EPFLAcforFinance17 5

FINANCIAL ANALYSIS
Accounting for Finance 1

Eric Cauvin, IAE Nice-Sophia-Antipolis
Overview
Identification of important trends over time.
Five year period, consider trends in key
indicators:
Sales (revenue)
Net assets
Operating profit
Profits after tax
Earnings per share
Financial ratios
Financial ratios can be used to compare the
performances of companies of different sizes
(benchmarking).
Ratios also provide a profile of a company,
its economic structure, its competitive
strategies, and its unique set of operating,
financial and investment characteristics.

Purpose of ratio analysis
Absolute figures are of little value. They only provide
insights if they can be compared with other relevant
amounts in ratios, e.g.:
Sales as a percentage of gross profits:
Allows prediction of likely increase in profit given an increased
level of sales
Profit as a percentage of sales:
Is the profit level satisfactory?
Need ‘standards’ for comparison…

Comparisons
1. Compare with earlier years:
Identification of a trend?
Does it represent an improvement?

Comparisons (Continued)
2. Compare it with the company's
plan:
Is it in line with the company’s expectations as
budgeted?
Not generally available in detail to an outside
investor,
But company might indicate forward-looking
aspects in Annual Reports.
3. Compare with those of other
companies in the same industry:
External standard,
No two companies are exactly alike, in products
or in markets,
Different accounting policies used, e.g.:
Depreciation, inventory valuation.
4. Compare with industrial average:
All the disadvantages of average figures.
Our company might be placed in a particular
part of the market and so it is of limited value to
compare with average of the industry.
Accounting policies may be different.
But provides a starting point.
Accounting policies
Ensure that the company has used consistent
accounting policies over time, especially:
inventory valuation
fixed asset revaluation
depreciation

Ratios Only a Starting Point
What did we expect? What did we find?
How does the company explain the difference?
Do we believe it?
What is our intuition?
Look for corroboration, e.g. link to cash flow
statement.

Ratios Only a Starting Point (Continued)
Indicates questions to ask.

For example, why has profit margin fallen?
Might be due to product market conditions;
or specific problems of the company; or
change in product mix.
Very often segmental information is needed.

Systematic analysis
Investor ratios: An aid to judging a company as a stock
market investment.
Management performance: An aid to judging how well
the company is being run by management.
Liquidity: Aids judgement of the adequacy of company's
cash and near cash resources.
Leverage: Measure of the company's financial risk.

Magma example

Income statement
Year 2 Year 1
£m £m £m £m
Sales (revenue) 720 600
Cost Of Goods Sold 432 348
Gross profit 288 252
Distribution costs (72) (54)
Administrative expenses (87) (81)
(159) (135)
Operating profit 129 117
Interest payable (24) (24)
Profit before tax 105 93
Taxation (42) (37)
Profit for the period 63 56
Balance sheet
Year 2 Year 1
£m £m £m £m
Land and buildings 600 615
Plant and equipment 555 503
1,155 1,118
Inventory 115 82
Trade receivables (debtors) 89 61
Prepayments 10 9
Bank 6 46
220 198

Balance sheet (Continued)
Year 2 Year 1
£m £m £m £m
Trade payables (creditors) (45) (30)
Taxation (21) (19)
Accruals (29) (25)
(95) (74)
Net current assets 125 124
1,280 1,242
Loan (400) (400)
880 842
Ordinary shares of £1 500 500
Retained profits 380 342
880 842
Statement of Changes in Equity
£m
Share capital and reserves end year 1 842
Less dividend paid (5.0 pence per share) (25)
Add profit year 2 63
Share capital and reserves end year 2 880
Directors’ report year 2

Directors propose to pay 30 as dividend.

Share Prices
Share price used in ratio analysis is the value
soon after the profits of the company have been
announced to the market.
The announcement is by press release called the
Preliminary Announcement. For a 31 December
year end the press release might be in the
following March.
Market price at March 1st, Year 2: 202 pence
Market price at March 1st, Year 3: 277 pence

Investor ratios

Investor ratios
Investors who buy shares in a company want
to be able to compare the benefit from the
investment with the amount they have paid
for their shares.
There are two measures of benefit to the
investors:
The profit of the period: earnings,
The dividend: the amount of cash paid to
the shareholders.
Earnings Per Share
Profit after tax for ordinary shareholders
Number of ordinary shares
Earnings per share: 63 = 12.6 pence
500
• Most often quoted measure of company

performance and progress.
• Measure percentage increase from year to year.
Strong focus on annual earnings: may cause ‘short-termism’

among investors and among company managers.
Price Earnings Ratio
Share price
Earnings per share
Price earnings ratio: 277 pence = 22 times
12.6 pence
• Compares the amount invested by the shareholder in the company
with the earnings per share. Number of years current profit
represented by share price.
• Reflects market's confidence in future prospects of the company.
• Compare with average P/E for the industry, given daily in the
Financial Times.
• Commonly used as a basis for investment decisions.

Dividend Per Share
Dividend of the period
Number of issued shares
Dividend per share: 30 = 6 pence per share
500
• Of immediate interest to many investors. Dividend is the
most immediate reward for share ownership.
• Most companies attempt to maintain a consistently
increasing trend.
• The Director’s Report will contain a note on the
recommended dividend which is to be paid to shareholders
following their agreement at the annual general meeting.
Dividend Cover (Payout Ratio)
Earnings per share
Dividend per share
Dividend cover: 12.6 p = 2.10 times

6.0 p
• Number of times dividend can be paid out of current
earnings.
• The higher the dividend cover, the ‘safer’ the
dividend.
Dividend Yield
Dividend per share x 100%
Share price
Dividend yield: 6.0 x 100% = 2.17%
277
• Compares dividend per share with the amount invested
by the shareholder.
• Might seem low yield compared to other types of
investment.
• Dividends are not the only benefit from share ownership.
There is an expectation of an increase in share price.
Retained profits generate growth in future profits.
Management performance

Management performance
Controls the use of resources for the benefit
of the owners. Two central questions:
How well did the management make use of
the investment in assets to create sales?
How carefully did the management control
costs so as to maximise the profit derived
from the sales?

Return on Shareholders’ Equity
Profit after tax x 100%
Share capital + Reserves
Return on shareholders’ equity:
63 x 100% = 7.2%
880
• Performance of company from the shareholders'

perspective: success of the company in using the funds
provided by shareholders to generate profit.
• This profit will provide new wealth to cover their dividend
and to finance future expansion of the business.
• Essential to use profit after tax and after interest charges.

Return on Capital Employed
Operating Profit (before interest and tax) x 100%
(Total assets – Current liabilities)
Return on capital employed: 129 x 100 = 10.1%
1,280
• Performance of company as a whole.

• Measure of management efficiency.
Total assets-current liabilities=Ordinary share capital+reserves+LT

loans
• Measure of how well the long-term finance is being used to
generate operating profits.
Return on Total Assets
Operating Profit (before interest and tax) x 100%
Total assets
129 x 100% = 9.4%
1,375
It is another variation on measuring how well the

assets of the business are used to generate operating
profit before deducting interest and tax.

Operating Profit on Sales
Operating profit (before interest and tax) x 100%
Sales (revenue)
Operating profit on sales:
129 x 100 = 17.9%
720
‘Operating profit margin’ the higher the better.
Reflects:
• degree of competitiveness in the market economic situation,
• ability to distinguish products,
• ability to control expenses.
Gross Profit Ratio
Gross profit x 100%
Sales (revenue)
Gross profit = Sales - All costs of sales
Gross profit ratio: 288 x 100 = 40%

720
• Concentrates on costs of making goods and services ready for
sale.
• Small changes in this ratio can be highly significant.
• There tends to be a ‘normal’ value for each industry.
• More details are provided by Management Accounting (per
product, …).
Total Assets Usage
Sales
Total assets
Total assets usage: 720 = 0.52 times

(1,155 + 220)
• Indicates how well a company has used its productive

capacity.
• Use in trends of what has happened over time.

Fixed Assets Usage
Sales
Fixed assets
Non-current (fixed) assets usage: 720 = 0.62 times

1,155
Interpreted as how many £s of sales have been generated

by each £ of assets, i.e. 62 pence of sales for each £1 of
fixed asset investment.
Comments
Companies are not obliged to seek high
margins.
Some cannot, because of strong competitive
factors. Yet they still make a satisfactory
Return on Capital Employed by making
efficient use of the equipment held as fixed
assets.

Profitability ratios
A first measure of profitability is the relationship
between the company’s costs and its sales. Actually the
ability to control costs in relation to revenues enhances
earning power. In particular:
The Gross Profit (or Margin) captures the

relationship between sales and manufacturing (or
merchandising) cost,
The Operating Profit (or Margin) provides
information about a company’s profitability from
the operations of its core business, excluding the
effects of:
Invesments,
Financing,
Tax position.
Profitability ratios (continued)
A second measure of profitability is the relationship between
profits and the investment required to generate them. In
particular:
Return on Assets (ROA) compares income with total assets
and it can be interpreted in two ways:
It measures management’s ability and efficiency in using
the company’s assets to generate operating profits,
It reports the total return accruing to all providers of
capital (debt and equity), independant from the source of
capital.
Return on Equity (ROE) measures the percentage return
generated by the company for the equity shareholders.

The Dupont Formula (ROA)
Sales
- Net Income
Return on
÷ Sales (ROS)
Total Costs
Sales
Return on
x Assets (ROA)
Sales
Current
Assets Asset
÷ Turnover
+ Total Assets
Fixed
Assets Accounting for Finance 38
The Dupont Formula (ROE)
Sales
- Net Income
Return on
÷ Sales (ROS)
Total Costs
Sales
x ROA
Sales
Current
Asset Return on
Assets ÷ Equity
Turnover x
Total Assets (ROE)
+
÷
Fixed Financial
Assets Leverage
Equity Accounting for Finance 39
ROS ASSET FINANCIAL ROE
TURNOVER LEVERAGE
Accor 4.77 0.81 1.95 7.55
Alcatel Alsthom 2.64 3.11 1.28 10.50
Bouygues 1.68 8.68 0.8 11.67
Canal+ 5.50 1.27 0.96 6.69
Carrefour 2.61 4.99 1.20 15.65
Danone 4.77 1.24 1.47 8.70
France Telecom 9.23 0.81 2.34 17.56
L’Oréal 6.61 1.76 1.18 13.73
Lafarge 7.12 0.91 1.31 8.48
LVMH 13.74 0.54 1.44 10.68
Michelin 4.36 1.71 2.49 18.53
Peugeot 0.55 2.61 1.16 1.66
TF1 5.99 6.37 0.69 26.36
Total 3.27 2.44 1.18 9.40
Valeo 4.33 2.68 1.07 12.40
Liquidity and Working Capital

Liquidity
Liquidity: availability of cash in the near future
after taking account of immediate financial
commitments.
Cash in the near future: bank deposits, sale
of stocks and cash collected from
customers.
Immediate financial commitments: current
liabilities.
Working capital
Working capital is the amount of finance, which

a business must provide to finance the current
assets of a business, to the extent that these are
not covered by current liabilities. It is calculated
by deducting current liabilities from current
assets.

Working Capital Cycle
The working capital cycle of a business is the

sequence of transactions and events, involving
current assets and current liabilities, through
which the business makes a profit.

Working Capital Cycle (Continued)
acquire goods for
use in production, for resale or
for use in providing a service
STOCK
pay sell goods or

suppliers CREDITORS DEBTORS service to
who have customers on
allowed time to pay CASH credit
collect cash
Calculated as current assets minus current

liabilities.
If the working capital is low, then the
business has a close match between
current asset and current liabilities but
may risk not being able to pay its
liabilities as they fall due.
If current assets are very much greater than

current liabilities, then the business has a large
amount of finance tied up in the current assets
when perhaps that finance would be better
employed in the acquisition of more non-
current (fixed) assets to expand the profit-
making capacity of the operations.

Current Ratio
Current assets/Current liabilities
Current Ratio: 220/95 = 2.3/1
Are short-term assets adequate to settle short-term liabilities?

• If less than 1/1, look closely at cash flow.
• Ability to generate daily cash might make this ratio
adequate, e.g. a retailer selling to the public.
• Must look at norm for the industry: usually between
1.5/1 and 2/1 for manufacturing industry.

Acid Test
Current assets minus inventory/Current liabilities
The acid-test (220 – 115) / 95 = 1.11/1
• Places emphasis on the most liquid assets.

• Excludes inventory (stock).
• Expected around 1/1 but varies from industry to industry.

Working Capital Needs and Working
Capital Funds
Working Capital Needs
Current Assets – Current Liabilities
Current Assets Current Liabilities

Fixed Assets Long Term Liabilities
Equity
Working Capital Funds

(Long Term Liabilities + Equity) – Fixed Assets
Working Capital Needs and Working
Capital Funds
Equation:
Cash = Working Capital Funds –
Working Capital Needs
WCF = (400 + 880) – 1,155 = 125
WCN = (115 + 89 + 10) – 95 = 119
WCF – WCN = 125 -119 = 6
Inventory Holding Period
Average inventories held x 365 days
Cost of sales
Inventory (stock) holding period: (115 + 82)/2 x 365 = 83 days

432
• How quickly goods move through the business:

– Generally, the shorter the better, but too short may risk
being ‘out of stock’.
– Assumption that year end figures represent normal level for
year.

Customers (debtors) Collection Period
Trade receivables x 365

Credit sales
Customers collection period: 89 x 365 = 45.1 days

720
• Speed of collecting from credit customers.

• Compare with the credit period given, or the normal credit
period for the industry.

Suppliers Payment Period
Trade payables x 365
Credit purchases
Purchases (If no purchases figure, use cost of sales) = Cost of sales
+ closing inventory – opening inventory
432 + 115 – 82 = 465
Suppliers payment period: 45 x 365 = 35.3 days

465
• Paying too fast – risk of cash shortage.

• Paying too slowly – risk of losing supplier.

Working Capital Cycle
Working capital Inventory (stock) holding period +

cycle Customers collection period –
Suppliers payment period
Inventory (stock) holding 83.2 days

Debtor collection 45.1 days
127.3 days
Creditor payment 35.3 days
Finance needed for 92.0 days
Leverage

Leverage
Describes the mix of loan finance and
equity finance in a company.
It is called Financial Gearing or Leverage
(US).

Leverage
Long-term loans x 100%
Ordinary share capital + reserves
Debt/equity ratio: 400 x 100 = 45.5%

880
• Most often quoted in the financial press. A high figure indicates

reliance on sources of long-term loan finance.
• A low gearing percentage indicates a low exposure to financial risk.
• ‘Long-term loan’ includes short-term portion of loans, in current
liabilities in balance sheet.
• Also bank overdraft, if a permanent feature.

Interest Cover
Profit before interest and taxes
Interest charge
Interest cover: 129 = 5.38 times

24
• Interest payments must always be met, so company has
exposure to interest rate movements.
• Indicates how ‘safe’ the annual interest payments are in
relation to profit.
• Indicates how many times profits can fall before the
company is unable to cover payments out of current profits.

Leverage
Company A has no Long-Term Loan (100,000 shares, €100 nominal
value per share), Company B issued 50,000 shares (€100 nominal value
per share) and has a Long-Term Loan, 5,000,000 (10 % per annum).
A B
Operating profit 1,500,000 1,500,000
Interest 0 500,000
Profit before tax 1,500,000 1,000,000
Profit after tax 750,000 500,000
Equity 10,000,000 5,000,000
Return on Equity 7.5 % 10 %

Leverage (continued)
Return on Equity is explained by:
The leverage: D/E
The Return on Capital
Employed.

ROCE = Operating Profit (before interest
and tax)/Total Assets-Current Liabilities
Total Assets-Current Liabilities = Equity

+ Long-Term Loan (Debt)

ROCE =
Operating Profit/Sales x Sales/Equity+LT Loan
ROCE combines a margin and an asset turnover

ROCE = Operating Profit/(E+D)
ROE = Net Income/E
Net Income = Profit after Tax

Net Income before Tax = Operating Profit – Interests
Interests = D x r
ROE = (OP – Dr) (1-Tr)
E
ROCE = OP/(E+D)
OP = ROCE x (E+D)
ROE = [ROCE x (E+D) – D x r] (1 - Tr)

E
ROE=(ROCE x E + ROCE x D - D x r)(1 - Tr)

E

ROE=(ROCE + ROCE x D - D x r) (1 - Tr)
E
ROE = [ROCE + D (ROCE - r)] (1 – Tr)

E
For the company A, ROE = ROCE = [15% + 0] (1-0.5), i.e., 7.5%,
For the company B, ROE = [0.15 + 5/5 (0.15-0.1)] (1-0.5)
ROE = 7.5% + 1 x (7.5%-5%)=10%
ROCE Leverage effect 66

Accounting for Finance
The difference between ROE and ROCE is
the leverage effect.
If the company has no debt: ROE = ROCE
If the company has debt: (1-Tax
rate)D/E(ROCE - r) measures the
contribution (positive or negative) of the debt
to the ROE.


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FINANCIAL ANALYSIS

Accounting for Finance 1

Accounting for Finance 3

Need ‘standards’ for comparison…

Accounting for Finance 4

Accounting for Finance 5

Accounting for Finance 9

Accounting for Finance 10

Indicates questions to ask.

Accounting for Finance 11

Accounting for Finance 12

Accounting for Finance 13

Land and buildings 600 615

Plant and equipment 555 503

Accounting for Finance 15

Directors’ report year 2

Accounting for Finance 17

Accounting for Finance 18

Accounting for Finance 19

• Most often quoted measure of company

Strong focus on annual earnings: may cause ‘short-termism’

Accounting for Finance 22

Dividend cover: 12.6 p = 2.10 times

Accounting for Finance 26

Accounting for Finance 27

• Performance of company from the shareholders'

Accounting for Finance 28

• Performance of company as a whole.

Total assets-current liabilities=Ordinary share capital+reserves+LT

It is another variation on measuring how well the

Accounting for Finance 30

Gross profit = Sales - All costs of sales

Gross profit ratio: 288 x 100 = 40%

Total assets usage: 720 = 0.52 times

• Indicates how well a company has used its productive

Accounting for Finance 33

Non-current (fixed) assets usage: 720 = 0.62 times

Interpreted as how many £s of sales have been generated

Accounting for Finance 35

The Gross Profit (or Margin) captures the

Accounting for Finance 37

Accounting for Finance 41

Working capital is the amount of finance, which

Accounting for Finance 43

The working capital cycle of a business is the

Accounting for Finance 44

pay sell goods or

Calculated as current assets minus current

If current assets are very much greater than

Accounting for Finance 47

Current Ratio: 220/95 = 2.3/1

Are short-term assets adequate to settle short-term liabilities?

Accounting for Finance 48

Current assets minus inventory/Current liabilities

The acid-test (220 – 115) / 95 = 1.11/1

• Places emphasis on the most liquid assets.

Accounting for Finance 49

Current Assets Current Liabilities

Working Capital Funds

Inventory (stock) holding period: (115 + 82)/2 x 365 = 83 days

• How quickly goods move through the business:

Accounting for Finance 52

Trade receivables x 365