Company Ratio Analysis

Company Ratio Analysis

Table of contents
1. Company Ratio Analysis ..................................................................................................................... 3 1.1. Overview ....................................................................................................................................... 3 1.2. Profitability .................................................................................................................................... 4 1.3. Operating Ratios ........................................................................................................................... 6 1.4. Liquidity......................................................................................................................................... 7 1.5. Solvency ....................................................................................................................................... 8 1.6. Predicting Failure .......................................................................................................................... 9 1.7. Exercise ...................................................................................................................................... 10

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Company Ratio Analysis

1. Company Ratio Analysis

1.1. Overview

Ratio analysis is a technique for assessing a companys financial condition and for making fair comparisons between companies (so-called comparable analysis). Specifically, ratios are used to assess a company's: Liquidity Profitability Operating efficiency Solvency

In this module we look at some of the ways in which ratio analysis can be applied and some of its limitations. Ratios are calculated from the published accounts, so fair comparisons can only be made if the reported figures have been adjusted to reflect any differences in accounting definitions. Commercial suppliers of company financial data use standard definitions and adjust the reported figures accordingly. One of the tasks in the exercises at the end of the modules is to compare the financial health of two companies by using ratio analysis.

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Company Ratio Analysis Learning Objectives By the end of this module, you will be able to: Define and interpret various financial ratios: o Profitability ratios o Operating ratios o Performance ratios o Liquidity ratios o Solvency ratios Explain the relationships between some of these ratios Draw appropriate conclusions about the evolution of these ratios over time Use these ratios in comparable analysis

1.2. Profitability
Profitability Ratios
Profitability (or performance) ratios are used to assess a company's economic performance, in particular the ability of the companys management to generate: Profit margins on sales An economic return on the assets or capital resources under their control.

Profit Margins
These ratios analyse the companys profitability per $1 dollar of sales. There is a whole set of them, each incorporating different expense items from the income statement. Below are the 3 most commonly-used ones. Gross margin = Gross profit x 100 Sales Gross margin gives an indication of the gross mark-up achieved on each unit of sales, before any other deductions or charges. Operating margin = Operating profit1 x 100 Sales Operating margin gives an indication of the companys operating efficiency, before those profits are apportioned to the various interested parties - the lenders, the tax collector and the shareholders. Pre-tax income margin = Profit on ordinary activities before tax2 x 100 Sales Pre-tax income (or profit) margin takes into account profits or losses on investments in associated companies, as well as interest payments. Depending on how they are financed, different companies with similar operating margins may have very different income margins.

Excluding exceptional items, to remove temporary distortions (see The Income Statement - Profit & Loss). 2 Excluding exceptional items.

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Company Ratio Analysis

Return on Assets
Return on capital = EBIT Total capital employed employed (ROCE) x 100

= Return on net assets (RONA) Where: EBIT Total capital employed Net assets = Earnings before interest, tax and exceptional items = Profit on ordinary activities before taxation - Exceptional items = All interest bearing liabilities + Capital & reserves + Minority interests = Fixed assets + Current assets - Trade creditors and other non interest bearing liabilities

ROCE attempts to measure the economic return generated by the company's capital resources, before those returns are apportioned among the different parties which supplied the capital - lenders or shareholders. Here, capital employed excludes non interest bearing liabilities such as creditors or tax liabilities, as in principle these are not meant to finance the company's operations (although in practice they often do!). ROCE and RONA are similar, except that RONA looks directly at the assets side of the balance sheet, while ROCE looks at how the assets are financed. If additional assets were purchased during the last reporting period (or additional debt or equity were issued) the analyst normally takes the simple average of the net assets (or capital employed) for the latest reporting date and the one immediately prior to it. Problems with ROCE ROCE may not be an accurate measure of return if the company's price to book value is significantly different from 1. ROCE overestimates true return if either the share price or the market value of the company's debt are at a premium to their book value i.e the market value of the company's capital is higher than its book value. In these circumstances, analysts prefer to look at EBIT to enterprise value ratios (see Company Valuation Cost of Capital).

Related Measures
For completeness, we include below two other return-on-assets ratios that analysts sometimes use. They differ in their definition of the denominator and are generally less commonly-used than ROCE / RONA. Return on = Net earnings x 100 fixed assets Fixed assets Return on total assets = Net earnings x 100 Total assets

Where: Net earnings = Profit attributable to ordinary shareholders before exceptionals

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Company Ratio Analysis These measure how effectively the company can generate earnings for its shareholders, either from its long-term assets - land, buildings, plant & machinery, etc. - or from all the assets under its control, including current assets. Return on equity (ROE) = Net Earnings Capital & reserves

This is the ratio of profit attributable to ordinary shareholders to the book value of the equity. Analysts often compare ROE with the company's earnings yield (the ratio of net earnings to the market value of the equity) - or with its reciprocal, the price/earnings ratio (see Equity Valuation Ratios Price/Earnings Ratio).

Interpreting Ratios
As a general point, you should always take care to apply these ratios consistently, and even more care in interpreting them:
1.

Some industry sectors operate on lower margins than others. For example, food retailers normally operate on relatively low margins, whereas luxury goods manufacturers operate on much bigger margins. Some industry sectors are fundamentally more capital-intensive than others The assets in most balance sheets are stated at their original acquisition cost (historic cost) rather than at what they might cost today (replacement cost), so the ratios calculated may not reflect economic reality. If a company decided to revalue some of its assets in line with current prices, this would have an immediate impact on the return-on-asset ratios, even though there was no change in operating efficiency.

2. 3.

4.

Ratio analysis is typically most effective when making comparisons between companies operating within the same sector. When used in this way, the ratios may highlight meaningful differences in operating efficiency, stock control or over-investment in fixed assets.

1.3. Operating Ratios

Operating ratios measure a company's efficiency in: Sales generation Stock control Debt collection Sales Net assets

Asset turnover =

Asset turnover measures the value of sales generated by each $1 of net assets at the company's disposal. The definition of net assets is the same as the one used to calculate RONA (or ROCE - see section Profitability). Inventory Turnover = Sales Inventory

Inventory turnover is a useful indicator of the value of inventory that the company maintains in order to achieve a given level of sales. Looked at another way, it is the number of times during a year that a company has sold its inventory. A lower than normal ratio might indicate poor stock control or the possibility that the company may be carrying obsolete inventory.

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Company Ratio Analysis Once again note that the 'normal' inventory level varies from sector to sector: some industries are compelled to keep high levels of inventory in order to provide the immediate delivery flexibility demanded by their customers. Receivables Turnover = Sales Debtors

Receivables turnover shows how many times in a given year a company completes the debt collection cycle, and therefore gives a guide to its relative efficiency in obtaining settlement from its trade debtors. An unusually low multiple might indicate a poor collections function, or perhaps that the companys customers are dissatisfied with its products/services and are deliberately withholding timely payment.

Equivalent Measures
These ratios are sometimes expressed in terms of days, rather than multiples. For example: Inventory days = = Inventory Sales per day Inventory Annual sales/365

= 365 / Inventory turnover Here we are looking at how many days' worth of sales are sitting in the firm's warehouses. Obviously, the lower the number of days the less capital is tied up in inventory. Trade debtor and trade creditor days may be similarly calculated by using, respectively, trade debtors and trade creditors in place of inventories. A company which offers standard payment terms of 30 days should normally have 30 days of debtor days. A larger figure would indicate that the firm is having problems collecting debts, or that customers are delaying payments

1.4. Liquidity
Liquidity ratios assess the extent to which a company is able to meet day-to-day demands on its cash resources. As the saying goes, cash is king. A company risks being forced into liquidation if it is unable to meet its debt obligations, no matter how profitable the operation. Many companies fail every year purely as a result of poor cash management.

Current Ratio
Current ratio = Current assets Current liabilities

Current ratio measures the companys ability to service its short term debt obligations and pay its trade creditors. A high multiple means that the company enjoys a high level of liquidity, although an inappropriately large amount of idle cash is also uneconomic. A problem with this measure of liquidity is that it includes the value of inventories on the assumption that they can, if necessary, be sold off for cash in order to meet creditors. This may not always work in practice, particularly at times of recession. In fact, current ratios often increase at the onset of recession, as companies find it increasingly difficult to move stock. Quick ratio = Current assets - Inventory Current liabilities Also known as: The acid test.

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Company Ratio Analysis

This is a much tougher test of a companys liquidity position because it excludes from current assets everything that is not immediately realisable into cash. Again, each company must be carefully considered against similar sized-companies operating in the same business sector before its quick ratio can assume real significance. Again, we must exercise care before drawing meaningful conclusions from this ratio. While large industrial companies normally operate with liquidity ratios of around 1.0, food retailers operate quite successfully with ratios of around 0.2 - 0.3. Sales in this sector are primarily on a cash basis and the nature of the inventory is such that it must be turned over very quickly. On the other hand, payments to suppliers tend to be on much longer terms!

1.5. Solvency
Solvency ratios measure the company's financing structure and its ability to meet its debt obligations.

Balance Sheet Gearing

Gearing = Interest bearing liabilities Capital & reserves Also known as: Gearing, Leverage. This ratio expresses the proportion of capital employed which is borrowed (both short and long term debt) against that which is attributable to holders of common stock (i.e. shareholders funds). When calculating gearing, total debt should include the par value of preference shares, if any, since this class of security represents a prior claim on the companys income ahead of common stock. Generally speaking, the net earnings of highly-geared companies are more sensitive to fluctuations in business activity. A highly-geared company will therefore represent a higher risk of bankruptcy for the company, and therefore a higher risk on the return to both the company's creditors and its shareholders. Again, gearing ratios differ widely across sectors: Capital-intensive industries tend to be more geared than service industries, but much of their debt is secured on specific assets Commercial banks can support very high gearing multiples, because interest on their assets (e.g. customer loans and investments) are highly correlated (duration-matched) with their funding costs (see Bond Market Risks - Using Duration).

Operational Gearing
Operational gearing = Percentage change in net profit Percentage change in sales Operational gearing and balance sheet gearing tend to go together. Since interest expenses are a function of balance sheet gearing, as sales increase shareholders in the more geared companies will benefit from a correspondingly higher percentage increase in distributable profits. In a falling sales environment, of course, the opposite will be the case.

Interest Cover
Interest cover = Operating profit Net interest payable

A companys profitability may vary, but the interest payments on its debt must be met in full and on a timely basis, otherwise the creditors may force the company into liquidation.

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Company Ratio Analysis Interest cover shows how many times the company is able to meet its interest charges from its operating profit. Highly geared companies tend to show low interest cover, and vice versa. In most commercial companies, ratios lower than 2 would be a cause for concern.

1.6. Predicting Failure

Analysts often combine financial ratios into an overall system for scoring companies, in terms of financial health. Depending on its score, a company may be regarded as robust and healthy, or weak and liable to failure. The approach was pioneered by Robert Altman in the 1970s. Altman's Z-score Z = 1.2 x Y1 + 1.4 x Y2 + 3.3 x Y3 + 0.6 x Y4 + 1.0 x Y5

Where: Y1 = Working capital / Total assets Y2 = Retained earnings to date / Total assets Y3 = Profit from ordinary activities before interest and tax / Total assets Y4 = Market value / Book value of total debt Y5 = Sales / Total assets Altman's model was developed mainly to score commercial banks. The ratios used and the weightings given to them were estimated empirically from extensive analysis of companies which had collapsed. It was found that such companies had common characteristics in terms of selected financial ratios. A company with a Z-score of between 1.8 and 2.7 was considered to be in the danger zone. Other scoring systems have been developed for other sectors of industry, notably Taffler's model, which is more relevant to manufacturing. Taffler's Model Z = 0.53 x Y1 + 0.13 x Y2 + 0.18 x Y3 + 0.16 x Y4

Where: Y1 = Pre-tax profit / Current liabilities Y2 = Current assets / Total liabilities Y3 = Current liabilities / Total assets Y4 = Sales / Total assets In this model a Z-score of between 0 and 0.3 puts the company in the danger zone. Z-score models are used routinely by most of the large banks and accountancy firms. They may be used to: Track a company's progress over time Compare companies of similar sizes in the same sector of industry

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Company Ratio Analysis

1.7. Exercise
Question 1
The broker's note below illustrates how analysts use the financial ratios we introduced in this module to support their share recommendations. Company: Kwik Save Plc Sector: Discount food retailer Recommendation: BUY Kwik Saves performance in the last year has been impressive, with sales 11.1% ahead in what must have been a difficult year for this sector. Like-for-like sales rose a more modest 7.5%, so the new stores account for a large proportion of this growth. The company managed to hold on to last years operating profit margin of 4%. This is much lower than the average for this sector of 7%, yet the group managed a ROCE of 30.2%, which compares very favourably with the 20.3% reported last week by Sainsburys, the market leader in food retailing. The company is cash-rich, with a very high current ratio of 74% and virtually no gearing, giving an interest cover of 57 times. This puts the company in a strong position to withstand continuing competition at the discount end of the market, which is where most of the growth is expected in the next 12 months. Kwik Saves share price has been in the doldrums in recent months, as the market awaited the first set of results from the leaders. With a clearer picture now emerging, we predict the shares to perform well relative to the sector - and indeed to the market as a whole. a) Match the highlighted keywords with their correct definitions. (Enter the letter in upper case). Operating profit margin ROCE Current ratio Gearing Interest cover A: Operating profit divided by interest payable B: Operating profit divided by sales C: Debt to equity ratio D: Current assets divided by current liabilities E: Operating profit divided by interest bearing debt plus equity

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Company Ratio Analysis

Question 2
Following a rather dull Christmas season, the management of Magic Carpets Ltd. is considering a promotional campaign. Two plans are under discussion: Plan A: "10% off all our stocks - if you pay cash!" Plan B: "No payments for the first six months!" a) What impact would you expect each plan to have on the companys profit margin, inventory turnover and receivables turnover? In each case enter (H)igher, (L)ower or (N)o change. Plan A Plan B Inventory turnover Profit margin Receivables turnover b) What factor(s) would you consider in deciding on which campaign to adopt? The company's liquidity position The company's profitability The company's market share The company's gearing

Question 3
The following figures were taken from the financial statements of Alcatel Alsthom and the Lufthansa Group for 1994. Alcatel Lufthansa FRF millions DEM 000 Net sales 167,643 18,835,690 Gross profit 34,506 10,919,172 Operating profit 9,624 596,493 Net Income 3,620 292,316 Shareholders equity 59,784 3,640,725 Interest bearing liabilities 51,671 7,224,619 Inventories 45,139 1,420,966 a) Calculate the following ratios to the nearest one decimal place: Alcatel Lufthansa Gross margin (%) Operating margin (%) Return on equity (%) Inventory turnover Gearing multiple

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Company Ratio Analysis b) Are the figures directly comparable? Yes No

Question 4
In Equity Valuation Ratios - Price/Earnings Ratio, we define earnings yield as the ratio of earnings per share to the companys share price. a) Companies ROE are much typically higher than their earnings yield because: Share prices typically trade at a discount to their book value Share prices typically trade at a premium to their book value The numerator in ROE is operating profit Equity in ROE includes minority interests

Question 5
The two companies below operate in the same market and have very similar operational profiles a) Complete the missing items in the table below. Zap Electronics Electromax Fixed assets Current assets Current liabilities: Loans Other creditors Net assets Long term debt Shareholders funds Total capital employed Gearing (to 1 decimal place) b) Which of the two companies would be riskier for a prospective equity investor? Electromax Zap 1,000 1,500 1,300 700 500 1,000 750 1,250 3,000 1,000 3,000 1,000

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