better indicator, given that profit is not equivalent to cash.

4.3.2

Section L – Liquidity

• The number of times the business’s short term assets cover its short term liabilities i.e. a measure of the business’s ability to meet its day to day commitments.

• Technically if the ratio falls below 1.1 then the business is illiquid, although the trading practice within the industry may make this acceptable (e.g. food retailers) and comparison needs to be made with others in the same industry.

It is essential when analysing this ratio to look at a number of factors such as the nature of the business, the quality of the assets and the seasonality of its trading.
• Who are the debtors/how well spread/age/how easy to ‘realise’?
• How saleable is the stock?
• If there is cash – where is it and is it, say, not tied up in overseas companies?

Although the current ratio is a banker’s traditional favourite, it is unfortunately one of the worst for predicting failure.

Quick Assets = Current Assets less Stock and Work in Progress (W.I.P.)

• A more conservative ratio than the current ratio as it removes stock and W.I.P., which reflects the assumption that these items will often take longer to convert to cash than the other current assets.
• If the acid test is appreciably lower than the current ratio this indicates that stock constitutes a large portion of current assets. Comparison of the ‘gap’/difference between current/acid test must therefore be monitored and particularly if the gap is widening, period on period, then stock investigations need to be made.

4.3.3

Section A – Asset Management

• A broad measure of asset efficiency. A ratio of 1.2 means that the business generates £1.20 of sales for each pound invested in assets.
• The ratio is a measure of capital intensity, with a low asset turnover signifying a capital-intensive business and a high turnover the reverse.

• One of the so-called activity ratios that measures the average time in days that it takes to collect payment from debtors and hence indicates the ability of management in controlling/collecting payments from trade debtors – compare with terms of trade and industry norms if these are available.

An increase in the ratio is generally a poor sign and could signify:

• Selling to larger, financially stronger customers who demand/take longer periods of credit.
• A build up of bad debts within debtors figure.
• Customer selling to less reputable/weaker customers who take longer to pay, in an effort to hold/increase sales levels.
• A relaxing of credit control
• A general decline in the industry or economy putting pressure on all ‘parties’ in the industry.

• Indicates the efficiency of stock control.
• Indicate the rate at which stocks & W.I.P. are turned into cash and therefore profit.
• Long and increasing period may indicate obsolete/unsaleable stocks being held.
• Check the ‘split’ between stock and W.I.P. where increasing W.I.P. could indicate inefficiencies in production processes and management.

All fluctuations need to be investigated:
• Increasing ratios could be a bad sign (see above) but new products/change in product mix could be a satisfactory explanation.
• Falling ratios could be a good sign but if the business is ‘forced’ to sell from stock to protect/preserve cash flow then the opposite may be the case.

• Indicates the length of credit in days taken from suppliers and extent therefore of reliance on creditors – compare with terms of trade and industry norms.
• Can be used to gauge the contribution made by suppliers (creditors) to working capital management – but care, excessive utilisation over the terms of trade may render the business vulnerable to loss of goodwill and pressure from creditors.
• Investigate particularly increases in this trend, which may be as a result of pressure on the business’s cash flow.

N.B. If cost of sales includes a substantial portion of non-supplier element – i.e. direct labour, machinery costs etc. the ratios will be distorted although still revealing a trend period on period (providing make up of cost of goods remains the same).

NWA includes only those current assets and current liabilities that vary in direct proportion to sales turnover assuming the terms of trade and stock-holding policy remain the same. It is a useful measure of the amount of money that is tied up in funding the day-to-day trading activities of the business.

• Provides a measure of the business’ efficiency in employing working capital to generate sales.
• Provides therefore a rough and ready guide to the likely amount of additional working capital funding required from a given increase in sales. If the net working assets to sales ratio is 15% this means that the company has to invest 15 pence in working capital for every incremental £1 of sales. Companies with high cash conversion cycles (see chapter three) will have to invest higher amounts.

4.3.4

Section S – Stake

• Indicates the capital sufficiency or insufficiency of the business.
• Indicates the extent to which a business relies on borrowed funds compared to shareholders funds. Total External Finance refers to interest-bearing liabilities.
• The more highly geared the business, the more vulnerable it is to a downturn in cash flow and profits, as the interest burden will become disproportionately heavier and thus restrict the scope for further borrowings. More seriously, the business may not be able to meet its debt repayments as they fall due.

Increases in the ratio could be caused by:

• Losses – reducing capital resources
• Sales increasing rapidly, with working capital funding requirement (see Net Working Assets to Sales) increasing faster than profit, requiring increased debt to finance ‘the gap’.
• A build of fixed assets (funded by borrowings) that are not making an adequate contribution to profitability.
• Margins depressed as a result of competition perhaps with a fall-off in profit and retained profits in the business.
• A low ratio may indicate the extent to which the business could raise further funds.
• Gearing varies from industry to industry, company to company. There is no “ideal” gearing ratio – the situation has to be assessed on a case by case basis and looked at in the context of the strength of the company’s cash flow and business risk.

• Indicates the extent to which a business relies on all liabilities compared to shareholders funds.
• Like gearing, a higher and increasing ratio indicates an increasing financial risk.
• In comparing leverage to gearing:

- If gearing is increasing whilst leverage remains static (or reducing) then external finance (borrowing) is taking the place of other creditors – if the reverse movement is seen, then there is more reliance on other creditors.
- Compare also with movements in Trade Creditors Period ratio.

• Indicates the extent to which a business is generating profit to meet its interest commitments.
• As long as a business is generating high levels of profits and interest rates are low, then it should be able to carry a large debt burden, i.e. cope with high levels of gearing, provided it is also generating sufficient operating cash flow to meet debt maturities as they fall due.
• A ratio of 1.0 occurs when the underlying profit before interest is sufficient only to cover the interest charge and allowing no profit retention to grow the capital base of the company.
• A ratio of less than 1.0 indicates potentially serious problems which cannot continue over long periods.

• Indicates the number of times the profit after tax covers the company’s declared dividend or drawings.
• If the ratio is less than 1.0 the directors are paying more to the shareholders than the company earned.

4.3.5

Section P – Profitability

• Reasonable sales growth is normally “a good thing”. It indicates an increasing market share or an expanding market or both.
• A negative sales growth may indicate that the company has cut out unprofitable lines and therefore improved the overall situation for the company or it may indicate that the company’s market is shrinking and/or its market share is decreasing

• Any material changes in this ratio must be questioned, as this ratio provides the measure of profitability of the core business of the business. A measure of success in the marketplace.
• Depreciation can on occasions be included within cost of sales, which will have an effect on gross profit. We need to enquire as to any changes in depreciation policy as this will have an impact on gross profit.
• A fall in the ratio whilst generally a poor sign could occur due to a change in the method of stock valuation. Look at the notes to the accounts to identify whether this is taking place.
• Any change in product mix where different margins apply will affect the overall margin. Does the management have separate management information to assist the company in understanding its impact?
• A rising ratio could be:

- Increased efficiency
- New cheaper raw material supplier utilised. Is quality affected?
- Discounts received on bigger raw material orders
- Cheaper labour costs when moving overseas

• This ratio provides a further measure of the efficiency of the business.
• It will be controlled by the pricing policy of the business along with its control of overheads.
• Different industries will achieve different returns e.g. manufacturing expects higher margins than food retailer which relies on high volume, low margins.
• If this ratio is out of line with gross margins, investigate the cause. Have overheads increased or decreased and why? Can they be controlled or are they sustainable?
• How significant are the overheads to overall profitability?
• Has there been a change in the depreciation policy?
• Have costs moved from being variable to fixed or vice versa?

• This ratio measures the return on all capital employed (including long-term debt as well as equity) against all net income (core and non-core business) before tax and interest.
• The business’s performance should be judged on ROCE, as it will not continue for long, without support, unless this return exceeds at least the cost of borrowing.

• A comprehensive measure of a company’s performance, especially from an equity investor’s perspective.
• From the banker’s perspective he needs to ensure that the equity investors are happy with the return from a company, given the level of risks involved in the company.

Some analysts place too much reliance on ratio analysis. Empirical studies such as those conducted by Professor Beaver demonstrate that such ratios are not reliable predictors of failure. Professor Altman invented the Z-Score – a weighted composite of financial ratios, but though a better predictor of failure than many individual ratios, it still could not achieve the 99% reliability required by the banker.