The numbers and other information in the accounts tell only part of the story, but there are also hidden meanings that we need to understand to get the full picture. Ratio analysis can help us with it. Such skill is vital to becoming an effective manager.
Ordinary annual report will have a statement of directors responsibilities on page 1, an independent auditors report on page 1-3, primary financial statements on page 6-7, the notes of financial statements and other pages of other material (strategy, corporate social responsibility, environmental reports and information about the board of directors and their pay).
Financial information are prepared on a basis of accounting rules and provide historical information.
The users of the financial accounts will ask questions such as how do the prices compare with competitors? (customers), Has the company enough money to pay my wages? (employees , Can the company pay its taxes? (government), What is the dividend like? (investors), Will I get my interest paid? (lenders), Is the company likely to stay in business (public), Will we get paid what we are owed? (suppliers).
These questions cannot always be answered directly from the financial statements.
The procedure for interpreting accounts
The procedure includes:
Collecting the information,
Analysing it,
Interpreting it,
Reporting the findings.
Collecting the information
We conduct a fairly general overview of the international economic, financial, political and social climate specific to the country in which the company operates. In short, we check whether the company is politically and socially stable with prospects to grow.
Then we look at particular industry in which the company operates, for example:
* Is the government supportive of the industry?
* Is there an expanding market for its products?
* Is there a sufficient land and space available for development?
* Is there a reliable infrastructure i.e utility suppliers and transport network?
* Are there any grands and loans available for developing enterprises?
* Is there an available and trained labour force available?
Once we have all the economic and social information, we need to obtain as much information about the entity as we can get.
We will need to find out about their history, structure, management, operations, products, markets, labour records and financial performance.
The entity financial statements provide a vast majority of the information. It is like a book that tells us a story of the business. As we know, companies are required to file their accounts to Companies House and we are able to downland the company information, including accounts from recent and previous years. Listed companies also generally have on their websites section with these information for their investors where we have access to the accounts as well as other important announcements. There are also large financial databases available of historical financial information for a whole range of companies. For example, Amadeus for private and public European companies.
Analysing the information
Analysing the information involves putting together all the information collected and make sense of it.
The main source of information would generally be the annual reports and accounts. There are four main techniques of interpreting financial information:
* Horizontal analysis,
* Trend analysis,
* Vertical analysis, and
* Ratio analysis.
Horizontal analysis
This technique involves making line-by-line comparison for the company accounts for each accounting period chosen for investigation. But this type of analysis may not be very effective when we are facing a large amount of detail. At least, we can calculate changes from one year to another. We may want to calculate the percentage increases year by year. This might, however, involve a lot of work.
Trend analysis
This is similar to horizontal analysis, except that all the figures in the first set on accounts in a series are given a baseline of 100 and the subsequent sets of accounts are converted to that baseline. For example if sales for 2014 were £50m, 2015 - £70m, 2016 - £85m then 2014 would be given 100. 2015 would become 140 (70X100/50) and 2016 would be given 170 (85X100/50). These figures then mean something because by converting them in this way they become more of our experience of money terms and value of the everyday life.
Vertical analysis
This techniques requires the figures in each financial statement ( generally the income statement and statement of financial position) to e expressed in % of total amount.
Ratio analysis
A ratio is simply a division of the arithmetical amount by another arithmetical amount expressed as a percentage or as a factor. It is known as the most effective way of comparing one figure to another because it expresses the relationship between loads of amounts in a simple way. If, for example, a cost of sales in 2015 was £12m and the sales revenue was £20 we would express the relationship as 60% ( 12X100/20) or 0.6 to 1 (12/20).
Interpreting the information
Now, we have to use all the information we have before we explain hat happened. We may ask ourselves such questions as:
* What does it tell me about the company's performance?
* Has the company done well in comparison with other financial periods?
* How does it compare with other companies?
* Are the world economic, social and political circumstances are favourable to trade generally?
* What are the prospects for the region in which the company does its business?
Here, we might realise that there are obvious strengths and weaknesses as well as variety of positive and negative factors and trends.
Reporting the findings
Lastly, we will most likely be required to file a report. Having to write something down helps us to think clearly and logically. The report should generally be broken down into 3 main sections. First section should be the introduction where we outline the nature and purpose of the report including a brief outline of its structure. The second part should include our discussion where we present our evidence and the assessment of what the evidence means. In the last concluding section, we summarise briefly the entire study, list our conclusions and state our recommendations.
The ratio analysis in more details
There are many ratios that we can produce and most accountants have their favourites. Each ratio has its definition that we need to check before using it. We need to choose our ratios wisely. For example if we use 20 ratios for the period of last 5 years we will come up with 100 different ratios and it might be a little bit too much to handle.
Ratios are generally covered within 5 main categories:
Liquidity (solvency) ratios - measure the extend to which an entity is able to settle its current liabilities and remain solvent. It tries to assess on how much cash the entity has available (normally within the next 12 months) to settle its liabilities.
Profitability ratios - measure the extend to which an entity has been able to generate adequate return in relation to the resources it has.
Efficacy ratios - tell us how the entity has been managed, for example how well its resources have been looked after by those who run the business.
Investment ratios - relates to the market value of company shares and dividends and are interest to investors in listed companies primarily.
Gearing (leverage) ratios - provide the information about the funding structure and measure the extend to which the business can settle its non-current obligations, for example a long term loan.
To check how the business is performing we would generally look at:
* Market/Demand - What is the size of the market? What is the quantity of the products sold? * Are there any bulk orders?
* Revenue related - What is the sales price?
* Cost related - what is the cost to produce?
* Cash - Who is the customers and how they are paying?
* Patent protection - is the product patented?
From this questions we can work out:
Revenue = Quantity sold X Sales price per item
Cost of goods sold = Quantity sold X Cost to produce per item
Revenue - Cost of the goods = Gross profit
The revenue, cost of goods sold and the Gross profit are already part of the income statements.
When we have this information we can then calculate the ratios.
Profit margin ratio (profitability ratio)
The profit margin shows what percentage of every £1 of sale is profit.
Profit margin = (Profit/Revenue) X 100
This ratio is generally expressed as percentage. The higher the margin the better the profit because there is more profit and also there is more buffer to absorb unfavourable economic and market events such as reduced customer sale or increase of supplier cost.
A business with 1% profit margin (making 1p profit of every £1 of products sold) does not have much scope to remain profitable then a company with, let's say 15% profit margin. In a capital intensive business (for example in manufacturing industry where a lot of assets is required) the margins tend to be higher.
Return on capital employed ratio (efficacy ratio)
This ratio gives an idea on how effective the business is using its resources in generating profit. Capital employed is the sum of equity and debt funding. Equity funding comes from equity investors and debt funding comes from banks and other creditors, such as ordinary loans.
We then calculate the return on capital:
Return on capital employed (ROCE) = (Profit / Capital employed) X 100
Return on capital employed (ROCE) = (Profit / Equity Funding + Debt Funding) X 100
This ratio is also usually expressed in percentage. The higher ROCE the better. A business making £1 million in profit with £100,000 of funding is much better investment then a business with £1 million profit with £500,000 of funding. The calculation of profit margin allows to compare profitability to other similar ventures. And return on capital employed allows to compare whether an investment in this venture is returning more when compared with other investment opportunities.
The two ratios may be used when assessing a start-up. Below we examine ratios when we have more financial information. In reality, we only need few ratios to check the business financial health. This is to check whether the company needs an excessive amounts of capital to generate its growth, whether it uses that capital effectively, whether it can generate growth internally and finally, whether it can turn operating profits into cash.
Two of them are the ROCE and profit margin already discussed.
The profit margin shows how much of sales is converted into profit, but profit may be gross profit, operating profit or net profit. If we use the gross profit figure then the ratio will be the gross profit margin ratio, if operating profit is used, then the ratio will be the operating profit ratio. Each will tell us slightly different information on how effectively the business is managed.
The bottom-line profits belong to those who own the business, but if it is not paid in dividends then they are reinvested into the business and contribute to the growth over time without external funding.
Capital turn ratio (efficacy ratio)
This ratio suggests that we use in capital turn:
Capital turn = Revenue / Capital employed
This ratio is generally expressed in a factor, for example 3:1. It gives an indication if how much sales is generated for every £1 capital employed. The more revenue it generates for £1 of funding, the better. For example if business made £2 million in sales with £1 million of funding provided from equity and debt sources, then in year two with unchanged funding in can made £10 million in sales. This is a clearly growing business. A consistency in ratio also indicates that the management is able to achieve stable sales regardless of how much capital was employed. Capital intensive business will have low capital turn ratio and the labour-intensive business will have higher ratio.
ROCE revisited (Function of capital turn and profit margin)
ROCE is a measure on how effective the management has been in using funding that was made available to the business - higher profits for the same capital represent more efficient use of resources. The ROCE is actually capital turn multiplied by profit margin. This means that it can be used across different types of business both capital and labour-intensive because capital-intensive businesses will tend to have low capital turn but high profit margins and the labour-intensive businesses just the opposite.
ROCE = ( Revenue / capital employed) X ( Profit / Revenue )
Then the Revenue balances will cancel out which will leave us with the ratio already presented:
RACE = ( Profit / Capital employed ) X 100
Operating cashflow to operating profit ratio (Liquidity ratio)
This ratio is about cash: the operating cash flow to operating profit. Here, we are specific about the profit line to be used as we use the operating profit.
Operating cash flow / Operating profit
It give an indication on how much cash is collected given the profits. This ratio is generally expressed as a factor. For example 1:2 says that for every £1 in profit, 50p is collected in cash. Collecting cash is a key to keep a healthy business and the higher the ratio, the better. It might mean that most of the sales is a cash sale or that if a business was on credit it would collect cash from customers in a timely manner.
Summary of main ratios
This ratios points to:
* a healthy profit margin for its industry as a back-up against unintended events in the trading environment and indication of potential growth that can be generated internally,
* a stable or improving capital turn - as an indication of a consistent performance of the business to check whether the resources are not being wasted,
* a good return on capital employed - indicates an efficient use of the resources to generate what matters (profits),
* profits being translated into cash promptly.
The four key ratios can give a good indication of the business financial health. However, there are other useful ratios we may want to use.
Current ratio (liquidity ratio)
It gives us an indication about a business ability to pay its current liabilities as they fall due. Current means as receivable or payable within the next 12 months.
We know that we need cash to pay liabilities and if we do not have cash, we can sell assets to generate cash. We are talking here about the current assets so that the current asset figure to current liabilities is taken into consideration.
Current ratio = Current assets / Current liabilities
This ratio is usually expressed in a factor, for example 3:1, but sometimes expressed in percentage ( 3:1 = 300%). We must remember, however, that some of the current liabilities do not have to be paid immediately, some debts or dividends may not have to be paid for several weeks. They company may receive in the meantime funds from debtors and balance it out. In some instances, ratio less then 2:1 may have indicated a significant financial position.
If company has more current assets then current liabilities it is a good position and it has enough to turn into cash and pay its liabilities as they fall within the next 12 months.
If the ratio is below 1 or even below 2 it signifies that there is not enough to pay creditors and more borrowing may be needed or the business may be forced into liquidation.
Debt to equity ratio (gearing ratio)
This ratio gives more information on how the business is funded.
Debt to equity = Debt funding / Equity funding
A business that has borrowed a lot is said to be highly geared as opposed to one that is primarily funded by shareholders. Generally a high geared business is considered more risky. It is also risky for a potential or current shareholder as if the company was to go wrong the assets would have been sold to pay the creditors. Equity investors come last to get the money back. If the company is doing well, it is generally good news for equity investor.
Earnings per share ratio (investor ratio)
If for example, we have 70% of the share for one entity and we have 30% of the share, the ratio would be 70:30 proportion. Earnings per share will tell us how much of the profit is attributed to each individual share to work out on how much we are entitled in total.
The earnings per share ratio calculates as below:
Earnings per share = Profit after tax / Number of shares issued
If a company made £400,000 after all expenses and tax and there are 2,000,000 shares held by investors then each share will be entitled to receive 20p dividend. A 10% investor who has 20,000 shares would be entitled to £40,000 of the £40,000 profit.
Lending money as a banker
As a banker to make a decision to lend we would need to make an assessment on how healthy the business is. Profits do not mean much in isolation. We know that profit is sanity but the cash is the reality. We would be interested if the business has enough cash to pay the debt (interests). We would need to know how much cash and cash equivalent the business has as well as the net cash inflow during the year. We need to know, however, how much borrowing the business has and the outlook of our situation changes. Then we check on whether the business has enough of current assets to cover their current liabilities, through checking the current ratio. We would need to check the operating cashflow to operating profit ratio to assess how the business is paid. And finally, we may want to be interested if enough assets exists that can be the collateral for the loan. If business cannot pay his creditors then it will be subject to liquidation, the assets will be sold and the creditors would recover some of their money.
Limitations of the ratios
Ratios can be a good way to interpret financial results and understand the context behind the numbers. They do, however, have certain limitations:
* they are based on past historical information and therefore refer to past performance,
* the financial statements only provide estimates, depreciation, allowance for doubtful debts and accruals. These have a potential to significantly change the situation.
* sometimes the information in financial statements may be wrong, even if audited,
* companies have different year ends and may be subject to different accounting rules for example US companies and UK companies if we want to compare.
Therefore, when calculating ratios we should take into consideration other company information before lending or investing in the business. It might be necessary to evaluate the business environment and economic sector in which the business operates.
Bibliography
Atrill P., McLaney E., 2017 "Accounting and finance for non-specialists", Pearson Education
Dyson J., 2017, "Accounting for non-accounting students", Pearsons Education, Chapter 10, pp. 227-246
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