Financial Ratios

Calculate & discuss financial performance measures - profitability, liquidity activity and gearing • Performance measurement aims to establish how well something /somebody is doing in relation to a planned activity • Is a vital part of control process • Performance measures/indicators can be divided into: 1. Financial (monetary) performance indictors (FPI) 2. Non-financial (non-monetary) performance indictors (NFPI)

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FPI • Used by financial analyst for making decision regarding credit & investments • Financial ratios are FPI • Comparisons can be made with:  Company’s past performance  Results of other parts of business  Results of other business  Industry average  Economy in general

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1. PROFITABILITY INDICATORS Shows the profitability of the product/services of the business & efficiency of utilising resources in earning profits a)

Gross profit Margin = Gross Profit x 100% Sales

It measures how efficiently materials & labour are used to produce a product at a lower cost b) Operating Profit Margin (Sales margin) = Profit Before Interest & Tax (PBIT) Sales It measures company’s success in earning profit from its operations ANM/FPI&NFPI

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1. PROFITABILITY INDICATORS c) Expenses ratio Indicate the percentage of sales that have been consumed by cost of goods sold (COGS) or other operating expenses i)COGS ratio = COGS Sales ii) Operating expenses ratio = Administrative + Selling expenses Sales iii) Distribution expenses ratio = Distribution expenses Sales

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1. PROFITABILITY INDICATORS d) Return on capital employed (ROCE) = PBIT______ Capital Employed Capital Employed

= Shareholders Funds + Non Current Liabilities = Total assets – Current Liabilities = Non Current Assets + WC

It measures return available for shareholders & debt holders

e)

Return on Investment (ROI)

It is interchangeable with ROCE & is used to measure divisional or investment centre

ROI = Operating Profit Margin x Operating asset turnover = EBIT x Sales__________ Sales Operating assets employed ANM/FPI&NFPI

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1. PROFITABILITY INDICATORS f) Return on Equity (ROE) = Profit after tax & preference dividend Shareholder’s Equity Shareholder’s Equity = Paid up Share capital + Share premium + Reserves + Accumulated Profit/Loss It measures return to ordinary shareholders g) Earnings per share (EPS) = Net profit available to equity shareholders Number of ordinary shares outstanding It measures the amount of profits attributable to each ordinary share ANM/FPI&NFPI

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1. PROFITABILITY INDICATORS h) Price earning ratio (P/E ratio) = Market price per share EPS It compares current market price of each share with the pershare earnings to assess the company’s performance i) Residual income (RI) = Profit – Imputed Interest Imputed interest = Cost of capital x Investment It is expressed in absolute terms (dollar amount) It is net income earned after deducting a charge (interest) for the funds invested in the division ANM/FPI&NFPI

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2. LIQUIDITY INDICATORS Liquidity ratios measure the ability of a business to meet its ST obligation & reflect the ST financial strength b)Current ratio = Current assets (CA) Current liabilities(CL) It measures ability of a firm to use its CA to pay off current liabilities when they fall due.

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2. LIQUIDITY INDICATORS c) Quick ratio (Acid Test) = CA – Inventory – Prepaid expense CL It measures ability to repay immediate obligations using cash or near cash assets. d) Operating cash-flow ratio = Cash flow from operation CL

It measures how well the cash flow generated by a company’s operations covers its CL

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2. EFFICIENCY INDICATORS e) Turnover ratio i) Receivables collection period = Average Receivables x 365 Credit Sales It measures average length of time it takes for a firm to collect payments from its customers ii) Inventory turnover period = Average Inventory x 365 COGS It measures how vigorously a business is trading iii) Payables Payment Period = Average Payables x 365 Credit Purchase It measures number of days the firm takes to pay its creditors.

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3. GEARING INDICATORS (LEVERAGE RATIOS) • Leverage ratios are indicative of LT solvency of a company • LT solvency is the ability of it to pay the LT lenders periodic interest during the period of loan & repayment of principal on maturity a) Debt-equity ratio = LT Debt + Preference Shares Shareholder’s equity • Used to describe relative importance of debt & equity in capital structure & to measure financial risk of a firm • High debt-equity ratio increases risk for equity shareholders • Low debt-equity ratio indicates the business is not using its cash & profits effectively to obtain assets

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3. FINANCIAL RISK INDICATORS b) Debt to total capital ratio = LT Debt + Preference Shares LT Debt + Preference Shares + Equity It measures a company’s financial strength c) Interest Cover = PBIT/Interest Charges It measures ability of firm’s profit to sustain interest payment EFECT OF GEARING ON EARNINGS • A highly geared company must earn enough profits to cover its interest charges before anything is available for equity • If return on investment is higher than cost of debt capital, then ROE will increase • Gearing increases probability of financial failure ANM/FPI&NFPI

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FINANCIAL& OPERATING LEVERAGE Debt ratio Debt to Total Capital Debt Equity

Debt Debt +Equity

INTEREST NEXT COVER OPERATING LEVERAGE CONTRIBUTION PBIT INTEREST PBIT

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4. OPERATING GEARING/LEVERAGE • Risk of making low profits or losses due to nature of the business • Used to measure cost structure (fixed & variable) of a firm • Firms with high proportion of FC relative to VC has high operating gearing • Break-even point will be high also • Profit performance is sensitive to relatively small changes in level of sales Examples of fixed operating costs: • Administrative salaries • Depreciation • Insurance premiums • Property taxes • Rent • Lease Charge ANM/FPI&NFPI

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4. OPERATING GEARING/LEVERAGE Operating gearing = Contribution / PBIT Contribution = Sales – VC

• If a high degree of costs are fixed & hence do not decline when demand decline, business risk will increase • If contribution is high but PBIT is low, FC is high & only just covered by contribution. Business risk is high • If contribution is not much bigger than PBIT, FC is low & fairly easily covered by contribution  Business risk is low

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Describe, calculate NFPIs • NFPIs are expressed in absolute terms such as units, or in relative terms such as %, ratios & indices Reasons for growing emphasis on NFPIs: 1. Concentration on too few variables If focus on financial indicators, managers ignore variables that cannot be expressed in monetary terms 2. Lack of information on quality.

Traditional responsibility accounting systems fail to provide information on quality 3. Changes in manufacturing environment New manufacturing technologies focus on minimising throughput times, inventory levels & set-up times. If focuses on costs, managers may concentrate on cost reduction & ignore other important strategic manufacturing goals.

4. NFPIs are a better indicator of future prospects.

Financial indicators tend to focus on ST & this may damage LT profitability

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ADVANTAGES OF NFPIs 1. NFPIs can be provided quickly for managers 2. Easier for non-financial managers to understand & to use effectively.

3. Anything can be compared if it is meaningful to do so.

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WORKED EXAMPLE: RATIOS (adapted from FMA past exams.)

KM is a commuter train service operating in Mayland. It runs the trains and as well as the stations facilities including railway track maintenance. It has been operating for more tha 10 years. In the recent years the KM service has been criticised as being not punctual, having poor safety and poor facilities at the stations. Company has made significant investment (about $9m) in the last year to upgrade service and improve image.

200X ($million)

200Y($million)

Sales

90

92

Operating profit

9

8

Interest

(1.6)

(2.5)

Tax

(2)

(1)

Profit after tax

5.4

4.5

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CONTINUED

Statement of financial position as 31/12 200x

200y

ASSETS Non Current Assets

50

59

Current Assets Inventory

2

3

Debtors

1

1.2

Cash

2

5

1.5

55

5.7 64.7

EQUITY and LIABILITIES Share capital

15

Accumulated profits

21

15 36

23

38

NON CURRENT LIABILITIES Debentures

8

Bank Loan

9

Liabilities due within one year ANM/FPI&NFPI

8 17

16

24

2

2.7

55

64.7 19

CONTINUED 1.

Calculate the following for both years. a. ROCE(based on closing capital employed) b. Net profit margin c. Asset turnover d. Current ratio e. Gearing ratio 2. Comment on the financial performance of KM. Suggest possible causes.

3. Suggest 3 non financial indicators for commuter train company.

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Answers 1. (a)ROCE

b) NPM

c)Asset TO

d)Current

e) Gearing

OP

OP

Sales

CA

Debt

CE

Sales

CE

CL

Equity

9

8

9

8

90

92

5

5.7

17

24

53

62

90

92

53

62

2

2.7

36

38

10.0%

8.70%

1.70

1.48

2.5 times

2.11 times

47.22% 63.16%

16.98% 12.9 % *55-2

2. Profitability

ROCE has decreased. Caused by drop in profit. Increase in costs. Maybe due to new investment to improve service.

Profit also dropped. Although revenue has gone up rising cost has reudec profit.

Lower sales generated per $ of revenue. Maybe new investment need time to improve revenue.

Liquidity

Current ration well above 2 showing co very capable of settling CL. Not facing cash flow problem.

Gearin /Leverage

Gearing has increase from additional debt. Risk has increased. Due to funding new investment with bank loan. Need to ensure can settle debt

3 NFPI

% of commuter trains delayed

% new passenger/ total passengers

Employee turnover

Rating on customer survey on comfort

Examples on Residual Income Perry plc is a large conglomerate company structured on a divisional basis. It seeks to maximise investor wealth. Head office avoids day to day involvement in divisional affairs and only intervenes if performance is considered unsatisfactory.

Divisional performance is measured by residual income. One of Perry’s larger divisions operates a chain of high class hotels throughout the United Kingdom. The division’s mission statement is ‘To be the hotel of first choice for business users and tourists’. Although the chain has generally been popular with tourists it is not proving quite so popular with business users and conference organisers.

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Cont’d Competition in the top segment of the hotel market is fierce, with customers expecting the highest standards of facilities, service and catering. Over the last two years the division has invested a large amount of money in modernising its hotels including the improvement of bedrooms and public rooms, installation of gymnasia and swimming pools and the information technology features required by business travellers. A large amount of money has also been spent on staff training to improve service levels and on a television advertising campaign to promote the improved hotels to business users. Head office is concerned that the performance of the hotel chain appears to have declined over the last few years despite this expenditure.

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Cont’d The following figures are available: £ million 2001

2002

2003

Capital employed

50

70

90

Operating profit

15

16

17

The cost of capital applicable to the hotel division is 20% per annum.

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Requirement a) Calculate the residual income for the hotel chain for each of the three years. £ million Operating profit

2001

2002

2003

15

16

17

Imputed interest charge £50m x 20%

(10)

£70m x 20%

(14)

£90m x 20% Residual Income

(18) 5 ANM/FPI&NFPI

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(1) 25

Requirement b) Discuss the advantages and disadvantages for residual income as a divisional performance measure.

Advantages: - It makes divisional managers aware of the cost of financing their divisions - It is an absolute measure of performance and not subject to the problems of relative measures such as return on investment - In the long run it supports the net present value approach to investment appraisal ANM/FPI&NFPI

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Cont’d Disadvantages: - It gives the symptoms not the causes of problems. If residual income falls, the figure give little clue as to why - When it is applied on a short term basis, it may lead managers to overlook projects whose payoffs are long term - Problems exist in comparing the performance of different sized divisions (large division will earn larger residual incomes simply due to their sizes)

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