Analytical Analysis – Selective Use of Ratios

1. Analytical Analysis – Selective Useof Ratios Chapter 29

2. By the end of the chapter, you should be able to: prepare and interpret common size statements of income and financial position; explain the use of ratios in determining whether a company is shariah compliant; explain the use of ratios in debt covenants; critically discuss various scoring systems for predicting corporate failure; critically discuss remuneration performance criterion; calculate the value of unquoted investments; critically discuss the role of credit rating agencies. Objectives

3. Making financial information more understandable and easier to analyse Making the information accessible The ICAS report in 1999 Business Reporting: the inevitable change? Making the information easier to interpret XBRL The reliability of current financial information Lack of confidence among investors.

4. Making financial information more understandable and easier to analyse (Continued) Audit independence needs to be strengthened Schemes have kept liabilities off balance sheet Auditors are not seen as protecting shareholders Future business prospects Pressure for managers to share their assessment of future business prospects so that investors can make informed investment decisions

5. Making financial information more understandable and easier to analyse (Continued) Disclosure of strategies In 1999 the ICAEW produced a report No Surprises: The Case for Better Risk Reporting Disclosure of risks and focus on relevant ratios ICAEW 1998 discussion paper, Financial Reporting of Risk.

6. The initial overview Prepare a common size statement of financial position A vertical analysis assesses the strength of the statement of financial position with assets and liabilities shown as a percentage of a base figure A horizontal analysis is then carried out on areas that require further investigation.

7. Common-size statements • Methods of ratio comparisons • Two methods of comparison can be used – cross-sectional and time-series. • Cross-sectional analysis - financial ratios of different companies within the same industry are compared. • Comparison of these ratios can indicate areas that require further investigation. Whether the figure being compared is better or worse than the standard is immaterial. Why? • Positive deviations can be indicators of problems just as much as negative deviations can. For example, a high asset turnover ratio could arise because production plant is being used at the expense of providing downtime for maintenance – leading to early breakdowns and thus lost production

8. Common-size statements • Time-series analysis is where performance over time is being assessed. • The current year’s performance is compared with previous years’ performance to ascertain whether or not the company is progressing as expected. Trends can be isolated, and as with cross-sectional analysis, can be investigated if they are not as expected

9. Vertical and horizontal analysis • Horizontal and vertical analyses of the financial statements helps interpretation of the above methods of analysis • Horizontal analysis is where changes in various items within the financial statements are compared from year to year. • For example, in the Income Statement, the change in sales or revenues from year 1 to year 2 is compared. • Amounts for comparative years are expressed as a percentage of the base year amount • Vertical analysis reveals the relationship of items within the financial statement to a base item. • All amounts of a year expressed as a percentage of a base amount (e.g., net sales revenue, total assets) • For example, in the Balance Sheet, individual items are expressed as a percentage of total assets, or of total liabilities and shareholders’ funds.

10. Year-to-Year Change Analysis • Use both absolute and percentages • Guidelines: • When an item has value in the base year and none in the next period, the decrease is 100% • A meaningful percent change cannot be calculated when one number is positive and the other number is negative • A percent change cannot be calculated when there is no figure for the base year.

11. Industry Variations • Financial components vary by type of industry • Merchandising • Inventory is a principal asset • Sales may be primarily for cash or on credit • Service • Inventory is low or nonexistent • Manufacturing • Large inventory holdings • Substantial investment in plant assets

12. Vertical analysis – common size statements The vertical analysis approach can, for eample, highlight the structure of the Statement of financial position by presenting Non-current assets, Working capital, Debt and Equity as a percentage of debt plus equity

13. Vertical Analysis • Each financial statement element is presented as a percentage of a designated base which is sales revenue on the Income Statement.

14. Vertigo. Financial structure – initial assessment – p. 743 • What can be deduced from the following figures? • The company has a high proportion of non-current assets and these are financed by the shareholders (equity)

15. Vertical analysis – financial structure inter-period comparison • What can you see from these figures?

16. Vertigo example – p.743-748. • The Balance sheet analysis shows Vertigo is financially sound in the long-term – see the debt-equity relationship. This shows that the shareholders (owners) have supplied 73.1% of the required funding for the business. • However, there appears to be some problems arising from the Income statement data.

17. Horizontal analysis A horizontal analysis looks at the percentage change that has occurred Concentrate on areas that seems to require closer investigation For example: Current assets and current liabilities if working capital percentage is increasing.

18. Horizontal Analysis • Each financial statement element is presented as a percentage of a base amount from a selected year.

19. Overview of the cost structures – Vertical analysis Preparing a Common size statements of income gives an indication of the cost structure Shows the relative significance of costs.

20. Relative significance of costs 20X8 20X9 £ % £ % Sales 3,296 100.0 3,461 100.0 Cost of sales* 2,240 68.0 2,458 71.0 Total gross profit 1,056 32.0 1,003 29.0 Distribution costs* 365 11.1 228 6.6 Admin expenses 588 17.8 659 19.0 Net Profit before tax 103 3.1 116 3.4 *The increase in COS has led to a fall in GP, but the fall in Distribution costs has been enough to provide an overall %age increase in net profit

21. Trend analysis

22. Vertigo example – p.746-748 • Sales have increased by 5% and operating profit by 12.6%. The gross profit margin has fallen with the 9.7% increase in the cost of sales.This requires further enquiry. • Has there been a change in the selling price? • Has there been a change to maintain sales volume at the expense of the profit margin? • Has there been discounting or longer running sales? • Has there been a change in the sales mix? • Have purchase prices risen? • Have there been currency effects? • Has there been a change in suppliers? If so, why? • Note that Distribution costs and Admin expenses have also changed considerably. We need to break the Income Statement analysis further:

23. Vertigo example – p.746-748

24. Vertigo example – p.746-748 • Review of distribution costs • Advertising reduced by 74.5% If the 20X8 levels were maintained, operating profit would reduce to ₤46,000 - a fall from the previous year of 55% rather than an increase of 12.6%. • There should be further enquiry to establish • the normal level over the previous three years - whether there was heavier advertising in 20X8 to achieve the 5% increase in sales in the light of the company's intention to attempt to obtain further investment in 20X9 • whether this is likely to have an adverse effect on future sales and • what the company’s reason was for reduced spending. • Bad debts have fallen although there has been an increase in sales and the credit period has increased to 126 days. This raises a query as to the company's credit control and possibility of more bad debts.

25. Vertigo example – p.743-748. • If we go back to the working capital aspects of the Balance Sheet, there are some additional quesitons that need to be answered. • Bad debts have fallen although there has been an increase in sales and the credit period has increased to 126 days. This raises a query as to the company's credit control and possibility of more bad debts.

26. Vertigo example – p.743-748. Review % changes 20X8 20X9 £000 £000 % change Current assets: Inventory 398 563 +41.5 Trade receivables 912 1,181 +29.5 Cash & bank 11 9 -18.1 Trade payables 398 498 +25.1 Accrued expenses 12 15 +25.0 Taxation 29 24 -17.2 Bank overdraft 41 97 +136.5 There was a 5% increase in sales for the year. What can we deduce from these figures and what else should we do?

27. Vertigo example – p.743-748 • There has been a buildup of inventory and the credit allowed and taken has increased significantly • The turnover ratios for trade receivables and payables show that the receivables credit period has increased from 101 days to 126 days and payables period has increased from 60 days to 69 days. Expressed in terms of turnover ratios, receivables have fallen from 3.6 times a year to 2.9 times. • In relation to trade receivables: • Has there been a change in the credit terms? • Has that been a formal arrangement? • Has the company changed its criteria for creating an allowance for bad debts? • Bad debts have fallen but is this due to a reluctance to chase late payment?

28. Vertigo example – p.743-748 • The turnover ratios for inventory lead to the following questions: • Why has the increase occurred? • Is there a greater risk of obsolescence or further pressure to reduce the gross profit margin to move the inventory? • The increase in working capital has led to a greater reliance on bank overdraft facilities and is a cause for concern. We need to ascertain the terms and limit of the overdraft.

29. Vertigo example – p.743-748

30. Stress testing Sensitivity check Effect of a fall in sales. What IF There were to be a fall in sales of say 5% in 20X9 resulting from the cut in the Advertising budget What would the impact be on the operating profit and interest cover?

31. Screen business activities Check financial ratios do not exceed specified limits. Sharia compliant investment

32. The indices are compiled after Screening companies to confirm that their business activities are not prohibited or (fall within the 5% threshold) Calculating three financial ratios based on total assets and Calculating a dividend adjustment factor that results in more relevant benchmarks, as they reflect the total return to an Islamic portfolio net of dividend purification. The MSCI Islamic indices

33. Sharia investment principles do not allow investment in companies that are directly active in, or derive more than 5% of their revenue (cumulatively) from, the following activities (‘prohibited activities’): Alcohol: Tobacco: Pork related products: Conventional Financial Services Defense / Weapons: Gambling / Casino: Music: Hotels. Business activity screening

34. Sharia investment principles do not allow investment in companies deriving significant income from interest or companies that have excessive leverage. MSCI Barra uses the following three financial ratios to screen for these companies: Total debt over total assets Sum of a company's cash and interest-bearing securities over total assets Sum of a company’s accounts receivables and cash over total assets None of the financial ratios may exceed 33.33%. Financial screening

35. Trend analysis Multivariate analysis – Z-scores H-scores A-scores Balanced scorecards Valuing shares of an unquoted company – quantitative process Valuing shares of an unquoted company – qualitative process Shareholder value analysis Financial reporting and risk.

36. Multivariate analysis Single value score Benchmark criteria applied to this score Combination of ratios, for example Working capital/Total assets Sales/Total assets Weighted for predictive capability, for example Working capital/Total assets Weight 0.012 Sales/Total assets Weight 0.999.

37. Multivariate analysis– types of scores Z-scores Altman’s Z-scores Taffler’s Z-scores PAS-score A-scores.

38. Altman Z-score – components and weighting in public domain Z = 0.012X1 + 0.014X2 + 0.033X3 + 0.006X4 + 0.999X5 X1 = Working capital/Total assets X2 = Retained earnings/Total assets X3 = EBIT/Total assets X4 = Market capitalisation/Book value of debt X5 = Sales/Total assets Score > 3 unlikely to fail Score < 1.8 likely to fail.

39. Audit report: fundamentaluncertainty – going concern In forming our opinion, we have considered the adequacy of the disclosure The validity of the going concern basis is dependant on the Company's ability to meet its future working capital requirements and generate free cash flow The accounts do not include any adjustments that would result from a failure to generate a free cash flow.

40. Audit report: fundamentaluncertainty – going concern (Continued) It is not practical to quantify the adjustments that might be required, but should any adjustments be required they would be significant In view of the significance of this fundamental uncertainty, we consider that it should be drawn to your attention but our opinion is not qualified in this respect.

41. Going concern uncertainty disclosed by directors Extract from the 2008 Financial Statements of INDEPENDENT INTERNATIONAL Investment Research Plc. The accounts have been prepared under the assumption that the Company is a going concern The Company is engaged in an industry where losses represent the Company's investment in its development and it has remained the directors policy to ensure that adequate finance is available to support this development.

42. Going concern uncertainty disclosed by directors (Continued) At the date of approving these accounts there exists a fundamental uncertainty concerning the Company’s ability to continue as a going concern This fundamental uncertainty relates to the Company’s ability to meet its future working capital requirements and therefore continue as a going concern.

43. Shareholder value analysis Growing interest Accounting measures (EPS) not related to share value Linkage with executive remuneration.

44. Shareholder value analysis – annual reports

45. Economic Value Added (EVA)

46. Professional risk assessors Companies are given a rating that can range from AAA for companies with a strong capacity to meet their financial commitments down to D for companies that have been unable to make contractual payments or have filed for bankruptcy with more than 10 ratings in between, for example BBB for companies that have adequate capacity but which are vulnerable to internal or external economic changes.

47. How ratings are set Internal company factors may include: An appraisal of the financial reports to determine: Trading performance, for example specific financial targets such as return on equity and return on assets earnings volatility; past and projected performance; how well a company has coped with business cycles Cash flow adequacy, for example EBITDA interest cover EBIT interest cover; free operating cash flow Capital structure, for example gearing ratio; debt structure implications of off balance sheet financing.

48. How ratings are set – internal factors A consideration of the notes to the accounts to determine possible adverse implications, for example contingent liabilities, heavy capital investment commitments which may impact on future profitability, liquidity and funding requirements Meetings and discussions with management Monitoring expectation, for example against quarterly reports, company press releases, profit warnings Monitoring changes in company strategy, for example changes to funding structure with company buyback of shares, new divestment or acquisition plans and implications for any debt covenants.

49. How ratings are set – external factors External factors may include: Growth prospects, for example trends in industry sector; technology possible changes; peer comparison Capital requirements, for example whether company is fixed capital or working capital intensive; future tangible fixed asset requirements; R&D spending requirements Competitors, for example the major domestic and foreign competitors; product differentiation; what barriers there are to entry.

50. Keeping a watching brief on macroeconomic factors, for example environmental statutory levies, tax changes, political changes such as restrictions on the supply of oil, foreign currency risks Monitoring changes in company strategy, for example implication of a company embarking on a heavy overseas acquisition programme that changes the risk profile, for example difficulty in management control and in achieving synergies, increased foreign exchange exposure. How ratings are set – external factors(Continued)