part 2 - novella.mhhe.comnovella.mhhe.com/.../0077173635/1082513/hillier_9780077173630_ch03.pdf ·...

hiL73635_ch03_063-092.indd 63 11/04/15 09:46 PM

One of the three central pillars of Corporate Finance is the investment decision. In Part 2, we will explore this topic in great detail and present a number of invaluable tools to assist you in making financial decisions. There are many types of information one can use to assess whether a potential project is worthwhile. In Finance, we almost always focus on cash flows, but there are other approaches (such as using accounting data) that provide valuable insights to the manager.

In Chapter 3 we start with the accounting figures of a company and, in particular, the income statement, balance sheet (or statement of financial position), and cash flow statement. A very common method of understanding the financial performance and health of a firm is to undertake a financial ratio analysis, and you are shown how to do this using an in-depth case study.

Chapter 4 is core to the remaining chapters of the book and introduces a concept called Time Value of Money. Time Value of Money takes both timing and risk into account to arrive at a present day value of any cash flow to be received in the future. Given the range of cash flow patterns that can be observed in business, Chapter 4 concerns itself with valuing these different cash flow streams.

The remaining chapters of Part 2 focus on practical applications. Chapter 5 shows how to value corporate bonds and equities, and Chapters 6 to 8 describe in some depth the various methods used by companies to value strategic investments. By the end of Part 2, you will be able to assess any investment or project and come to a conclusion on its value to your firm.

Value and Capital Budgeting

PART 2

Final PDF to printer

hiL73635_ch03_063-092.indd 64 11/04/15 09:46 PM

In November 2014, shares in the global engineering firm, Babcock International Group plc, were trading for about £10.89. At that price, Babcock had a price–earnings (PE) ratio of 24.66, meaning that investors were willing to pay £24.66 for every pound in income earned by Babcock. At the same time, investors were willing to pay £19.56 and £29.75 for each pound earned by BG Group and Smith & Nephew, respectively. Although their PE ratios are different from Babcock, the share prices were similar (£10.43 and £10.57 respectively). There are also many companies like Groupon and Facebook which, despite having very little or negative earnings (that is, they made a loss), have very high share prices. Meanwhile, the average equity in the FTSE 100 index, which contains 100 of the largest publicly traded companies in the United Kingdom, had a PE ratio of about 14.

Are the PE ratios of Babcock, BG Group and Smith & Nephew unnaturally high? What do PE ratios tell us and why are they important? To find out, this chapter explores a variety of ratios and their use in financial analysis and planning. However, before examining PE ratios, we need to spend some time on the source of this ratio – the company’s financial statements.

ROE Return on equity

ROA Return on assets

EPS Earnings per share

NCF Net cash flow

CF(O) Cash flow from operations

CF(I) Cash flow from investing activities

CF(F) Cash flow from financing activities

PE Price–earnings ratio

KEY NOTATIONS

Financial Statement Analysis

CHAPTER

3


The Statement of Financial Position 65

hiL73635_ch03_063-092.indd 65 11/04/15 09:46 PM

3.1 The Statement of Financial Position

The statement of financial position or balance sheet is an accountant’s snapshot of a firm’s accounting value on a particular date, as though the firm stood momentarily still (see Chapter 1, Section 1.1 for more information). The statement of financial position has two sides: on the left are the assets and on the right are the liabilities and shareholders’ equity. The statement of financial position states what the firm owns and how it is financed. The accounting definition that underlies

the statement of financial position and describes the relationship is:

Assets ≡ Liabilities + Shareholders’ equity

We have put a three-line equality in the balance equation to indicate that it must always hold, by definition. In fact, the shareholders’ equity is defined to be the difference between the assets and the liabilities of the firm. In principle, equity is what the shareholders would have remaining after the firm discharged its obligations.

Table 3.1 gives the 2014 statement of financial position for the satellite media firm, Sky plc. The assets in the statement of financial position are listed in order by the length of time it normally would take an ongoing firm to convert them into cash. The asset side depends on the nature of the business and how management chooses to conduct it. Management must make decisions about cash versus marketable securities, credit versus cash sales, whether to make or buy inventory, whether to lease or purchase items, the types of business in which to engage, and so on. The liabilities and the shareholders’ equity are also listed in the order in which they would typically be paid over time.

Chapter 1 Page 2

Table 3.1 2014 Statement of Financial Position (Balance Sheet) of Sky plc

Assets £m Equity and Liabilities £m

Non-Current Assets Non-Current Liabilities

Intangible Assets 1,829 Bank and Other Borrowings 2,658

Property, Plant and Equipment 1,088 Non-Current Trade and Other Payables 56

Investments and Joint Ventures 706 Other Non-Current Liabilities 144

Other Non-Current Assets 253

3,876 2,858

Current Assets Current Liabilities

Inventories 546 Borrowings 11

Trade and Other Receivables 635 Trade and Other Payables 2,286

Short-Term Deposits 295 Other Current Liabilities 222

Cash and Cash Equivalents 1,082 2,519

Other Current Assets 15 Total Liabilities 5,377

2,573 Total Equity 1,072

Total Assets 6,449 Total Equity and Liabilities 6,449

The liabilities and equity side reflects the types and proportions of financing, which depend on management’s choice of capital structure, as between debt and equity and between current debt and long-term debt.

When analysing a statement of financial position, the financial manager should be aware of three concerns: liquidity, debt versus equity, and value versus cost.

LiquidityLiquidity refers to the ease and quickness with which assets can be converted to cash (without significant loss in value). Current assets are the most liquid and include cash and assets that will be turned into cash within a year from the date of the statement of financial position. Trade receivables are amounts not yet collected from customers for goods or services sold to them (after adjustment for potential bad debts). Inventories are composed of raw materials to be used in production, work in progress and finished goods. Non-current assets are the least


Chapter 3 Financial Statement Analysis66

hiL73635_ch03_063-092.indd 66 11/04/15 09:46 PM

liquid kind of assets. Tangible non-current assets include property, plant and equipment. Non-current assets do not convert to cash from normal business activity, and they are not usually used to pay expenses such as payroll.

Some non-current assets are intangible. Intangible assets have no physical existence but can be very valuable. Examples of intangible assets are the value of a trademark or the value of a patent. Goodwill is an accounting term that reflects the premium paid by companies when they acquire other companies. Further analysis of Sky’s intangible assets figure of £1,829 million is that it consists of £1,019 million in goodwill and £810 million in other intangibles such as brands, software and contractual business relationships.

The more liquid a firm’s assets, the less likely the firm is to experience problems meeting short-term obligations. Thus, the probability that a firm will avoid financial distress can be linked to the firm’s liquidity. Unfortunately, liquid assets frequently have lower rates of return than non-current assets; for example, cash generates no investment income. To the extent a firm invests in liquid assets, it sacrifices an opportunity to invest in more profitable investment vehicles.

Debt versus EquityLiabilities are obligations of the firm that require a payout of cash within a stipulated period. Many liabilities involve contractual obligations to repay a stated amount and interest over a period. Thus, liabilities are debts and are frequently associated with nominally fixed cash burdens, called debt service, that put the firm in default of a contract if they are not paid. Shareholders’ equity is a claim against the firm’s assets that is residual and not fixed. In general terms, when the firm borrows, it gives the bondholders first claim on the firm’s cash flow. Bondholders can sue the firm if the firm defaults on its bond contracts. This may lead the firm to declare itself bankrupt. Shareholders’ equity is the residual difference between assets and liabilities:

Assets – Liabilities ≡ Shareholders’ equity

This is the shareholders’ ownership of the firm stated in accounting terms. The accounting value of shareholders’ equity increases when retained earnings are added. This occurs when the firm retains part of its earnings instead of paying them out as dividends.

Value versus CostThe accounting value of a firm’s assets is frequently referred to as the book value of the assets. Firms in different countries use various accounting standards to report the value of their assets. All listed companies in the European Union are required to use International Financial Reporting Standards (IFRS). IFRS value assets at theoretically true market or fair values. Market or fair value is the price at which willing buyers and sellers would trade the assets. Unfortunately, even with fair value accounting (IFRS), the tradable value of assets is likely to be different from their accounting value. This is because in many cases there is no liquid market that allows the calculation of an asset’s accounting fair value. In these situations, the financial manager must estimate a fair value from a similar asset or a theoretical model. In this book, we will treat IFRS as the main accounting system.

3.2 The Income Statement

The income statement measures performance over a specific period – say, a year. The accounting definition of income is:

Revenue - Expenses ≡ Income

If the statement of financial position is like a snapshot, the income statement is like a video recording of what the people did between two snapshots. Table 3.2 gives the income statement for Sky for year ending 2014.

The income statement usually includes several sections. The operations section reports the firm’s revenues and expenses from principal operations. Among other things, the non-operating section of the income statement includes all financing costs, such as interest expense. Usually a second section reports as a separate item the amount of taxes levied on income. The last item on the income statement is the bottom line, or net income. Net income is frequently expressed per share of equity – that is, earnings per share.

When analysing an income statement, the financial manager should keep in mind non-cash items, time and costs.


The Income Statement 67

hiL73635_ch03_063-092.indd 67 11/04/15 09:46 PM

Non-cash ItemsThe economic value of assets is naturally connected to their future incremental cash flows. However, cash flow does not appear on an income statement. There are several non-cash items that are expenses against revenues but do not affect cash flow. The most important of these is depreciation. Depreciation reflects the accountant’s estimate of the cost of equipment used up in the production process. For example, suppose an asset with a 5-year life and no resale value is purchased for €1,000. According to accountants, the €1,000 cost must be expensed over the useful life of the asset. If straight-line depreciation is used, there will be five equal instalments, and €200 of depreciation expense will be incurred each year. From a finance perspective, the cost of the asset is the actual negative cash flow incurred when the asset is acquired (that is, €1,000, not the accountant’s smoothed €200-per-year depreciation expense).

In practice, the difference between cash flows and accounting income can be quite dramatic, so it is important to understand the difference. For example, while Sky made a total profit of £865 million for the year ending 2014, their cash only increased by £267 million. We look at financial cash flow in more detail in Section 3.5.

Time and CostsIt is often useful to visualize all of future time as having two distinct parts, the short run and the long run. The short run is the period in which certain equipment, resources and commitments of the firm are fixed; but the time is long enough for the firm to vary its output by using more labour and raw materials. The short run is not a precise period that will be the same for all industries. However, all firms making decisions in the short run have some fixed costs – that is, costs that will not change because of fixed commitments. In real business activity, examples of fixed costs are bond interest, overhead and property taxes. Costs that are not fixed are variable. Variable costs change as the output of the firm changes; some examples are raw materials and wages for employees on the production line.

In the long run, all costs are variable. Accountants do not distinguish between variable costs and fixed costs. Instead, accounting costs usually fit into a classification that distinguishes product costs from period costs. Product

Table 3.2 The 2014 Income Statement of Sky plc

£m

Revenue 7,632

Operating Expenses 6,471

Operating Profit 1,161

Income from Joint Ventures and Investments 61

Profit Before Interest and Taxation 1,222

Finance Costs (Interest) 140

Profit before Tax 1,082

Tax 217

Profit After Tax 865

Number of Shares 1,575.59

Earnings per Share 0.549

Source: Sky plc annual accounts (2014).

Earnings per share = Profit for the period attributable to equityholders

____________________________________________ Total shares outstanding

= £865 million ______________ 1,575.59 million

= £0.549 per share



hiL73635_ch03_063-092.indd 68 11/04/15 09:46 PM

costs are the total production costs incurred during a period – raw materials, direct labour and manufacturing overheads – and are reported on the income statement as cost of goods sold. Both variable and fixed costs are included in product costs. Period costs are costs that are allocated to a time period; they are called selling, general and administrative expenses. One period cost would be the company chief executive’s salary.

3.3 Taxes

Taxes can be one of the largest cash outflows a firm experiences. For example, for the year ending 2013, Royal Dutch Shell’s profit before taxes was €26.9 billion. Its tax bill for this period was €17.1 billion or about 63.6 per cent of its pretax earnings. The size of the tax bill is determined by the tax code of the region your firm operates in, an often amended set of rules, and any deferred taxes from an earlier year. In this section, we examine corporate tax rates and how taxes are calculated.

If the various rules of taxation seem a little bizarre or convoluted to you, keep in mind that the tax code is the result of political, not economic, forces. As a result, there is no reason why it has to make economic sense.

Corporate Tax RatesAn overview of corporate tax rates that were in effect for 2014 for a sample of countries is shown in Table 3.3. Corporate taxes are not normally a simple arithmetic deduction from profit before taxes. Almost all countries in the world allow firms to carry forward losses they have made in previous years to offset their tax bill in the future.

This is what happened to Royal Dutch Shell in 2013. Although the corporate tax rate in the UK is much lower than 63.6 per cent, Royal Dutch Shell would have had to pay tax in different jurisdictions, many of which would have been greater than in the UK, as well as past taxes deferred from earlier years. (See Chapter 15, Section 15.5 and Chapter 16, Section 16.4 for more information on corporate tax.)

Chapter 15 Page 410Chapter 16 Page 435

Table 3.3 Corporate Tax Rates Around the World

Country Corporation Tax (%) Country Corporation Tax (%)

Australia 30 New Zealand 30

Austria 25 Norway 28

Bahrain 0 Oman 12

Belgium 33.99 Poland 19

Canada 34 Portugal 23

China 25 Russia 20

Denmark 24.5 Singapore 17

Finland 20 South Africa 28

France 33.33 Spain 30

Germany 29.58 Sweden 22

Greece 26 Switzerland 11.48–24.43

India 33.99 Tanzania 30

Ireland 12.5 Thailand 20

Italy 31.4 Turkey 20

Japan 35.64 United Arab Emirates 0

Malaysia 25 United Kingdom 20

Netherlands 20/25 United States 40

Source: © KPMG 2014.


Net Working Capital 69

hiL73635_ch03_063-092.indd 69 11/04/15 09:46 PM

The tax rates presented in Table 3.3 are average tax rates for the largest companies. Many countries apply differential taxation depending on how much a company earns in any given year. In the Netherlands, for example, there are two corporation tax bands. Firms that earn between €0 and €200,000 per annum have a tax rate of 20 per cent. Firms that earn above €200,000 must pay 25 per cent (as presented in Table 3.3).

Average versus Marginal Tax RatesIn making financial decisions, it is frequently important to distinguish between average and marginal tax rates. Your average tax rate is your tax bill divided by your taxable income – in other words, the percentage of your income that goes to pay taxes. Your marginal tax rate is the tax you would pay (in per cent) if you earned one more unit of currency. The percentage tax rates shown in Table 3.3 for the Netherlands are marginal rates. The first €200,000 earned by Dutch firms must pay 20 per cent tax. Any extra earnings are charged 25 per cent tax. Put another way, marginal tax rates apply to the part of income in the indicated range only, not all income.

The difference between average and marginal tax rates can best be illustrated with a simple example. Suppose our Dutch corporation has a taxable income of €400,000. What is the tax bill? Using Table 3.3, we can figure our tax bill like this: 0.20 × €200,000 = € 40,000 0.25 × (€400,000 – 200,000) = 50,000

€ 90,000

Our total tax is thus €90,000.In our example, what is the average tax rate? We had a taxable income of €400,000 and a tax bill of €90,000, so

the average tax rate is €90,000/400,000 = 22.5 per cent. What is the marginal tax rate? If we made one more euro, the tax on that euro would be 25 cents, so our marginal rate is 25 per cent.

Example 3.1

Deep in the Heart of Taxes Assume that TomTom, the Dutch satellite navigation firm, has a taxable income of €850,000. What is its tax bill? What is its average tax rate? Its marginal tax rate?

From Table 3.3, we see that the tax rate applied to the first €200,000 is 20 per cent; and the rate applied to the next €650,000 is 25 per cent. So TomTom must pay 0.20 × €200,000 + 0.25 × 650,000 = €202,500. The average tax rate is thus €202,500/850,000 = 23.82 per cent. The marginal rate is 25 per cent because TomTom’s taxes would rise by 25 cents if it had another euro in taxable income.

3.4 Net Working Capital

Net working capital is current assets minus current liabilities. Net working capital is positive when current assets are greater than current liabilities. This means the cash that will become available over the next 12 months will be greater than the cash that must be paid out. The net working capital of Sky plc in 2014 was £54 million:

Current assets (£ millions)

–Current liabilities

(£ millions)=

Net working capital (£ millions)

2014 2,573 – 2,519 = 54

2013 2,569 – 2,317 = 252

In addition to investing in fixed assets (i.e., capital expenditure), a firm can invest in net working capital. This is called the change in net working capital. The change in net working capital in 2014 is the difference between

With a flat-rate tax, there is only one tax rate, so the rate is the same for all income levels. With such a tax, the marginal tax rate is always the same as the average tax rate. As it stands now, corporate taxation in the United Kingdom is based on a modified flat-rate tax.

Normally, the marginal tax rate will be relevant for financial decision-making. The reason is that any new cash flows will be taxed at that marginal rate. Because financial decisions usually involve new cash flows or changes in existing ones, this rate will tell us the marginal effect of a decision on our tax bill.



hiL73635_ch03_063-092.indd 70 11/04/15 09:46 PM

the net working capital in 2014 and 2013. In Sky’s case, this is £54 million − £252 million = –£198 million. What is causing the drop in net working capital? A further analysis of Sky’s accounts shows that although current assets marginally increased by £4 million, its current liabilities jumped by £202 million, principally caused by a £200 million increase in Trade Payables.

3.5 Cash Flow

Perhaps the most important item that can be extracted from financial statements is the actual cash flow of the firm. An official accounting statement called the statement of cash flows helps to explain the change in accounting cash and equivalents, which for Sky was £267 million in 2014. (See Chapter 4 for more information on cash flows.)

The first point we should mention is that cash flow is not the same as net working capital. For example, increasing inventory requires using cash. Because both inventories and cash are current assets, this does not affect net working capital. In this case, an increase in inventory is associated with decreasing cash flow.

A firm’s cash flow comes from or goes to three main areas: operating activities, CF (O), investing activities, CF (I), and financing activities, CF (F). Just as we established that the value of a firm’s assets is always equal to the combined value of the liabilities and the value of the equity, the net cash flow in a firm during a particular period is the sum of cash flows resulting from operating, investing and financing activities. A negative cash flow represents a movement of cash out of the firm.

NCF ≡ CF(O) + CF(I) + CF(F)

The first step in determining cash flows of the firm is to figure out the operating cash flow or, more formally, net cash provided by operating activities. As can be seen in Table 3.4, operating cash flow is the cash flow generated by business activities, including sales of goods and services. Operating cash flow reflects tax payments, but not financing, capital spending or changes in net working capital.

Chapter 4 Page 93

Table 3.4 Cash Flow of Sky plc

£m

Cash Flow from Operating Activities

Cash Generated from Operations 1,769

Income from other activities 27

Tax Paid –240

Net Cash from Operating Activities 1,556

Cash Flow from Investing Activities

Purchase of Property, Plant & Equipment –241

Purchase of Intangible Assets –302

Decrease in Short-Term Deposits 300

Other Investments –1

Net Cash used in Investing Activities –244

Cash Flow from Financing Activities

Interest Paid –137

Dividends Paid –485

Purchase of Own Shares –430

Other Financing Activities 7

Net Cash used in Financing Activities –1,045

Net Increase in Cash and Cash Equivalents 267


Cash Flow 71

hiL73635_ch03_063-092.indd 71 11/04/15 09:46 PM

Another important component of cash flow involves changes in cash flow from investing activities. The net change in cash flow from investing activities equals the acquisition of non-current assets plus any security investments minus the sales of non-current assets. The result is the cash flow used for investment purposes. In Sky’s cash flow statement, this amounts to a net outflow of £244 million in 2014.

Cash flows also come from financing purposes, such as the firm buying back its own shares, issuing new shares to the market and increasing or decreasing borrowing. For Sky in 2014, cash outflows from financing activities were £1,045 million. This was largely because the company paid interest of £137 million, dividends of £485 million, and bought back £430 million of its stock.

Total net cash flows generated by the firm’s assets in 2014 were then equal to:

(£ millions)

Net cash provided by operating activities 1,556

Net cash provided by investing activities –244

Net cash provided by financing activities –1,045

Net cash flow 267

Some important observations can be drawn from our discussion of cash flow:

1 Several types of cash flow are relevant to understanding the financial situation of the firm. Operating cash flow measures the cash generated from operations not counting cash flows arising from investment expenditure or financing. It is usually positive; a firm is in trouble if operating cash flow is negative for a long time because the firm is not generating enough cash to pay operating costs. The total cash flow of the firm includes adjustments for capital spending and new financing. It will frequently be negative. When a firm is growing at a rapid rate, spending on inventory and non-current assets can be higher than operating cash flow.

2 Profit is not cash flow. The profit made by Sky in 2014 was £865 million, whereas cash flow was only £267 million. The two numbers are not usually the same. In determining the economic and financial condition of a firm, cash flow is more revealing.

A firm’s total cash flow sometimes goes by a different name, free cash flow. Of course, there is no such thing as ‘free’ cash. Instead, the name refers to cash that the firm is free to distribute to creditors and shareholders because it is not needed for working capital or investments. We will stick with ‘total cash flow of the firm’ as our label for this important concept because, in practice, there is some variation in exactly how free cash flow is computed. Nonetheless, whenever you hear the phrase ‘free cash flow’, you should understand that what is being discussed is cash flow from assets or something quite similar.

Real World Insight 3.1

BAE Systems PlcBAE Systems is a global defence, aerospace and security company employing around 88,200 people worldwide. Its products and services cover air, land and naval forces, as well as advanced electronics, security, information technology, and support services. The company’s income statement is presented below. All figures are in £millions.

Income Statement

2014 £m

2013 £m

Sales 16,637 18,180

Underlying EBITA 1,702 1,925

Return on sales 10.2% 10.6%

Non recurring items - 6

EBITA 1,702 1,931

Amortisation of intangible assets (184) (189)



hiL73635_ch03_063-092.indd 72 11/04/15 09:46 PM

3.6 Financial Statement Analysis

A good working knowledge of financial statements is desirable simply because such statements, and numbers derived from those statements, are the primary means of communicating financial information both within the firm and outside the firm. In short, much of the language of business finance is rooted in the ideas we discuss in this chapter.

Clearly, one important goal of the accountant is to report financial information to the user in a form useful for decision-making. Ironically, the information frequently does not come to the user in such a form. In other words, financial statements do not come with a user’s guide. This chapter is a first step in filling this gap.

Standardizing Statements One obvious thing we might want to do with a company’s financial statements is to compare them to those of other, similar companies. We would immediately have a problem, however. It is almost impossible to directly compare the financial statements for two companies because of differences in size.

For example, Ryanair and Air France-KLM are obviously serious rivals in the European flights market, but Air France-KLM is much larger (in terms of assets), so it is difficult to compare them directly. For that matter, it is difficult even to compare financial statements from different points in time for the same company if the company’s size has changed. The size problem is compounded if we try to compare Air France-KLM and, say, International Airlines Group (IAG, formerly British Airways and Iberia). Since IAG’s financial statements are denominated in British pounds, we have size and currency differences.

To start making comparisons, one obvious thing we might try to do is to somehow standardize the financial statements. One common and useful way of doing this is to work with percentages instead of total monetary amounts. The resulting financial statements are called common-size statements.

Common-size statements of financial position can be constructed by expressing each item as a percentage of total assets. In this form, financial statements are relatively easy to read and compare. For example, just looking at the statement of financial position for Sky, we can see that current assets were 40 per cent of total assets in 2014. Current liabilities were 39 per cent of total assets over that same time. Similarly, shareholders’ equity comprised 16.6 per cent of total asset value.

A useful way of standardizing the income statement shown in Table 3.2 (see page 67) is to express each item as a percentage of total revenues. A common-size income statement tells us what happens to each cash unit in revenues. For Sky, 2014 taxes ate up £0.0284 out of every pound made in revenues. When all is said and done, only £0.1133 of each pound in revenues flows through to the bottom line (net income). These percentages are useful in

Income Statement

2014 £m

2013 £m

Impairment of intangible assets (170) (887)

Finance costs (448) (392)

Taxation expense (148) (287)

Profit for the year 752 176

There are many items of information a reader must take in when looking at an income statement. For example, have revenues increased or decreased over time? How have costs changed over the same period? Is any component of the cost base changing in an unusual way? What is the overall operating income of the company and is it improving? Is the company making a profit or loss? Is the profit acceptable to the firm?

Source: BAE Systems Annual Report 2014 from companieshouse.gov.uk.


Ratio Analysis 73

hiL73635_ch03_063-092.indd 73 11/04/15 09:46 PM

comparisons. For example, a relevant figure is the cost percentage. For Sky, £0.848 of each £1.00 in revenues goes in operating expenses. It would be interesting to compute the same percentage for Sky’s main competitors to see how the firm stacks up in terms of cost control.

3.7 Ratio Analysis

Another way of avoiding the problems involved in comparing companies of different sizes is to calculate and compare financial ratios. Such ratios are ways of comparing and investigating the relationships between different pieces of financial information. We cover some of the more common ratios next (there are many others we do not discuss here).

One problem with ratios is that different people and different sources frequently do not compute them in exactly the same way, and this leads to much confusion. The specific definitions we use here may or may not be the same as ones you have seen or will see elsewhere. If you are using ratios as tools for analysis, you should be careful to document how you calculate each one; and, if you are comparing your numbers to those of another source, be sure you know how their numbers are computed.

We will defer much of our discussion of how ratios are used and some problems that come up with using them until later in the chapter. For now, for each ratio we discuss, several questions come to mind:

1 How is it computed?

2 What is it intended to measure, and why might we be interested?

3 What is the unit of measurement?

4 What might a high or low value be telling us? How might such values be misleading?

5 How could this measure be improved?

Financial ratios are traditionally grouped into the following categories:

1 Short-term solvency, or liquidity, ratios

2 Long-term solvency, or financial leverage, ratios

3 Asset management, or turnover, ratios

4 Profitability ratios

5 Market value ratios.

We will consider each of these in turn. In calculating these numbers for Sky, we will use the ending statement of financial position (2014) figures unless we explicitly say otherwise.

Short-term Solvency or Liquidity Measures As the name suggests, short-term solvency ratios as a group are intended to provide information about a firm’s liquidity, and these ratios are sometimes called liquidity measures. The primary concern is the firm’s ability to pay its bills over the short run without undue stress. Consequently, these ratios focus on current assets and current liabilities.

For obvious reasons, liquidity ratios are particularly interesting to short-term creditors. Because financial managers are constantly working with banks and other short-term lenders, an understanding of these ratios is essential.

One advantage of looking at current assets and liabilities is that their book values and market values are likely to be similar. Often (though not always), these assets and liabilities just do not live long enough for the two to get seriously out of step. On the other hand, like any type of near-cash, current assets and liabilities can and do change fairly rapidly, so today’s amounts may not be a reliable guide to the future.

Current Ratio One of the best-known and most widely used ratios is the current ratio. As you might guess, the current ratio is defined as:

Current ratio = Current assets ________________ Current liabilities

(3.1)



hiL73635_ch03_063-092.indd 74 11/04/15 09:46 PM

For Sky, the 2014 current ratio is:

Current ratio = £2,573

______ £2,519

= 1.02 times

Because current assets and liabilities are, in principle, converted to cash over the following 12 months, the current ratio is a measure of short-term liquidity. The unit of measurement is either in cash units (such as £s) or times. So, we could say Sky has £1.02 in current assets for every £1 in current liabilities, or we could say Sky has its current liabilities covered 1.02 times over.

To a creditor, particularly a short-term creditor such as a supplier, the higher the current ratio, the better. To the firm, a high current ratio indicates liquidity, but it also may indicate an inefficient use of cash and other short-term assets. Absent some extraordinary circumstances, we would expect to see a current ratio of at least 1; a current ratio of less than 1 would mean that net working capital (current assets less current liabilities) is negative. This would be unusual in a healthy firm, at least for most types of businesses.

The current ratio, like any ratio, is affected by various types of transactions. For example, suppose the firm borrows over the long term to raise money. The short-run effect would be an increase in cash from the issue proceeds and an increase in long-term debt. Current liabilities would not be affected, so the current ratio would rise.

Example 3.2

Current Events Suppose a firm were to pay off some of its suppliers and short-term creditors. What would happen to the current ratio? Suppose a firm buys some inventory. What happens in this case? What happens if a firm sells some merchandise?

The first case is a trick question. What happens is that the current ratio moves away from 1. If it is greater than 1 (the usual case), it will get bigger, but if it is less than 1, it will get smaller. To see this, suppose the firm has £4 in current assets and £2 in current liabilities for a current ratio of 2. If we use £1 in cash to reduce current liabilities, the new current ratio is (£4 − 1)/(£2 − 1) = 3. If we reverse the original situation to £2 in current assets and £4 in current liabilities, the change will cause the current ratio to fall to 1/3 from 1/2.

The second case is not quite as tricky. Nothing happens to the current ratio because cash goes down while inventory goes up – total current assets are unaffected.

In the third case, the current ratio would usually rise because inventory is normally shown at cost and the sale would normally be at something greater than cost (the difference is the markup). The increase in either cash or receivables is therefore greater than the decrease in inventory. This increases current assets, and the current ratio rises.

Finally, note that an apparently low current ratio may not be a bad sign for a company with a large reserve of untapped borrowing power.

Quick (or Acid-test) Ratio Inventory is often the least liquid current asset. It is also the one for which the book values are least reliable as measures of market value because the quality of the inventory is not considered. Some of the inventory may later turn out to be damaged, obsolete or lost.

More to the point, relatively large inventories are often a sign of short-term trouble. The firm may have overestimated sales and overbought or overproduced as a result. In this case, the firm may have a substantial portion of its liquidity tied up in slow-moving inventory.

To further evaluate liquidity, the quick, or acid-test, ratio is computed just like the current ratio, except inventory is omitted:

Quick ratio = Current assets − Inventory

_________________________ Current liabilities

(3.2)

Notice that using cash to buy inventory does not affect the current ratio, but it reduces the quick ratio. Again, the idea is that inventory is relatively illiquid compared to cash.

For Sky, this ratio in 2014 was:

Quick ratio = £2,573 − 546

____________ £2,519

= 0.80 times


Ratio Analysis 75

hiL73635_ch03_063-092.indd 75 11/04/15 09:46 PM

The quick ratio for Sky is lower because of the £546 million of inventory in the company. Managers would need to keep an eye on this ratio to ensure that inventory levels were not becoming too high, thereby reducing the quick ratio to unacceptably low levels.

To give an example of current versus quick ratios, based on recent financial statements, Sky and Inmarsat plc, the global satellite firm, had current ratios of 1.02 and 0.57, respectively. Inmarsat’s current ratio is exceptionally low and concerning. Looking at the quick ratio, because Inmarsat has very little inventory, there is almost no difference between the quick ratio (0.53) and current ratio. Inmarsat would need to address the very low liquidity because it appears that it will have difficulty meeting its obligations over the coming year without some form of injection of cash.

Cash Ratio A very short-term creditor might be interested in the cash ratio:

Cash ratio = Cash and cash equivalents

________________________ Current liabilities

(3.3)

You can verify that this works out to be 0.43 times for Sky.

Long-term Solvency Measures Long-term solvency ratios are intended to address the firm’s long-run ability to meet its obligations or, more generally, its financial leverage. These ratios are sometimes called financial leverage ratios or just leverage ratios. We consider three commonly used measures and some variations.

Total Debt Ratio The total debt ratio takes into account all debts of all maturities to all creditors. It can be defined in several ways, the easiest of which is this:

Total debt ratio = Total assets − Total equity

________________________ Total assets

= £6,449 − 1,072

_____________ £6,449

= 0.8338 times (3.4)

In this case, an analyst might say that Sky uses 83.38 per cent debt. Whether this is high or low or whether it even makes any difference depends on whether capital structure matters, a subject we discuss in a later chapter.

Sky has £0.8338 in debt for every £1 in assets. Therefore, there is £0.1662 in equity (£1 − 0.8338) for every £0.8338 in debt. With this in mind, we can define two useful variations on the total debt ratio, the debt–equity ratio and the equity multiplier:

Debt–equity ratio = Total debt/Total equity

= £0.8338/£0.1662 = 5.016 times (3.5)

Equity multiplier = Total assets/Total equity

= £1/£0.1662 = 6.016 times (3.6)

The fact that the equity multiplier is 1 plus the debt–equity ratio is not a coincidence:

Equity multiplier = Total assets/Total equity = £1/£0.1662 = 6.016 times

= (Total equity + Total debt)/ Total equity

= 1 + (Debt/equity ratio) = 6.016 times

The thing to notice here is that given any one of these three ratios, you can immediately calculate the other two, so they all say exactly the same thing.

Times Interest Earned Another common measure of long-term solvency is the times interest earned (TIE) ratio. Once again, there are several possible (and common) definitions, but we will stick with the most traditional. The TIE formula is:

Times interest earned ratio = Profit Before Interest and Taxes _____________________________ Interest

= £1,222

______ £140

= 8.73 times (3.7)



hiL73635_ch03_063-092.indd 76 11/04/15 09:46 PM

Profit before Interest and Taxes is also known as Earnings before Interest and Taxes or EBIT. As the name suggests, this ratio measures how well a company has its interest obligations covered, and it is often called the interest coverage ratio. For Sky, the interest bill is covered 8.73 times over.

Cash Coverage A problem with the TIE ratio is that it is based on EBIT, which is not really a measure of cash available to pay interest. The reason is that depreciation, a non-cash expense, has been deducted out. Because interest is most definitely a cash outflow (to creditors), one way to define the cash coverage ratio is:

Cash coverage ratio = EBIT + Depreciation

___________________ Interest

= £1,222 + 407

____________ £140

= 11.64 times (3.8)

The numerator here, EBIT plus depreciation, is often abbreviated EBITD (earnings before interest, taxes and depreciation). It is a basic measure of the firm’s ability to generate cash from operations, and it is frequently used as a measure of cash flow available to meet financial obligations. You may be wondering where the depreciation figure came from as it does not appear in any of the tables so far. This is because the information is taken from the notes to the financial reports, which is found in the full 2014 Sky plc annual report. Interested readers should check this from the company’s website.

Asset Management or Turnover Measures We next turn our attention to the efficiency with which Sky uses its assets. The measures in this section are sometimes called asset management or utilization ratios. The specific ratios we discuss can all be interpreted as measures of turnover. What they are intended to describe is how efficiently, or intensively, a firm uses its assets to generate sales. We first look at two important current assets: inventory and receivables.

Inventory Turnover and Days’ Sales in Inventory To calculate inventory turnover, one must first consider the cost of goods sold. This is the direct cost of earning the company’s main revenues during the year. The costs should include materials used, labour costs, managerial salaries and other costs of earning the revenues. Depreciation is included in the figure if it is being charged on assets directly related to the main revenue stream. Otherwise, it is left out. In Sky’s case, the depreciation would be charged for reduction in the value of their satellite equipment and so this figure should be included in the cost of goods sold figure.

For Sky, the concept of inventory turnover and days’ sales in inventory is not appropriate because the firm does not have any real inventories to speak of. You would, therefore, not consider these ratios for this type of firm.

Normally, inventory turnover can be calculated as:

Inventory turnover = Cost of goods sold

_________________ Inventory

(3.9)

As long as your company is not running out of stock and thereby forgoing sales, the higher this ratio is, the more efficiently your company is at managing inventory. For Sky, this is:

Inventory turnover = Operating expenses

__________________ Inventory

= £6,471

______ £546

= 11.85

The Inventory turnover figure of 11.85 tells us that Sky turned their inventory over 11.85 times during the year. We can immediately figure out how long it took them to turn it over on average. The result is the average days’ sales in inventory:

Days’ sales in inventory = 365 days

__________________ Inventory turnover

= 365 _____ 11.85

= 31 days (3.10)

This tells us that, roughly speaking, inventory sits 31 days on average before it is sold. Alternatively, assuming we used the most recent inventory and cost figures, it will take about 31 days to work off our current inventory.


Ratio Analysis 77

hiL73635_ch03_063-092.indd 77 11/04/15 09:46 PM

Receivables Turnover and Days’ Sales in Receivables Our inventory measures give some indication of how fast we can sell products. We now look at how fast we collect on those sales. The receivables turnover is defined in the same way as inventory turnover:

Receivables turnover = Revenues ________________ Trade receivables

= £7,632

______ 635

= 12.02 times (3.11)

Loosely speaking, Sky collected its outstanding credit accounts and lent the money again 12.02 times during the year.

This ratio makes more sense if we convert it to days, so the days’ sales in receivables is:

Days’ sales in receivables = 365 days

____________________ Receivables turnover

= 365 _____ 12.02

= 30 days (3.12)

Therefore, on average, Sky collects on its credit sales in 30 days. For obvious reasons, this ratio is frequently called the average collection period (ACP). Also note that if we are using the most recent figures, we can also say that Sky has 30 days’ worth of sales currently uncollected.

Unfortunately, this ratio illustrates the dangers of using financial ratios without really understanding their true meaning. The receivables turnover ratio and days’ sales in receivables figure implicitly assumes that all sales in a firm are credit sales. When this is not true, only credit sales figures should be used – not total sales. For firms that take payment immediately, such as low budget airlines, credit sales will only make up a small proportion of total sales. If we had the data, we should have used only credit sales in the numerator of Equation (3.11).

Total Asset Turnover Moving away from specific accounts like inventory or receivables, we can consider an important ‘big picture’ ratio, the total asset turnover ratio. As the name suggests, total asset turnover in 2014 for Sky is:

Total asset turnover = Revenues ___________ Total assets

= £7,632

______ £6,449

= 1.18 times (3.13)

In other words, for every pound in assets, Sky generated £1.18 in sales.

Example 3.4

More Turnover Suppose you find that a particular company generates £0.40 in annual sales for every pound in total assets. How often does this company turn over its total assets?

The total asset turnover here is 0.40 times per year. It takes 1/0.40 = 2.5 years to turn assets over completely.

Example 3.3

Payables Turnover Here is a variation on the receivables collection period. How long, on average, does it take for Sky to pay its bills? To answer, we need to calculate the trade payables turnover rate using cost of goods sold. We will assume that Sky purchases everything on credit.

The operating expenses or cost of goods sold is £6,471 million, and trade payables are £2,286 million. The turnover is therefore £6,471/£2,286 = 2.83 times. So, payables turned over about every 365/2.83 = 129 days. On average, then, Sky takes 129 days to pay. As a potential creditor, we might take note of this fact.



hiL73635_ch03_063-092.indd 78 11/04/15 09:46 PM

Profitability Measures The three measures we discuss in this section are probably the best known and most widely used of all financial ratios. In one form or another, they are intended to measure how efficiently the firm uses its assets and how efficiently the firm manages its operations. The focus in this group is on the bottom line – net income, also labelled as Earnings after Tax or Profit after Tax.

Profit Margin Companies pay a great deal of attention to their profit margin:

Profit margin = Net income ___________ Revenues

= £865 ______ £7,632

= 11.33% (3.14)

This tells us that Sky, in an accounting sense, generated a little more than 11 pence in profit for every pound in sales during the year ending 2014.

All other things being equal, a relatively high profit margin is obviously desirable. This situation corresponds to low expense ratios relative to sales. However, we hasten to add that other things are often not equal.

For example, lowering our sales price will usually increase unit volume but will normally cause profit margins to shrink. Total profit (or, more importantly, operating cash flow) may go up or down, so the fact that margins are smaller is not necessarily bad.

Profit margins are very different for different industries. Grocery stores have a notoriously low profit margin, generally around 2 per cent. In contrast, the profit margin for the pharmaceutical industry is about 18 per cent.

Return on Assets Return on assets (ROA) is a measure of profit per asset value. It can be defined several ways, but the most common is:

Return on assets = Net income ___________ Total assets

= £865 ______ £6,449

= 13.41% (3.15)

Return on Equity Return on equity (ROE) is a measure of how the shareholders fared during the year. Because benefiting shareholders is our goal, ROE is, in an accounting sense, the true bottom-line measure of performance. ROE is usually measured as:

Return on equity = Net income ___________ Total equity

= £865 ______ £1,072

= 80.69% (3.16)

Therefore, for every pound in equity, Sky generated nearly 81 pence in profit during 2014; but, again, this is correct only in accounting terms.

Because ROA and ROE are such commonly cited numbers, we stress that it is important to remember they are accounting rates of return. For this reason, these measures should properly be called return on book assets and return on book equity. Whatever it is called, it would be inappropriate to compare the result to, for example, an interest rate observed in the financial markets.

The fact that ROE exceeds ROA reflects Sky’s use of financial leverage. We will examine the relationship between these two measures in the next section.

Market Value Measures Our final group of measures is based, in part, on information not necessarily contained in financial statements – the share price. Obviously, these measures can be calculated directly only for publicly traded companies.

At the end of November 2014, Sky had 1,575.59 million shares outstanding and its equity sold on the London Stock Exchange for £9.225. If we recall that Sky’s net income was £865 million, then we can calculate that its earnings per share were:

EPS = Net income __________________ Shares outstanding

= £865 ________ 1,575.59

= £0.549 (3.17)


Ratio Analysis 79

hiL73635_ch03_063-092.indd 79 11/04/15 09:46 PM

Price–Earnings Ratio The first of our market value measures, the price–earnings (or PE) ratio (or multiple), is defined as:

PE ratio = Price per share

_________________ Earnings per share

= £9.225 ______ £0.549

= 16.80 times (3.18)

In the vernacular, we would say that Sky equity sells for just under 17 times earnings, or we might say that Sky shares have, or ‘carry’, a PE multiple of 16.80.

Because the PE ratio measures how much investors are willing to pay per unit of current earnings, higher PEs are often taken to mean that the firm has significant prospects for future growth. Of course, if a firm had no or almost no earnings, its PE would probably be quite large; so, as always, care is needed in interpreting this ratio.

Market-to-Book Ratio A second commonly quoted measure is the market-to-book ratio:

Market-to-book ratio = Market value per share

_____________________ Book value per share

= £9.225 ______________ £1,072/1,575.69

= 13.56 times (3.19)

Notice also that book value per share is total equity (not just ordinary shares) divided by the total number of shares outstanding.

Book value per share is an accounting number that reflects historical costs. In a loose sense, the market-to-book ratio therefore compares the market value of the firm’s investments to their cost. A value less than 1 could mean that the firm has not been successful overall in creating value for its shareholders. Sky plc’s market-to-book ratio is exceptionally high at 13.56 and reflects the value and growth prospects of the firm.

This completes our definition of some common ratios. We could tell you about more of them, but these are enough for now. We will leave it here and go on to discuss some ways of using these ratios instead of just how to calculate them. Table 3.5 summarizes the ratios we have discussed.

Table 3.5 Common Financial Ratios

I. Short-term Solvency, or Liquidity, Ratios

Current ratio = Current assets _______________ Current liabilities

Days’ sales in receivables = 365 days

__________________ Receivables turnover

Quick ratio = Current assets − Inventory

_______________________ Current liabilities

Total asset turnover = Sales __________ Total assets

Cash ratio = Cash _______________ Current liabilities

Capital intensity = Total assets __________ Sales

II. Long-term Solvency, or Financial Leverage, Ratios IV. Profitability Ratios

Total debt ratio = Total assets − Total equity

_______________________ Total assets

Profit margin = Net income __________ Sales

Debt–equity ratio = Total debt/Total equityEquity multiplier = Total assets/Total equity

Return on assets (ROA) = Net income __________ Total assets

Times interest earned ratio = EBIT _______ Interest

Cash coverage ratio = EBIT + Depreciation

__________________ Interest

Return on equity (ROE) = Net income ___________ Total equity

ROE = Net income __________ Sales

× Sales ______ Assets

× Assets ______ Equity



hiL73635_ch03_063-092.indd 80 11/04/15 09:46 PM

III. Asset Utilization, or Turnover, Ratios V. Market Value Ratios

Inventory turnover = Cost of goods sold

________________ Inventory

Price–earnings ratio = Price per share

________________ Earnings per share

Days’ sales in inventory = 365 days

________________ Inventory turnover

Market-to-book ratio = Market value per share

____________________ Book value per share

Receivables turnover = Sales _________________ Accounts receivable

3.8 The Du Pont Identity

As we mentioned in discussing ROA and ROE, the difference between these two profitability measures reflects the use of debt financing or financial leverage. We illustrate the relationship between these measures in this section by investigating a famous way of decomposing ROE into its component parts.

A Closer Look at ROE To begin, let us recall the definition of ROE:


If we were so inclined, we could multiply this ratio by Assets/Assets without changing anything:


= Net income ___________ Total equity

× Assets ______ Assets

= Net income ___________ Assets

× Assets ___________ Total equity

Notice that we have expressed the ROE as the product of two other ratios – ROA and the equity multiplier:

ROE = ROA × Equity multiplier = ROA × (1 + Debt–equity ratio)

Looking back at Sky, for example, we see that the debt–equity ratio was 5.016 and ROA was 13.41 per cent. Our work here implies that Sky’s ROE, as we previously calculated, is:

ROE = 13.41% × (1 + 5.016) = 80.69%

The difference between ROE and ROA can be substantial, as you can see for Sky plc. This is because of the amount of debt that the company has taken on.

We can further decompose ROE by multiplying the top and bottom by total sales:

ROE = Sales _____ Sales

× Net income ___________ Assets


If we rearrange things a bit, ROE is:

ROE = Net income ___________ Sales

× Sales ______ Assets


Return on assets

= Profit margin × Total asset turnover × Equity multiplier (3.20)

What we have now done is to partition ROA into its two component parts, profit margin and total asset turnover. The last expression of the preceding equation is called the Du Pont identity after the Du Pont Corporation, which popularized its use.

We can check this relationship for Sky by noting that the profit margin was 11.33 per cent and the total asset turnover was 1.18. ROE should thus be:


Using Financial Statement Information 81

hiL73635_ch03_063-092.indd 81 11/04/15 09:46 PM

ROE = Profit margin × Total asset turnover × Equity multiplier

= 11.33% × 1.18 × 6.0159

= 80.69%

This 80.69 per cent ROE is exactly what we had before.The Du Pont identity tells us that ROE is affected by three things:

1 Operating efficiency (as measured by profit margin)

2 Asset use efficiency (as measured by total asset turnover)

3 Financial leverage (as measured by the equity multiplier).

Weakness in either operating or asset use efficiency (or both) will show up in a diminished return on assets, which will translate into a lower ROE.

Considering the Du Pont identity, it appears that the ROE could be leveraged up by increasing the amount of debt in the firm. However, notice that increasing debt also increases interest expense, which reduces profit margins, and this acts to reduce ROE. More important, the use of debt financing has a number of other effects, and, as we discuss at some length in later chapters, the amount of leverage a firm uses is governed by its capital structure policy.

The decomposition of ROE we have discussed in this section is a convenient way of systematically approaching financial statement analysis. If ROE is unsatisfactory by some measure, then the Du Pont identity tells you where to start looking for the reasons.

3.9 Using Financial Statement Information

Our next task is to discuss in more detail some practical aspects of financial statement analysis. In particular, we will look at reasons for doing financial statement analysis, how to go about getting benchmark information, and some of the problems that come up in the process.

Choosing a Benchmark Given that we want to evaluate a division or a firm based on its financial statements, a basic problem immediately comes up. How do we choose a benchmark, or a standard of comparison? We describe some ways of getting started in this section.

Time Trend Analysis One standard we could use is history. Suppose we found that the current ratio for a particular firm is 2.4 based on the most recent financial statement information. Looking back over the last 10 years, we might find that this ratio had declined fairly steadily over that period.

Based on this, we might wonder if the liquidity position of the firm has deteriorated. It could be, of course, that the firm has made changes that allow it to use its current assets more efficiently, that the nature of the firm’s business has changed, or that business practices have changed. If we investigate, we might find any of these possible explanations behind the decline. This is an example of what we mean by management by exception – a deteriorating time trend may not be bad, but it does merit investigation.

Peer Group Analysis The second means of establishing a benchmark is to identify firms similar in the sense that they compete in the same markets, have similar assets, and operate in similar ways. In other words, we need to identify a peer group. There are obvious problems with doing this: no two companies are identical. Ultimately, the choice of which companies to use as a basis for comparison is subjective.

One common way of identifying potential peers is based on Standard Industrial Classification (SIC) codes. In the UK, these are called UK Standard Industrial Classification (SIC) Codes and in the European Union, they are called the Industrial Classification System or ‘Nomenclature des Activités Économiques dans la Communauté Européenne’ (NACE). These are alphabetical categories subdivided by four-digit codes that are used for statistical reporting purposes. Both SIC and NACE codes are virtually identical and firms with the same SIC or NACE code are frequently assumed to be similar.

In total, there are 21 industry groups, categorized by alphabetical letter. The first SIC code digit establishes the general type of business. For example, firms engaged in finance, insurance and real estate have SIC codes



hiL73635_ch03_063-092.indd 82 11/04/15 09:46 PM

beginning with 6. Each additional digit narrows the industry. Companies with SIC codes beginning with 64 are mostly banks and banklike businesses, those with codes beginning with 64.19 are mostly commercial banks, and SIC code 64.11 is assigned to central banks. Table 3.6 lists selected two-digit codes (the first two digits of the four-digit SIC codes) and the industries they represent.

Table 3.6 Selected Two-Digit SIC Codes

Code Industry Code Industry

01–09 Agriculture, Forestry, Fishing 50–51 Wholesale Trade

10–14 Mining 52–59 Retail Trade

15–17 Construction 60–67 Finance, Insurance, Real Estate

20–39 Manufacturing 70–89 Services

40–49 Transportation & Public Utilities 91–99 Public Administration

Industry classification codes are far from perfect. For example, suppose you were examining financial statements for Tesco plc, one of the largest retailers in the world. However, Tesco are not just involved in supermarket retailing. They also have Tesco Telecom Services and Tesco Personal Finance, which includes credit cards and personal mortgages. Which industry code would Tesco plc have?

As this example illustrates, it is probably not appropriate to blindly use SIC code as the basis for carrying out a peer analysis. Instead, analysts often identify a set of primary competitors with similar activities and then compute a set of averages based on just this group. Also, we may be more concerned with a group of the top firms in an industry, not similar firms. Such a group is called an aspirant group because we aspire to be like its members. In this case, a financial statement analysis reveals how far we have to go.

There are many sources of financial information on the Internet that an analyst can access. For example, www.ft.com, Reuters and Yahoo! Finance show a variety of ratios for publicly traded companies. Table 3.7 shows a screenshot of some profitability ratios (called ‘Management Effectiveness’ on Reuters) for the German automobile firm, BMW, together with peer statistics (‘TTM’ stands for ‘trailing twelve months’).

Table 3.7 Management Effectiveness

Industry Sector Company

Return on assets (TTM) 9.62 9.37 4.08

Return on assets – 5-year average 11.75 11.14 3.20

Return on investment (TTM) 17.19 16.12 6.38

Return on investment – 5-year average 19.93 18.56 5.07

Return on equity (TTM) 21.67 20.24 16.55

Return on equity – 5-year average 25.03 23.19 14.36

Source: Data from Reuters.

In looking at numbers such as these, recall our caution about analysing ratios that you do not calculate yourself: different sources frequently do their calculations somewhat differently, even if the ratio names are the same.

Problems with Financial Statement Analysis We continue our chapter on financial statements by discussing some additional problems that can arise when using them. In one way or another, the basic problem with financial statement analysis is that there is no underlying theory to help us identify which quantities to look at and to guide us in establishing benchmarks.

As we discuss in other chapters, there are many cases in which financial theory and economic logic provide guidance in making judgements about value and risk. Little such help exists with financial statements. This is why we cannot say which ratios matter the most or what a high or low value might be.


Using Financial Statement Information 83

hiL73635_ch03_063-092.indd 83 11/04/15 09:46 PM

One particularly severe problem is that many firms are conglomerates, owning more or less unrelated lines of business. Anglo American plc is a well-known example. Anglo American was originally founded in South Africa as a mining firm but is now involved in packaging, paper, coal and a variety of metal extraction activities. It is now listed on the London Stock Exchange and is commonly regarded as a metals conglomerate. Similar to Tesco plc, the consolidated financial statements of Anglo American do not really fit any neat industry category. More generally, the kind of peer group analysis we have been describing is going to work best when the firms are strictly in the same line of business, the industry is competitive, and there is only one way of operating.

Another problem that is becoming increasingly common is that major competitors and natural peer group members in an industry may be scattered around the globe. The automobile industry is an obvious example. The problem here is that financial statements in many countries do not necessarily conform to IFRS (i.e. the accounting standards used in most countries). For example, US firms follow US GAAP whereas European firms follow IFRS. The existence of different standards and procedures makes it difficult to compare financial statements across national borders.

Even companies that are clearly in the same line of business may not be comparable. For example, electric utilities engaged primarily in power generation are all classified in the same group. This group is often thought to be relatively homogeneous. However, most utilities operate as regulated monopolies, so they do not compete much with each other, at least not historically. Many have shareholders, and many are organized as cooperatives with no shareholders. There are several different ways of generating power, ranging from hydroelectric to nuclear, so the operating activities of these utilities can differ quite a bit. Finally, profitability is strongly affected by the regulatory environment, so utilities in different countries can be similar but show different profits.

Several other general problems frequently crop up. First, different firms use different accounting procedures, such as for inventories. This makes it difficult to compare statements. Second, different firms end their fiscal years at different times. For firms in seasonal businesses (such as a retailer with a large Christmas season), this can lead to difficulties in comparing statements of financial position because of fluctuations in accounts during the year. Finally, for any particular firm, unusual or transient events, such as a one-time profit from an asset sale, may affect financial performance. Such events can give misleading signals as we compare firms.

Real World Insight 3.2

BAE Systems Comparative Financial Ratio AnalysisAs stated above, one can look at the financial ratios of a firm over time or compare them to other companies in the same industry. The table below shows a comparative analysis from Google Finance of key financial ratios for BAE Systems and its peers.

There is a lot of information to take in. The closest firm in size to BAE Systems is Rolls-Royce Holdings. A simple comparison shows that BAE Systems has less liquidity (current ratio) and more leverage (Long-Term Debt to Assets), but is performing better (Return on Assets, Return on Equity). Profitability (Margins) is roughly similar across both companies, with Rolls-Royce performing slightly better.

Valuation Financial ratios Operating metrics Margins

Company nameP/E ratio

Mkt Cap Current ratio

Lt debt to assets

Lt debt to equity

Return on avg assets

Return on avg equity

Net profit margin

EBITD margin

Operating margin

BA BAE Systems plc 22.99 16,934.67M 0.74 14.49 155.70 3.81 28.34 4.87 11.63 8.43

COB Cobham plc 114.62 3,526.17M 1.58 40.38 130.18 0.97 2.67 1.57 18.46 3.11

MGGT Meggitt plc 26.16 4,507.47M 1.51 15.77 29.05 4.58 8.39 11.39 25.80 15.20

BAB Babcock Intl. Gro… 22.13 5,001.88M 0.77 21.13 65.88 6.13 18.50 5.66 10.99 7.02

CHG Chemring Group plc 420.90M 1.94 24.41 51.95 -0.18 -0.41 -0.35 16.87 3.32

RR Rolls-Royce Holdi… 17,422.09M 1.46 9.87 34.36 -0.37 -1.22 -0.61 15.58 10.07

QQ QinetiQ Group plc 1,196.07M 1.37 14.85 40.74 -1.15 -3.11 -1.37 14.04 1.87

SPX Spirax-Sarco Engi… 26.37 2,638.45M 2.80 6.64 11.13 14.01 23.78 14.83 25.94 21.83

ULE Ultra Electronics… 56.84 1,189.09M 1.15 20.06 53.85 0.79 6.52 0.91 18.28 5.54

GKN GKN plc 35.06 5,861.73M 1.33 13.13 59.30 2.69 10.39 2.49 12.30 4.14

WSG Westminster Group… 14.75M 1.52 15.06 30.15 -40.11 -264.18 -21.95 -30.52 -20.64

Source: Google Finance. Google and the Google logo are registered trademarks of Google Inc., used with permission.



hiL73635_ch03_063-092.indd 84 11/04/15 09:46 PM

Summary and Conclusions

This chapter focuses on working with information contained in financial statements. Specifically, we studied standardized financial statements and ratio analysis.

1 We explained that differences in firm size make it difficult to compare financial statements.

2 Evaluating ratios of accounting numbers is another way of comparing financial statement information. We defined a number of the most commonly used ratios, and we discussed the famous Du Pont identity.

After you have studied this chapter, we hope that you have some perspective on the uses and abuses of financial statement information. You should also find that your vocabulary of business and financial terms has grown substantially.

In the online supplement to this chapter, we extend the discussion to include long-term financial planning and sustainable growth rates.

CONCEPT 1 Accounting and Cash Flows What does the term ‘window dressing’ mean in the context of financial

statements? Identify three window-dressing techniques that companies use. What implications does this have for cash flows in terms of its relationship with reported revenue and cost figures?

2 Book Values versus Market Values Explain the difference between book value and market value. Under standard accounting rules, it is possible for a company’s liabilities to exceed its assets. When this occurs, the owners’ equity is negative. Can this happen with market values? Why or why not?

3 Operating Cash Flow Identify two circumstances where negative operating cash flow might not necessarily be a sign of deteriorating financial health. When can negative operating cash flow become problematic for a company?

4 Financial Ratio Analysis A financial ratio by itself tells us little about a company because financial ratios vary a great deal across industries. There are two basic methods for analysing financial ratios for a company: time trend analysis and peer group analysis. Why might each of these analysis methods be useful? What does each tell you about the company’s financial health?

5 Sales Forecast Why do you think most long-term financial planning begins with sales forecasts? Put differently, why are future sales the key input?

6 The DuPont Identity Both ROA and ROE measure profitability. What does each of them measure, and which one is more useful for comparing two companies? Why?

7 Building a Statement of Financial Position According to AEB Systems plc financial statements as of June 2015, the firm had current assets of £6.642 billion, non-current assets of £16.521 billion, current liabilities of £11.283 billion, and non-current liabilities of £6.589 billion. What is the value of the shareholders’ equity for AEB Systems? How much is net working capital?

8 Building an Income Statement In 2015, the UK insurance firm, Wheeler & Fox, had revenue of £38,440 million, total expenses of £37,133 million, tax of £487 million and zero depreciation. What is the net income for the firm? Wheeler & Fox paid out £238 million in cash dividends. What is the addition to retained earnings?

9 Earnings per Share In 2015, the Swedish bank, Nordicbank, had a price–earnings ratio of 6.35. If the firm’s share price was SKr71.70, what was its earnings per share?

10 Market Values and Book Values Your company has just sealed a deal to sell a tract of land with accompanying warehouse for €3.2 million. This is significantly lower than the €7 million your firm paid when the plot was purchased at the height of the property boom. International Accounting Standards have been followed by your firm and so you will not make an accounting loss on the sale (why?). The company

Questions and Problems


85Questions and Problems

hiL73635_ch03_063-092.indd 85 11/04/15 09:46 PM

has non-current assets of €4 million, non-current liabilities of €2.2 million and net working capital (current assets less current liabilities) of €0.9 million. What impact does the sale have on your firm’s statement of financial position?

11 Calculating Taxes The Dutch firm, Herrera NV, had €273,000 in taxable income. Using Table 3.3, what is the company’s average tax rate? What is its marginal tax rate?

12 Calculating NCF A firm has net revenues of £6,065 million (including net non-cash expenses). Net non-cash expenses (including depreciation) were £2,380 million. Cash outflows from investing activities (including capital expenditures) were £3,270 million. The firm paid a total cash dividend of £1,380 million and net interest expense was £3,410 million. What was the firm’s net cash flow?

13 Calculating Net Capital Spending Morena’s Driving School’s 2015 statement of financial position showed non-current assets of £4.2 million. One year later, the 2016 statement of financial position showed non-current assets of £4.7 million. The company’s 2016 income statement showed a depreciation expense of £925,000. What was Morena’s net capital spending for 2016?

14 Building a Statement of Financial Position The following table presents the long-term debt and shareholders’ equity of Tumbler SA one year ago:

(€)

Long-term debt 60,000,000

Preference shares 18,000,000

Ordinary shares (€1 par value) 25,000,000

Capital surplus 49,000,000

Accumulated retained earnings 89,000,000

During the past year, Tumbler issued 20 million shares at a total price of €52 million, and issued €16 million in new long-term debt. The company generated €14 million in net income and paid €8 million in dividends. Construct the current statement of financial position reflecting the changes that occurred at Tumbler during the year.

REGULAR15 Calculating the Du Pont Identity Find the annual income statements and statement of financial

positions for two firms in the same industry from your own country. Calculate the Du Pont identity for each company for the most recent 3 years. Comment on the changes in each component of the Du Pont identity for each company over this period and compare the components between the two companies. Are the results what you expected? Why or why not?

16 Return on Equity Firm A and Firm B have debt–total asset ratios of 70 per cent and 30 per cent, and returns on total assets of 20 per cent and 30 per cent, respectively. Which firm has a greater return on equity?

17 Ratios and Foreign Companies As of December 2014, the Royal Bank of Scotland plc made a net loss of £3.47 billion on revenues of £18.197 billion. What was the company’s profit margin? Does the fact that these figures are quoted in pounds sterling make any difference to a Spanish investor. Why? In euros, revenues were €24.73 billion. What was the net loss in euros?

18 Cash Coverage Ratio For the year ending 2015, TJC plc has revenues of £1,027 million and total costs (excluding interest) of £817 million. Net interest expense was £29 million and depreciation was £12 million. What is the firm’s cash coverage ratio?

19 Days’ Sales in Receivables A company has net income of €173,000, a profit margin of 8.6 per cent, and a trade receivables balance of €143,200. Assuming 75 per cent of sales are on credit, what is the company’s days’ sales in receivables?

20 Ratios and Fixed Assets Le Verd SA has a ratio of long-term debt to total assets of 0.70 and a current ratio of 1.20. Current liabilities are £850, revenues are £4,310, profit margin is 9.5 per cent, and ROE is 21.5 per cent. What is the amount of the firm’s non-current assets?

21 Calculating the Cash Coverage Ratio Titan SpA’s net income for the most recent year was €4,850. The tax rate was 33 per cent. The firm paid €2,108 in total interest expense and deducted €1,687 in depreciation expense. What was Titan’s cash coverage ratio for the year?

22 Cost of Goods Sold Guthrie plc has current liabilities of £340,000, a quick ratio of 1.8, inventory turnover of 4.2 and a current ratio of 3.3. What is the cost of goods sold for the company?



hiL73635_ch03_063-092.indd 86 11/04/15 09:46 PM

CHALLENGEFor questions 23 and 24, consider the summarized financial statements for Sement AG (in € millions):

Summarized Statement of Income

Revenue 77,327

Cost of goods sold 56,284

Operating income 21,043

Less:

Depreciation 2,130

Other expenses 16,039

Income from continuing operations before income taxes 2,874

Summarized Statement of Income

Income taxes 1,015

Income from continuing operations 1,859

Income from discontinued operations, net of taxes 4,027

Net income 5,886

Summarized Statement of Financial Position

Assets Liabilities

Current assets Current liabilities

Cash and cash equivalents 6,893 Trade payables 8,860

Trade and other receivables 15,785 Other current liabilities 33,591

Inventories 14,509 Total current liabilities 42,451

Other current assets 6,055 Long-term debt 14,260

Total current assets 43,242 Other non-current liabilities 10,372

Non-current assets 51,221 Total liabilities 67,083

Equity 4,391

Retained earnings 22,989

Total assets 94,463 Total liabilities and equity 94,463

23 Financial Ratios Calculate all relevant financial ratios for Sement AG.

24 Financial Statement Analysis What are the weaknesses in the Sement examples for interpreting its financial well-being? Explain.

25 Financial Ratios Lewellen (2004) makes a strong case for why financial ratios, such as dividend yield, book-to-market ratio and earnings per share, will predict prices. Discuss this argument and his main findings to support his view.

26 Cash Flow Volatility Rountree et al. (2008) show that investors do not like cash flow volatility. Consider the financial ratios presented in this chapter. Can you adapt an existing financial ratio or construct a new one that may reflect the findings in Rountree et al. (2008)? Use your ratio to compare some firms in the same industry in your country. What are the strengths and weaknesses of your ratio?

Questions 27–37 relate to Montgomery Organizations plc, whose annual accounts are given below. The firm has 14,685,856 shares and the share price is £2.78.

Fixed Assets (£ millions) 2015 2014 2013 2012

Tangible assets 164 167 180 188

Land and buildings 71 70 68 66

Freehold land 71 70

Fixtures and fittings 78 81 93 103

Plant and vehicles 15 15 19 19


87Questions and Problems

hiL73635_ch03_063-092.indd 87 11/04/15 09:46 PM

Fixed Assets (£ millions) 2015 2014 2013 2012

Plant 15 15

Intangible assets 832 832 832 832

Investments 520 521 509 518

Fixed assets 1,517 1,520 1,521 1,538

Current Assets

Stock and WIP 1

Stock 1

WIP 0

Finished goods

Trade debtors 2 4 1

Bank and deposits 47 58 43 34

Other current assets 662 35 28 26

Group loans (asset) 618 0 0 0

Directors loans (asset) 0 0 0 0

Other debtors 12 5 28 26

Prepayments 32 30

Current assets 711 97 72 61

Current Liabilities

Trade creditors −7 −10 −14 −18

Short-term loans and overdrafts −1,924 −1,325 −1,260 −1,255

Bank overdrafts 0 0 0 0

Group loans (short t.) −1,923 −1,324 −1,259 −1,255

Director loans (short t.) 0 0 0 0

Hire purch. and leas. (short t.) 0 −1 −1 0

Hire purchase (short t.)

Leasing (short t.) −1

Other short-term loans 0 0 0 0

Total other current liabilities −105 −78 −102 −102

Corporation tax −29 −28 −36 −29

Dividends 0 0 0 0

Accruals and def. inc. (sh. t.) −33 −21 −41 −37

Social securities and VAT −19 −18 −20 −21

Other current liabilities −25 −11 −5 −15

Current liabilities −2,035 −1,413 −1,376 −1,374

Net current assets (liab.) −1,324 −1,316 −1,304 −1,313

Net tangible assets (liab.) −639 −628 −615 −607

Working capital −1,324 −1,316 −1,304 −1,313

Total assets 2,228 1,617 1,593 1,599

Total assets less cur. liab. 193 204 217 225

Long-Term Liabilities

Provisions for other liab. −12 −13 −31 −14

Deferred tax −12 −13 −13 −12

Other provisions −19 −2

Pension liabilities −23 −31

Long-term liabilities −35 −44 −31 −14

Total assets less liabilities 158 160 186 210



hiL73635_ch03_063-092.indd 88 11/04/15 09:46 PM

Shareholders’ Funds

Issued capital 1 1 1 1

Ordinary shares 1 1

Preference shares

Other shares

Total reserves 157 158 184 209

Share premium account 3 3 3 3

Profit (loss) account 159 162 180 205

Other reserves –5 −6 1 1

Shareholders’ funds 158 160 186 210

Turnover 14,569 13,480 13,337 7,127

Cost of sales −13,932 −12,870 −12,708 −6,800

Gross profit 637 610 629 327

Administration expenses −388 −369 −502

Other operating income pre OP −377

Exceptional items pre OP −13

Operating profit 260 210 260 −175

Other income 10 33 30 486

Total other income and int. received 22 43 30 486

Exceptional items −16 −18

Profit (loss) before interest paid 282 253 274 293

Interest received 12 10

Interest paid −28 −37 −84 −92

Other interest paid −28 −37

Net interest −16 −27 −84 −92

Profit (loss) before tax 254 216 190 201

Taxation −53 −46 −49 −18

Profit (loss) after tax 201 170 141 183

Dividends −210 −175 −150 −20

Retained profit (loss) −9 −6 −9 163

Depreciation 26 27 30 26

27 Earnings per share What is the earnings per share for each year between 2012 and 2015 for Montgomery Organizations plc? What is your interpretation of these figures? Is EPS a reliable measure of performance?

28 Tax Rate What is the effective tax rate for Montgomery Organizations plc for each year?

29 Net Working Capital What is the net working capital of Montgomery Organizations plc in each year? What is the cause of the figures? Is this a healthy situation for the firm? Explain.

30 Common-size Statements Construct common-size statements for Montgomery Organizations plc.

31 Liquidity How would you rate the liquidity position of Montgomery Organizations plc between 2012 and 2015? Provide a brief report of the company’s liquidity over time.

32 Long-term solvency How would you rate the long-term solvency position of Montgomery Organizations plc between 2012 and 2015? Provide a brief report of the company’s long-term solvency over time.

33 Operations How efficient have Montgomery Organizations plc’s operations been during 2015? Provide a brief report of the company’s asset efficiency over time.

34 Profitability What is the profitability of Montgomery Organizations plc like over the period 2012 and 2015? Provide a brief report of the company’s profitability over time. Do profitability ratios give a good insight into company performance?


89Exam Question (45 minutes)

hiL73635_ch03_063-092.indd 89 11/04/15 09:46 PM

35 Market Valuation Provide an overview on the company’s relative market valuation over the period 2012–2015. What can be inferred from the company’s relative market valuation?

36 Du Point Identity Undertake a full Du Pont Identity analysis for the year 2015 to provide insights into the drivers of its return on equity.

37 Du Point Identity Discuss the advantages and disadvantages of ratio analysis.

Exam Question (45 minutes)

You are tasked with analysing the last 2 years of accounts of a global mining firm. A simplified statement of financial position and income statement are provided below.

Period Ending Yr-0 Yr-1 Yr-2 Yr-3

Total revenue 7,931 6,579 8,204 6,502

Cost of revenue 5,787 5,136 5,318 3,840

Gross profit 2,144 1,443 2,886 2,662

Depreciation 321 182 201 412

Other expenses 100 134 115 247

EBIT 1,723 1,127 2,570 2,003

Interest 1,135 957 1,272 1,009

EBT 588 170 1,298 994

Tax 153 44 337 258

Net income 435 126 961 736

Statement of Financial Position (£ millions)

Period Ending Yr-0 Yr-1 Yr-2 Yr-3

Assets

Current assets

Cash and cash equivalents 390 381 458 1,585

Short-term investments 6,849 4,547 4,608 578

Net receivables 693 533 1,025 932

Inventory 1,261 909 1,299 880

Other current assets 200 250 86 74

Total current assets 9,393 6,620 7,476 4,049

Property, plant and equipment 10,201 10,920 10,300 10,350

Goodwill 21 23 28 40

Total non-current assets 10,222 10,943 10,328 10,390

Total assets 19,615 17,563 17,804 14,439

Liabilities

Current liabilities

Accounts payable 1,715 1,190 975 620

Short/current long-term debt 8,945 5,836 3,656 1,727

Other current liabilities 111 169 303 655

Total current liabilities 10,771 7,195 4,934 3,002

Long-term debt 7,161 3,816 1,557 1,478

Total liabilities 17,932 11,011 6,491 4,480

Shareholders’ equity

Total shareholders’ equity 1,683 6,552 11,313 9,959

Equity plus liabilities 19,615 17,563 17,804 14,439



hiL73635_ch03_063-092.indd 90 11/04/15 09:46 PM

1 Using the information above, carry out a full financial statement analysis using a variety of financial ratios. (60 marks)

2 How do you think the company has been performing over the past 5 years? Has there been an improvement or deterioration in the firm’s fortunes? What is driving the changing performance? Write a report, outlining your analysis and findings. (40 marks)

Ratios and Financial Planning at West Coast Yachts

Dan Ervin was recently hired by West Coast Yachts Ltd to assist the company with its short-term financial planning and also to evaluate the company’s financial performance. Dan graduated from university 5 years ago with a finance degree, and he has been employed in the treasury department of a FTSE 100 company since then.

West Coast Yachts was founded 10 years ago by Larissa Warren. The company’s operations are located in a well-known marina, Inverkip, on the west coast of Scotland. The firm is structured as a private limited company. The company has manufactured custom midsize, high-performance yachts for clients over this period, and its products have received high reviews for safety and reliability. The company’s yachts have also recently received the highest award for customer satisfaction. The yachts are purchased primarily by wealthy individuals for pleasure use. Occasionally, a yacht is manufactured for purchase by a company for business purposes.

The custom yacht industry is fragmented, with a number of manufacturers. As with any industry, there are market leaders, but the diverse nature of the industry ensures that no manufacturer dominates the market. The competition in the market, as well as the product cost, ensures that attention to detail is a necessity. For instance, West Coast Yachts will spend 80 to 100 hours on hand-buffing the stainless steel stem-iron, which is the metal cap on the yacht’s bow that conceivably could collide with a dock or another boat.

To get Dan started with his analyses, Larissa has provided the following financial statements. Larissa has gathered the industry ratios for the yacht manufacturing industry.

WEST COAST YACHTS Income Statement 2015

£ £

Operating revenues 128,700,000

Operating expenses 90,700,000

Operating profit 38,000,000

Depreciation 4,200,000

Other non-operating expenses 15,380,000

Interest 2,315,000

Profit before taxes 16,105,000

Taxes (28%) 4,509,400

Profit for period attributable to equity holders 11,595,600

Dividends 6,957,360

Addition to retained earnings 4,638,240

WEST COAST YACHTSStatement of Financial Position as of 31 December 2015

Assets Liabilities and Equity

Current assets Current liabilities

£ £

Cash 2,340,000 Trade payables 4,970,000

Mini Case


91Mini Case

hiL73635_ch03_063-092.indd 91 11/04/15 09:46 PM

WEST COAST YACHTSStatement of Financial Position as of 31 December 2015

Assets Liabilities and Equity

Trade receivables 4,210,000 Notes payable 10,060,000

Inventory 4,720,000

Total 11,270,000 Total 15,030,000

Non-current assets Non-current liabilities 25,950,000

Net plant and equipment 72,280,000

Shareholders’ equity

Ordinary shares 4,000,000

Retained earnings 38,570,000

Total equity 42,570,000

Total assets 83,550,000 Total liabilities and equity 83,550,000

Yacht Industry Ratios

Lower Quartile Median Upper Quartile

Current ratio 0.50 1.43 1.89

Quick ratio 0.21 0.38 0.62

Total asset turnover 0.68 0.85 1.38

Inventory turnover 4.89 6.15 10.89

Receivables turnover 6.27 9.82 14.11

Debt ratio 0.44 0.52 0.61

Debt–equity ratio 0.79 1.08 1.56

Equity multiplier 1.79 2.08 2.56

Interest coverage 5.18 8.06 9.83

Profit margin (%) 4.05 6.98 9.87

Return on assets (%) 6.05 10.53 13.21

Return on equity (%) 9.93 16.54 26.15

1 Calculate all of the ratios listed in the industry table for West Coast Yachts.

2 Compare the performance of West Coast Yachts to the industry as a whole. For each ratio, comment on why it might be viewed as positive or negative relative to the industry. Suppose you create an inventory ratio calculated as inventory divided by current liabilities. How do you interpret this ratio? How does West Coast Yachts compare to the industry average?

3 Calculate the sustainable growth rate of West Coast Yachts. Calculate external funds needed (EFN) and prepare pro forma income statements and statements of financial position assuming growth at precisely this rate. Recalculate the ratios in the previous question. What do you observe?

4 As a practical matter, West Coast Yachts is unlikely to be willing to raise external equity capital, in part because the owners do not want to dilute their existing ownership and control positions. However, West Coast Yachts is planning for a growth rate of 20 per cent next year. What are your conclusions and recommendations about the feasibility of West Coast’s expansion plans?

5 Most assets can be increased as a percentage of sales. For instance, cash can be increased by any amount. However, non-current assets often must be increased in specific amounts because it is impossible, as a practical matter, to buy part of a new plant or machine. In this case a company has a ‘staircase’ or ‘lumpy’ fixed cost structure. Assume that West Coast Yachts is currently producing at 100 per cent of capacity. As a result, to expand production, the company must set up an entirely new line at a cost of £25,000,000. Calculate the new EFN with this assumption. What does this imply about capacity utilization for West Coast Yachts next year?



hiL73635_ch03_063-092.indd 92 11/04/15 09:46 PM

Choose a listed company from your own country. Download the financial accounts from its website and carry out a full financial statement analysis. You should calculate financial ratios for not only the most recent year but past years as well. Write a brief report on your interpretation and the company’s future well-being.

Practical Case Study

Given that this chapter is concerned with interpreting financial statements, all international accounting standards are relevant. However, the most important ones are IAS 1 Presentation of Financial Statements, IAS 7 Statement of Cash Flows, IAS 27 Consolidated and Separate Financial Statements, and IAS 33 Earnings per Share. For an excellent summary of these and other international accounting standards, visit the IASPlus website (www.iasplus.com).

Relevant Accounting Standards

Lewellen, J. (2004) ‘Predicting Returns with Financial Ratios’, Journal of Financial Economics, Vol. 74, No. 2, 209–235.

Rountree, B., J.P. Weston and G. Allayannis (2008) ‘Do Investors Value Smooth Performance?’ Journal of Financial Economics, Vol. 90, No. 3, 237–251.

Reference

The interested reader can find a whole range of readings to peruse in accounting journals such as Journal of Accounting Research, The Accounting Review, Journal of Accounting and Economics, Journal of Business Finance and Accounting and Accounting and Business Research. Important recent papers that relate to corporate finance are:

1 Faulkender, M., M.J. Flannery, K. Watson Hankins and J.M. Smith (2012) ‘Cash Flows and Leverage Adjustments’, Journal of Financial Economics, Vol. 103, No. 3, 632–646. US.

2 Hutton, A.P., A.J. Marcus and H. Tehranian (2009) ‘Opaque Financial Reports, R2, and Crash Risk’, Journal of Financial Economics, Vol. 94, No. 1, 67–86. US.

3 Lewellen, J. (2004) ‘Predicting Returns with Financial Ratios’, Journal of Financial Economics, Vol. 74, No. 2, 209–235.

4 Rountree, B., J.P. Weston and G. Allayannis (2008) ‘Do Investors Value Smooth Performance?’ Journal of Financial Economics, Vol. 90, No. 3, 237–251.

Additional Reading

1 Accounting conventions can be confusing and each country follows its own accounting standards. The most common one is published by the International Accounting Standards Board and is called International Financial Reporting Standards (IFRS). This is used by over 100 countries, including countries in the European Union, who made the standards mandatory for all listed companies from 2005. Unlisted

and private companies have more flexibility in their approach to presenting financial statements. A major change in financial statement presentation took place in January 2009, when IFRS dropped the term ‘balance sheet’ and replaced it with ‘statement of financial position’. Given that the focus of this textbook is on listed companies, we will adopt the conventions as laid out by the IASB.

Endnote


part 2 - novella.mhhe.comnovella.mhhe.com/.../0077173635/1082513/hillier_9780077173630_ch03.pdf ·...

Documents