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Lesson 7

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

Copyright 2008 University of Warwick

7.1 IntroductionBack 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 analysisIt 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

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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.

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7.3 ContextThis is split into two sections external and internal.

7.3.1 ExternalUnderstanding 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.

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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 InternalThe 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

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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