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Enrolment Key: EBAD4012023

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Fundamentals of Corporate Finance
5th South African Edition Study Unit 3
Chapter 3

Working with
Financial
Statements

Slides by Dr J Krüger &

Prof C Rootman

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 H&M targets expansion in SA
While Hennes & Mauritz (H&M) may have delivered an
impressive full-year performance in SA amid a constrained
consumer environment, the Swedish company’s group results
show that global retail is struggling as much as the local
sector.
H&M reported South African sales of about R1bn last year
from its fewer than 10 stores. In the fourth quarter of its 2016
financial year, H&M local sales grew by 111% in rand terms.
H&M opened its doors in SA in 2015.
"We see a lot of potential in the South African market and
have an aggressive expansion strategy in place. We will be
opening another two stores in Nelspruit at the Ilanga Mall and
in Polokwane at the Mall of the North," said Woudstra.
Source: https://www.businesslive.co.za/bd/companies/retail-and-consumer/2017-02-02-hampm-targets-expansion-in-sa/ 3
H&M targets expansion in SA (cont)
What did H&M consider before deciding on
aggressive expansion strategy?
Working capital decisions?

Capital structure?

Capital budgeting?

= Capital budgeting or long-term investment

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decisions
 Learning outcomes
After studying this chapter you should be able to:

1 distinguish between the different ways in which

firms obtain and use cash
2 trace the flow of cash through the firm
3 indicate the rationale for standardising financial
statements
4 compute and interpret important financial ratios
5 compute and interpret financial performance
using the Du Pont identity
6 describe the problems and pitfalls associated
with financial statement analysis
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 Learning outcomes one and two
Distinguish between the different ways in which
firms obtain and use cash
Trace the flow of cash through the firm
(Pages 43 – 46)

• Recall from SU2 that

• CF plays a crucial role in FM
• CF from assets = CF to lenders + CF to
shareholders

Now we need to take a closer

look at the sources and uses of cash
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Learning outcomes 1 and 2 (cont)

• Sources of cash

• A cash inflow occurs when we “sell”

something
•  in an asset account
• E.g. inventory
•  in a liability or equity account
• E.g. LT debt is higher which means we
received funds

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Learning outcomes 1 and 2 (cont)

• Uses (or application) of cash

• A cash outflow occurs when we “buy”

something
•  in an asset account
• E.g. buying more inventory
•  in a liability or equity account
• E.g. Accounts Payable is lower which
means we paid them

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Learning outcomes 1 and 2 (cont)

• Difference between sources and uses of cash

represents net addition to cash over a specific
period

• See example of Bushbuck Company (Pages

43 – 46 of textbook)

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Learning outcomes 1 and 2 (cont)

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Learning outcomes 1 and 2 (cont)

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Learning outcomes 1 and 2 (cont)

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Learning outcomes 1 and 2 (cont)
• Why do we distinguish between sources and
uses of cash?
• They serve as inputs when setting up a CF
statement

• A CF statement reflects three types of CFs

• CFs from operating activities

• Includes net income and changes in current
accounts

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Learning outcomes 1 and 2 (cont)
• CFs from investing activities
• Includes changes in non-current assets

• CFs from financing activities

• Includes changes in notes payable, long-term
debt and equity accounts as well as dividends

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 Learning outcome three
Indicate the rationale for standardising
financial statements (Pages 46 – 64)

• Why?
• We want to compare financial statements of
companies of different sizes, particularly
within the same industry
• Called a peer group or comparative
analysis
• We want to get an overview of how a
business performs over time
• Called time-trend analysis
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 Learning outcome three (cont)
• How?
• Common-size balance sheets
• Compute all accounts as a % of total
assets
• Common-size income statements
• Compute all line items as a % of sales
• See example of Bushbuck Company (Pages 46
– 48 of textbook)

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Learning outcome three (cont)

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Learning outcome three (cont)

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Learning outcome three (cont)

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 Learning outcome four
Compute and interpret important financial ratios
(Pages 49 – 64)

• Ratios also allow for a better comparison between

companies and through time
• A ratio on its own has no meaning – we need
benchmarks
• The company’s performance in previous periods
• Visit http://www.reuters.com

Source: http://www.reuters.com/finance/stocks/financial
Highlights?symbol=CLSJ.J
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 Learning outcome four (cont)
• Categories of ratios
• Short-term solvency or liquidity ratios
• Long-term solvency or financial leverage
ratios
• Asset management or turnover ratios
• Profitability ratios
• Market value ratios

• Refer to the 2016 income statement and

balance sheet of KWAGGA Ltd (see study
guide page 24) for the respective calculations

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 Short-term solvency or liquidity
measures (cont)
• Current ratio = CA / CL
• KWAGGA = 5 120 / 4 491 = 1.14
• Interpretation: For every R1 in CL the firm
has R1.14 in CA

• Norm 2:1 (depending on the industry)

• Lenders and suppliers like high ratios
• Improve?  CL or  CA or both
• BUT: This ratio should not be too high as this
indicates that NWC is not managed optimally

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 Short-term solvency or liquidity
measures (cont)
• Quick (or acid test) ratio
= (CA – Inventory) / CL

• Recall that inventory is seen as the least

liquid CA. As such we remove it from the
equation…

• KWAGGA = (5 120 – 885) / 4 491= 0.94

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 Short-term solvency or liquidity
measures (cont)
• Interpretation:
For every R1 in CL the firm has R0.94 in cash,
debtors and other short-term investments

• Norm 1:1 (depending on the industry)

• Improve?  CL,  Inventory or  CA

• Question: What is the impact on the current and

quick ratios if a firm buys inventory using cash?

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 Short-term solvency or liquidity
measures (cont)
• Other liquidity ratios (used for various
purposes)

• Cash ratio = Cash / CL

• NWC to total assets = (CA – CL) / Total
assets
• Interval measure = CA / Average daily
operating costs

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 Short-term solvency or liquidity
measures (cont)
• See study guide page 33. Perform a trend and
comparative analysis on the current ratio of
Furniture Group Ltd.

• Consistently > 1
• All the current ratios far higher than norm
(2:1)
• As from 2012 – 2014 the current ratio was
slightly lower than the industry average;
however not in 2015

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 Long-term solvency or financial
leverage ratios (cont)
• Total debt ratio = (TA – TE) / TA
• Where: TA = total assets (remember Total
Assets is exactly the same as Total Capital
since A = L + E) and
TE = Total equity
• Alternatively we could say:
Total debt ratio = Total debt / TA
Where: Total debt = S-T debt + L-T debt
• KWAGGA = (TA – TE) / TA
=(26 840 – 14 914) / 26 840
= 0.4443 27
 Long-term solvency or financial
leverage ratios (cont)
• Using the alternative equation
= (L-T debt + S-T debt) / TA
= (7 435 + 4 491) / 26 840
= 0.4443

• NB: you should get the same answer

irrespective of the equation you use.

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 Long-term solvency or financial
leverage ratios (cont)
• Total debt ratio (cont.)
• Two ways of interpreting this ratio:
• For every R1 in total capital, the firm
has R0.44 in total debt
• 44.43% of KWAGGA’s total assets are
financed with debt

• Question: should this ratio be high or low?

• That depends! We will spend entire
chapter to answer this question …

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 Long-term solvency or financial
leverage ratios (cont)
➢ Debt/Equity ratio = TD / TE
➢ Where
TD = Total Debt = L-T debt + S-T debt
TE = Total Equity

➢ KWAGGA = (7 435 + 4 491) / 14 914

= 0.7996 = 0.80

➢ Interpretation:
For every R1 of Total Equity, the firm has
R0.80 in Total debt
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 Long-term solvency or financial
leverage ratios (cont)
• See study guide page 28. Perform a trend and
comparative analysis on the D:E ratio of
Furniture Group Ltd.

• They have consistently increased the

amount of debt they have relative to equity
from 2011 to 2014, and slightly decreased it
in 2014 and 2015
• In the period 2012 – 2015 they had
considerably less debt compared to the
industry average, the industry also
consistently increased their usage of debt 31
 Long-term solvency or financial
leverage ratios (cont)
• Given a D:E ratio of 0.29 in 2015, what was the
total debt ratio of Furniture Group Ltd?
• Well, if the firm has 29c of TD for every R1 of
TE, this implies that Total Capital = R1.29
• Total debt ratio = TD / TA
= (0.29 / 1.29) x 100 = 22.48%

• Equity multiplier = TA / TE = 1 + D/E

• KWAGGA = 26 840 / 14 914 = 1.80
• Alternatively = 1 + 0.80 = 1.80
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 Long-term solvency or financial
leverage ratios (cont)
• Times Interest Earned (TIE) = PBIT / Interest
• Shows us how well a company has its interest
obligations covered (therefore also called the
interest coverage ratio)
•KWAGGA = 2 911 / 836 = 3.48 times
•Two ways to interpret this ratio:
• For every R1 of interest to be paid, the firm
had R3.48 in PBIT
• PBIT can decline 3.48 times before the firm
will be unable to pay interest payments
• Question: What type of trend is optimal here?
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 Long-term solvency or financial
leverage ratios (cont)
• Recall from SU2 that profit  CF and recall that
financial managers are more concerned with
CF
• Hence: Cash coverage ratio
= (PBIT + Depreciation) / Interest
• KWAGGA = (2 911 + 1 890) / 836 = 5.74
• Interpretation: For every R1 of interest to
be paid, firm had R5.74 in CF to do so
• Suppliers and lenders particularly interested in
this ratio
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 Asset management or
turnover ratios
• We’re going to look at various types of assets

• Inventory turnover
= Cost of goods sold / Inventory

• KWAGGA = 4 874 / 885 = 5.51 times

• Two ways to interpret this ratio:

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 Asset management or
turnover ratios (cont)
• The entire inventory of the firm is turned into
sales 5.51 times p.a. (i.e. close to every 2
months)

• For every R1 invested in inventory, R5.51 is

earned in sales

• The higher the turnover, the better

• How could firms improve their turnover?

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 Asset management or
turnover ratios (cont)
• Inventory turnover (cont.)
• Be careful when evaluating this ratio for
service industries!
• The use of average inventory as
denominator is actually better where
average inventory
= (Beginning + closing inventory) / 2

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 Asset management or
turnover ratios (cont)
• Days’ Sales in Inventory
= Inventory x (365 / Cost of goods sold)
• KWAGGA = 885 x (365 / 4 874) = 66.28 days
• Interpretation: Inventory is held, on average, for
66 days (just over 2 months) before it is sold
• Is this good or bad?

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 Asset management or
turnover ratios (cont)
• Receivables turnover = Sales / Accounts
receivable
• KWAGGA = 9 675 / 3 975 = 2.43 times
• Interpretation: The firm collects their debtors
2.43 times per year
• Should this ratio be high or low?

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 Asset management or
turnover ratios (cont)
• Days’ sales in receivables = AR x (365 / Credit
sales)
• KWAGGA = 3 975 x (365 / 9 675) = 149.96
days (NB: we assume that all KWAGGA’s
sales were on credit…)
• Interpretation: It takes on average 149.96
days (+/- 5 months) to collect AR
• This ratio is also called the average
collection period

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 Asset management or
turnover ratios (cont)
• We can do a similar calculation for payables
turnover
• Looking at the bigger picture we can calculate
NWC turnover, non-current asset turnover and
total asset turnover (in each case only the
denominator will change)

• Total Asset Turnover (TAT)

= Sales / Total Assets
• KWAGGA = 9 675 / 26 840 = 0.36 times
• Interpretation: For every R1 invested in TA,
R0.36 is generated in sales 41
 Asset management or
turnover ratios (cont)
• Total Asset Turnover (cont.)
• Measure of asset use efficiency
• Not unusual for TAT < 1, especially if a firm
has a large amount of non-current assets
• What type of trend is preferable here?

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 Profitability ratios

• This is a very NB category of ratios

• Always express your answers as %
• Profit Margin = Net profit after tax / Sales
• KWAGGA = 1 494 / 9 675 = 15.44%
• Interpretation: Of every R1 made in sales,
only 15c remain as NPAT

• How can one improve this ratio?

• Increase sales ( price and/or quantity)
• Calls for better marketing efforts
• Decrease expenses
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 Profitability ratios (cont)
• One can also calculate other profit margins e.g. PBIT
and operating margins – same principles apply

• See study guide page 28. Perform a trend and

comparative analysis on the operating profit margin
of Furniture Group Ltd.
• Interpretation of 2015 figure: for every R1 made
in sales, an operating profit of 23.45c was made
• Margin decreased from 2011 to 2012 and
increased slightly from 2012 to 2015
• Operating profit margin was higher for period
2012 – 2015 when compared to industry average
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 Profitability ratios (cont)

• Return on Assets (ROA) = Net profit after tax / Total

Assets

• NB: ROA is the same as Return on total capital

• KWAGGA = 1 494 / 26 840 = 5.57%

• Interpretation: For every R1 lenders and
shareholders invested in the firm, they received
5c in return – The higher the better!

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 Profitability ratios (cont)

• See study guide page 28. Perform a trend and

comparative analysis on the ROA of Furniture Group
Ltd.

• This ratio has decreased over time – from

24.82% in 2011 to 17.77% in 2013, but increased
slightly from 2013 to 2015 (19.05%).
• For 2012 Furniture Group’s ROA was higher than
that of the industry average, but for 2013 to 2015
it was well below the industry average

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 Profitability ratios (cont)

• Return on Equity (ROE) = Net Profit after Tax /

Total Equity

• KWAGGA = 1 494 / 14 914 = 10.02%

• Interpretation: For every R1 shareholders
invested in the firm, they received 10.02c in
return
• The higher the better!

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 Profitability ratios (cont)

• See study guide page 32. Perform a trend and

comparative analysis on the ROE of Furniture Group.

• This ratio decreased from 23.53% in 2011 to

18.07% in 2013, but then increased slightly from
2013 to 2014 (19.10%), and then decreased
slightly again from 2014 to 2015 (18.73%)
• In 2012 Furniture Group’s ROE’s was higher than
industry average, but for the period 2013 to 2015
it was well below the industry average

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 Market value ratios
• P/E Ratio = Price per share / EPS
• Where: EPS = NPAT / No of shares in issue

• Compute and interpret the P/E ratio of Clicks using the

following info:
• 2 February 2017: EPS = 462.40c; Closing price =
R124.72 thus P/E = 26.97 times

• Interpretation: the shares of Clicks were selling for

nearly 27 times the earnings on 2 February 2017
• Higher P/E ratios signify prospects for future growth

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 Market value ratios (cont)
• Market-to-book ratio = market value per share /
book value per share
• Where:
• market value per share is the current share
price (P0) and
• Book value per share = Total equity /
number of shares in issue
• Should preferably be > 1

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 Learning outcome five
Compute and interpret financial performance
using the Du Pont identity (Pages 64 – 68)
• This model breaks down ROE into three parts
• Profit margin is a measure of the firm’s operating
efficiency – how well it controls its costs
• Total asset turnover is a measure of the firm’s
asset use efficiency – how well it manages its assets
• Equity multiplier is a measure of the firm’s financial
leverage – how much debt it has
• ROE = PM x TAT x EM

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 Learning outcome six
Describe the problems and pitfalls associated
with financial statement analysis
(Pages 68 – 69)
• There is no underlying theory – which ratios are
most relevant?
• Benchmarking is difficult for diversified firms
• Tigerbrands – food or medicine?
• Globalisation and international competition
• Differences in accounting regulations
• Varying accounting procedures, i.e. FIFO vs LIFO
• Different fiscal years
• Extraordinary events
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 Group Assignment Reminder
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student numbers are on the cover page when
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DUE DATE: 05 MAY 2023 BEFORE 12:00PM 53

 Chapter 3 – Practice work

• HOMEWORK
• Practice questions 2 on Moodle re Financial
Statements:
• Protek Group Ltd
• Organic Foods Ltd

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