afm l07 ibm 08

Lesson 7

1The Warwick MBA: Accounting and Financial Management

7 ANALYSING FINANCIAL

STATEMENTS (1)

7.1 IntroductionBack in Lesson 1, we discussed measuring performance andintroduced accounting as a method of assessing how wellorganisations are performing. Looking at profit and loss accounts andbalance sheets can reveal some aspects of this and we have alreadyused common size analysis in Lesson 2. Here we start to use theinformation provided in published accounts more intelligently andattempt 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 thatwe shall ignore some technical difficulties in this one and return tothem in Lesson 8. For example, we will use a simplified set of accountsfor calculating ratios here, and then consider the problems of pickingthe numbers from a full set of accounts in Lesson 8. We will leaveconsideration of the effects of accounting policy choice on analysisuntil Lesson 8 too.

Reading Black Chapter 10 would be useful at this point. We will thengo over some of the same ground, but with more detail – especially inthe next lesson.

7.2 A framework for financialanalysis

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

The set reading for thislesson is:

Black, Chapter 10and from the Readingssection:

Moon and Bates,‘Core Analysis inStrategic PerformanceAppraisal’

Copyright © 2008University of Warwick

Audio Clip

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

straightforward task, and it would be easy to think that once such aspreadsheet was written, analysing a company’s accounts would besimply a matter of entering the data from the financial statements andthen looking at the resulting ratios and figures. As long as we weretreating financial analysis as a recreational exercise, with little or nointrinsic worth beyond the personal satisfaction achieved from thecompletion of the table of numbers, then this approach would bequite adequate.

However, most people have sufficiently interesting lives that they areable to find better leisure activities. Financial analysis is onlyundertaken 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 peopleboth within and outside the organisation; so the level of pay rise thecompany could afford to pay might be asked, perhaps, by an outsideagency such as a trades union. Note also that in answering thesequestions financial analysis – that is, interpreting the financialstatements – will only be a part of the answer. As we have mentionedbefore, understanding the industry and the background to thesituation is vital.

The reading provided for this lesson, Moon and Bates (1993),introduced a model for financial analysis which is known by themnemonic ‘CORE’. The central thrust of this is to make sure the analystunderstands the competitive environment, the company itself and hasan overview of the success or failures of the company, before rushinginto a myriad of calculations. In other words, we need to havecaptured the ‘big picture’ before we look at the detail. The aim of theexercise is to evaluate the company, so the final stage of the model isto 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.

Lesson 7

2 The Warwick MBA: Accounting and Financial Management

7.3 ContextThis is split into two sections – external and internal.

7.3.1 ExternalUnderstanding the background to the industry in which the companyoperates is always the best place to start, and you will find thisincreasingly straightforward as your MBA studies progress. Some ofthe models introduced in marketing and strategy will enable you todescribe the competitive environment clearly and to assess the relativestrengths of players in the market. To begin with, the PEST (sometimesthe letters are arranged in a different order!) model and Porter’s FiveForces model (Porter, 1980) provide enough information to give a feelfor what is going on. I am sure that my marketing and strategycolleagues will introduce better or more complex models, but theseshould 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 theplayers in an industrial context. Although it is sometimes difficult todecide 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 othercompanies and other markets in the UK – it is the company’s coremarket. We will also consider the UK food retail industry as a casestudy during the September Seminar.

So, for the food retailing industry in the UK, the following might besome relevant factors:

g Political

i. Planning regulations governing the placing of out-of-townstores.

ii. Government attitude to competition – discouraging furtherconsolidation, 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:

The aim here is to describe the key players in the competitiveenvironment and consider their relative ‘power’ and influence.Assuming we worked for Tesco, the market leader, the competitors areother food retailers – and indeed, general retailers, as they expandtheir range into non-food – in the countries in which it operates. Newentrants would be potential competitors moving into the market,while alternatives are companies that meet customers’ needs in adifferent way – the need to eat could also be satisfied by restaurants,for example. Customers are those who buy food from supermarketsand they could probably usefully be grouped into categories forassessing their needs and relative purchasing power – some retailersuse loyalty cards in order to gather such information in more detail.Finally suppliers are food processors and growers from whom thesupermarkets buy their goods. If we were to look at each of thesegroups in more detail, we would be able to form a view on theirrelative strength and power – and hence, likely future ability to makeprofits, for example.

These models help us, but should not be followed blindly. They distortreality by trying to put complex situations into neat boxes and assumethat the environment is external to the firm (‘exogenous’), whereasrelationships between the boxes in the Five Forces diagram are likelyto be much more dynamic. They also have a tendency to describe thesituation in a static way, when it is actually dynamic (that is, changingand evolving).

Nevertheless, we can build up a useful picture of the environment andthe place of our chosen target for analysis within it.

7.3.2 InternalThe internal context of the company requires us to consider a little ofthe company’s past and how it is structured. Some companies provideinteresting information on divisional structures and a little information

Lesson 7


Figure 7.1

Porter’s five forces

on the relative profitability of the different divisions. A study ofMarconi, for example, would show that the troubled Telecomequipment company had a history and management style steeped inmanufacturing and power generation, rather than the fast-changingworld of telecoms. Such a realisation may have made you think twiceabout the company as an investment, or indeed about having atrading relationship with Marconi. At one time, the shares were inexcess of £12 and then fell rapidly to a few pence. The company isnow 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 February2006, one fund manager, Fidelity International, owned 5% of theshares, but no other company or individual owns over 3% (the levelrequiring to be disclosed in the UK). However, one of its keycompetitors in the UK, Sainsbury’s, has a large remaining familyholding, which, arguably, affected its ability to respond to changeduring the 1990s.

The character and background of key members of the managementteam might also reveal likely attitudes to risk and possible approachesto growing the company. If all the directors have grown up in thecompany then it would be fair to assume that the only likely strategyis more of the same. Indeed, any other would be high risk.

The context provides the backdrop to understanding the company’sfinancial performance. In a highly competitive market, any gain inmargin may be an excellent achievement, for example.

7.4 OverviewThough we will probably have used the wordy parts of the annualreview of a company, among other sources, to complete the context,we now turn to the financial numbers themselves. The key questionhere is: ‘Are we looking at a successful, growing company?’ Again,answering this before producing a raft of numbers will make sure weinterpret the numbers in context. Success, if measurable at all, comesin many forms. Answering questions such as those listed below wouldhelp 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 lastyear?

g Has operating cash flow improved?

g Did capital expenditure increase?

g Has debt increased?

g Is the company employing more people?

Lesson 7


For much of this information, we turn our focus to the incomestatement, balance sheet and cash flow statement.

In order to keep the numbers as simple as possible, a simplified versionof Tesco’s accounts is set out below (Table 7.1). We will use thesenumbers for the rest of the lesson, returning to the full accounts forLesson 8. Note that it has become custom and practice to put the latestyear on the left and the year before on the right, though always checkthe top of the columns when reading a set of accounts.

For financial year ending: 25 February 2006 2006 2005

£ million % £ million %

Turnover 39,454 100.0 33,866 100.0

Cost of sales 36,426 92.3 31,231 92.2

Gross profit 3,028 7.7 2,635 7.8

Administrative expenses –748 –1.9 –683 –2.0

Operating profit 2,280 5.8 1,952 5.8

Other items 82 0.2 74 0.2

Profit before interest 2,362 6.0 2,026 6.0

Finance costs –241 –0.6 –235 –0.7

Finance income 114 0.3 103 0.3

Profit before tax 2,235 5.7 1,894 5.6

Tax –649 –1.6 –541 –1.6

Profit for the year 1,586 4.0 1,353 4.0

Loss from discontinued operations –10 0.0 –6 0.0

Profit for the period 1,576 4.0 1,347 4.0

Minorities –6 0.0 –3 0.0

Profit attributable to equity holders of the parent 1,570 4.0% 1,344 4.0

Earnings per share

Basic 20.70p 17.44p

Diluted 19.79p 17.22p

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Table 7.1

Tesco – consolidatedincome statement

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

2006 2005

As at 25 February 2006 £ million % £ million %

Tangible assets 15,882 70.4 14,521 72.0

Intangible assets 1,525 6.8 1,408 7.0

Investments 1,237 5.5 1,002 5.0

Total non-current assets 18,644 82.6 16,931 84.0

Inventories 1,457 6.5 1,306 6.5

Other 175 0.8 3 0.0

Debtors: Trade 530 2.3 459 2.3

Other 362 1.6 310 1.5

Other 70 0.3 0 0.0

Cash 1,325 5.9 1,146 5.7

Current assets 3,919 17.4 3,224 16.0

Overdraft/Short term loans –1,885 –8.4 –482 –2.4

Trade creditors –5,083 –22.5 –4,974 –24.7

Other –550 –2.4 –224 –1.1

Current liabilities –7,518 –33.3 –5,680 –28.2

Net current liabilities –3,599 –16.0 –2,456 –12.2

Total assets less current liabilities 15,045 66.7 14,475 71.8

Bank loans, etc. –3,742 –16.6 –4,563 –22.6

Derivative liabilities –294 –1.3 0 0.0

Other creditors –349 –1.5 –517 –2.6

Pension obligations –1,211 –5.4 –735 –3.6

Provisions –5 0.0 –6 0.0

Non-current liabilities –5,601 –24.8 –5,821 –28.9

Net assets 9,444 41.9 8,654 42.9

Called up share capital 395 1.8 389 1.9

Share premium 3,988 17.7 3,704 18.4

Other reserves 40 0.2 40 0.2

Preference shares 0 0.0 0 0.0

Profit and loss account 4,957 22.0 4,470 22.2

9,380 41.6 8,603 42.7

Minorities 64 0.3 51 0.3

Total equity 9,444 41.9 8,654 42.9

Lesson 7


Table 7.2

Tesco – consolidatedbalance sheet

The percentage columns above are expressed as a percentage of totalassets (non-current assets plus current assets), though this number isnot shown in this particular format.

Using this information, we can now look at the answers to the eightoverview questions we set ourselves.

All these numbers have risen, although rising debt is not necessarilygood. To work out the retained profit, the dividend figure wassubtracted from the profit for the year – retained profit is, effectively,the shareholders reinvesting in the business. Finally treat the numberof employees figure with caution. Tesco gives us the full-time

£ million unless % 2006 2005

Turnover 39,454 33,866

% increase 17%

Operating profit 2,362 2,026

% increase 17%

Retained profit 898 747

% increase 20%

Operating cashflow 2,619 2,176

% increase 20%

Market capitalisation 26,332 24,011

% increase 10%

Capital and acquired expenditure 2,615 2,278

% increase 15%

Total debt 5,627 5,045

% increase 12%

Employees 273,024 242,980

% increase 12%

2006 2005

Total assets 22,563 20,155

Net cashflow from operating activities 2,619 2,176

Capital expenditure 2,561 2,197

Acquisition expenditure 54 81

Net debt 4,509 3,899

No. of shares (million) 7,783 7,894

Market capitalisation million (year end) 26,332 24,011

Dividends (p or cents per share) 8.63 7.56

Employees (average FTE) 273,024 242,980

Total payroll 4269 3696

Depreciation 838 743

Lesson 7


Table 7.3

Tesco – other data

Table 7.4

Tesco – overview

equivalent (FTE) number, but other companies do not. Bear in mind allthe financial numbers need to grow by more than the rate of inflationin order to show real growth.

If you are looking at a less successful company than Tesco and thecompany made a loss or had negative cashflow, then please be carefulin calculating and interpreting the percentages. In such circum-stances, recording the improvement or worsening as a number, ratherthan a percentage, can be clearer.

7.5 Ratios Our next aim is to calculate a set of ratios, where each one answers anindividual question regarding aspects of the company’s performance.Having carried out the overview, we may have certain areas of theaccounts and particular ratios where we wish to focus.

There is no set or prescribed way of working out a ratio; the key is touse an appropriate method, given the business issue that motivatedyou to do the analysis. In this lesson, a fairly standard set of ratios willbe calculated and briefly discussed. These fall into four distinct groups.

Performance ratios address the issue of how well managementperformed 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 offinancial risk the company has taken on. Finally the shareholder ratiosconsider the company from the investor’s angle. This final set will bedeveloped 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 theproblems 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 thiswe will finish the analysis model.

7.6 EvaluationAt the end of producing perhaps 20 ratios for two or three years, itwould be easy to think that the task of analysis is over. However,remembering that there would have been a reason for undertakingthis task, we need to bring together the information from the threeearlier sections in order to draw a logical conclusion and recommenda decision to the rest of the management team. We will return to thisonce we have crunched the ratios.

Lesson 7


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

7.8 Performance ratios

7.8.1 Return on net assets (RONA)This is sometimes referred to as the key ratio. ‘Return on capitalemployed’ (ROCE1) is worked out in much the same way. The ideabehind the ratio is to give the percentage return generated by thecompany on the long-term capital tied up in the business. Thisconcept was introduced in Lesson 1. The net assets figure is the non-current and current assets less the current liabilities – giving the samenumber as the long term funding in the business. Profit is taken beforeinterest and tax. To take the profit after interest and tax wouldnormally be a mistake, as we are comparing the profit generated withthe total of debt and equity invested in the business. To deduct intereston debt before the comparison would unbalance the ratio as one ofthe 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 otherwiseidentical companies with identical performance, but one with highdebt, the other with low debt, ought to appear equal with this ratio,as each company’s operating management have done an equallygood 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 oncapital.

2006 2005

Return on net assets 15.70% 14.00%

Gross margin 7.67% 7.78%

Sales margin 5.99% 5.98%

Asset turnover 2.62 2.34

Sales per employee £144,507 £139,378

Profit per employee £8,651 £8,338

Lesson 7


Table 7.5

Tesco – performance

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

7.8.2 Sales marginSales 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 becomesprofit.

This is an important ratio in any industry and different industries willhave very different levels of margin.

The terms ‘gross margin’ and ‘net margin’ are sometimes used. Theintention behind these figures is that the gross margin will assess themargin only after accounting for cost of sales and the net marginshould be after all costs.

The figures for Tesco’s margins in 2006 are:

Gross margin:

Gross profit 3,028———————— = ————— = 7.67%

Turnover 39,454

Net margin:

Profit before interest 2,362————————————— = ————— = 5.99%

Turnover 39,454

This will be of use within the organisation, but the level of informationfrom published accounts makes such a distinction difficult, andpotentially misleading, when comparing companies that haveclassified their costs in different ways. You could also use the operatingprofit in the net margin calculation.

7.8.3 Asset turnoverMost of you will have come across return and margin before, but assetturnover is not such a headliner. This is a shame as it is of equalimportance as margin, as we shall see below. This ratio measures howwell each pound tied up in the company has been used in generatingturnover.

Generally it is a good idea to take the same number here for assets asthe figure used is RONA.

Turnover 39,454——————————— = ————— = 2.62 for 2006Capital employed 15,045

A little care is needed in interpreting this number, because if acompany has old, depreciated fixed assets, then the asset turnoverratio will be high, but this may not be a good thing for the futureprosperity of the company. We are using the closing balance sheet

Lesson 7


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

7.8.4 The relationship between sales marginand asset turnover

Why is asset turnover as important as sales margin? Because when thetwo are multiplied together, they produce the RONA.

Sales margin × asset turnover = return on net assets

In Tesco’s 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 pleasantshopping environment, though at some cost. It would be possible fora low-cost food retailer, renting run-down shops, to have an assetturnover of seven. For the low-cost retailer a margin of 4% would stillresult in a RONA of 28%, better than Tesco. We will return to this andbuild upon the possibility of logically building ratio pyramids inLesson 8.

7.8.5 Sales and profit per employeeThese two ratios are obvious and straightforward. Having markedmore exam scripts than I care to remember, the biggest problemseems to be in getting the decimal point in the right place! Tesco’ssales and profits are in millions, the people are not; hence we need toadjust our calculations to take account of this.

Turnover per employee:

Turnover x 1,000,000 £39,454,000,000—————————————— = ——————————— = £144,507 for 2006Number 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 theuse of people. In some circumstances, people and capital arealternatives. A company with little technology will have a lot of people(high asset turnover, low sales per employee), whereas a high-tech

Lesson 7


competitor will have few people (low asset turnover, but high salesper employee). One cannot say that one is necessarily better than theother, but perhaps just different strategies for meeting differentcustomer needs. Tesco’s figures are fairly flat, rising at 4%, just a littleabove inflation.

Performance ratios are usually important in any company assessment.Any segmental information available might allow some or all of theabove calculations to be worked out for each of the divisions of thecompany too. This would be useful in working out which parts of theorganisation were performing better than others.

7.9 Working capital ratiosFrom the lesson on cash flows, you will recall that working capitalneeds to be managed tightly. A gradual reduction in inventory anddebtors year by year would be anticipated by shareholders as a signthat management were improving control. However, if a company isgrowing 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 endof the next, without some adjustment for the increase in sales. If salesdoubled, one might assume that inventory would need to double too,in order to support the additional selling activities, and, certainly, thelevel 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 commonlogic and could potentially be graphed together. Debtors are normallymeasured in this manner, inventory often is, but ‘stock turn’ (howmany times the inventory is turned over in a year) is also common.

7.9.1 Inventory daysRemembering that inventory is held at cost, we can work outapproximately how many days of inventory are held at the year end bythe following ratio:

365 x inventory 365 x 1,457—————————— = ———————— = 14.6 days in 2006Costs of sales 36,426

Multiplying by 365 just converts inventory as a proportion of annualcosts into a more easily understood number. Occasionally companieshave a long or short financial period and the ‘365’ would needadjusting accordingly for each of these working capital ratios. So, atthe year end, Tesco had 15 days of inventory.

2006 2005

Stock days 14.6 15.3

Debtor days 4.9 4.9

Creditor days 57.9 66.1

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Table 7.6

Tesco – working capital

7.9.2 Debtor daysThis is a very similar calculation to inventory days, but customers owethe selling price of the products, not just the costs. As with all otherratios here, this is just one suggested way of calculating a figure forunderstanding the level of debtor control. Receivables is an alternativeword for debtors.

365 x debtors 365 x 530————————— = ——————— = 5 days in 2006

Turnover 39,454

Be a little wary of the debtor figure from the balance sheet, as it caninclude other sums owed to the company besides trade debtors (thatis, monies owed from customers). Many companies make the tradedebtor number clear in a note to the accounts (indeed, we found £530million in Note 16 of Tesco’s accounts); we will revise this number inLesson 8.

7.9.3 Creditor daysIn order to keep the calculation simple, a similar ratio is calculated foroutstanding payments to suppliers. The trade creditors figure is oftennot displayed on the published balance sheet but will always be in thenotes. Trade creditors at the year end are compared with the totalcosts for the period, less costs that do not involve payments tosuppliers in the year – payroll costs and depreciation. Both numberswill always be found in the notes to the financial statements. Thisproportion is then converted into days, as before.

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

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

2006 in days58838269,4748426,63

083,5365

ondepreciaticostspayrollexpensessalesofCostscreditorstrade365

=−−+

×

=−−+

×

Lesson 7


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

7.10.1 Current ratioThis compares the current assets of the business with the currentliabilities. In other words, the level of funds flowing into the companyin the near future, versus the requirement to pay out monies in thenext 12 months. The lesson on cash showed the importance of cashmanagement and that working capital management is a crucial part ofthis. Some textbooks suggest that this ratio needs to be two in orderfor a company’s financial position to be safe. Tesco’s ratio shows thisis profoundly untrue.

Current assets 3,919———————————— = ———— = 0.52 in 2006Current liabilities 7,518

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

7.10.2 Acid testSometimes referred to as the quick ratio, this ratio assumes that theinventory 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 undulycautious; for a manufacturer with a 20-week production period, it isprobably 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 sameindustry would enable you to judge whether this is goodmanagement. Clearly if Tesco did not have a large cash balance theratio would be much lower.

7.10.3 Interest coverThe downside of debt is having to pay interest on the sumoutstanding. The more that is borrowed, the more interest that has tobe paid. One way of assessing whether a company can afford the levelof debt it has taken on is to compare the profit before interest and taxwith the interest that needs to be paid.

2006 2005

Current ratio 0.52 0.57

Acid test 0.30 0.34

Interest cover 9.80 8.62

Gearing 0.60 0.59

Lesson 7


Table 7.7

Tesco – liquidity andsolvency

Profit before interest 2,362—————————————————————— = ———— = 9.8 in 2006Interest payable or finance expenses 241

This ratio states that Tesco’s profit covered the net interest 10 times –a high and safe multiple. The more volatile the industry, the more onewould be concerned by a low ratio – two or three. In an industry suchas automotive manufacture, where companies oscillate between largeprofits and large losses, a low ratio would be worrying. When it isdifficult to make a profit, interest payments become one furtherburden that a company can ill-afford. For a stable, profitable company,a reasonable level of debt is a cost-effective way of raising finance. InLesson 9 we will consider whether a set of accounts always presentsthe split between debt and equity (and therefore interest and dividendpayments) in quite the way we might like for our analysis.

7.10.4 GearingGearing refers to the split of the long-term capital of the companybetween debt and equity. Equity is regarded as safe, but expensive. Ifno dividend is paid, the shareholders can only sell. The long-termnature of shares and the potential volatility of the dividend mean thatshareholders require the likelihood of a good return beforeundertaking to purchase shares. Debt holders, on the other hand, arelikely to be able to take drastic (for example, legal) steps if interest isnot 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 somedebt as part of the long-term capital of the business is probablysensible, but having too much potentially means losing control to thedebt holders, often banks and payments of large amounts of interestthat cannot easily be avoided.

The gearing (or leverage) of a company can be expressed in a numberof ways. The meaning changes little, but the result of the calculationcan change considerably, so always be aware of how it has beencalculated before interpreting the answer. The method here takes thedebt of the company – that is, amounts that the company owes andon which it is required to pay interest or a finance charge for theprivilege of having the money (sometimes referred to as ‘interestbearing liabilities’) – and compares it with shareholders’ funds. If thefigure is one, that would imply that debt holders have invested asmuch money in the company as shareholders – not necessarily a badthing, but a useful benchmark for who has dug deepest into theirpockets. A company with low borrowings has more opportunity togrow, as it will have the chance to borrow more. The company withhigh debts will have limited flexibility in its future decision making.

Short and long term debt 3,742 + 1,885———————————————— = —————————— = 0.60

Shareholders’ funds 9,444

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

Lesson 7


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

7.11 The shareholders’ viewOur final pair of ratios here considers the company from theshareholders’ perspective. There are many reasons for analysis, andeven shareholders should be concerned about how managers haveperformed with the resources at their disposal. Here, though, wesimply address the level of return to the shareholders and the securityof the dividend.

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

7.11.1 Return on ordinary shareholders’ fundsAfter all other stakeholders have received their reward or share of thecompany’s profits, the shareholders are left with the ‘profit for theyear’ or ‘profit after tax’. An American would use the phrase ‘earnings’.This can be compared with the level of shareholders’ funds in thebalance sheet, to give a feel for the return that the shareholders haveachieved during the year.

Profit for the yearattributable to the shareholders

of the parent 1,570————————————————— = ———— = 16.7% in 2006

Shareholders’ funds 9,380

So for every pound in shareholders’ funds, it would seem that Tescoshareholders are 16.7 pence better off at the end of the year. This maybe reinvested in the company or paid out as a dividend. Note that wehave defined shareholders’ funds here excluding minorities. Minoritiesare, almost always, an immaterial item.

2006 2005

Return on ordinary shareholders’ funds 16.74% 15.62%

Dividend cover 2.34 2.25

Lesson 7


Table 7.8

Shareholders’ view

7.11.2 Dividend coverThe dividend flow from a company is relied on by some investors andeveryone in the stock market would see the maintenance or increaseof dividends as a sign of financial strength. Dividends are paid out ofprofits, however, and an investor could be justifiably concerned aboutthe continuance of the dividend, if profits were barely covering thedividend payments. It is possible to pay dividends when making a loss,but this could not be a long-term strategy.

Profit for the yearattributable to the shareholders

of the parent 1,570 million————————————————— = —————————————————

Shareholders’ funds 8.63p x 7.783 billion shares

= 2.34 in 2006

Tesco’s dividend is covered 2.34 times by profit for the year. Onewould suspect that the company would not want to see this slipbelow two. Very low dividend cover can suggest that managementhave no need to retain any profits, one assumes because they have noideas of what to spend it on.

7.12 Assessing the numbersWhen carrying out a series of calculations, it is easy to forget thepurpose for which we are doing them. Earlier in the chapter weintroduced 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 fewparagraphs. An interesting question is how the ratios fitted with theenvironmental analysis and the perceived relative power of the playersin the market. Tesco appear to be a growing company carrying outsignificant investment and making a good return.

The nature of the evaluation is dependent on the original businessdecision being considered. Deciding whether to supply a potentialcustomer would focus on their ability to pay and on the long-termprospects for business. Assessing an acquisition would focus on futureopportunities that the target might have, the synergies with thepotential acquirer and the likely cost of purchasing the company.

This lesson has covered both a framework for financial analysis and acalculation of some of the more common ratios. The next lesson willcover some of the difficulties in carrying out analysis, consider astructured pyramid of ratios and look at how particular groups ofanalysts have developed further approaches to enhance their decision making.

Lesson 7


7.13 References and further readingMoon, P. and Bates, K. (1993)‘Core Analysis in Strategic Performance Appraisal’Management Accounting Research, 4, 2, pp. 139–52

Porter, M.E. (1980)Competitive Strategy: Techniques for Analyzing Industries andCompetitorsLondon: Free Press, a division of Simon & Schuster

Lesson 7


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

Question 1

Wal-MartWal-Mart is the world’s largest retailer and is based in the US butoperates in many countries – for example, it owns ASDA in the UK. Itis renowned for its aggressive pricing policies and low costs. There areonly a couple of lines taken from the cash flow statement because cashflow statements in the US and UK are too different to convertmeaningfully. Use these simplified accounts to produce an overviewand ratios for 2001 and 2002.

(These accounts are produced under US GAAP, but re-presentedslightly to fit in with the rest of the chapter.)

Income statement 2001 2002

$m % $m %

Turnover 191,329 100.0 219,812 100.0

Operating expenses –179,839 –94.0 –207,735 –94.5

Other items 0 0.0 0 0.0

Profit on ordinary activities 11,490 6.0 12,077 5.5

Interest –1,374 –0.7 –1,326 –0.6

Profit before tax 10,116 5.3 10,751 4.9

Tax –3,692 –1.9 –3,897 –1.8

Profit for the year 6,424 3.4 6,854 3.1

Dividends –1,073 –0.6 –1,247 –0.6

Retained profit 5,351 2.8 5,607 2.6

Lesson 7


Question 2

ICITo contrast with retailers who show an excellent performance, thenext company is ICI PLC, the chemical company. Obviously, there willbe a number of differences from Tesco and Wal-Mart. Again, you needto carry out an overview of the company and then work out the ratios.What are your conclusions regarding the state of ICI? (These accountsare drawn up under UK standards, but again re-presented to beconsistent with the chapter.)

Balance sheet 2001 2002

$m % $m %

Tangible assets 40,934 52 45,750 55

Intangible assets 9,059 12 8,595 10

Investments 1,582 2 860 1

Total non-current assets 51,575 66 55,205 66

Inventory 21,442 27 22,614 27

Debtors 1,768 2 2,000 2

Short term investments 1,291 2 1,471 2

Cash 2,054 3 2,161 3

Current assets 26,555 34 28,246 34

Total assets 78,130 100 83,451 100

Overdraft/Short term loans 4,375 6 2,405 3

Trade creditors 17,378 22 16,360 20

Other 7,196 9 8,517 10

Current liabilities 28,949 37 27,282 33

Bank loans, etc., over one year 15,655 20 18,732 22

Provisions 1,043 1 1,128 1

Shareholders’ funds 31,343 40 35,102 42

Minorities 1,140 1 1,207 1

Total liabilities 78,130 100 83,451 100

Cash flow information 2001 2002

$m $m

Net cash flow from operating activities

9,604 10,260

Capital expenditure –8,714 –7,146

Debt at year end 17,976 18,976

Other information

Number of employees 1,244,000 1,383,000

Lesson 7


Income statement 2000 2001

£m % £m %

Turnover 7,748 100.0 6,425 100.0

Operating expenses –7,486 –96.6 –5,950 –92.6

Other items –103 –1.3 41 0.6

Profit on ordinary activities 159 2.1 434 6.8

Interest –246 –3.2 –229 –3.6

Profit before tax –87 –1.1 205 3.2

Tax –117 –1.5 –56 –0.9

Minorities –24 –0.3 –28 –0.4

Profit for the year –228 –2.9 121 1.9

Dividends –232 –3.0 –116 –1.8

Retained profit –460 –5.9 5 0.1

Balance sheet 2000 2001

£m % £m %

Tangible assets 2,398 34 2,186 35

Intangible assets 609 9 613 10

Investments 327 5 374 6

Total non-current assets 3,334 47 3,173 50

Inventory 843 12 753 12

Debtors 2,244 32 1,913 30

Short term investments 415 6 159 3

Cash 255 4 301 5

Current assets 3,757 53 3,126 50

Total assets 7,091 100 6,299 100

Overdraft/Short term loans 1,231 17 1,668 26

Trade creditors 917 13 804 13

Other 1,360 19 1,129 18

Current liabilities 3,508 49 3,601 57

Bank loans, etc., over one year

2,231 31 1,705 27

Provisions 1,509 21 1,225 19

Shareholders’ funds –216 –3 –283 –4

Minorities 59 1 51 1

Total liabilities 7,091 100 6,299 100

Lesson 7


A guide answer to these questions is given overleaf.

Cash flow statement 2000 2001

£m % £m %

Net cashflow from operating activities

586 100 637 100

Interest paid and received –225 –38 –207 –32

Taxation –104 –18 –58 –9

Capital expenditure –226 –39 –206 –32

Acquisitions and disposals –138 –24 –92 –14

Dividends paid –231 –39 –185 –29

Cash outflow before liquid resources and financing

–338 –58 –111 –17

Management of liquid resources

–12 –2 253 40

Financing 336 57 –77 –12

Increase in cash –14 –2 65 10

Increase in net debt –452 –77 –118 –19

Debt at year end –2,799 –478 –2,917 –458

Other information

Number of employees 45,130 38,600

Lesson 7


Answer to Self-Assessed AssignmentQuestion 1

Wal-Mart

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

Overview 2001 2002 % change

$m $m

Turnover 191,329 219,812 14.9

Operating profit 11,490 12,077 5.1

Dividend payments 1,072.8 1,246.84 16.2

Retained profit 5,351 5,607 4.8

Operating cash flow 9,604 10,260 6.8

Capital investment and acquisitions

8,714 7,146 –18.0

Debt 17,976 18,976 5.6

Employees 1,244,000 1,383,000 11.2

Performance 2001 2002

Return on net assets 23.87% 21.94%



Sales per employee $153,801 $158,939

Profit per employee $9,236 $8,732

Working capital 2001 2002

Inventory days 44 40

Debtor days 3 3

Creditor days 35 29

Liquidity and solvency 2001 2002


Acid test 0.18 0.21


Gearing 0.64 0.60

Shareholders’ view 2001 2002

Return on ordinary shareholders’ funds

20.50% 19.53%

Dividend cover 5.99 5.50

Lesson 7


Return and margin fell slightly, but are still impressive, even comparedwith Tesco. Asset turnover is stable and lower than Tesco, implyingthat they might be a little more downmarket in style. The profit andsales per employee are fairly constant.

They managed to reduce inventory days down by four to 40. Bear inmind that they have a much larger non-food proportion than Tesco atpresent 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 acidtest is in much the same range – reassurance that Tesco’s low numberis not a problem. Interest cover and gearing fell slightly, showing thatthe growth in debt was less than the growth of the company as awhole.

While dividend cover and return on shareholders’ funds both fell alittle, return is still around 20% and dividend cover gives generouscomfort to shareholders.

Why not download Wal-Mart’s latest accounts from the web andconsider how things have changed over the last five years.

Question 2

ICIThe difference between ICI and Wal-Mart (or Tesco) is stark.

Overview 2000 2001 % change

£ £

Turnover 7,748 6,425 –17.1

Operating profit 159 434 173.0

Dividend payments 232 116 –50.0

Retained profit –460 5

Operating cash flow 586 637 8.7

Capital investment and acquisitions

226 206 –8.8

Debt 2,799 2,917 4.2

Employees 45,130 38,600 –14.5

Performance 2001 2002

Return on capital employed 7.67% 29.46%



Sales per employee £171,682 £166,451

Profit per employee £3,523 £11,244

Lesson 7


ICI is downsizing, with dramatic falls in turnover and employment.Capital investment also fell and is below 3% of turnover, which onemight consider unsustainable for a specialist chemical manufacturer.

Surprisingly, dividends were paid in each year, although the level hasbeen reduced. The loss means that it is wise not to attempt to calculatea percentage change in profit. Debt rose slightly.

Return on capital employed looks excellent in 2002, but this is due tothe diminished resources of the business – shareholders’ funds arenegative 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 theexplanation. In calculating capital employed for Tesco and Wal-Mart,we ignored provisions – amounts that the company may be liable topay at some point in the future. One might question this approachhere, as provisions are a very material item, given the state ofshareholders’ funds. The employee figures highlight the improvementin profit.

Inventory days and debtor days both lengthened, suggesting thatmanagement focus might be elsewhere in these difficult times. Tradecreditors 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 ismeaningless numerically, as shareholders’ funds are negative. Thenegative number does highlight that the shareholders have,effectively, no remaining stake in the business beyond their votingrights. The debt holders will be the ones that management have tolisten to closely, as their continuing support is vital to the company. Acompany is bankrupt when it is in a position where it cannot meet itsfinancial obligations (that is, pay its bills), not when shareholders’funds become negative. KPMG audited the accounts and gave ICI aclean bill of health with no adverse comments.

Working capital 2001 2002

Inventory days 41 46

Debtor days 106 109

Creditor days 45 49

Liquidity and solvency 2001 2002


Acid test 0.83 0.66


Gearing –16.03 –11.92

Shareholders’ view 2001 2002

Return on ordinary shareholders’ funds

105.56% –42.76%

Dividend cover –0.98 1.04

Lesson 7


Again, the negative shareholders’ funds make the return onshareholders’ funds meaningless. It has been included to make twoimportant mathematical points – divide a negative by a negative andyou get a positive (2001) and secondly divide a positive by a negativeand you get a negative (2002) – we would tend to assume the minuscomes from a negative number on the top of the equation.

If you were to download ICI’s latest accounts you will see there havebeen significant improvements.

Footnote1. You may find US textbooks use ROCE to refer to return on common

equity, which we look at as return on shareholders’ funds inLesson 8, Section 8.3.4.

End of Lesson 7

Lesson 7


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

afm l07 ibm 08

Documents

cash flow

turnover operating

low asset

parent shareholders

working capital

tax tax profit

financial

balance sheet