Lesson 7

ANALYSING FINANCIAL STATEMENTS (1)

The set reading for this lesson is: Black, Chapter 10 and from the Readings section: Moon and Bates, Core Analysis in Strategic Performance Appraisal

Audio Clip
Before beginning this lesson, you should first listen to the Lesson 7 audio clip Analysing Financial Statements (1).

Copyright 2008 University of Warwick

7.1 Introduction
Back in Lesson 1, we discussed measuring performance and introduced accounting as a method of assessing how well organisations are performing. Looking at profit and loss accounts and balance sheets can reveal some aspects of this and we have already used common size analysis in Lesson 2. Here we start to use the information provided in published accounts more intelligently and attempt to find answers to further questions regarding performance, strategy and organisational flexibility. The lesson splits into the following sections: g a framework for financial analysis g performance ratios g working capital ratios g liquidity and solvency ratios g the shareholders view g assessing the numbers. Bear in mind that there are two lessons on financial analysis and that we shall ignore some technical difficulties in this one and return to them in Lesson 8. For example, we will use a simplified set of accounts for calculating ratios here, and then consider the problems of picking the numbers from a full set of accounts in Lesson 8. We will leave consideration of the effects of accounting policy choice on analysis until Lesson 8 too. Reading Black Chapter 10 would be useful at this point. We will then go over some of the same ground, but with more detail especially in the next lesson.

7.2 A framework for financial analysis

It is all too easy to get carried away with producing masses of numbers that have little meaning. Writing a spreadsheet to compute the list of ratios that we will eventually complete in this chapter is a fairly

The Warwick MBA: Accounting and Financial Management

Lesson 7

straightforward task, and it would be easy to think that once such a spreadsheet was written, analysing a companys accounts would be simply a matter of entering the data from the financial statements and then looking at the resulting ratios and figures. As long as we were treating financial analysis as a recreational exercise, with little or no intrinsic worth beyond the personal satisfaction achieved from the completion of the table of numbers, then this approach would be quite adequate. However, most people have sufficiently interesting lives that they are able to find better leisure activities. Financial analysis is only undertaken because there is a question that needs answering. Common business questions that need financial analysis include: g From which potential supplier should we purchase? g Should we supply this customer? g Would this company be a good one for which to work? g What level of pay rise could the company afford to pay? g Which of our customers should we regard as strategic? g What can we learn about our competitors? g What are the long-term prospects for our competitors? g Should we consider acquiring this company? Note that these questions would be asked by a wide variety of people both within and outside the organisation; so the level of pay rise the company could afford to pay might be asked, perhaps, by an outside agency such as a trades union. Note also that in answering these questions financial analysis that is, interpreting the financial statements will only be a part of the answer. As we have mentioned before, understanding the industry and the background to the situation is vital. The reading provided for this lesson, Moon and Bates (1993), introduced a model for financial analysis which is known by the mnemonic CORE. The central thrust of this is to make sure the analyst understands the competitive environment, the company itself and has an overview of the success or failures of the company, before rushing into a myriad of calculations. In other words, we need to have captured the big picture before we look at the detail. The aim of the exercise is to evaluate the company, so the final stage of the model is to pull together all the information gained. CORE stands for: C Context O Overview R Ratios E Evaluation We will consider each element of the model.

The Warwick MBA: Accounting and Financial Management

Lesson 7

7.3 Context
This is split into two sections external and internal.

7.3.1 External
Understanding the background to the industry in which the company operates is always the best place to start, and you will find this increasingly straightforward as your MBA studies progress. Some of the models introduced in marketing and strategy will enable you to describe the competitive environment clearly and to assess the relative strengths of players in the market. To begin with, the PEST (sometimes the letters are arranged in a different order!) model and Porters Five Forces model (Porter, 1980) provide enough information to give a feel for what is going on. I am sure that my marketing and strategy colleagues will introduce better or more complex models, but these should indicate the sort of information required in order to form an information backdrop to an analysis. PEST is short for Political, Economic, Socio-cultural and Technological. These are four areas of the wider environment that will affect all the players in an industrial context. Although it is sometimes difficult to decide where to place a particular feature of the environment, nevertheless it does make the analyst ask some good questions. To illustrate the context we will use the food retail industry in the UK. Whilst Tesco is involved in other markets food retail in other companies and other markets in the UK it is the companys core market. We will also consider the UK food retail industry as a case study during the September Seminar. So, for the food retailing industry in the UK, the following might be some relevant factors: g Political i. Planning regulations governing the placing of out-of-town stores. ii. Government attitude to competition discouraging further consolidation, for example. g Economic i. Rate of growth and stability of the economy. ii. Income distribution (you might put this under sociological). g Socio-cultural i. Demographic trends aging population. ii. Attitudes to health increasing concerns about healthy diet. g Technological i. Rise in the use of the Internet for shopping. ii. Credit cards.

The Warwick MBA: Accounting and Financial Management

Lesson 7

The five forces model is usually drawn as below:

Figure 7.1 Porters five forces

The aim here is to describe the key players in the competitive environment and consider their relative power and influence. Assuming we worked for Tesco, the market leader, the competitors are other food retailers and indeed, general retailers, as they expand their range into non-food in the countries in which it operates. New entrants would be potential competitors moving into the market, while alternatives are companies that meet customers needs in a different way the need to eat could also be satisfied by restaurants, for example. Customers are those who buy food from supermarkets and they could probably usefully be grouped into categories for assessing their needs and relative purchasing power some retailers use loyalty cards in order to gather such information in more detail. Finally suppliers are food processors and growers from whom the supermarkets buy their goods. If we were to look at each of these groups in more detail, we would be able to form a view on their relative strength and power and hence, likely future ability to make profits, for example. These models help us, but should not be followed blindly. They distort reality by trying to put complex situations into neat boxes and assume that the environment is external to the firm (exogenous), whereas relationships between the boxes in the Five Forces diagram are likely to be much more dynamic. They also have a tendency to describe the situation in a static way, when it is actually dynamic (that is, changing and evolving). Nevertheless, we can build up a useful picture of the environment and the place of our chosen target for analysis within it.

7.3.2 Internal
The internal context of the company requires us to consider a little of the companys past and how it is structured. Some companies provide interesting information on divisional structures and a little information

The Warwick MBA: Accounting and Financial Management

Lesson 7

on the relative profitability of the different divisions. A study of Marconi, for example, would show that the troubled Telecom equipment company had a history and management style steeped in manufacturing and power generation, rather than the fast-changing world of telecoms. Such a realisation may have made you think twice about the company as an investment, or indeed about having a trading relationship with Marconi. At one time, the shares were in excess of 12 and then fell rapidly to a few pence. The company is now on a firmer footing after a most unusual financial restructuring. Who owns the company? is a particularly important question to ask. When Tesco published its annual report for the year ending February 2006, one fund manager, Fidelity International, owned 5% of the shares, but no other company or individual owns over 3% (the level requiring to be disclosed in the UK). However, one of its key competitors in the UK, Sainsburys, has a large remaining family holding, which, arguably, affected its ability to respond to change during the 1990s. The character and background of key members of the management team might also reveal likely attitudes to risk and possible approaches to growing the company. If all the directors have grown up in the company then it would be fair to assume that the only likely strategy is more of the same. Indeed, any other would be high risk. The context provides the backdrop to understanding the companys financial performance. In a highly competitive market, any gain in margin may be an excellent achievement, for example.

7.4 Overview
Though we will probably have used the wordy parts of the annual review of a company, among other sources, to complete the context, we now turn to the financial numbers themselves. The key question here is: Are we looking at a successful, growing company? Again, answering this before producing a raft of numbers will make sure we interpret the numbers in context. Success, if measurable at all, comes in many forms. Answering questions such as those listed below would help us get to grips with whether we were examining a healthy, stagnant or declining organisation. g Did sales turnover grow last year? g Did operating profit rise? g Did the company increase its dividend payments to shareholders? g Was the company able to increase the level of profit retained last year? g Has operating cash flow improved? g Did capital expenditure increase? g Has debt increased? g Is the company employing more people?

The Warwick MBA: Accounting and Financial Management

Lesson 7

For much of this information, we turn our focus to the income statement, balance sheet and cash flow statement. In order to keep the numbers as simple as possible, a simplified version of Tescos accounts is set out below (Table 7.1). We will use these numbers for the rest of the lesson, returning to the full accounts for Lesson 8. Note that it has become custom and practice to put the latest year on the left and the year before on the right, though always check the top of the columns when reading a set of accounts.

Table 7.1 Tesco consolidated income statement

For financial year ending: 25 February 2006

2006 million % 100.0 92.3 7.7 1.9 5.8 0.2 6.0 0.6 0.3 5.7 1.6 4.0 0.0 4.0 0.0 4.0%

2005 million 33,866 31,231 2,635 683 1,952 74 2,026 235 103 1,894 541 1,353 6 1,347 3 1,344 % 100.0 92.2 7.8 2.0 5.8 0.2 6.0 0.7 0.3 5.6 1.6 4.0 0.0 4.0 0.0 4.0

Turnover Cost of sales Gross profit Administrative expenses Operating profit Other items Profit before interest Finance costs Finance income Profit before tax Tax Profit for the year Loss from discontinued operations Profit for the period Minorities Profit attributable to equity holders of the parent

39,454 36,426 3,028 748 2,280 82 2,362 241 114 2,235 649 1,586 10 1,576 6 1,570

Earnings per share Basic Diluted 20.70p 19.79p 17.44p 17.22p

The Warwick MBA: Accounting and Financial Management

Lesson 7

2006 As at 25 February 2006 Tangible assets Intangible assets Investments Total non-current assets million 15,882 1,525 1,237 18,644 % 70.4 6.8 5.5 82.6

2005 million 14,521 1,408 1,002 16,931 % 72.0 7.0 5.0 84.0

Table 7.2 Tesco consolidated balance sheet

Inventories Other Debtors: Trade Other Other Cash Current assets

1,457 175 530 362 70 1,325 3,919

6.5 0.8 2.3 1.6 0.3 5.9 17.4

1,306 3 459 310 0 1,146 3,224

6.5 0.0 2.3 1.5 0.0 5.7 16.0

Overdraft/Short term loans Trade creditors Other Current liabilities Net current liabilities Total assets less current liabilities

1,885 5,083 550 7,518 3,599 15,045

8.4 22.5 2.4 33.3 16.0 66.7

482 4,974 224 5,680 2,456 14,475

2.4 24.7 1.1 28.2 12.2 71.8

Bank loans, etc. Derivative liabilities Other creditors Pension obligations Provisions Non-current liabilities Net assets

3,742 294 349 1,211 5 5,601 9,444

16.6 1.3 1.5 5.4 0.0 24.8 41.9

4,563 0 517 735 6 5,821 8,654

22.6 0.0 2.6 3.6 0.0 28.9 42.9

Called up share capital Share premium Other reserves Preference shares Profit and loss account

395 3,988 40 0 4,957 9,380

1.8 17.7 0.2 0.0 22.0 41.6 0.3 41.9

389 3,704 40 0 4,470 8,603 51 8,654

1.9 18.4 0.2 0.0 22.2 42.7 0.3 42.9

Minorities Total equity

64 9,444

We will also require some other information which we can dig out of the annual report. Some of these numbers are easier to find than others: dividend relating to the year is the highlighted dividend per share (p. 2 of the Annual Report) multiplied by the number of shares.

The Warwick MBA: Accounting and Financial Management

Lesson 7

The percentage columns above are expressed as a percentage of total assets (non-current assets plus current assets), though this number is not shown in this particular format.
Table 7.3 Tesco other data

2006 Total assets Net cashflow from operating activities Capital expenditure Acquisition expenditure Net debt No. of shares (million) 22,563 2,619 2,561 54 4,509 7,783

2005 20,155 2,176 2,197 81 3,899 7,894

Market capitalisation million (year end) Dividends (p or cents per share) Employees (average FTE) Total payroll Depreciation

26,332 8.63 273,024 4269 838

24,011 7.56 242,980 3696 743

Using this information, we can now look at the answers to the eight overview questions we set ourselves.
Table 7.4 Tesco overview

million unless % Turnover % increase Operating profit % increase Retained profit % increase Operating cashflow % increase Market capitalisation % increase Capital and acquired expenditure % increase Total debt % increase Employees % increase

2006 39,454 17% 2,362 17% 898 20% 2,619 20% 26,332 10% 2,615 15% 5,627 12% 273,024 12%

2005 33,866

2,026

747

2,176

24,011

2,278

5,045

242,980

All these numbers have risen, although rising debt is not necessarily good. To work out the retained profit, the dividend figure was subtracted from the profit for the year retained profit is, effectively, the shareholders reinvesting in the business. Finally treat the number of employees figure with caution. Tesco gives us the full-time

The Warwick MBA: Accounting and Financial Management

Lesson 7

equivalent (FTE) number, but other companies do not. Bear in mind all the financial numbers need to grow by more than the rate of inflation in order to show real growth. If you are looking at a less successful company than Tesco and the company made a loss or had negative cashflow, then please be careful in calculating and interpreting the percentages. In such circumstances, recording the improvement or worsening as a number, rather than a percentage, can be clearer.

7.5 Ratios
Our next aim is to calculate a set of ratios, where each one answers an individual question regarding aspects of the companys performance. Having carried out the overview, we may have certain areas of the accounts and particular ratios where we wish to focus. There is no set or prescribed way of working out a ratio; the key is to use an appropriate method, given the business issue that motivated you to do the analysis. In this lesson, a fairly standard set of ratios will be calculated and briefly discussed. These fall into four distinct groups. Performance ratios address the issue of how well management performed with the resources at their disposal over the last year. Working capital examines the efficiency of management of inventory, debtors and creditors. Liquidity and solvency ratios focus on the level of financial risk the company has taken on. Finally the shareholder ratios consider the company from the investors angle. This final set will be developed further in Lesson 9. Caution needs to be used in both calculating and interpreting ratios. We will focus on calculating them in this lesson, and then consider the problems in Lesson 8. Here we will produce a complete set of ratios, so that you have a chance to consider each in turn. Before doing this we will finish the analysis model.

7.6 Evaluation
At the end of producing perhaps 20 ratios for two or three years, it would be easy to think that the task of analysis is over. However, remembering that there would have been a reason for undertaking this task, we need to bring together the information from the three earlier sections in order to draw a logical conclusion and recommend a decision to the rest of the management team. We will return to this once we have crunched the ratios.

The Warwick MBA: Accounting and Financial Management

Lesson 7

7.7 Ratio calculation

Whilst it might be good to look at a longer time horizon than two years, the introduction of IFRS means that any numbers before 2004 have not been adjusted and may, therefore, not be consistent in the method used to calculate them.

7.8 Performance ratios

Table 7.5 Tesco performance

2006 Return on net assets Gross margin Sales margin Asset turnover Sales per employee Profit per employee 15.70% 7.67% 5.99% 2.62 144,507 8,651

2005 14.00% 7.78% 5.98% 2.34 139,378 8,338

7.8.1 Return on net assets (RONA)

This is sometimes referred to as the key ratio. Return on capital employed (ROCE1) is worked out in much the same way. The idea behind the ratio is to give the percentage return generated by the company on the long-term capital tied up in the business. This concept was introduced in Lesson 1. The net assets figure is the noncurrent and current assets less the current liabilities giving the same number as the long term funding in the business. Profit is taken before interest and tax. To take the profit after interest and tax would normally be a mistake, as we are comparing the profit generated with the total of debt and equity invested in the business. To deduct interest on debt before the comparison would unbalance the ratio as one of the providers of capital would have been rewarded and the other, equity, not. The aim of the ratio is to assess management performance, regardless of where the financing has come from. Two otherwise identical companies with identical performance, but one with high debt, the other with low debt, ought to appear equal with this ratio, as each companys operating management have done an equally good job. The calculation for 2006 is as follows: Profit before interest 2,362 = = 15.70% Total assets less current liabilities 15,045 For a low-risk industry this seems an excellent level of return on capital.

10

The Warwick MBA: Accounting and Financial Management

Lesson 7

Return on capital employed is basically the same ratio. Only the presence of provisions stops the two ratios being identical as the two sides of the balance sheet must add to the same number.

7.8.2 Sales margin

Sales margin is also referred to as profit margin, as well as, confusingly, return on sales (not a term that will appear in your exam). Here we calculate the margin the company is able to make on sales in other words, how many pence in each pound of sales becomes profit. This is an important ratio in any industry and different industries will have very different levels of margin. The terms gross margin and net margin are sometimes used. The intention behind these figures is that the gross margin will assess the margin only after accounting for cost of sales and the net margin should be after all costs. The figures for Tescos margins in 2006 are: Gross margin: Gross profit Turnover Net margin: Profit before interest Turnover = 2,362 = 5.99% 39,454 = 3,028 39,454 = 7.67%

This will be of use within the organisation, but the level of information from published accounts makes such a distinction difficult, and potentially misleading, when comparing companies that have classified their costs in different ways. You could also use the operating profit in the net margin calculation.

7.8.3 Asset turnover

Most of you will have come across return and margin before, but asset turnover is not such a headliner. This is a shame as it is of equal importance as margin, as we shall see below. This ratio measures how well each pound tied up in the company has been used in generating turnover. Generally it is a good idea to take the same number here for assets as the figure used is RONA. Turnover 39,454 = = 2.62 for 2006 Capital employed 15,045 A little care is needed in interpreting this number, because if a company has old, depreciated fixed assets, then the asset turnover ratio will be high, but this may not be a good thing for the future prosperity of the company. We are using the closing balance sheet

The Warwick MBA: Accounting and Financial Management

11

Lesson 7

figures and a company with large capital investments, like Tesco, will not have been using all the assets all year, so the turnover will not have been generated by all the assets. An awareness that the asset turnover figure is a little understated is probably all that is required. Remember that companies are analysed in order to make decisions, not for the satisfaction of mathematical precision. Some textbooks suggest taking the average of opening and closing balance sheets, but this can introduce further problems and unnecessary extra calculation.

7.8.4 The relationship between sales margin and asset turnover

Why is asset turnover as important as sales margin? Because when the two are multiplied together, they produce the RONA. Sales margin asset turnover = return on net assets In Tescos case, 5.99% 2.62 = 15.70% ...allowing for a little rounding. So any change in either sales margin or asset turnover affects RONA. For a food retailer, Tesco has a very low asset turnover because, generally, it has modern, purpose-built stores that create a pleasant shopping environment, though at some cost. It would be possible for a low-cost food retailer, renting run-down shops, to have an asset turnover of seven. For the low-cost retailer a margin of 4% would still result in a RONA of 28%, better than Tesco. We will return to this and build upon the possibility of logically building ratio pyramids in Lesson 8.

7.8.5 Sales and profit per employee

These two ratios are obvious and straightforward. Having marked more exam scripts than I care to remember, the biggest problem seems to be in getting the decimal point in the right place! Tescos sales and profits are in millions, the people are not; hence we need to adjust our calculations to take account of this. Turnover per employee: Turnover x 1,000,000 39,454,000,000 = = 144,507 for 2006 Number of employees 273,024 Profit per employee: Profit before interest x 1,000,000 2,362,000,000 = Number of employees 273,024 = 8,651 for 2006 Rising sales and profits per employee show improving efficiency in the use of people. In some circumstances, people and capital are alternatives. A company with little technology will have a lot of people (high asset turnover, low sales per employee), whereas a high-tech

12

The Warwick MBA: Accounting and Financial Management

Lesson 7

competitor will have few people (low asset turnover, but high sales per employee). One cannot say that one is necessarily better than the other, but perhaps just different strategies for meeting different customer needs. Tescos figures are fairly flat, rising at 4%, just a little above inflation. Performance ratios are usually important in any company assessment. Any segmental information available might allow some or all of the above calculations to be worked out for each of the divisions of the company too. This would be useful in working out which parts of the organisation were performing better than others.

7.9 Working capital ratios

From the lesson on cash flows, you will recall that working capital needs to be managed tightly. A gradual reduction in inventory and debtors year by year would be anticipated by shareholders as a sign that management were improving control. However, if a company is growing sales, it would be unfair to compare the amount of inventory, debtors or creditors at the end of one year with the amount at the end of the next, without some adjustment for the increase in sales. If sales doubled, one might assume that inventory would need to double too, in order to support the additional selling activities, and, certainly, the level of outstanding payments from customers would rise. There are a number of ways of assessing working capital performance. The three ratios below are suggested because they have a common logic and could potentially be graphed together. Debtors are normally measured in this manner, inventory often is, but stock turn (how many times the inventory is turned over in a year) is also common.
2006 Stock days Debtor days Creditor days 14.6 4.9 57.9 2005 15.3 4.9 66.1
Table 7.6 Tesco working capital

7.9.1 Inventory days

Remembering that inventory is held at cost, we can work out approximately how many days of inventory are held at the year end by the following ratio: 365 x inventory 365 x 1,457 = = 14.6 days in 2006 Costs of sales 36,426 Multiplying by 365 just converts inventory as a proportion of annual costs into a more easily understood number. Occasionally companies have a long or short financial period and the 365 would need adjusting accordingly for each of these working capital ratios. So, at the year end, Tesco had 15 days of inventory.

The Warwick MBA: Accounting and Financial Management

13

Lesson 7

7.9.2 Debtor days

This is a very similar calculation to inventory days, but customers owe the selling price of the products, not just the costs. As with all other ratios here, this is just one suggested way of calculating a figure for understanding the level of debtor control. Receivables is an alternative word for debtors. 365 x debtors Turnover 365 x 530 = = 5 days in 2006 39,454

Be a little wary of the debtor figure from the balance sheet, as it can include other sums owed to the company besides trade debtors (that is, monies owed from customers). Many companies make the trade debtor number clear in a note to the accounts (indeed, we found 530 million in Note 16 of Tescos accounts); we will revise this number in Lesson 8.

7.9.3 Creditor days

In order to keep the calculation simple, a similar ratio is calculated for outstanding payments to suppliers. The trade creditors figure is often not displayed on the published balance sheet but will always be in the notes. Trade creditors at the year end are compared with the total costs for the period, less costs that do not involve payments to suppliers in the year payroll costs and depreciation. Both numbers will always be found in the notes to the financial statements. This proportion is then converted into days, as before.
365 trade creditors = Costs of sales + expenses payroll costs depreciation 365 5,083 = 58 days in 2006 36,426 + 748 4,269 838

Companies gain by paying their suppliers late keeping hold of cash as long as they can. However, this unethical approach has downsides too, so interpreting changes in this ratio as good or bad is not obvious. If it does lengthen considerably, then you may wish to consider whether the company can pay its suppliers perhaps cash is in short supply. The next set of ratios will take this last point further.

7.10 Liquidity and solvency ratios

Liquidity concerns the availability of short-term financial resources to meet upcoming bills. Solvency is a longer term concept concerning the level of debt in the company and how well positioned the company is to service the debt (that is, pay the interest).

14

The Warwick MBA: Accounting and Financial Management

Lesson 7

2006 Current ratio Acid test Interest cover Gearing 0.52 0.30 9.80 0.60

2005 0.57 0.34 8.62 0.59

Table 7.7 Tesco liquidity and solvency

The current ratio and acid test are liquidity ratios. Interest cover and gearing relate to solvency.

7.10.1 Current ratio

This compares the current assets of the business with the current liabilities. In other words, the level of funds flowing into the company in the near future, versus the requirement to pay out monies in the next 12 months. The lesson on cash showed the importance of cash management and that working capital management is a crucial part of this. Some textbooks suggest that this ratio needs to be two in order for a companys financial position to be safe. Tescos ratio shows this is profoundly untrue. Current assets = Current liabilities 3,919 = 0.52 in 2006 7,518

Other companies, especially those in heavy manufacturing, need a current ratio much higher than this to be safe from the threat of defaulting on financial obligations.

7.10.2 Acid test

Sometimes referred to as the quick ratio, this ratio assumes that the inventory may well take a while to become cash, and hence, recalculates the balance between current assets and current liabilities, without taking inventory into account. For Tesco, this is unduly cautious; for a manufacturer with a 20-week production period, it is probably judicious. Current assets less inventory 3,919 1,632 = = 0.30 in 2006 Current liabilities 7,518 Trends over time and comparisons between companies in the same industry would enable you to judge whether this is good management. Clearly if Tesco did not have a large cash balance the ratio would be much lower.

7.10.3 Interest cover

The downside of debt is having to pay interest on the sum outstanding. The more that is borrowed, the more interest that has to be paid. One way of assessing whether a company can afford the level of debt it has taken on is to compare the profit before interest and tax with the interest that needs to be paid.

The Warwick MBA: Accounting and Financial Management

15

Lesson 7

Profit before interest 2,362 = = 9.8 in 2006 Interest payable or finance expenses 241 This ratio states that Tescos profit covered the net interest 10 times a high and safe multiple. The more volatile the industry, the more one would be concerned by a low ratio two or three. In an industry such as automotive manufacture, where companies oscillate between large profits and large losses, a low ratio would be worrying. When it is difficult to make a profit, interest payments become one further burden that a company can ill-afford. For a stable, profitable company, a reasonable level of debt is a cost-effective way of raising finance. In Lesson 9 we will consider whether a set of accounts always presents the split between debt and equity (and therefore interest and dividend payments) in quite the way we might like for our analysis.

7.10.4 Gearing
Gearing refers to the split of the long-term capital of the company between debt and equity. Equity is regarded as safe, but expensive. If no dividend is paid, the shareholders can only sell. The long-term nature of shares and the potential volatility of the dividend mean that shareholders require the likelihood of a good return before undertaking to purchase shares. Debt holders, on the other hand, are likely to be able to take drastic (for example, legal) steps if interest is not paid on time. Even long-term debt is often only of five or 10 years duration, so the risk of not receiving the expected return is much less, and therefore, debt holders require lower returns. Hence having some debt as part of the long-term capital of the business is probably sensible, but having too much potentially means losing control to the debt holders, often banks and payments of large amounts of interest that cannot easily be avoided. The gearing (or leverage) of a company can be expressed in a number of ways. The meaning changes little, but the result of the calculation can change considerably, so always be aware of how it has been calculated before interpreting the answer. The method here takes the debt of the company that is, amounts that the company owes and on which it is required to pay interest or a finance charge for the privilege of having the money (sometimes referred to as interest bearing liabilities) and compares it with shareholders funds. If the figure is one, that would imply that debt holders have invested as much money in the company as shareholders not necessarily a bad thing, but a useful benchmark for who has dug deepest into their pockets. A company with low borrowings has more opportunity to grow, as it will have the chance to borrow more. The company with high debts will have limited flexibility in its future decision making. Short and long term debt Shareholders funds = 3,742 + 1,885 = 0.60 9,444

Tesco, therefore, has 60p of debt for every 1 of shareholders funds.

16

The Warwick MBA: Accounting and Financial Management

Lesson 7

We have included short-term (defined as being repayable within 12 months) debt as well as long-term, because some companies use short-term financing continually and we run the risk of understating a companys gearing if we do not include it. As with some other ratios, we will question the meaningfulness of this ratio a little more in the next lesson.

7.11 The shareholders view

Our final pair of ratios here considers the company from the shareholders perspective. There are many reasons for analysis, and even shareholders should be concerned about how managers have performed with the resources at their disposal. Here, though, we simply address the level of return to the shareholders and the security of the dividend.
2006 Return on ordinary shareholders funds Dividend cover 16.74% 2.34 2005 15.62% 2.25
Table 7.8 Shareholders view

In Lesson 9 some more investor ratios will be introduced, enabling you to understand the tables in the financial press.

7.11.1 Return on ordinary shareholders funds

After all other stakeholders have received their reward or share of the companys profits, the shareholders are left with the profit for the year or profit after tax. An American would use the phrase earnings. This can be compared with the level of shareholders funds in the balance sheet, to give a feel for the return that the shareholders have achieved during the year.
Profit for the year attributable to the shareholders of the parent Shareholders funds

1,570 = 16.7% in 2006 9,380

So for every pound in shareholders funds, it would seem that Tesco shareholders are 16.7 pence better off at the end of the year. This may be reinvested in the company or paid out as a dividend. Note that we have defined shareholders funds here excluding minorities. Minorities are, almost always, an immaterial item.

The Warwick MBA: Accounting and Financial Management

17

Lesson 7

7.11.2 Dividend cover

The dividend flow from a company is relied on by some investors and everyone in the stock market would see the maintenance or increase of dividends as a sign of financial strength. Dividends are paid out of profits, however, and an investor could be justifiably concerned about the continuance of the dividend, if profits were barely covering the dividend payments. It is possible to pay dividends when making a loss, but this could not be a long-term strategy.
Profit for the year attributable to the shareholders of the parent Shareholders funds

1,570 million 8.63p x 7.783 billion shares

= 2.34 in 2006 Tescos dividend is covered 2.34 times by profit for the year. One would suspect that the company would not want to see this slip below two. Very low dividend cover can suggest that management have no need to retain any profits, one assumes because they have no ideas of what to spend it on.

7.12 Assessing the numbers

When carrying out a series of calculations, it is easy to forget the purpose for which we are doing them. Earlier in the chapter we introduced CORE and having completed R, we can now move onto E (evaluation). It is useful to try to sum up the findings from analysis in a few paragraphs. An interesting question is how the ratios fitted with the environmental analysis and the perceived relative power of the players in the market. Tesco appear to be a growing company carrying out significant investment and making a good return. The nature of the evaluation is dependent on the original business decision being considered. Deciding whether to supply a potential customer would focus on their ability to pay and on the long-term prospects for business. Assessing an acquisition would focus on future opportunities that the target might have, the synergies with the potential acquirer and the likely cost of purchasing the company. This lesson has covered both a framework for financial analysis and a calculation of some of the more common ratios. The next lesson will cover some of the difficulties in carrying out analysis, consider a structured pyramid of ratios and look at how particular groups of analysts have developed further approaches to enhance their decision making.

18

The Warwick MBA: Accounting and Financial Management

Lesson 7

7.13 References and further reading

Moon, P. and Bates, K. (1993) Core Analysis in Strategic Performance Appraisal Management Accounting Research, 4, 2, pp. 13952 Porter, M.E. (1980) Competitive Strategy: Techniques for Analyzing Industries and Competitors London: Free Press, a division of Simon & Schuster

The Warwick MBA: Accounting and Financial Management

19

Lesson 7

Self-Assessed Assignment
Here are two sets of simplified accounts. The primary intention is that you practise ratio analysis. The Wal-Mart accounts are an approximate translation from an American set of accounts. If you wish to compare Wal-Mart with Tesco, using a :$ exchange rate of $1.90 to the would be an approximate exchange rate.

Question 1 Wal-Mart
Wal-Mart is the worlds largest retailer and is based in the US but operates in many countries for example, it owns ASDA in the UK. It is renowned for its aggressive pricing policies and low costs. There are only a couple of lines taken from the cash flow statement because cash flow statements in the US and UK are too different to convert meaningfully. Use these simplified accounts to produce an overview and ratios for 2001 and 2002. (These accounts are produced under US GAAP, but re-presented slightly to fit in with the rest of the chapter.)
Income statement $m Turnover Operating expenses Other items Profit on ordinary activities Interest Profit before tax Tax Profit for the year Dividends Retained profit 191,329 179,839 0 11,490 1,374 10,116 3,692 6,424 1,073 5,351 2001 % 100.0 94.0 0.0 6.0 0.7 5.3 1.9 3.4 0.6 2.8 $m 219,812 207,735 0 12,077 1,326 10,751 3,897 6,854 1,247 5,607 2002 % 100.0 94.5 0.0 5.5 0.6 4.9 1.8 3.1 0.6 2.6

20

The Warwick MBA: Accounting and Financial Management

Lesson 7

Balance sheet $m Tangible assets Intangible assets Investments Total non-current assets Inventory Debtors Short term investments Cash Current assets Total assets Overdraft/Short term loans Trade creditors Other Current liabilities Bank loans, etc., over one year Provisions Shareholders funds Minorities Total liabilities Cash flow information $m Net cash flow from operating activities Capital expenditure Debt at year end Other information Number of employees

2001 % 52 12 2 66 27 2 2 3 34 100 6 22 9 37 20 1 40 1 100 $m 40,934 9,059 1,582 51,575 21,442 1,768 1,291 2,054 26,555 78,130 4,375 17,378 7,196 28,949 15,655 1,043 31,343 1,140 78,130 2001 $m

2002 % 55 10 1 66 27 2 2 3 34 100 3 20 10 33 22 1 42 1 100 45,750 8,595 860 55,205 22,614 2,000 1,471 2,161 28,246 83,451 2,405 16,360 8,517 27,282 18,732 1,128 35,102 1,207 83,451 2002

9,604 8,714 17,976

10,260 7,146 18,976

1,244,000

1,383,000

Question 2 ICI
To contrast with retailers who show an excellent performance, the next company is ICI PLC, the chemical company. Obviously, there will be a number of differences from Tesco and Wal-Mart. Again, you need to carry out an overview of the company and then work out the ratios. What are your conclusions regarding the state of ICI? (These accounts are drawn up under UK standards, but again re-presented to be consistent with the chapter.)

The Warwick MBA: Accounting and Financial Management

21

Lesson 7

Income statement m Turnover Operating expenses Other items Profit on ordinary activities Interest Profit before tax Tax Minorities Profit for the year Dividends Retained profit Balance sheet m Tangible assets Intangible assets Investments Total non-current assets Inventory Debtors Short term investments Cash Current assets Total assets Overdraft/Short term loans Trade creditors Other Current liabilities Bank loans, etc., over one year Provisions Shareholders funds Minorities Total liabilities 2,398 609 327 3,334 843 2,244 415 255 3,757 7,091 1,231 917 1,360 3,508 7,748 7,486 103 159 246 87 117 24 228 232 460

2000 % 100.0 96.6 1.3 2.1 3.2 1.1 1.5 0.3 2.9 3.0 5.9 2000 % 34 9 5 47 12 32 6 4 53 100 17 13 19 49 m 2,186 613 374 3,173 753 1,913 159 301 3,126 6,299 1,668 804 1,129 3,601 m 6,425 5,950 41 434 229 205 56 28 121 116 5

2001 % 100.0 92.6 0.6 6.8 3.6 3.2 0.9 0.4 1.9 1.8 0.1 2001 % 35 10 6 50 12 30 3 5 50 100 26 13 18 57

2,231 1,509 216 59 7,091

31 21 3 1 100

1,705 1,225 283 51 6,299

27 19 4 1 100

22

The Warwick MBA: Accounting and Financial Management

Lesson 7

Cash flow statement m Net cashflow from operating activities Interest paid and received Taxation Capital expenditure Acquisitions and disposals Dividends paid Cash outflow before liquid resources and financing Management of liquid resources Financing Increase in cash Increase in net debt Debt at y ear end Other information Number of employees 45,130 586 225 104 226 138 231 338 12 336 14 452 2,799

2000 % 100 38 18 39 24 39 58 2 57 2 77 478 m 637 207 58 206 92 185 111 253 77 65 118 2,917

2001 % 100 32 9 32 14 29 17 40 12 10 19 458

38,600

A guide answer to these questions is given overleaf.

The Warwick MBA: Accounting and Financial Management

23

Lesson 7

Answer to Self-Assessed Assignment

Question 1 Wal-Mart
Overview Turnover Operating profit Dividend payments Retained profit Operating cash flow Capital investment and acquisitions Debt Employees Performance Return on net assets Sales margin Asset turnover Sales per employee Profit per employee Working capital Inventory days Debtor days Creditor days Liquidity and solvency Current ratio Acid test Interest cover Gearing Shareholders view Return on ordinary shareholders funds Dividend cover 2001 $m 191,329 11,490 1,072.8 5,351 9,604 8,714 17,976 1,244,000 2001 23.87% 6.01% 3.97 $153,801 $9,236 2001 44 3 35 2001 0.92 0.18 8.36 0.64 2001 20.50% 5.99 2002 $m 219,812 12,077 1,246.84 5,607 10,260 7,146 18,976 1,383,000 2002 21.94% 5.49% 3.99 $158,939 $8,732 2002 40 3 29 2002 1.04 0.21 9.11 0.60 2002 19.53% 5.50 14.9 5.1 16.2 4.8 6.8 18.0 5.6 11.2 % change

Wal-Mart is clearly an enormous and successful business. Sales increased by a bigger percentage than profits, revealing a squeezing of margins. Capital expenditure also fell, but $7 billion is still a great many new shops. Debt levels increased a little.

24

The Warwick MBA: Accounting and Financial Management

Lesson 7

Return and margin fell slightly, but are still impressive, even compared with Tesco. Asset turnover is stable and lower than Tesco, implying that they might be a little more downmarket in style. The profit and sales per employee are fairly constant. They managed to reduce inventory days down by four to 40. Bear in mind that they have a much larger non-food proportion than Tesco at present and hence, the inventory days are not directly comparable. Creditor days also fell and would appear to be quite low. The higher inventory than Tesco inflates the current ratio, but the acid test is in much the same range reassurance that Tescos low number is not a problem. Interest cover and gearing fell slightly, showing that the growth in debt was less than the growth of the company as a whole. While dividend cover and return on shareholders funds both fell a little, return is still around 20% and dividend cover gives generous comfort to shareholders. Why not download Wal-Marts latest accounts from the web and consider how things have changed over the last five years.

Question 2 ICI
The difference between ICI and Wal-Mart (or Tesco) is stark.
Overview Turnover Operating profit Dividend payments Retained profit Operating cash flow Capital investment and acquisitions Debt Employees Performance Return on capital employed Sales margin Asset turnover Sales per employee Profit per employee 2000 7,748 159 232 460 586 226 2,799 45,130 2001 7.67% 2.05% 3.74 171,682 3,523 2001 6,425 434 116 5 637 206 2,917 38,600 2002 29.46% 6.75% 4.36 166,451 11,244 8.7 8.8 4.2 14.5 17.1 173.0 50.0 % change

The Warwick MBA: Accounting and Financial Management

25

Lesson 7

Working capital Inventory days Debtor days Creditor days Liquidity and solvency Current ratio Acid test Interest cover Gearing Shareholders view Return on ordinary shareholders funds Dividend cover

2001 41 106 45 2001 1.07 0.83 0.65 16.03 2001 105.56% 0.98

2002 46 109 49 2002 0.87 0.66 1.90 11.92 2002 42.76% 1.04

ICI is downsizing, with dramatic falls in turnover and employment. Capital investment also fell and is below 3% of turnover, which one might consider unsustainable for a specialist chemical manufacturer. Surprisingly, dividends were paid in each year, although the level has been reduced. The loss means that it is wise not to attempt to calculate a percentage change in profit. Debt rose slightly. Return on capital employed looks excellent in 2002, but this is due to the diminished resources of the business shareholders funds are negative and for a manufacturer to have an asset turnover of 4.36, when Tesco (who only need selling space and distribution depots) could only achieve 2.85, clearly suggests that mere efficiency is not the explanation. In calculating capital employed for Tesco and Wal-Mart, we ignored provisions amounts that the company may be liable to pay at some point in the future. One might question this approach here, as provisions are a very material item, given the state of shareholders funds. The employee figures highlight the improvement in profit. Inventory days and debtor days both lengthened, suggesting that management focus might be elsewhere in these difficult times. Trade creditors lengthened a little to 49 days or seven weeks. Both liquidity measures fell, the acid test by a significant proportion, which is worrying. Interest cover improved. The gearing calculation is meaningless numerically, as shareholders funds are negative. The negative number does highlight that the shareholders have, effectively, no remaining stake in the business beyond their voting rights. The debt holders will be the ones that management have to listen to closely, as their continuing support is vital to the company. A company is bankrupt when it is in a position where it cannot meet its financial obligations (that is, pay its bills), not when shareholders funds become negative. KPMG audited the accounts and gave ICI a clean bill of health with no adverse comments.

26

The Warwick MBA: Accounting and Financial Management

Lesson 7

Again, the negative shareholders funds make the return on shareholders funds meaningless. It has been included to make two important mathematical points divide a negative by a negative and you get a positive (2001) and secondly divide a positive by a negative and you get a negative (2002) we would tend to assume the minus comes from a negative number on the top of the equation. If you were to download ICIs latest accounts you will see there have been significant improvements.

Footnote
1. You may find US textbooks use ROCE to refer to return on common equity, which we look at as return on shareholders funds in Lesson 8, Section 8.3.4.

You should now attempt the online question bank for this lesson. This can be found via a web link in the Accounting and Financial Management module on my.wbs.

End of Lesson 7

The Warwick MBA: Accounting and Financial Management

27