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"A company financial model is developed using factor analysis and published accounting data expressing financial performance as
a
single
statistic
summarising and weighting company financial dimension"
BY HAS SAN NIKRHAH BABAEI
B.Sc in Cost Accounting, Tehran, Iran, M.B.A, Texas, U.S.A.
A THESIS SUBMITTED TO THE UNIVERSITY OF BRADFORD POSTGRADUATE SCHOOL OF STUDIES IN INDUSTRIAL TECHNOLOGY, IN FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY. 1988
DEDICATION Shahnaz, Shahrooz, Farhood
I
ACKNOWLEDGMENT
I would like to thank Dr. J. Betts and Dr. D. Belhoul for their sincere and helpful advice and friendly assistance throughout my research for which I am really grateful.
I also wish to thank the computer center advisers who were very helpful to me.
II
ABSTRACT
Auditors and financial managers often need to have a picture of companies' financial strengths and weaknesses which is also required by shareholders. The necessary analysis has been done well in some cases and failed in others because of lack of evidence or lack of a scientific approach and consequently it has not been possible to prevent companies failing financially and ultimately going into receivership.
In Iran in recent years many companies have experienced financial difficulties and some have gone into receivership, because the owners were not aware of their company's weaknesses and how to protect them at the relevant time. The
causes of these companies financial stress have been many and varied, for instance; inflation, the influence of trade unions, government regulations, social responsibilities,
pollution and increased competition. To avoid such stress company owners need to be more careful about their activities. They need up to date information about the past financial performance of their companies. They need also to be able to prepare reliable plans for the future based on the past data and the current situation. This can be done by using quantitative tools and financial models.
The aim of this research is to find a model for analysing company's financial performance by using a quantitative approach which can be easily computerised and applied. This model could be used to indicate companies' financial strengths
III
and weaknesses and to anticipate and guide companies future performance in such a way that ensures their continued financial health and growth.
This thesis considers the use of financial ratios in the analysis of company's overall performance. After a brief
introductory chapter, it reviews the historical background of financial analysis in Chapter Two by looking at financial ratios analysis in general. It then continues in Chapter
Three by identifying the most important financial ratios as measurement tools. In Chapter Four these tools are grouped and analysed using factor analysis and a financial model has been constructed for measuring company's financial performance using techniques described in the Chapter Five. Chapter Six presents a company financial performance classification and comparison. Chapter Seven describes a method by which
companies financial performance can be improved or stabilised.
IV
Page No. DEDICATION ACKNOWLEDGMENT ABSTRACT TABLE OF CONTENTS LIST OF TABLES LIST OF FIGURES CHAPTER 1: INTRODUCTION 1.1 DEFINITION OF PRIMARY DATA 1.2 DEFINITION OF RATIOS 1.3 THE MANAGEMENT'S TOOLS 1.4 MEASUREMENT OF PERFORMANCE AND CORPORATE ACCOUNTING 1.5 DEFINITION OF TREND 1.6 BANKRUPTCY AND LIQUIDATION 1.7 OUTLINE OF RESEARCH 1.8 CONCLUSION CHAPTER 2: HISTORICAL BACKGROUND OF FINANCIAL ANALYSIS 2.1 CORPORATE FINANCIAL STATEMENTS
2.2 FINANCIAL ANALYSIS DEVELOPMENT
V VIII X
3 4 5
6 7 8 9 11
13 14
2.3 ADDED VALUE AS A PERFORMANCE MEASUREMENT 16 2.4 SECURITY ANALYSIS 2.5 RATIO CLASSIFICATION 2.6 INDUSTRIAL AVERAGE ANALYSIS 2.7 DISCRIMINANT ANALYSIS 2.8 FINANCIAL RATIOS IDENTIFICATION 2.9 SOME LIMITATIONS OF THE RATIO ANALYSIS 2.10 CONCLUSION 27 31 34 38 44 48 50
V
CHAPTER 3: BASIC TOOLS OF PERFORMANCE MEASUREMENT 3.1 CAUSES OF FAILURE 3.2 DETECTION OF FAILURE BY RATIOS 3.3 PROFITABILITY 3.4 MEASURING THE PROFITABILITY 3.5 BEHAVIOURAL EQUATIONS 3.6 PROFIT VS PROFITABILITY 3.7 RISK VS PROFITABILITY 3.8 RESTRAINTS IN PROFITABILITY ANALYSIS 3.9 PROFITABILITY RATIOS 3.10 MANAGERIAL PERFORMANCE 3.11 MANAGEMENT VS RISKINESS OF LOAN 3.12 MANAGERIAL PERFORMANCE RATIOS 3.13 OPTIMUM AMOUNT OF CASH 3.14 LEVERAGE ANALYSIS 3.15 SOLVENCY RATIOS 3.16 CONCLUSION CHAPTER 4: METHODOLOGY OF FACTOR ANALYSIS 4.1 EXTAT LIMITATION 4.2 FACTOR ANALYSIS 4.3 CORRELATION COEFFICIENTS 4.4 THE MODEL OF FACTOR ANALYSIS 4.5 FACTOR EXTRACTION 4.6 FACTOR ROTATION 4.7 THE KAISER VARIMAX METHOD 97 102 104 111 117 120 124 54 55 56 60 63 65 66 69 71 73 75 76 79 89 92 94
4.8 INTERPRETATION OF FACTOR ANALYTIC RESULTS 132 4.9 CONCLUSION 134
VI
CHAPTER 5: DEVELOPING A FINANCIAL MODEL OF COMPANIES' PERFORMANCE 5.1 FACTOR SCORE ESTIMATION 5.2 BUILDING COMPOSITE FACTOR SCORES FROM THE FACTORSCORE COEFFICIENT MATRIX 5.3 TESTING THE EFFECTIVENESS OF THE MODEL 5.4 CONCLUSION CHAPTER 6: PERFORMANCE CLASSIFICATION AND COMPARISON 6.1 CLASSIFICATION OF THE PERFORMANCES 6.2 FAILURE PREDICTION STUDIES 6.3 COMPARISON OF THE MODEL WITH SIMILAR MODELS AND STUDIES 6.4 CONCLUSION CHAPTER 7: PERFORMANCE STABILISATION 7.1 PERFORMANCE STABILISATION 7.2 PERFORMANCE IMPROVEMENT 7.3 A GRAPHICAL ILLUSTRATION OF IDEAL PERFORMANCE 7.4 CONCLUSION CHAPTER 8: CONCLUSIONS AND RECOMMENDATIONS 8.1 SUMMARY OF THE MAIN CONCLUSIONS 8.2 RECOMMENDATION FOR FURTHER STUDY DYNAMIC ASPECT OF RATIOS APPENDICES 1) GEOMETRIC PRESENTATION OF THE FACTOR MODEL 309 2) FACTOR ROTATION 3) FACTOR EXTRACTION BY THE CENTROID METHOD COMPUTER PROGRAMS LIST OF REFERENCES 319 323 330 345 305 302 244 299 232 238 224 230 211 218 141 145 209 137
VII
LIST OF TABLES Page No. CHAPTER 2 2.3.1 Comparison of Return on Capital for four Imaginary Companies 2.3.2 Manpower Productivity and Capital Productivity 2.3.3 Primary Production Data from Payroll 2.3.4 Elementary Production Ratios 2.5.1 Ratio Classification 2.6.1 Ranges of Selected Ratios and Measures by Industry taken from Dun & Bradstreet 36 CHAPTER 3 3.3.1 The Factor Combined to Yield Return On Investment (ROI) 58 59 22 23 25 32 19
3.3.2 Submodels of Profitability
3.7.1 Typical Profitability Objectives for Companies having different level of Risk 68
3.7.2 Influence of Profitability and Risk on the Value of firm's stock 69 91 92
3.14.1 Company's Financial Structure 3.14.2 Company's Financial Structure CHAPTER 4
4.3.1 Ratios with Volatile Standard Deviations 108 4.3.2 Ratios with the Highest Correlation Coefficient 4.7.1 Varimax rotation of two (x,y) factors 110 127
VIII
4.7.2 Ratios with the Highest Varimax Rotated Factors after Rotation with Kaiser Normalisation 129 131 134
4.7.3 Transforming the Table 4.7.2
4.8.1 Scale of RatioFactor Correlation CHAPTER 5 5.1.1 Factor Score Coefficients
140
5.3.1 Classification of Companies Performance 146 5.3.2 Effectiveness of the Model 5.3.3 Overall Effectiveness of the Model CHAPTER 6 6.1.1 Applying the New Classification to the Sample Companies 6.2.1 The Altman's Predictive Accuracy 215 223 205 208
6.3.1 A Comparison of Current Ratios with differing Levels of Overall Financial Performance 225 6.3.2 A Comparison of Profitability Ratios with differing Levels of Overall Comapny's Financial Performance 6.3.3 A Comparison of Cash Position Ratios with differing Levels of Overall Company's Financial Performance 6.3.4 The Classification Accuracy of some Financial Performance Models CHAPTER 7 7.1.1 Comparison of Ideal Path with its Actual Path 236 228 227 226
7.2.1 Performance Improvement Recommendations 241
IX
▪
LIST OF FIGURES CHAPTER 3 Page No. 3.13.1 Determine the Expected Number of Unit Periods of Cash Stock 3.13.2 The Miller Model of Optimal Amount of Cash CHAPTER 5 5.3.1 Testing the Effectiveness of Model on General Electric Co. 5.3.2 5.3.3 5.3.4 5.3.5 5.3.6 5.3.7 5.3.8 5.3.9 5.3.10 5.3.11 5.3.12 5.3.13 5.3.14 5.3.15 5.3.16 5.3.17 5.3.18 " 5.3.19 5.3.20 5.3.21
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196 197 198
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214
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XII
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XIII
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XIV
CHAPTER 1 INTRODUCTION
CHAPTER 1: INTRODUCTION
The financial goals of manufacturing enterprises should be 1) The continuance of profit generation consistent with their financial health. 2) To improve their competitiveness through the reduction of costs generated internally by using more cost effective production processes, and by eliminating or improving costly systems. 3) Guarding against unusual and unnecessary changes. 4) Being alert to the possibility of generating new profit centres. 5) To maximise the use of their resources.
Profit planning for the longer term must include action for growth and survival, the maximisation of profits over the short term is no guarantee of financial health. In fact, when profits are maximised to the exclusiam of considerations, other
a company can get into serious difficulties.
The drive for high profits has forced many companies to the brink of bankruptcy because of the strain placed on the capital structure by supporting those drives. For example,
the company's financial structure may not be able to stand the cost of new equipment or new expansion for making high profits, because this will reduce the company's liquidity and so interfere with their ability to pay their current obligations promptly or in their due time.
1
Today industrial competitiveness is improved by modifying company's manufacturing processes and its productivity which might have been neglected in the past. Increasing profit now is possible by guarding against changes that do not increase a company's productivity and from activating new profit centres.
Once a company has established itself, its survival might not appear to be its primary goal. Its aim should be to
maximise the use of its resources. Companies often see this as a completely different goal, although efficiency and survival are closely interrelated, since a company not
utilising its resources efficiently will experience financial trouble, and its financial viability will be in question (Anthony, 1960).
Achieving these objectives is the task of management, who have to be informed, skillful, balanced and able to act swiftly for optimum good to the company.
To accomplish these tasks the manager must 1) Be in frequent and intimate con act with all activities in his company. 2) Receive proper data by which he can evaluate these activities, make decisions and project a future plan. accurate, information. 3) Feel secure with the data and free to spend time on other activities for the good of the company. 4) Take action at the appropriate time. and These data must be up to date and contain useful financial
2
5) Consider action in any area not separately, but as part of an organic whole.
Without proper tools, management is not able to accomplish all these duties correctly and efficiently.
1.1 DEFINITION OF PRIMARY DATA
In general, data refers to factual material used as a basis for discussion or decision making and in statistics it refers to the numerical material available for analysis interpretation. and
Primary data are defined as those data which can not in themselves be used to predict or appraise performance objectively. Primary data are used as the basis for making
the necessary predictions and evaluations. Primary financial data are used as the ingredients for various types of measure including financial ratios which can give economic meaning to events and permit objective diagnoses and decision making. A reportable primary data can be written as Indirect labour has increased by 6% Unusable waste is about 10% Production activity is off 15%
Management must know about the elements causing these events while they are happening so that he may be able to influence the character of the reported data, and take the proper action to correct a negative circumstance after it has been reported.
3
1.2 DEFINITION OF RATIOS
Primary financial data in themselves need not necessarily have any economic meaning. They can stand alone, being
unrelated to any thing else that they affect or that affects them. A piece of isolated, unrelated primary data requires another piece of primary data to which it can be compared. Only when primary data are interrelated, can they become meaningful to management. action on what they reveal. This allows management to take
A common method of establishing financial relationships is by constructing ratios between pieces of primary data. Thus one piece is weighted against another for evaluation of effect. Each ratio should be developed for a specific
purpose, for a particular area, and the desirable movement of each ratio should be known in advance. Primary data are absolute, and these data have no value unless they are related to something else. In ratios, the primary data lose their
identity and are evaluated by effect, not magnitude.
For example current assets and current liabilities are both primary data and do not have economic meaning unless they are related to each other in the current ratio which is obtained by dividing current assets by current liabilities. This ratio measures the working capital of a company.
4
1.3 THE MANAGEMENT'S TOOLS
A tool commonly used by financial management is a set of ratios from all departments or cost centres comprising a company with which managers can observe positive and negative movements in the company's performance. Since many activities and events are related to each other, it is not easy for management to know which movements are negative and which are positive. For example the rise of indirect labour employed
may be positive if it is coupled with higher direct labour and is negative if it is not. Similarly an event in sales will have an impact in the sales department, but it will also have an impact in production, and financial areas such as inventory level, current assets and so on. These unlimited activities and events which need to be reported, ought to have their interelationships' analysed.
On the other hand, the manager must be able to carry on his plans for the company which becomes increasingly difficult each year. Thus, he will need more and better data with which to manage his company so as to compete and survive in a highly competitive environment. managerial However, when there are proper
tools, management can make valid appraisals
quickly. They can make decisions with the greatest confidence and objectivity. areas fruitfully. They can also spend time on other vital
The second managerial tool needed is some form of visualisation of the way the movement of some ratios affect
5
other ratios and other performance aspects of the company. Each company needs a kind of control chart which shows interactions of movements. From these charts, management can draw inferences and make decisions with maximum knowledge of their effects.
1.4 MEASUREMENT OF PERFORMANCE AND CORPORATE ACCOUNTING
Although the individual items appearing on a balance sheet are important, the basic objective behind all balance sheets and income statements is performance measurement. Accounting provides a historical perspective, which enables matching against current achievement. In this way managers, owners, creditors, governments and the general public can determine how well or how poorly a company is doing. A better picture of a company's underlying strengths and weaknesses can be obtained from the balance sheet, where the assets are compared with liabilities. For example, excessive borrowing has caused many companies to seriously reduce their net w rth by paying high interest, which can eventually lead to bankruptcy. Such problem can be easily identified by correct scrutiny of the company balance sheet. To do this and assess the performance of a company it is necessary to understand corporate accounting.
We must also understand the basic elements that make for success or failure of various kinds of businesses, and how fluctuations in the market effects their performance. We must be able to find the facts, evaluate them critically, and act
6
on our conclusions with good judgement and a fair amount of imagination.
The soundness of future performance of a company is determined by future developments and not by past history or statistics. However the future can not be analysed, we can
seek only to anticipate it intelligently and to prepare for it prudently. Here past performance can be of help, because long experience tells us that performance anticipations, like other business anticipations, can not be sound or dependable unless they relate themselves to past performance. In measuring past performance we should give consideration to both trends and averages.
1.5 DEFINITION OF TREND
A trend represents the relationship of the individual data in a time series. Thus, like any statistical measure, it is derived from the period selected, and is, of course, subject to any fundamental distortions which exist in the data. The fundamental difference between the use of a trend line to measure past performance and its use as a means of projecting future performance should be stressed. To estimate future
performance by projecting the past trend and then accepting that projection as a basis for valuing the business may be sound in specific instances, but it must be used with extreme caution.
Figures and mathematical equation are involved in computing a trend, and some people believe that for that reason a trend
7
projection is credible. But while a definite trend shown in the past is a fact, "future trend" is only an assumption. It is because there are so many events and uncontrollable changes in future which can not be predicted, such as new acts and regulations by the government to adjust or readjust the business activities.
1.6 BANKRUPTCY AND LIQUIDATION
Bankruptcy in the UK refers to the realisation of the assets of an insolvent individual in order to try to meet the legitimate claims of his creditors. In the USA, the term
'bankruptcy' also applies to companies, but in the UK the term 'liquidation', or 'winding up' are used. The management of the insolvent company is removed from the hands of its directors, its assets are realised by a 'liquidator', and its debts are paid, with any balance going to shareholders. A
company may be put into liquidation by a court order, by a voluntary resolution of members of the company in a general meeting, or by a voluntary resolution supervised by the court.
John Freear(1980) found at the end of 1973, over 600000 companies were registered in Britain of which only around 3 percent were public, listed companies. In Britain in 1973, about 1.3 percent (8000) were liquidated. In 1978, the number had fallen to about 5000. In addition some companies merely fade away without any positive action on the part of owners or creditors, and are removed from the register. If these are
considered, a total of about 5 percent (30000) of all
8
registered companies in Britain disappear each year.
Freear lists the 'order of priority' for the payment of money realised from the sale of assets.
List of payments in order of priority 1) The cost, charges and expenses of the liquidation. 2) Creditors secured by a fixed charge on property. 3) Preferential creditors a) certain taxes, duties, national insurance contributions and rates due to central and local government. b) wages and salaries of employees. 4) Creditors secured by a floating charges. 5) Other unsecured and nonpreferential creditorstrade creditors, the government (for some taxes). 6) Members of the company in proportion to the nominal value of the shares held, as modified by the Articles of Association of the company.
1.7 OUTLINE OF RESEARCH
A brief outline of aims of the research is given below 1) To develop a single statistic model for measuring companies' financial performance. 2) To use this model: 2.1) To indicate companies' financial strength and weaknesses.
9
2.2) To anticipate and guide companies' future performance in such a way that ensures their health and continued growth. 2.3) To detect the causes of failure and success in identifying individual changes and how these individual changes affect overall company performance. 2.4) To advise on financial planning taking
accounts for companies existing strengths and weaknesses. 2.5) To determine ideal levels for important financial dimensions such as current assets, current liabilities, cash and so on. 2.6) To demonstrate the effectiveness of the model compared to similar models available elsewhere. 3) A review of other models available and how they compare against each other.
10
1.8 CONCLUSION
The difficulty with monetary units is that they tend to change in value over a period of time; consequently, when examining them in relationship with future plans, it is essential to put them both on the same basis of valuation. This problem can be overcome to
a certain extent by the use of
percentages, that all values have been affected in the same way and to the same degree. Because of this, in the
evaluation of a company's financial performance, percentages and ratios are the key methods for measuring financial performances.
The role played by and the reason for using financial ratios has been discussed in this chapter. Hopefully it has the been established that it is in, interests of management to recognise the advantages of ratio analysis and be aware of the need to understand it. Once ratios have been computed, action can be taken to influence a company's future performance.
11
CHAPTER 2 HISTORICAL BACKGROUND OF FINANCIAL ANALYSIS
12
CHAPTER 2: HISTORICAL BACKGROUND OF FINANCIAL ANALYSIS
Over the past fifty years a number of studies have been undertaken to investigate the usefulness of financial ratios. Most of these studies have concentrated on the predictive aspect of ratios, especially with respect to their ability to predict various types of corporate difficulties. A number of other writers have advocated that certain ratios should be used for particular areas of financial statement analysis. Some of these studies were done by Tucker (1961), Nelson (1963), Pringle (1973) and Laurent (1979).
2.1 CORPORATE FINANCIAL STATEMENTS
"In 1866 the Treasurer of the Delaware, Lackawanna, and Western Railroad company, once reported to a request for information from the New York Stock Exchange by writing, 'the Delaware, Lackwanna RR CD. make no reports and publish no statements and have done nothing of the kind for last five years'."
Since last century corporate reporting has increasingly improved. The first book to appear on this subject was that Entire sections of Graham and
of Graham and Dodd (1934).
Dodd's work are devoted to the fine points of recasting a corporation's income statement and balance sheet into a more meaningful form and explaining other techniques of financial statement analysis. Security Analysis was first published in the era of the Great Depression, when investors had good
13
reason to question whether a corporation with a high level of bonded indebtedness would be able to refinance its debt or meet its interest payments as they fell due. Each investor
had to make his own assessment of the probability of a firm's failure.
By the end of nineteenth century commercial banks started requesting financial statements to "borrowers of money". Then around the beginning of the twentieth century the comparison of the current assets of firms to their current liabilities became a widespread practice. Foulke (1961) states that a current ratio of 2.5 was considered to be a reasonable margin of protection in those times.
The conditions that prevailed when Graham and Dodd wrote their work are not prevalent today, however. Various
companies acts like the corporate income tax law and the heightened sophistication of the accounting profession have gradually forced most businesses to keep better records and to adopt more adequate accounting practices.
2.2 FINANCIAL ANALYSIS DEVELOPMENT
Since the end of World War 2, the discipline of corporate finance has developed and made popular a large number of analytical tools, including cash budgeting, profit planning, and capital budgeting. The financial manager of a
corporation, who is trained in these techniques is now able to anticipate cash flows and plan the earnings of a corporation much more precisely. By obtaining reliable data about the
14
rate of return that the corporation is expected to earn, from either the management of the corporation, its customers, or its competitors, a proper valuation can be made.
Today some corporations reveal to their underwriters, the major brokerage firms, and large shareholders limited amounts of information about key developments that will influence the corporation's expected rate of return. These parties, in
turn, frequently report their findings to the public at large.
A second major development that has had a profound impact on the course of financial analysis is portfolio management as a separate, distinct field of study. Questions were arising for instance, How might one obtain the maximum return from the portfolio as a whole, with a given variability in the return? What is the meaning of diversification? What kinds of risk can management guard against? To answer such questions, more sophisticated techniques, such as quadratic factor analysis and
programming can be useful.
The practical
application of these techniques has been made feasible by computers. In short, to the permanent large investor, the
relationship among the securities within a portfolio is now a matter of serious concern, for this reason portfolio
management has become an important field of study in its own right.
The third major development that has influenced financial analysis is the use of abstract models in the study of the interrelationship of the firm and the market. To understand these models a knowledge of calculus, matrix algebra, and
15
statistics is needed.
In short, the field of financial
analysis has changed radically over the years. Sophisticated tools have been developed to attack problem areas that were previously thought to be impossible to solve. Wall & Dunning (1928), Tamari (1966) and Shashua (1974) showed that the use of financial ratios on an univariate basis presents some shortcomings. This is because the interrelation between the different ratios is not taken into account and they may release conflicting signals. But the use of multivariate
analysis offers a solution to these problems in that several weighted ratios are combined. Thus, at present, mathematical models are being built, tested, and amended in the search for interrelationships within the valuation process and the financial analysis is becoming a professional discipline.
The tremendous changes in financial analysis can perhaps be more readily appreciated by reviewing briefly its
developments.
2.3 ADDED VALUE AS A PERFORMANCE MEASUREMENT
The difference between the value of sales and the value of purchases is called added value. Added value can be used to measure business performance and productivity. Added value was used by Harris (1968) to develop a new concept of "work done and resources used", Raven (1971) used it as a profit improvement and finally Hochman & Razin (1973) analysed investment in terms of productive capital.
Return on capital ratios are useful for investors, but
16
added value ratios are important for both employees and investors. Profit ratios can vary widely with accounting
practices, but added value figures are less readily distorted. For measuring efficiency in the use of resources, the added value concept has advantages over other techniques. It is
less distorted by inflation. Most important, it emphasises the fundamental connection between capital investment, manpower productivity and wages.
Wood (1978) indicated that the users of added value can be grouped into four categories as follows: 1) For measuring output a) Basis of national accounting b) Measuring business performance c) Measuring the productivity of manpower and capital 2) For communication a) Explaining what business is about b) Presenting accounting information
C) Basis for employee participation
3) For rewarding employees a) Basis for wages and salary policy b) Basis for group bonus schemes 4) For business policy a) Marketing strategy b) Capital investment policy c) Business ratios
He compares the profitability, as the traditional measure of business performance with added value as a new concept for
17
performance measurement which he claims is more stable and more reliable than the profitability. He says that the
profitability has the following serious defects. a) As a measure of performance, misleading. b) In the modern climate of public opinion, it takes a somewhat narrow view. C) It can not be applied to nonprofitseeking organisations which nevertheless need to measure and improve their performance. it can be
One problem with profit is the difficulty of definition. In theory, two companies could be identical in terms of the types of products, sales revenue, materials used, numbers employed, capital employed, etc, yet they could have deferent profit figures that would arise from differences in
depreciation policy, sources of finance and level of wages. See Table (2.3.1) for the analysis of companies. four imaginary
18
TABLE 2.3.1: An Example of Comparisons of Return on Capital for four Imaginary Companies
COMPANY (
000s)
Al
D
SALES PURCHASES
I I
1000 400
I I
1000 400
I I
1000 400
I I
1000 400
ADDED VALUE WAGES, etc DEPRECIATION INTEREST ON LOANS
600 450 100
600 450 75
600 450 75 25
600 425 75 25
PROFIT CAPITAL LOANS
50 500
75 525
50 325 200
75 325 200
RETURN ON CAPITAL Z
10
14.3
j
15.4
I
23
I
A further problem in comparing return on capital is that of asset valuation. Expert opinions on the value of land and buildings may vary widely. High rates of inflation have made a mockery of balance sheet values based on historical costs. Even without inflation it can be argued that the asset value depends on the profit record and potential rather than on the historical price or replacement cost. Finally, two companies with identical total assets could show different figures of capital employed if one has a higher proportion of external liabilities in the form of creditors, overdraft and other
19
loans. This is because the capital employed is equal to total assets minus current liabilities and there may be different capital figures because of different current liabilities when the total assets are identical.
Comparing one company with another in terms of return on capital is difficult because of the above factors. Even
comparisons within one company over periods of time may be distorted by some of the factors outlined above. Inflation
accounting techniques can help to reduce the distortion of return on capital ratios, but profitability can be very misleading as an index of company performance.
Wood claims that if the technical problems of defining profit and capital could be overcome, there are emotional problems of using return on capital to measure company performance. This is because profit is seen by some people as evil. The world is associated with the exploitation of
workers. The social climate has changed with the declining power of individual capitalists and the rising power of the trade unions and government. A wider view of business performance is needed. investors but of governments. It must take account not just of customers, suppliers and
employees,
If however profitability is not reliable or acceptable as a measure of performance, what is the alternative?
Profitability relates a very small part of the output, the profit, to only one of the factors of production, the capital employed. What is needed is a broader measure relating the
20
total output to all the factors
of
production.
The
appropriate word is productivity, the ratio of output to input.
In order to establish a measure of performance, the output must be divided by the inputs. The main inputs are materials, manpower and capital. The use of added value for measuring output discounts the cost of materials. So the main inputs are manpower and capital. The index of productivity can then be expressed in terms of the ratio below: PRODUCTIVITY = OUTPUT/INPUT = ADDED VALUE/(MANPOWER + CAPITAL)
Unfortunately, there is no easy way of adding together manpower and capital. Various ideas have been put forward for converting the value of capital into manpower equivalent. But no answer has yet proved to be acceptable.
Wood says that instead of attempting to achieve the difficult task of adding together manpower and capital, performance can be compared in terms of the trends of manpower productivity and capital productivity over periods of time. What matters is not so much the ratios in one particular period, but the trends. If added value per employee is rising and, at the same time, the added value per unit of capital is also rising, the rewards to both employees and investors can increase. If both ratios are falling, the reward to one or
both must suffer. One index rising and the other static is a better situation than both static or one falling whilst the other is static. There are nine possible combinations of
21
rising, static or falling productivity of manpower and capital (Table 2.3.2). Table 2.3.2: Manpower Productivity and Capital Productivity
MANPOWER PRODUCTIVITY (ADDED VALUE PER EMPLOYEE)
CAPITAL PRODUCTIVITY (ADDED VALUE PER UNIT OF CAPITAL) RISING
I
STATIC
1
FALLING
1
1 1
RISING STATIC FALLING
EXCELLENT GOOD POOR
I
I
GOOD STATIC BAD
I
POOR BAD VERY BAD
1
1
1
As Wood has described, for obtaining a better picture of the business performance we should evaluate the productivity rather than profitability. For productivity analysis we must have the proper analytical tools, which can be a set of ratios. These ratios must focus on all the possible areas
that are directly or indirectly related to the productivity of the company.
Spencer and Tucker(1961) constructed these needed ratios between pieces of primary data which have been extracted from payroll analysis (Table 2.3.3). The data they used come from a plant engaged in the manufacture of a line of proprietary consumer products and employed 275 people. This plant is chosen as an example, because it has got almost the same departments or cost centres as other plants and it can be considered as a typical plant for productivity analysis.
22
Table 2.3.3: Primary Production Data from Payroll
Item
1 1
Pounds code
1 1
Hours code
1 1
total gross paid payroll total clocked payroll direct labour: on standard: earned on standard: clock off standard: clock Total direct labour Indirect labour: downtime: miscellaneous waits for equipment repairs for tool repairs excess direct labour: Jig and die trouble Equipment trouble Material trouble other: Tool and fixture making Setup Maintenance and repairs Salvage, rework, reprocess Service Supervision Factory engineering Factory clerical Total indirect labour
1
2
24 25
3
26 27
4 5
28 29
6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
30 31 32 33 34 35 36 37 38 39 40 41 42 43 44
23
Direct labour subsidy (lost) Direct incentive premium (gained) indirect incentive premium
21 22 23
Table 2.3.4 is a partial list of typical production ratios that can be developed from the primary data appearing in table 2.3. To the right of the table 2.4 is the letter U or D.
This refers to whether an upward or downward movement of the ratio value is considered positive.
24
Table 2.3.4: Elementary Production Ratios
t.1
Ratio title
Formula
1P.D 1
1 no
1
1 I I I I
gross productivity net productivity ; 1
26/27 (2745+46)/27 27/29 (2745+46)129 (2745+46)125 45/46
U U
3 I 4 I 5 I
6
work standards coverage performance index improvement index worker standards consistency indirect support indirect support cost indirect usage indirect usage cost subsidy excess cost downtime cost excess direct labour cost tool and fixture cost setup index setup cost maintenance and repair index maintenance and repair
I I I
U U U D
II I I I 7 I
8
441(29+46) 20/5 44/24 20/1 45/27 (6+7+8+9+10+11+15+21)/5 (6+7+8)/5 (9+10+11)/5 12/5 37/29 13/5 38/29
I I
D D D D D D D D D D D D
9 I
1 10 I 11 I
1 12 I
I 13
1 14
I 15 1 16 I I 17
1 18 I
I 1 19
I
14/5
D
Icost
1 20 I
service index
40/29
D
25
21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48
service cost supervisory ratio supervisory production factory engineering cost factory clerical cost support index support cost incentive support incentive cost setup effectiveness maintenance effectiveness productivity planning direct usage cost direct usage index variable indirect variable indirectdirect premium avoidable cost avoidable content machinerylabour economy production, indirect servicepayroll index directproductive index productivity yield index indirect yield index net payroll productivity gross payroll productivity servicewait index indirect payroll
11/5 41/25 41/29 18/5 19/5 (40+41+42+43)/29 (16+17+18+19)15 (4645+47)/29 (21+22+23)/5 37/26 38/26 22/6 5/1 29+46/24 6+7+8+9+10+11+13+14+15/20 6+7+8+9+10+11+13+14+15/5 22/(14+15) (14+15)/5 (7 10+14)/5 (44/24)(29/20) 40/24 (29+46)/(44+45) (2745+46)/24 (2745+46)/44 (2945+46)/24 (2945+46)/25 (6+16)/5 (44+45)/24
26
So by evaluating all or a part of the above ratios depending on the purpose of the analysis it is possible to identify the strength or weaknesses in productivity or the whole company performance. By improving and increasing the
manpower productivity and capital productivity we will achieve the goals of the company and ensure its health and growth.
Although there is a debate on whether to use added value instead of profit related ratios (Ball, 1968), the use of a single ratio as a mean of evaluating performance is common practice among managers, and are generally accompanied by some measures of growth. However, this practice has been
criticised on the grounds that a single ratio can not reflect every aspect of a company performance and sets of ratios have been proposed to allow a better evaluation of the financial profile of firms.
2.4 SECURITY ANALYSIS
As discussed in (2.1) security analysis was based on new techniques and a sophisticated concept of financial statement analysis for the first time in 1934 by Graham & Dood and then in 1973 by Barnea & Dennis, which is discussed in further detail in this section. Again in security analysis ratios are used. By evaluating these ratios investors can have more confidence and be more accurate investing their money in the right place and at the right time.
Graham, Dood and Cottle(1962) tried to establish and construct a new security analysis using ratios which are most
27
demanded by shareholders and creditors.
The key ratios in
security analysis which assess the quality of a company are as follows: 1 profitability ratios 2 growth ratios 3 stability ratios 4 payout ratios 5 credit ratios 6 price ratios
The first five groups measure the performance and financial strength of a company, considered apart from the valuation placed upon it in the market (ratio 6).
PROFITABILITY RATIOS
An important indicator of the success of a company is the percentage earned on invested capital. That is the percentage earned on the longterm (noncurrent) debt and preferred stock plus the book value of the common stock. The fundamental merit of returnoninvested capital ratio is that it measures the basic or overall performance of a business in terms of the total funds provided by all longterm investors rather than a single class. Four ratios are used to measure this aspect: Ratio 1 earnings before depreciation per pound of capital funds Ratio 2 earnings per pound of capital funds (return on capital)
28
Ratio 3 sales per pound of capital funds (sales ratio) Ratio 4 earnings per pound of sales (earnings margin)
GROWTH RATIOS
The test of growth is most informative when they are made between years representing about the same phase of successive business cycles. Ratio 5 pound sales=sales of 2nd business cycle(BC)/sales of 1st BC Ratio 6 net profit on total capital in pounds=net profit after tax (NPAT) for 2nd BC/NPAT for 1st BC Ratio 7 earnings per share=EPS for 2nd BC/EPS for 1st BC
STABILITY RATIOS
In stability ratios the lowest year is measured against the average of 3 previous years to indicate the stability of the company's activity over time. For example the maximum decline in rate of return or minimum coverage of charges indicate the fluctuations or stability in activities. Ratio 8 minimum coverage of senior charges Ratio 9 maximum decline in earnings rate on total capital
29
The latter ratio may be supplemented by measuring the maximum decline in the return earned on commonstock capital and/or in pershare earnings.
Blum (1974) emphasised on including the stability of earnings in the variables assessing companies' performance where in his failing company model, the standard deviation of the net income over a period of three years was among the variable he selected and included in a discriminant function identifying possible failures amongst going companies.
PAYOUT RATIO
The percentage of available earnings paid out in common dividends often has an important effect upon the market's attitude category. Ratio 10 payout ratio=common dividends/net profit for common shares toward those issues not in the "growthstock"
CREDIT RATIOS
The ability of company to meet its short and long term obligations are measured here as credit ratios which are listed as follow: Ratio 11 workingcapital ratio=working capital/ current assets Ratio 12 commonstock ratio=commonstock equity/ total capital
30
Ratio 13 coverage of senior charges = senior charges/(fixed dividend) charges + preferred
PRICE RATIOS
Evaluation of company based on its common stock at market value are presented here as follows: Ratio 14 sales per pound of common, at market = sales/common stock at market value Ratio 15 earnings per pound of common, at market (earning yield) = net profit for common/ common stock at market value Ratio 16 dividends per pound of common, at market (dividend yield) = common dividends/common stock at market value Ratio 17 net assets per pound of common at market (asset ratio) = common stock equity(book value)/common stock at market value
2.5 RATIO CLASSIFICATION
The above set of ratios can be reduced in number because many measure the same dimension of a company's performance. The reduced set can then be classified. By classifying these ratios it is possible to assess company performance and therefore identify changes that could be made to improve company performance.
31
Weston and Brigham(1975) classified the useful ratios into four fundamental types:
LIQUIDITY RATIOS
measure the firm's ability to meat its maturity short term obligations. a) current ratio= current assets/current liabilities b) quick ratio= current assets  inventory/current liabilities
Richard (1964) suggested some ranges for ratios to clarify and indicate the extends of the company's financial strength or weaknesses, such a classification can be done for any company as below, R is equal to current assets/current liabilities. Table 2.5.1 Ratio Classification
Liquidity Ratio
I
Description
Position
R > 2.0 2.0 > R > 1.5 1.5 > R > 1.0 R  1.0 1.0 > R R < 0.5 0.5
overliquidity optimal liquidity under liquidity marginal liquidity payment difficulties danger of bankruptcy
excellent very good good sufficient deficient
insufficient
LEVERAGE RATIOS
measure the extent to which the firm has been financed by debt.
C) debt ratio= total debts/total assets
d) time interest earned= EBIT/interest charges e) fixed charge coverage =EBIT + lease/interest charges + lease
ACTIVITY RATIOS
measure how effectively the firm is using its resources. f) inventory turnover= sales/inventory g) average collection period= receivables/sales per day h) fixed assets turnover= sales/net fixed assets i) total assets turnover= sales/total assets
PROFITABILITY RATIOS
measure management's overall effectiveness as shown by the returns generated on sales and investment. k) profit margin= NPAT/sales j) return on total assets= NPAT/total assets m) return on net worth= NPAT/net worth
33
2.6 INDUSTRIAL AVERAGE ANALYSIS
Ball (1967) and Lev (1969) argued that interindustry differences exist among some financial ratios, but it is not clear whether all the ratios are affected in the same direction by industrial characteristics and whether this influence is consistent over all the financial dimensions of companies. Horrigan (1965) showed that financial ratios are uncorrelated to size. The same conclusions were later reached by Beaver (1967) and Singh & Whettington (1968). Edminster
(1972) carried out some studies with the aim of finding pairs of companies which possessed as many common characteristics as possible. Pair of companies should be drawn from the same
industrial sector, have the same size and come from the same financial year. Although finding a significant number of
ideally paired companies is not impossible, the work involved is enormous and costly. Edminster examined about 110'000
companies before finding 21 pairs.
Probably the most widely known and used of the industrial average ratios are those compiled by Dun & Bradstreet, Inc. D &B provides fourteen ratios calculated for a large number of industries. Comprising 125 lines of business activity based The 125 types of business
on their financial statements.
activity consist of 71 manufacturing and construction categories, 30 categories of wholesalers, and 24 categories of retailers. Sample ratios and explanations are shown in Table The
2.6.1. The complete data give the fourteen ratios.
median ratios can be illustrated by an example. The median
34
ratio of current assets to current debt of manufacturers of airplane parts and accessories were arranged in a graded series, with the largest ratio at the top and the smallest at the bottom. The median ratio of 1.81 is the ratio halfway
between the top and the bottom. To simplify the D & B tables, we can consider: LB & NR = Line of Business and Number of concerns Reporting CA = Current Assets CD  Current Debt NP  Net Profits NS  Net Sales TNW = Tangible Net Worth NWC = Net Working Capital CP = Collection Period In  Inventory FD = Funded Debts FA = Fixed Assets TD  Total Debt D  Days LR  Largest Ratio MR  Median Ratio SR = Smallest Ratio
35
Table 2.6.1: Ranges of selected ratios and measures by industry taken from Dun and Bradstreet.
LB
CA
NP
NP
NP
NS
NS

1 1 CP 1
NR
CD
NS
TNW
NWC
TNW
NWC
1
DI
Agricultural Implements & Machinery (74)
LR MR SR
3.78 2.27 1.52
.0715 .0412 .0323
.2144 .1459 .083
.3682 .2068 .1495
5.27 3.21 2.34
8.13 4.6 2.98
1 1
25 39 52
1 1
1
1
Airplane parts & Accessories (59)
LR MR SR
2.4 1.81 1.42
.0812 .0525 .031
.2778 .1811 .119
.4496 .3221 .1776
4.46 3.43 2.72
8.27 5.29 4.2
1 1
34 46 61
1 1
1
1
Automobile Parts & (84) Accessories
LR MR SR
3.77 2.58 2.03
.0675 .0459 .0332
.1889 .146 .0865
.3211 .2032 .1409
3.89 2.99 2.19
6.54 I 4.63 I 3.23 I
35 42 51
1 1
1
Bedsprings & Mattresses (49)
LR MR SR
3.6 2.33 1.87
.0269 .0206 .008
.1153 .0646 .0271
.1503 .1095 .0511
5.85 3.48 2.61
8.52 5.79 I 4.34 I
30 42 55
1 1
1
Breweries (27)
LR MR SR
3.34 2.59 1.88
.0648 .0475 .0128
.1515 .1038 .0255
.6372 .3427 .0823
3.23 2.49 1.72
11.34 8.51 5.13
I 1
8 16 24
1 1
1
1
Chemicals, Agricultural (33)
LR MR SR
2.98 1.73 1.33
.0387 .0202 .0095
.1178 .0758 .0156
.4491 .1773 .028
5.11 3.46 1.98
13.41 6.72 4.15
1 1
32 55 87
1 1
1
1
36
Chemicals, Industrial (60)
7.05 1 39 1 ILR I 2.77 1. 0815 1.1 6 07 1.5001 I 3.09 MR I 2.28 p.0553 J.1245 1. 303 2 I 1.95 I 5.03 1 50 1 ISR I 1.51 J.0393 1. 090 3 1.1795 I 1.52 I 3.39 1 59 1
Contractors, LR Building (188) MR construction SR
2.06 .0314 .1904 .3304 12.51 20.41 1 1.49 .0138 .1239 .1638 8.09 11.52 1 1.27 .0074 .0620 .0914 4.32 5.79 1
b 1 b 1 b 1
continues of Table 2.6.1
LB
NS
FA TNW
CD
TD
In
CD 1 FD 1  1  1 In 1 NWC I
NR
In
TNW
TNW
NWC
Agricultural Implements & Machinery (74)
LR MR SR
6.1 3.9 3.1
.215 .335
.225 .493
.475 .713 .800 1.049 1.496 1.614
.446 1 .178 1 .720 1 .370 1 .984 1 .509 1
.636 1.153
Airplane parts & Accessories (59)
LR MR I SR
8.6 .279 5.9 I .484 3.9 .755 1
1 1 .738 I .879 1 .141 1 11.034 I 1.00 1 .475 1 1 1.125 11.791 1.547 1.419 .558 1 .432 1 .580 .615 11.035 1
LR 8.0 Automobile .257 .235 .473 .778 Parts & (84) 5.3 .396 .380 MR Accessories SR 4.2 .555 .634
.605 .862
.585 1 .146 1 .797 1 .416 1 1.137 1 .599 1
1.169 1.005
Bedsprings & Mattresses (49)
LR MR SR
11.7 8.2 5.5
.156 .281 .493
.229 .459 .763
.487 .728
.548 .768
.556 1 .036 1 .936 1 .266 1 1.548 1 .521 1
1.339 1.145
Breweries
1 1 1 1LR I 21.6 I .537 I .131 1 .204 1 .333 11.082 1 .096 1 1MR 16.4 .594 I .213 I .386 1 .465 11.378 11.186 1 37
(27)
+
Chemicals, Agricultural (33)
1 II
1SR LR MR SR
11.4
1 I
.819
1 I
.341
1 I
.975
1 I
.877 11.949
1
762
1 +
I
.621 1.066 1.605 .895 1.229 2.373
10.4 6.6 5.0
.295 .536 .712
.336 .731 1.23
.584 1.11 1.659
1 1 1
.241 .479 .752
1 1 1
Chemicals, Industrial (60)
LR MR SR
10.1 6.9 5.5
.426 .688 .889
.201 .300 .500
.318 .589 1.06
.652 .847 1.001
.761 .985
1 1
.440 .942
1 1 1
1.287 11.524
Constructors, Building (188) Construction
LR MR SR
b b b
.095 .222 .421
.617 1.38 2.398
1.194 1.884 3.180
b b b
1 1 1
.119 .274 .834
1 1 1
b Building trades constructors have no inventories in the credit senses of the term. As a general rule, they have no customary selling terms, such contracts being a special job for which individual terms are arranged.
2.7 DISCRIMINANT ANALYSIS
The prediction of corporate performance using financial ratios data and a multivariate statistical approach is a well researched area in finance and accounting. The discriminant
analysis technique is a multivariate statistical procedure with application aimed at distinguishing between the members of two or more distinct populations on the basis of their characteristics represented by vector variables. A set of
discriminant functions is derived using data from two or more distinct groups. These functions can then be used to classify
38
further individuals whose data has been used in constructing the discriminant functions. In the company bankruptcy
situation the twogroups are the samples of failed and nonfailed firms.
Walter
(1959) and Smith (1965) studied common share Smith used
analysis in the area of financial analysis.
discriminant analysis to classify common stocks into five investment categories, namely, growth, stability, quality, income and speculative. Walter selected from a sample of five hundred companies the highest and the lowest fifty E. P.
(inverse of price earning) ratio firms. He then analysed the characteristics specific to each of these groups discriminant analysis. using
Several analysis have attempted to reproduce bond ratings, using multivariate methods. Although the first studies
employed multiple regression analysis as the base for their predictive model, Horrigan (1965) and Pinches (1973) found multiple discriminant analysis more appropria e to tackle the problem.
The use of discriminant analysis in regard to the analysis of company failure was done recently by Taffler (1976), (1982), and Betts & Belhoul (1982) in the UK. Belhoul (1983) investigated the financial performance of companies using multiple discriminant analysis together with methods for the identification of potential high performance companies.
Taffler (1977) and Mulondo (1981) have restricted their analysis to companies quoted on the stock exchange, but many
39
studies related to comparison of performance have been carried out on mixtures of quoted and unquoted companies by Roosta (1979) and Pohlman & Hollinger (1981). Mulondo study was
concerned with industrial enterprises quoted on the London Stock Exchange. The bankrupt set of firms from which the discriminant model was derived consisted of all those companies meeting certain conditions for inclusion which failed between 1968 and 1973, a period of 6 years. Failure was defined as liquidation for the benefit of creditors, winding up by court order, or entry into receivership. All told a total of 31 firms met the necessary requirement although of these only 23, the FAILED23 set, provided turnover figures in their last available income statement.
61 companies were chosen as the nonfailed firms, termed the ALL61 set. However not all these could be considered
financially healthy and to arrive at the necessary solvent subset, the investment analysis of the broking firm were requested to rate each of them on an investment. 45 firms
were considered sound on the grounds of his fundamental analysis, the G00D45 set. The remaining 16 were termed the POOR16 set. Different discriminant functions were derived
using the G00D45 and ALL61 groups.
THE VARIABLES
The variables used in this study were selected on the basis of effectiveness in previous and related studies, popularity in the literature, theoretical arguments based on the liquid
40
assets flow model of the firm of Beaver and Blum (1974) adapted from Walter and suggestions by financial analysts based on their experience. Three classes of variable were initially developed, conventional ratios computed from income statement and balance sheet items, four year trend measures and ratios computed from the funds statement.
However,
despite the theoretical arguments in the
literature asserting the utility of the funds flow ratios, measuring changes in working capital, turned out without exception to be highly volatile from one year to the next and as a result not amenable to any form of statistical analysis. Consequently they were not considered further. The
distributions of the remaining ratios were carefully examined for the failed and continuing groups separately and appropriately transformed to improve normality. Outliers
beyond 4 standard deviations from the mean of the remaining observations in each case were replaced by the mean and those between 2.5s and 4s by the appropriate 2.5s limit. Because a number of these ratios were highly nonn rmal, they were rejected. When they were removed 52 ratios were left for further analysis together with 26 trend measures.
Initial discriminant runs using the FAILED23 and G00D45 sets were then undertaken to examine whether trend measures added anything to the power of the discriminant model. However the trend measure did not contribute to discrimination and so were not used in further analysis. Of the remaining 52 measures certain were omitted from subsequent discriminant runs on the advice of knowledgeable financial analysts as
41
being potentially industry dependent, particularly many of the turnover ratios, others were added and definitions of some were changed on the basis of experience gained in the earlier examinations. This reduced the numbers to 50 as follows: 1. 2. 3. 4. 5. FUNDS FLOW(GROSS TRADING PROFIT)/TOTAL ASSETS FUNDS FLOW/NET WORTH FUNDS FLOW/TOTAL LIABILITIES FUNDS FLOW/CURRENT LIABILITIES FUNDS FLOW/NET TRADING CAPITAL(EQUITY+TOTAL LIABILITIESCASH) 6. FUNDS FLOW/NET CAPITAL EMPLOYED(EQUITY+LONG TERM LIABILITIES) 7. 8. 9. 10. 11. 12. 13. EBIT/TOTAL ASSETS EBIT/NET WORTH(EQUITY) EBIT/TOTAL LIABILITIES EBIT/CURRENT LIABILITIES EBIT/NET TRADING CAPITAL EBIT/NET CAPITAL EMPLOYED CASH FLOW(RETAINED PROFITS  EXCEPTIONAL ITEMS + DEPRECIATION)/TOTAL ASSETS 14. 15. 16. 17. 18. 19. 20. 21. 22. CASH FLOW/NET WORTH CASH FLOW/TOTAL LIABILITIES CASH FLOW/CURRENT LIABILITIES CASH FLOW/NET TRADING CAPITAL CASH FLOW/NET CAPITAL EMPLOYED TOTAL LIABILITIES/NET WORTH log (FIXED ASSETS/NET WORTH) FIXED ASSETS/NET CAPITAL EMPLOYED TOTAL LIABILITIES/CURRENT ASSETS
42
23. 24. 25. 26.
CURRENT LIABILITIES/TOTAL ASSETS TOTAL LIABILITIES/TOTAL ASSETS TOTAL LIABILITIES/NET CAPITAL EMPLOYED DEBT/EQUITY
27.
28. 29. 30. 31.
log
(QUICK ASSETS/CURRENT LIABILITIES)
(CURRENT ASSETS/CURRENT LIABILITIES) (QUICK ASSETS/TOTAL ASSETS) (CURRENT ASSETS/TOTAL ASSETS) (WORKING CAPITAL/TOTAL ASSETS)
32. 33.
34. 35.
log log
(QUICK ASSETS/NET WORTH) (CURRENT ASSETS/NET WORTH)
WORKING CAPITAL/NET WORTH (QUICK ASSETS/TOTAL LIABILITIES)
36. 37.
38.
log log
(QUICK ASSETS/NET CAPITAL EMPLOYED) (CURRENT ASSETS/NET CAPITAL EMPLOYED)
WORKING CAPITAL/NET CAPITAL EMPLOYED
39.
log
(INVENTORY/WORKING CAPITAL + SHORT TERM
LOANS  CASH)
40.
41. 42. 43.
log
(SALES/WC+SHORT TERM LOANSCASH)
SALES/AVERAGE INVENTORY DAYS DEBTORS DAYS CREDITORS
44.
log
(READY ASSETS(CASH+7 DAYS DEBTORS)/CURRENT
LIABILITIES 45. log (READY ASSETS/TOTAL ASSETS)
46. 47.
48.
log log
(READY ASSETS/NET WORTH) (READY ASSETS/TOTAL LIABILITIES)
READY ASSETS/NET CAPITAL EMPLOYED
43
49.
log [(ACCOUNTS RECEIVABLE+INVENTORY)/ACCOUNTS PAYABLE]
50.
(WC+SHORT TERM LOANSCASH)/NET TRADING CAPITAL
2.8 FINANCIAL RATIOS IDENTIFICATION
In selecting financial ratios for investigation we must ensure that the chosen set covers all the aspects of the company. If any financial dimension is not considered the
overall conclusions are not reliable because the ratio profile is not complete. One of the earlier efforts to identify these ratios was by Courtis(1978). Such identification enables the analyst to modify his own preferred set of ratios or if he chooses not to, at least it will place him in a sounder position to justify to clients (and himself) his reliance upon specific ratios when giving investment advice. Identification of financial ratios which have been found to be more significant are summarised below.
PROFITABILITY RATIOS
(a) Return on Investment
net income to total assets net income to net worth net income to working capital EBIT to total assets EPS to price per share NI minus pref. dividends to common OE earning per share
44
gross profit to total assets dividends to net income dividends to cash flow dividends per share net income to total debt
(b) Profit Margin
net income to sales gross profit to sales
(C) Capital Turnover
sales to total assets sales to net worth sales to working capital sales to fixed assets
MANAGERIAL PERFORMANCE
(a) Inventory
sales to inventory inventory to current assets current liabilities to inventory cost of sales to average goods inventory inventory to total assets inventory to working capital days in period to inventory turnover
(b) Credit Policy
accounts receivable to sales per day
45
sales to accounts receivable accounts payable to average purchases per day
(c) Administration
operating expenses plus cost of sales to sales operating expenses to gross margin cost of sales to sales operating expenses to total assets
(d) Asset Equity Structure
debt to total debts working capital to net worth retained earnings to total assets debt to working capital current liabilities to working capital cash current asset to total current assets net worth to total assets fixed assets to net worth fixed assets to debt fixed assets to total assets book value per share total debt plus pref. stock to total assets debt to total assets current liabilities to total assets retained earnings to net income
SOLVENCY
46
(a) Short Term Liquidity
current assets to current liabilities current liabilities to net worth working capital to total assets no credit interval cash to total assets cash to sales quick assets to current liabilities cash to current liabilities basic defensive interval quick assets to total assets current assets to total assets quick assets to sales current assets to sales cash interval reduced sales interval reduced operations interval
(b) Long Term Solvency
total debts to net worth net worth to fixed assets EBIT to interest total debt to total assets market value of equity to book value of total debt EBIT to fixed charges unsubordinated debt to capital funds
(c) Cash Flow
47
cash flow to total debt annuals funds flow to current liabilities cash flow per common share cash flow to current liabilities working capital to cash flow cash flow to sales cash flow to total assets cash flow to net worth cash flow to current maturities of long term debt
Courtis (1978) indicated that empirical research into predictive ability of financial ratios has been concerned only with preselected phenomena, for example, specifics such as, default experience over corporate bond issues, loan defaults, corporate failure, small business failure, corporate
bankruptcy, corporate bond ratings, corporate rate of return rankings, and corporate take overs. Generalising the
predictive ability of this ratios beyond the context of their specific studies ought to be tempered with caution.
Nevertheless, the analyst has available a batt ry of financial ratios with some experience in filtering corporate financial characteristics.
2.9 SOME LIMITATIONS OF RATIO ANALYSIS
1 Ratios are constructed from accounting data,
and
accounting data are subject to different interpretations and even to manipulation. For example two firms may use different depreciation methods or
inventory evaluation
methods.
48
2
Similar differences can be encountered in the treatment
of research and development expenditures, pension plan costs, mergers, product warranties, and baddebt reserves.
3 If firms use different fiscal years, and if seasonal factors are important, this can influence the comparative ratios.
4 A high inventory turnover ratio could indicate efficient inventory management, but it could also indicate a serious shortage of inventories and suggest the likelihood of stockouts.
5
Absence of clearly defined accounting standards,
covering all reporting of company data, makes it possible that two companies report similar economic events in different ways.
6 While ratios do provide information about the current status of the firm, they do not contain information about the alternative strategies and the intervening economic conditions confronting management and investors, such as mergers and deferral of payments.
7 The value of human factors and customer loyalty are not included in financial analysis. The problem with these two factors is that they are totally intangible and impossible to measure exactly.
8 Intangible assets are normally omitted because the value utilised in the business in respect of these assets is uncertain.
49
Ratios, then are extremely useful tools. But as with other analytical methods, they must be used with judgment and caution, not in an unthinking, mechanical manner.
2.10 CONCLUSION
In the first decade of the twentieth century, financial ratios began to be increasingly used because credit evaluation became of major importance. Initially the most frequently
used ratio was the current ratio which was used to determine the firm's solvency position. However, because of the
limitation of this ratio as an indicator, it was realised that additional ratios were needed to provide a more comprehensive view of the firm's economic situation. Since then, anal,sis by means of the calculation of a series of ratios rapidly became a popular method of analysis of financial statements.
In spite of considerable advantages of using the added value technique over profitability methods of measuring companies' financial performances, it is obvious that a single measure such as added value can not reflect every aspect of company performance and so sets of ratios have been proposed to allow a better evaluation of the financial performance of a company.
An additional advantage of using financial ratios is that they allow comparisons of company performance for companies of different sizes and even in different industrial sectors.
More recently multivariate techniques such as discriminant
50
analysis and factor analysis have been gaining in popularity. This is because of the increased accessibility of the
necessary hardware and software required to carry out such analysis.
51
CHAPTER 3 BASIC TOOLS OF PERFORMANCE MEASUREMENT
52
CHAPTER 3: BASIC TOOLS OF PERFORMANCE MEASUREMENT
The business failures can be categorised in four different types: 1) Economic failures A business is an enterprise organised for profit. It may be said therefore, that a business that does not make a profit and has no reasonable expectancy of profitable operations is a failure. This is true even though it has been successful in meeting its obligations to creditors. 2) Legal failures The classification of business
failures that follows relates to difficulties of a company with its creditors. The business has difficulty in meeting, or can not meet, the legally enforceable obligations due its creditors. 3) Financial insolvency When there has been a
decline of current asset values to an extent requiring new money, or necessary conversion of fixed assets into cash, or sacrifices by creditors to correct the situation, the company is sometimes called financially insolvent. 4) Total insolvency Total assets, tangible and
intangible, are less than obligations due to creditors. Obviously, the most drastic remedies are necessary here. Perhaps the only hope of creditors is to bring about a liquidation and forced sale of assets under a bankruptcy proceeding.
53
3.1 CAUSES OF FAILURE
The causes of failure in a specific situation are, like the reasons for success, difficult to isolate. Failures seem frequently to occur from a 'complex of diseases', rather than from one outstanding cause. Lack of working capital is often named as a cause for failure. It is, however, merely a symptom of some more deeprooted ailement that has brought about the resulting condition. Although incompetence on the part of the management may in general be cited as the cause of practically all business failures. Lack of capital, so often cited as the immediate cause, usually indicates lack of skill in planning. A brief classification of the causes of business failures were done by Bonneville, Dewey and Kelly (1959) as follows: 1) uneconomic or defective initial promotion 2) weak production or distribution policies 3) unwise dividend policy, and paying dividends from capital 4) over expansion 5) cutthroat competition 6) poor financial planning 7) unforeseen and severe economic readjustment, brought about by a sudden cessation of demand for the product, revolutionary or unusual legislation, wars, radical tariff changes and so on. 8) operation of the business cycle 54
9) disasters, such as, earthquakes, fires, floods. 10) dishonesty and fraud
3.2 DETECTION OF FAILURE BY RATIOS
One of the most important means of checking progress and detecting tendencies in
a business failure is through the
preparation and study of significant ratios, which indicate relationships between important items reported in the balance sheets and profit and loss statements of a business. Usually
a number of ratios must be used and to be of value must be
compared with the same ratios which have been prepared from financial statements for several periods in the past. In this way, changes may be observed, their causes analysed, and trends detected. Johnson (1970) was concerned with failure predictive aspects of financial ratios analysis.
As we have seen in previous discussions the main causes of company's failure are classified into three basic categories: 1) profitability deficiency 2) management deficiency 3) solvency deficiency
On the other hand if we accept the premise that shareholders are interested in increasing the value of their capital investment, and that the longrun survival of the company is an essential goal, then interested parties might ask three vital questions. 1) Is the company making any money? (profitability)
55
2)
Is
the management any good?
(managerial
performance) 3) Is the company going to stay in business? (solvency)
In so far as these questions can be answered at all from financial analysis, ratios measuring "profitability",
"managerial performance" and "solvency" were selected.
For a complete and overall performance analysis and detecting the causes of failures and successes we need to look at all possible ratios as measurement tools. In this way
individual changes can be identified and quantified and the way in which these individual changes affect overall company performance analysed. Finally it would seen desirable to
develop a statistic that summarised those different effects. This single statistic could then be used to assess company's financial health.
3.3 PROFITABILITY
As has been stated one of the main types of business failure is called 'economic failure', which means that the company can not make adequate profit. Making a profit is what business is all about. Profits are adequate when they return to business owners the cost of their personally contributed resources, a reward for their enterpreneurship, and
compensation for the risks involved. The adequacy of profits is generally measured in terms of profitability as a return on invested capital (ROI) which is demonstrated by the popular
56
due Pont system in Table 3.3.1 in which certain ratios are interrelated meaningfully. The changes and trends in each of the components affect the family of ratios as a whole. has been some other There
studies such as Haugen (1970),
Litzenberger & Joy (1971), Whittington (1972) and Vickers (1966) which were analysing the rate of return as a
measurement of profitability.
57
Table 3.3.1 The factors combined to yield Return on Investment (ROI)
WORKINGI FIXED FIXED CAPITAL' 'INVESTMENT' 'CHARGE RATEI
I I I I I
'LABOR' 'MATERIALS' 'VARIABLE (OVERHEAD
I I I I I
PLUS
I
I
TIMES
I
PLUS
I
PLUS
I
I
FIXED COSTS
I
(VARIABLE
I
I
I
I
COSTS
I
PLUS
I I
TOTAL
I
I
NET SALES
I
I I I
I
TOTAL COST
I
I
I I
I I
I I
I I
'INVESTMENT
I
DIVIDED INTO
MINUS
IPRETAX 'PROFIT
I
I
INCOME TAXES
I
I
MINUS
I
NET
I
(PROFIT ' DIVIDED INTO
I
CAPITAL TURNOVER RATE
I
'PROFIT 'MARGIN
I
I
I
I
TIMES
I
RETURN ON
I
IINVESTMENT
I
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Submodels
provide another means
of analysis.
A
profitability model can be broken down into a group of separate and distinct submodels, which are shown in the following Table(3.3.2). Table 3.3.2 Submodels of Profitability
(UNITS SOLD)(NET PRICE PER UNIT)= NET SALES 1) MARKET OR INCOME NET SALES  SELLING COSTS = NET INCOME FROM SALES
UNIT COST(MATERIAL+LABOR+VARIABLE OVERHEAD)(UNITS 2) MANUFACTURING COST 0 PRODUCED) = DIRECT MANUFACTURING COST (DMC) DMC + FIXED OVERHEAD + CAPITAL CHARGES = TOTAL MANUFACTURING COSTS
DEPRECIABLE INVESTMENT(BUILDINGS AND EQUIPMENT)+ A 3) INVESTMENT EXPENSES & AMORTISED INVESTMENT(ENGINEERING, R & D,I STARTUP)+LAND+WORKING CAPITAL (RECEIVABLE & INVENTORY)=TOTAL CAPITAL REQUIREMENT
(TOTAL DEPRECIABLE INVESTMENT)(DEPRECIATION RATE) 4)DEPRECIATION = ANNUAL DEPRECIATION CHARGE
NET INCOME FROM SALES  TOTAL MANUFACTURING COST
59
5) PROFIT
— NET OPERATING INCOME (NOI) NOI  DEPRECIATION  EXCEPTIONAL ITEMS = NET PROFIT BEFORE INCOME TAXES  INCOME TAXES = NET PROFIT AFTER TAXES
NET PROFIT AFTER TAXES+DEPRECIATION+EXCEPTIONAL 6) CASH FLOW ITEMS = NET CASH INFLOW NET CASH INFLOW  NET CASH OUTFLOW(TOTAL CAPITAL REQUIREMENT) = NET CASH FLOW
3.4 MEASURING THE PROFITABILITY
The return on asset ratio is regarded by many financial analysts as an adequate measure of overall efficiency. This
view has been shared in many studies such as Harrington (1977) and Fadel (1977). However, other measures of overall
efficiency have been opposed to EBIT/total assets ratio on the ground that it only evaluate the contribution of capital resources.
The rate of return on invested assets (r) sometimes referred to as the return on investment or ROI, can be defined as follow r (profits/sales)(sales/assets)
The first item on the right hand side of the identity is termed the profit margin and the second item the turnover ratio. The profit margin is intended to serve as a measure of the relative efficiency with which the firm produces its
60
output, whereas the turnover figure is designed to measure the efficiency with which the firm utilises its plant and equipment. Lerner and Carlton (1966) extracted profits from the above equation which is P where P Profits (1T)(rAiL)
T ... corporate tax rate
3  rate of return on assets (EBIT/assets) A  level of assets i = interest rate paid on debts (I/L) L = liabilities (borrowed funds)
To modify this expression somewhat further if we let the symbol E equity. Since A = L+E, the equation can also read P (1T)[rL+rEiL]
or P = (1T)[r+(ri)L/E]E or P I E = (1T)[r+(ri)L/E]
Assume that the goal of the corporation is to maximise the rate of return on shareholder's equity,P/E. Management would then have to determine what capital structure (LIE) will lead to this result. Taking the partial derivative of the rate of return on equity (P/E) with respect to the L/E ratio, and setting it equal to zero. d(P/E)/d(L/E) = (1T)(ri) = 0 Since (1T) > 0 Therefore (ri) = 0 and r = i
61
This is that the corporation should expand its ratio of debt to equity (LIE) until the rate of return on assets (r) is equal to the rate of interest. This has also been used as a "rule" for determining the cutoff point for the use of debt. The theory is that the use of funds by a company and, in particular, funds obtained by borrowing, should be no more than the amount that yields a rate of return, r, equal to the rate of interest, i.
Unfortunately, there are two serious difficulties with this conclusion 1) In taking the derivative of P/E with respect to LIE we treated the values of 'r' and 'i' as constants rather than as function of other economic variables. But if they are constants, there is no mechanism that permits the values of 'r' and 'i' to be identical! 2) If the firm should find that its rate of return on assets equal the interest rate it pays on debt, it still would have no idea whether the rate of return on equity was a maximum or a minimum value, for equation (P/E) is linear and therefore has second and higher derivatives identically equal to zero.
How then can the optimal relationship between the rate of return on equity and the capital structure be determined? One widely used method is to treat i as a function of some other variable. For example assuming that the interest rate is a rising function of the ratio of debt to equity, and the rate of return is independent of changes in the firm's size and capital structure.
62
P/E = (1T)[r+(ri)L/E] i f(L/E) dL/B ===> d > 0
r r 0
by substituting P/E (1T)[r + Cr dL/B)L/E] 0 0 2 (1T)[r + r LIE  d(L/E) ] 0 0
P/E
d(P/E)/d(L/E)= (1T)(r 2dL/E) = 0 0 r 0 L/E r /2d 0 2dL/E = 2i
Since the second derivative of this expression with respect to LIE is 2d(1T) the rate of return on equity with respect to changes in capital structure (LIE) will be a maximum when the first derivative equals zero.
3.5 BEHAVIOURAL EQUATIONS
The information available to the financial analyst consists primarily of the corporation's historical accounting records, the task of financial analysis is to go behind such data to reveal the economic structure of the corporation's
performance. The task of going behind corporate financial records to uncover the underlying economic processes is complicated by the presence of two closely related problems:
63
First the complex interdependence of the relevant variables. Second, the presence of a high degree of uncertainty in the corporation's decision making environment.
To attack the problem of interdependence,
accounting
statement equations (such as A = L + E) must be combined with statements specifying the economic relationships between variables (such as the rate of return (r) is a declining function of the rate of growth (g) of corporate assets). The
economic statements will be called "behavioural statements", "behavioural equations", or "behavioural constraints". The
behavioural aspects of accounting data was investigated using multivariate procedures and regression analysis by Chambers (1966), Benston (1966) and Burns (1970). When the accounting and behavioural statements are combined, they result in a model or a system of equations that can be used both as a frame of reference and as a tool for analyzing observed data.
accounting equation= P/E= (1T)[r+ (ri)L/E] behavioural equation= i= dL/E exogenous variable= r= r 0
It is impossible to derive behavioural relationships that describe completely all details of reality, the analytic power of reasonable approximations brought together in a systematic way can be immense.
Including the relevant variables in appropriate functional form can never be complete, there will always remain
64
unexplained influences on the behaviour of corporate profits. The effects of such residual influences, which together can often be important, are usually taken into account by the inclusion of a relationship. Thus i= dL/E is rewritten as i= dL/E + u random error term in the behavioural
where u is a random variable. The statistical properties of u are very important.
As we have seen so far it is almost impossible to evaluate corporate profitability just by a single criterion. It might be better to evaluate and analyse all the possible financial ratios which are directly or indirectly related to profitability.
3.6 PROFIT VS PROFITABILITY
Profitability is a concern of highlevel management but requires conscious attention at all levels of an organisation if it is to be attained. different concepts. measure of profit. Profit and profitability are the
Accounting principles determine
Profit is fundamentally a shortterm
evaluation that is an income statement for 1 year and is therefore amenable to distortion. It is possible for a
company to show a profit for 1 year when in truth it is losing money over the long run. The recognition of time as a
fundamental constituent of profitability is paramount, and profitability is a longterm concept.
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Profitability can be evaluated only after time has elapsed and future profitability can only be estimated. For example the automobile industry showed a profit for the late 1970s, but it failed to tool up for the oncoming demand for small, economical automobiles. The year 1980 was a disaster for profits and revealed in retrospect that the profits of the late 1970s were false because the investment necessary for change and modernisation had been disregarded. Again nothing should be given an ultimate judgement on a shortterm basis, and even a shortterm venture should be evaluated on the basis of its longterm effect since it will influence the future beyond its termination.
3.7 RISK VS PROFITABILITY
Risks may be of either a technical or economic nature. Some risks must be taken, because they are too inviting to forego. While some risks are too great to be taken. In any
event, the primary concern should not be with eliminating risks, but with selecting the right risks to be taken. The only way to avoid risk is to do nothing, which is actually the greatest risk of all in business. Actually, risks in business can never be avoided. Even a course of action that minimises risk is not always desirable. According to Friend & Blume (1970) and Wagner & Lau (1971) studies, there are several ways that risk and uncertainty can be anticipated and handled so that their possible harmful effects can be minimised.
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The calculation of desired profitability or ROI of a company should consider three major elements: 1) pure interest 2) compensation for management 3) compensation for risk
The pure interest represents the return that could be realised by placing the available funds in some alternative secure, interestpaying investment. This alternative
investment might be certificates of deposit, treasury bills, highgrade bonds, or other investment media. In general, the rate of pure interest applicable to invested funds fluctuates between 8 and 10 percent, depending on the condition of the money market. Another 1 or 2 percent should be included in the ROI as reward for management's seeking out, evaluating, and reaching a decision on where the funds could best be placed. Finally, the risk portion of the business return must be added. This is strictly a judgment factor and can range from 1 to 40 percent or more, depending on the particular business. Typically, a business having average risk should earn from 6 to 10 percent just on the basis of its risk, plus another 8 to 10 percent for pure interest a d 1 to 2 percent allowance for investment management. The average business, then, should earn from 15 to 20 percent, after taxes, averaging about 18% ROI.
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Table 3.7.1 Typical profitability objectives for companies having different levels of risk.
Allowance for Risk level Interest !Management (2) (2) 1 Risk
(2)
Total return
(2)
Typical return (2)
1 1
1
1) very low 2) below average 3) average 4) above average 5) high
810 810 810 810 810
01 12 12 12 12
13 26 610 1220 2040
914 1118 1522 2132 2952
11 15 18 25 41
1 1
I 1
1 +
Another consideration about risk
and
profitability
relationship is that financial decisions affect the value of a firm's stock by influencing both profitability and riskiness of the firm. This relationships are illustrated in Figure 3.7.2.
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Table 3.7.2 Influence of profitability and risk on the value of firm's stock.
CONSTRAINTS Antitrust Product safety Hiring Pollution control and so on 
POLICY DECISIONS Line of business size of firm type of equipment use of debt Liquidity position and so on Risk Value of Firm
An increase in the cash position, for instance, reduces risk, however, since cash is not an earning asset, converting other assets to cash also reduce profitability. Similarly, the use of additional debt raises the rate of return, or the profitability, on the stockholders' net worth, at the same time, more debt means more risk. The financial manager seeks to strike the particular balance between risk and
profitability that will maximise the wealth of the firm's stock holders. Wippern (1966) and Elliott (1972) are
recommended for further study.
3.8 RESTRAINTS IN PROFITABILITY ANALYSIS
1) A single criterion is inadequate for a full evaluation of profitability. 2) The most important estimates in the evaluation of profitability are the predictions of cash flows, with sales
69
volume and sales price being the most critical factors. The possibility of enormous changes in raw materials costs and availability are becoming commonplace in a world that seems to be running short of everything. 3) Operating costs are more critical than investment since the former are repetitive and the latter is made only once. 4) Some restraint should be used when comparing cash flows. Although it is not a definition, cash flow is principally the sum of profit plus depreciation. A high cash flow may merely signify a high depreciation expense, that is, a high cost for wear and tear of equipment caused by frequent replacement. 5) Future improvement in quality control must be anticipated since a competitor may offer a superior product. Reliability of production may be a factor, involving attention to inventories from raw materials. 6) Allocation of overhead costs can have an
important influence on apparent costs and profitability of individual products and services. 7) The influence of government is important. Plants have closed because they were unable to meet for example antipollution requirements. 8) During periods of inflation, there is a
temptation to capitalise expenses. A fixed amount, written off in part of or wholly as a future expenses, will appear to be less at a future time, when the value of the money is less. 9) There are different ideas among researchers
regarding which value to use as denominator of ratio related
70
to
profitability and the possible mathematical pitfalls Recently, some financial
accompanying the use of ratios.
researchers, such as Taffler (1976) and Mao (1976) among others, have advocated the use of average or beginning of year figures rather than the usual yearend figures for items placed in the denominator of profitability and turnover ratios.
The essential ingredients for profitability for a company are as follows: 1) profitability should be judged on a longterm basis. 2) operations must be as efficient as possible, recognising that technology is always in flux. 3) the diffusion effect of peripheral activities should be held to a minimum.
3.9 PROFITABILITY RATIOS
Profitability ratios are intended to indicate whether there has been a satisfactory rate of return for being in business. To achieving this goal, all the profitability ratios which have been studied in chapter 2 are summarised here as a primary ratios for financial analysis.
R 1 R 2 R 3 R 4
NPAT/SALES NPAT/TOTAL ASSETS NPAT/NET WORTH(SHAREHOLDERS' FUND) NPAT/WORKING CAPITAL
71
R = NPAT/TOTAL DEBT(TASF) 5 R = NPAT/CURRENT ASSETS 6 R = NPAT/FIXED ASSETS 7 R = NPAT/(PREF.DIVIDENDS+COMMON DIVIDENDS) 8 R = NPAT/(TOTAL ASSETS  CURRENT LIABILITIES) 9 R = (NPATPREF. DIVIDENDS)/COMMON STOCK 10 R = EARNING BEFORE INTEREST AND TAX(EBIT)/TOTAL ASSETS 11 R = EBIT/SALES 12 = EBIT/NET WORTH(SF) R 13 R = EBIT/(TOTAL LIABILITIES  CURRENT LIABILITIES) 14 R = (EBIT + DEPRECIATION)/NET WORTH(SF) 15 = (EBIT + DEPRE.)/(TOTAL LIABILITIES  CURRENT LIABILITIES) R 16 R = NET PROFIT FOR COMMON/COMMON STOCK AT MARKET VALUE 17 R = EARNING PER SHARE(EPS)/PRICE PER SHARE 18 R = EPS 19 R = SALES/(LONG TERM DEBTS+PREF. STK+COMMON STK) 20 R = SALES/TOTAL ASSETS 21 R = SALES/NET WORTH 22 R = SALES/WORKING CAPITAL 23 R = SALES/FIXED ASSETS 24 R = SALES/CURRENT ASSETS 25 R = SALES/TOTAL DEBT(TASF) 26 R = (SALESVARIABLE COSTS)/EBIT 27 R = DIVIDENDS/NPAT 28 R = DIVIDENDS/NET CASH FLOW(NPAT+DEPRE. +EI) 29 R = DIVIDENDS PER SHARE 30 R = NET PROFIT PER SHARE OF COMMON FOR 2nd B.C/ 31 NPPS OF COMMON FOR 1ST BC R = LOWEST NPADAVERAGE 3 PREVIOUS YEARS OF NPAD/ 32 AVERAGE 3 PREVIOUS YEARS OF NPAD 72
R 33
(DEPRECIATION+TOTAL INTEREST+TOTAL TAX)/(TOTAL CAPITAL)
3.10 MANAGERIAL PERFORMANCE
Sharpe (1963), Radnor, Rubenstein & Ben (1968) and Thornton & Byham (1982) were concerned in their studies with the managerial performance assessment. A study in the USA by Dun and Bradstreet (1973) came to the conclusion that 93 percent of the causes of failure stemmed from, managerial inexperience and incompetence, the rest being 'neglect' 2 percent, 'fraud' 2 percent, 'disaster' 1 percent, and 'unknown' 2 percent, the evidence for 'bad management' was a) Inadequate sales b) Competitive weakness C) Heavy operating expenditure d) Inadequate control of debtors e) Excessive fixed assets f) Inadequate inventory control g) Poor geographical location h) Others 44 percent 24 percent 9 percent 8 percent 4 percent 4 percent 2 percent 4 percent
Argenti (1976) identified five characteristics of bad management: 1) Oneman rule (not by any means necessarily a oneman business) 2) A nonparticipating board of directors 3) An unbalanced team of managers (in the functional and personality senses) 4) A weak finance function
73
5) A company in which the chairman and chief executive are the same person
The consequences of the poor management are: 1) Deficient accountancy information 2) Not responding to changes 3) Overtrading 4) Launching a big project 5) Rising company's gearing
The deficiencies in the accountancy information system relate particularly to inadequate budgetary control, cash flow forecasts and costing system. Because there is no established way of planning for changes, change or failure will be forced on the company. In the last few months before failure, the symptoms of failure become more frequently observable and more severe. The stock market will already have reduced the
price of the company's securities, but even now, Argenti claimed, 'top managers are protesting that all is well, that the embarrassment is temporary or nonexistent'. Argenti quoted Sir Denning Pearson, chairman of Rolls Royce Ltd as saying, seven months before the company's insolvency in 1971, 'the company is in good shape'. Normal dividends are often paid, and the accounts continue to show that things are not as bad as other indicators suggest. By this time, the owners of the company have almost certainly lost their money, and the creditors are well on the way to losing theirs.
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3.11 MANAGEMENT VS RISKINESS OF LOAN
The supply of funds that a lender will advance to a corporation is not unlimited. Rather, the supply is a
function of both the interest rate the lender receives and the riskiness of the loan. The higher the interest rate, the greater the quantity of funds that a lender will advance, on the other hand, the higher the risk exposure, the lower the quantity offered. Both of these variables, the gross interest rate and the riskiness of the loan, are functions of other variables: Gross interest rate is a function of: 1) competitive conditions 2) growth of the markets serviced by the lending institutions 3) monetary and fiscal policy of the notion Riskiness of a loan is the function of: 1) ability of the corporation's management 2) debt/equity
In general, the better the management, the less risky the loan, for the likelihood that the loan will be repaid is greater. As the ratio of debt to equity rises, however, the loan becomes more risky. A company with a low debtequity ratio may still fall into bankruptcy if its liabilities fall due at a time when its assets are unsalable. Nevertheless, we may safely assume that in most cases the smaller the debtequity ratio of any one firm, the less likely it is that the firm will encounter financial difficulty. To summarise this,
75
the risk exposure of a loan (e) can be expressed as a function of both Firm's management ability and its debtequity ratio. e = f(M, LIE) where M  an index of management ability the partial derivatives are
de/dM = f <0 and de/d(L/E) = f >0 1 2 Since f is negative, the risk exposure of a loan will fall as 1 management improves, since f is positive, the risk exposure 2 will rise as debtequity ratio increases.
3.12 MANAGERIAL PERFORMANCE RATIOS
From 1966 to 1978, some studies were undertaken to investigate the usefulness of financial ratios in measuring the managerial performance by Page & Canaway (1966), Prasad (1966), Stokes (1968), Berkwitt (1971), Simons (1974), Jones (1976) and Beer, Dawson & Kauanagh (1978).
Although it may be argued that all ratios in some way help to asses the efficiency of management's actions, there are specific management functions which can be investigated directly by ratios. Frequently referred to as efficiency or activity ratios, they embrace such issues as the time it takes to receive payment from customers, the time taken to pay suppliers, the length of the cash conversion cycle, the
76
turnover of inventory, the cost efficiency of operations, and relative "balance" of debtequity working capitalassets components within the overall structure of financial position. All these ratios are summarised as:
R 34 R
SALES/INVENTORY
SALES/DEBTORS 35 R = SALES/ACCOUNT RECEIVABLES 36 R = SALES/COMMON STOCK AT MARKET PRICE 37 R SALES/AVERAGE ACCOUNT RECEIVABLES 38 R = SALES OF 2nd BUSINESS CYCLE/SALES OF 1st BUSINESS CYCLE 39 R (SALES + CHANG IN INVENTORY)/INVENTORY 40 R INVENTORY/TOTAL ASSETS 41 R INVENTORY/WORKING CAPITAL 42 R INVENTORY/SALES 43 R INVENTORY/CURRENT LIABILITIES 44 R INVENTORY/(TOTAL ASSETS  CURRENT LIABILITIES) 45 R INVENTORY/CURRENT ASSETS 46 R DEBT/WORKING CAPITAL 47 R  CURRENT LIABILITIES/INVENTORY 48 R = CURRENT LIABILITIES/WORKING CAPITAL 49 R  CURRENT LIABILITIES/TOTAL ASSETS 50 R  (TOTAL LIABILITIES + PREF. STOCK)/TOTAL ASSETS 51 R  COMMON DIVIDENDS/COMMON STOCK AT MARKET VALUE 52 R COMMON DIVIDENDS/NET PROFIT FOR COMMON 53 R COMMON DIVIDENDS/NPAT 54 R  COMMON STOCK (BOOK VALUE)/TOTAL CAPITAL 55 COMMON STOCK (BOOK VALUE) /COMMON STOCK (MARKET VALUE) R 56
77
R ... COMMON STOCK/NET WORTH 57 R = FIXED ASSETS/NET WORTH 58 R = FIXED ASSETS/DEBT 59 ... FIXED ASSETS/TOTAL ASSETS R 60 R  FIXED ASSETS/(TOTAL ASSETS  CURRENT LIABILITIES) 61 R =. RECEIVABLES/SALES PER DAY 62 R = RETAINED EARNINGS/TOTAL ASSETS 63 R ... RETAINED EARNINGS/NPAT 64 R ... RETAINED EARNINGS/NET WORTH 65 R = ACCOUNT PAYABLE/PURCHASE PER DAY 66 R ... OPERATING EXPENSES/GROWTH MARGIN 67 R = OPERATING EXPENSES/TOTAL ASSETS 68 R ... (OPERATING EXPENSES+COST OF SALES)/SALES 69 R = COST OF SALES/AVERAGE GOODS INVENTORY 70 R = COST OF SALES/SALES 71 R = DAYS IN PERIOD/INVENTORY TURNOVER 72 R = CASH/CURRENT ASSETS 73 R = NET WORTH/TOTAL ASSETS 74 R  TOTAL INTEREST/TOTAL ASSETS 75 R = TOTAL INTEREST/EBIT 76 R  TOTAL TAX/NPAT 77 R = (PBT+INTEREST CHARGES+LEASE CHARGES)I(INTEREST CHARGES 78 + LEASE) R ... BOOK VALUE PER SHARE 79
78
3.13 OPTIMUM AMOUNT OF CASH
The manager's objective is to maintain sufficient cash on hand or at short call to meet any normally predictable expense without resorting to expensive overdrafts or other costly emergency measures. Ideally, however, he will gauge matters so finely that he never actually has more cash on hand than will be needed, because surplus cash is an idle asset, and as such it incurs an opportunity cost: the cost to the company of what it could earn if invested elsewhere in securities or in longerterm deposits. The extent to which cash is put to
effective use within the business will reflect agreeably in the profit level: the more the better, to put it simply. But there are limits. The loss of liquidity due to maintaining very low cash balances could lead the company into difficulties. The key to the management of cash and of all working capital is therefore a matter of striking a balance between liquidity and profitability. The success of working capital management or cash management depends upon knowledge of the cash flow position of the company.
Bierman (1960), Archer (1966), Wright (1973) and Samuels & Wilkes (1975) developed some models and quantitative
techniques for determination of company cash balance. Samuels and Wilkes(1975) suggested that a decision on the optimum amount of cash a company should hold is a similar question to the decision on the optimum amount of inventory. Let Q Optimum amount of cashlike assets to be obtained from outside sources. 79
D = The amount of cash to be used in the next time period IC= Fixed cost of financial transactions involved in obtaining new funds. k The interest cost of holding cash
D is amount of cash to be used in each of a number of succeeding time periods and Q is the total amount to be raised to provide for this, therefore T = Q/D (no of periods involved)
So The average fixed cost per period will be KIT KD/Q
The second cost, representing the interest lost through holding cashlike assets, has an average cost that increases as the amount of money raised at each attempt increases. The cash on hand at the beginning of the period is the amount raised Q, at the time the next amount of cash is raised, the stock of cash will have fallen to zero and so the average level of cash is 1/2(Q+0) = 1/2(Q) the average cost of carrying cash = (kQ)/2
The average total cost incurred per period in maintaining a certain average level of cash is therefore: C =kQ/2 + KD/Q
As shown in the section on inventories, using differential calculus the optimum value of Q is:
80
= \/(2KD/k)
This analysis has assumed that the amount of cash required during a period is known with certainty. It assumes that, it is possible to forecast the amount that will be required over the period. In reality it may not be possible to predict with certainty the amounts that will be required. There may well be a cost attached to running out of cash. There are also the normal cost of holding cash. In a situation of uncertainty, formulation of an optimum policy involves weighting the costs of carrying funds against the costs of running out of cash. More precisely, where uncertainty exist the usual objective is to minimise 'expected' costs per period of time. Expected Costs (EC) . Expected transactions cost per period + expected holding cost per period + expected shortage cost per period
Where the transactions cost is a known constant K, as
are k(the interest cost of holding 1 pound for one period) and c(the cost of being short of 1 pound for one period) we should expect c>k.
The calculation of expected costs implies that
the
probability distribution of costs are known. It is also assumed to be the same for each time period. Often there is a lag between deciding new funds are required and them materialising. Here the lag is given the symbol L
81
If the expected demand rate is D so the expected cycle length is
EC  Kii + kP 1 where P 1 P 2
+ cP /i 2
the expected number of unit periods of cash stock the expected number of unit periods of cash shortage
Figure 3.13.1 can help to determine the expected number of unit periods of cash stock. Figure 3.13.1
A
Time
R  the 'reorder point'
n
P
1/2TQ + i(Rh)
h  expected leadtime demand  LD D  distribution EH (expected holding cost per period) = i(iT/2+RLE)K/i S =, expected number of shortage EC 
KE/ii + k( l if2+RL17)) + cl(151/&)
82
Which should be minimised witb respect to R. Usually this would involve an enumerative procedure selecting various values of R and drawings from the distribution of D rather than mathematical minimisation.
83
THE MILLER MODEL
The Miller (1975) model has four sets of assumptions.
1.1) The firm has two types of assetcash and
a separately
managed portfolio of liquid assets whose marginal and average yield is u per pound per day.
1.2) transfers between the two asset accounts can take place, at a marginal cost of y per transfer.
1.3) such a transfer takes place instantaneously, there is no leadtime
2)
there is a minimum level below which a firm's bank
balance is not permitted to fall.
3) Let 1/t = some small fraction of working day thus 1(8= one hour. During this time the cash balance will either increase by 'm' pounds with probability p, or decrease by 'm' pounds with probability q = 1p.
4)
It is assumed the firm wishes to minimise its longrun
average cost of managing its cash balance. The cash balance will be allowed to wander freely between an upper and a lower limit. As long as the balance is within these limits no action will be taken, but when the balance reaches the upper limit (h) above the safety level or the lower limit, a transfer will take place between the two asset accounts, to restore the balance to a required level (z) above the safety level.
84
Let E(M) = average daily cash balance E(N) = expected number of portfolio transfers (in either direction)
y = cost per transfer
u = daily rate of interest earned on a portfolio 2 sd = variance of the daily demand for cash
Then cost per day of managing the firm's cash balance over a finite planning horizon of T is E(C) = y[E(N)/T] + u[E(M)]
The objective is to minimise this function  this is, the cost per day. The result is that (starred variables represent optimum values)
2 * 3,/ Z = \ (3ysd t/4u)
*
*
h = 3Z The model obtains a relationship between the average cash holding of the firm and the three explanatory variables of the form
2 M = 413\ 3ysd /4u Where M is the average cash balance the firm wishes to maintain for transaction purposes. The control actions are: (a) When the balance held for transaction purposes falls to 85
*
the safety level, sell securities of amount Z pounds. (b) When the balance held for transaction purposes rises to
*
h above the safety level, buy securities of amount 2Z pounds. Figure 3.13.2 The Miller Model of Optimum Amount of Cash
CRI1 •.....
a)
C.)
g M
H 0
x
_ . 1_ 2z
..0
.4
C.)
m as
h 
PI H • rl 0 1::)
z
Safety leve A B (1
Time At the time A the transaction balance reached zero, so securities to the value of Z pounds were sold. At time B
transaction balance went below the safety level so the securities to the amount of (z+a) pounds were sold. At the
time C the balance exceeded the safety level by L pound, so cash was used to buy securities to the value of 2Z pounds, thereby reducing the transaction balance to Z pounds above the safety level.
MATHEMATICAL PROGRAMMING APPROACH
The mathematical programming technique was developed by Haley (1967), Calman (1968), Rao (1973), and Charnes, Cooper & Miller (1975). Charnes, Cooper & Miller stated that the amount of cash available might be limited by the sales and purchases.
86
purchases.
The amount of cash available at any time balance(inventory) + sales  purchases
opening
Let TP  total profits up to the planning horizon n  the number of periods in the planning horizon P estimated selling price(per ton) in period j
C  estimated purchase price(per ton) in period j
Y  the quantity to be sold in period j (tons)
X  the quantity to be purchased in period j (tons)
B  warehouse capacity (tons) A  initial stock at warehouse (tons) The objective is to maximise:
TP =t13
Y j j
ItCX j=1 j j
subject to i1 
<B A j1 j
i1
(i = 1,2,3,....,n)
j = 1 j Y j=1 j
X <A 3=0 j
(i = 1,2,3,....,n)
X ,Y > 0 j j
(j  1,2,3 ..... ,n)
At any time (i), purchases in the period (X ), shall not
exceed the warehouse capacity initially available (B  A) plus i1 sales up to
i ( k__ Y
j=1 j
) minus previous purchases (
X ). j=1 j
87
for example if i = 2 X <BA+Y +Y  X 1 1 2 2 (buying constraints)
On the other hand the amount available for sale is the initial stock A plus total purchases up to and including the i1 previous period (C: X ) minus total sales up to and including j=1 j i1 the previous j = 1 period ( Y ) j=1 j
for example if i = 3 Y 3 <A+X+XY1 2 1 Y 2 (selling constraints)
M  the initial cash balance 0 M  the minimum cash balance permissible and write i1 7 PY<Mj=1 j j 0
CXj=1 j j
M
(i = 1,2,3,....,n)
Financial constraints require that the value of purchases in a period shall not exceed the excess of the initial cash balance over the requisite minimum cash balance (M M) plus
0
the total value of sales up to and including the previous
period
i1 (=IP Y ) minus the total value of purchases up to j=1 j j
i1 and including the previous period (ZC X ). j=1 j j For example in the third period it is required that C X 33 <MM+PY+PY CX CX 11 0 22 11
22
88
In the above it is being assumed that collection of debts takes one period but allowance can be made for lags in both the collection of debts and the payment of creditors. If it
is assumed that payments are made g periods after purchase, and cash is collected r periods after the sale, then the financial constraints can be written as
C X j=1 jg jg
P Y j=1 jr jr
<M M 0
3.14 LEVERAGE ANALYSIS
The major financial markets available to corporations include corporate bonds, corporate equities, commercial bank loans, and commercial paper. Corporate bonds, equities, and bank loans constitute the most important sources of longterm capital used in financing companies. Bank loans and
commercial paper are employed extensively as sources of relatively shortterm working capital.
Park and Jackson (1984) determined the annual interest cost of a bond as: 1) Current market price 2) Redemption or maturity value 3) Coupon rate or annual interest payment 4) Years to maturity
Given price, coupon rate, and maturity date, the present value can be determined to establish the attractiveness of the bond as an investment. 89
P = M/(1+R) + C[((l+R) 1)/R(1+R) ] Where P = present value M = redemption or maturity value C = annual interest payment determined by the coupon rate R = an appropriate discount rate N = number of years until the bond matures
A 1000 pound bond maturing in 16 years and bearing a 5 percent coupon (yielding 50 pound annually) is, at a 7 percent discount rate, worth
16 P = 1000/(1.07) + 50[(1.07)1]/0.07(1.07) = 339 + 472 = 811
The present value of this bond's redemption value is 339 pound, and the annual interest payments are worth 472 pound at the 7 percent discount rate.
Under these conditions, if the bond is sold for less than 811 pound it will yield(or cost its issuer) more than 72 annually, similarly, if the bond is priced above 811 pound it will yield or cost less than 7% annually over its remaining life.
90
Optimal financial and capital structure was studied by Lintner (1963) and Krouse (1972). Consider a company having the following financial structure. Table 3.14.1 Company's Financial Structure
+ I
1 I 1 PERCENT OF AFTER TAX(a) 'TOTAL CAPITAL I COST (Z)
I
I
I 1 +
WEIGHTED COST (Z)
SHORT TERM DEBT LONG TERM DEBT SHAREHOLDERS' EQUITY
+ 1 1 +
5.0 15.0 80.0
6.0 8.0 10.0
0.30 1.20 8.0
1
+
TOTAL
100.0
9.50
I +
a) Interest paid is deductible from gross income, dividends are not. 1) Shareholders' equity = Capital stock(common+pref) + retained earnings + other long term reserves 2) Cost of debt=average market rate for short term debt = 6% 3) Cost of debt=average market rate for long term debt  8% 4) Overall cost of capital  9.5%
If we change the above capital structure to: Table 3.14.2 Company's Financial Structure
SHORT TERM DEBT LONG TERM DEBT SHAREHOLDERS' EQUITY
10
30 60
6.0 8.0 10.0
.60 2.4 6.0
1 1
1
TOTAL
100.0
9.0
1
The overall cost of capital would drop to 9%. This company obviously would prefer debt to equity financing.
3.15 SOLVENCY RATIOS
In the third category, ratios are used in an attempt to assess the question of whether current debts will be paid on their due dates, and the capability of meeting both the principal and interest payment on longterm obligations. In addition to liquidity aspects, analysts calculate
capitalisation ratios to determine the extent to which a firm is trading on its equity and the resultant financial leverage. Accordingly there is an attempt to assess the financial risk associated with common owners' equity.
R  CURRENT ASSETS/CURRENT LIABILITIES 80 R CURRENT ASSETS/TOTAL ASSETS 81 R  CURRENT ASSETS/SALES 82
92
R = CURRENT ASSETS/NET WORTH 83 R = (CURRENT ASSETS  INVENTORY)/TOTAL ASSETS 84 R = (CURRENT ASSETS  INVENTORY)/SALES 85 R = (CURRENT ASSETS  INVENTORY)/CURRENT LIABILITIES 86 R = CASH/(TOTAL ASSETS  CURRENT LIABILITIES) 87 R = CASH/SALES 88 R = CASH/CURRENT LIABILITIES 89 R = CASH INTERVAL 90 R  CASH FLOW/SALES 91 R = CASH FLOW/TOTAL ASSETS 92 R = CASH FLOW/NET WORTH 93 R = CASH FLOW/CURRENT MATURITIES OF LONG TERM DEBT 94 R = CASH FLOW/CURRENT LIABILITIES 95 R = CASH FLOW PER COMMON SHARE 96 R  CASH FLOW/TOTAL LIABILITIES 97 R = WORKING CAPITAL/INVENTORY 98 R = WORKING CAPITAL/FIXED ASSETS 99 R = WORKING CAPITAL/TOTAL ASSETS 100  WORKING CAPITAL/CASH FLOW R 101 = WORKING CAPITAL/SALES R 102 R = WORKING CAPITAL/NET WORTH 103 R = CURRENT LIABILITIES/TOTAL LIABILITIES(TASF) 104 R = CURRENT LIABILITIES/(CURRENT ASSETS  INVENTORY) 105 R = CURRENT LIABILITIES/NET WORTH(SF) 106 R = CURRENT LIABILITIES/CURRENT ASSETS 107 R = TOTAL LIABILITIES/TOTAL ASSETS 108 = TOTAL LIABILITIES/NET WORTH R 109
93
R 110 R 111 R 112 R 113 R 114 R 115 R 116 R 117 R 118 R 119 R 120 R 121 R 122 R 123 R 124 R 125 R
= TOTAL LIABILITIES/CURRENT ASSETS = NET WORTH/FIXED ASSETS = NET WORTH/TOTAL LIABILITIES = EBIT/INTEREST = EBIT/FIXED CHARGES NO CREDIT INTERVAL = ANNUAL FUNDS FLOW/CURRENT LIABILITIES = REDUCED SALES INTERVAL  REDUCED OPERATIONS INTERVAL DEBITORS/CAPITAL FUNDS = LONG TERM LIABILITIES/(STOCK+SURPLUSINTANGIBLE ASSETS) = DEPRECIATION/TOTAL ASSETS = CREDITS/NET WORTH = BASIC DEFENSIVE INTERVAL = MARKET VALUE OF EQUITY/TOTAL LIABILITIES  MARKET VALUE OF EQUITY/LONG TERM LIABILITIES
= (CASH+MARKET SECURITIESCURRENT LIABILITIES)/PROJECTED 126 DAILY OPERATING EXPENDITURE
3.16 CONCLUSION
An analysis of the literature discussed in Chapter Two reveals that 33 different profitability ratios, 46 different managerial performance ratios and 47 different liquidity ratios have been used as the main variables for financial performance analysis.
The mechanics
of these ratios were discussed and
demonstrated in the preceding chapter. An examination of the
94
literature reveals that the techniques available in the past were wholly inadequate for proper analysis. Also an almost complete lack of theory pointed to the need to develop further both the theory and practice of financial analysis. These aspects of financial analysis and the problems of their application have been discussed in this chapter; particularly, the desirability of a shift from univariate to multivariate financial analysis.
The
three
dimensions
represented by profitability,
managerial and solvency ratios which were discussed in this chapter jointly measure nearly every aspect of a company's performance. This indicates that companies' financial affairs can be effectively controlled by concentrating on these three dimensions only. Considering just one aspect does not mean that a company is necessarily doing very well as a whole. For example if a company is profitable it may not necessarily be performing well as a whole.
At their best, these three categories of financial ratios provide a meaningful and quantitative representation of the results of decisions and the effects of external conditions. They can and do serve as tools for detecting irregularities in managerial behaviour and company performance.
95
CHAPTER 4 METHODOLOGY OF FACTOR ANALYSIS
96
CHAPTER 4: METHODOLOGY OF FACTOR ANALYSIS
Considering all the ratios from three different categories which have been described in Chapter Three, there are 126 different ratios in total. These ratios will comprise the
main source of initial variables which are going to be analysed and investigated throughout this thesis.
In analysing all these ratios in an attempt to arrive at some underlying conclusions there is a need to select the most important and most reliable ratios. In other words, not all of the ratios identified in the three categories are essential for initial analysis, because of correlation between ratios. We should select those ratios, which we use in forming a profile of corporate financial characteristics. Correlation of the various ratios with each other, can be expected to exist simply because ratios use common components as their numerators and their denominators. Because of this
statistical property only a small number of ratios can provide a lots of information. Two or three ratios selected from each category should be sufficient for at east the initial analysis of a firm's financial statements. Undue
concentration of ratios from one category could bias an overall appraisal of a firm's position.
4.1 EXSTAT LIMITATION
EXSTAT is a service provided by Extel Statistical Service
97
Plc of company data in a computer readable form. It covers over 3000 British, other European, Australian and Japanese quoted and unquoted concerns. Information included in EXSTAT for all companies is as reported in the individual company's accounts.
The main problem in using the EXSTAT data in the computer centre at University of Bradford is that not all the financial data have been made available, such as, market value of equity, credit interval, cash interval,operating expenditures, common stock at market value, EPS, price per share, dividend per share, net profit per share, purchase per day, cost of sales and so on.
By eliminating uncomputable ratios then we have the following 86
ratios
left which are the whole battery of ratios
for further analysis.
R = 1 R = 2 R = 3 R = 4 R = 5 R = 6 R = 7 R = 8 R = 9 R 10 R 11
NI/SALES NI/TA NI/SF NI/(CACL) NI/(TASF) NI/CA NI/FA NI/(PD+CD) NI/(TACL) = (NIPD)/0C (PBT+TI)/TA
98
R 12 R 13 R 14 R 15 R 16 R
= (PBT+TI)/SALES = (PBT+TI)/SF = (PBT+TI)/(TLCL) = (PBT+TI+DEPRE)/SF = (PBT+TI+DEPRE)/(TLCL) = SALES/(TLCL)
20 R = SALES/TA 21 R = SALES/SF 22 R  SALES/(CACL) 23 R = SALES/FA 24 R = SALES/CA 25 = SALES/(TASF) R 26  (PD+CD)/NI R 28 R  (PD+CD)/(NI+DEPRE+EI) 29 R  CD/SF 30 = (DEPRE+TI+TT)/(P5+0C+DC) R 33 R = SALES/INVENT 34 R = SALES/DEBTS 35 R = INVENT/TA 41 R = INVENT/(CACL) 42 R = INVENT/SALES 43 R = INVENT/CL 44 R = INVENT/ (TACL) 45 R = INVENT/CA 46 = (TASF)/(CACL) R 47 R = CL/INVENT 48 R  CL/TA 50
99
R = (TA+PS)/TA 51 R = CD/NI 54 R = OC/SF 57 R = FA/SF 58 R = FA/(TASF) 59 R = FA/TA 60 R = RE/TA 63 R = RE/NI 64 R = RE/SF 65 R = CASH/CA 73 R = SF/TA 74 R = TI/TA 75 R = TI/(PBT+TI) 76 R = TT/NI 77 R = CA/CL 80 R = CA/TA 81 R = CA/SALES 82 R = CA/SF 83 R = (CAINVENT)/TA 84 R = (CAINVENT)/SALES 85 R = (CAINVENT)/CL 86 R = CASH/(TACL) 87 R = CASH/SALES 88 R = CASH/CL 89 R = (NI+DEPRE+EI)/SALES 91 R = (NI+DEPRE+EI)/TA 92 R = (NI+DEPRE+EI)/SF 93
100
= (NI+DEPRE+EI)/(TASF) 94 R = (NI+DEPRE+EI)/CL 95 = (CACL)/INVENT R 98 = (CACL)/FA R 99 = (CACL)/TA R 100 (CACL)/(NI+DEPRE+EI) R 101 = (CACL)/SALES R 102 = (CACL)/SF R 103 = CL/(TASF) R 104 = CL/(CAINVENT) R 105 = CL/SF R 106 R = CL/CA 107 R = (TASF)/TA 108 (TASF)/SF R 109 R = (TASF)/CA 110 R = SF/FA 111 R = SF/(TASF) 112 R = (PBT+TI)/TI 113 R DEBITS/SF 119 R = DEPRE/TA 121 R = CREDITS/SF 122 R
One of the best techniques for summarising these ratios is Factor Analysis which extracts a relatively small number of factor constructs that serve as satisfactory substitutes for a much larger number of variables. These factor constructs are themselves variables that may prove to be more useful than the original variables from which they were derived.
101
4.2 FACTOR ANALYSIS
Factor analysis is a technique for analysing the interrelationships of a set of variables using different multivariate procedures. To recognise the interrelationships between the ratios is particularly important in our type of study since multivariate methods have the ability of exploiting the information content of seemingly insignificant ratios on an univariate basis (Cooly & Lohnes, 1962, Altman, 1969).
The earliest studies in factor analysis was in Psychology by Burts & Baks (1947), Thomson (1951), Harley & Cattel (1962), Hendrickson & White (1964) and Turcker, Koopman & Linn (1969). These studies were based upon a theory of general
intelligence whereby, in a battery of intellectual activity tests there exists a factor that is measured by all the tests. Then it was developed rapidly to investigate the interrelationships among multivariate data.
In some scientific fields the variables are less precisely defined, there is not so much agreement among scientists concerning the interrelationship between variables.
Factor analysis is increasingly being used in these less developed sciences. Factor analytic methods can help
scientists to define their variables more precisely, and decide which variables they should study and relate to each other in the attempt to develop the knowledge of their science to a higher level. Factor analytic methods can also help
102
these scientists to gain a better understanding of the complex and poorly defined interrelationships among a large number of imprecisely measured variables.
MAJOR STEPS IN FACTOR ANALYSIS
Comrey (1973) classified factor analysis into five major steps as follows: 1) Selecting the ratios. 2) Computing the matrix of correlations among the ratios. 3) Extracting the unrotated factors. 4) Rotating the factors. 5) Interpreting the rotated factor matrix.
When the correlation matrix has substantial correlation coefficients in it, this indicates that the ratios involved are related to each other, or overlap in what they measure, just as weight, for example, is related to height. On average, tall people are heavier and short people are lighter, giving a correlation between height and weight in the neighbourhood of .60. With a large number of ratios, of which many can be highly correlated it is difficult to identify their interrelationships. Factor analysis provides a way of thinking about these interrelationships by positing the existence of underlying "factors" or "factor constructs" that account for the value appearing in the matrix of intercorrelations among these ratios. For example, a "factor" of "Bigness" could be used to account for the correlation
103
between height and weight. Both height and weight would be substantially correlated with the factor of Bigness. The correlation between height and weight would be accounted for by the fact that they both share a relationship to the hypothetical factor of bigness. For further information see Maxwell (1961), Joreskog (1963), Horst (1965), Mattsson, Olsson & Rosen (1966), Guertin & Bailey (1970), Lawley & Maxwell (1971) and Comrey (1973).
4.3 CORRELATION COEFFICIENTS
Factor analysis is based on the assumption that there are a number of general factors which cause the different relations between the ratios to arise. Such interdependence can be
regarded as a kind of basic pattern of interrelations between the ratios in question. As Schilderinck (1977) defined the aim of factor analysis is to group by means of a kind of transformation the unarranged empirical data of the ratios under examination in such a way that: a) A smaller whole is obtained from the original ratios, whereby all the information given is reproduced in summarised form. b) Factors are obtained which each produce a separate pattern of motion or relation between the ratios. C) The pattern of motion can be interpreted logically.
In general, factor analysis does not begin with the
104
original observations of the ratios. It sets about normalising them in a certain way in order to make a mutual comparison possible. Normalization is done by expressing the deviations from the original observations with regard to their arithmetical mean and their standard deviations. Some researchers such as Afifi (1973) and Bartlett (1937) have developed several tests for multivariate normality, but most of them are difficult to implement.
If the number of observations ranges from 1 to T and the number of ratios from 1 to n, and Zi represents a ratio for which the observations have been normalised, then the following formula is obtained:
Z it Where
x /Sx i it
x
it
= X it
 X i
(i=1,2,3,...,n, t=1,2,3 ....
. ,T)
Tx
i t=1 it
IT
Sx =
= \//k1 (X 1 t=1 it

2 /T 2 X ) /T = \/ x /T t=1 it i
The ratios, normalised satisfy therefore the conditions: T _ Z =Z IT ===x /TSx =(Z=X TX )/TSx =(TR TX )/TSx =0 i i i i t=1 it i i t=1 it t=1 it 2 S z T 2 Z /T i t=1 it 2 2 2 /TS x = S x IS x = 1 i t=1 it T 2
=Z:x
(i=1,2,3,..,n)
Herewith all the ratios are expressed in the same, uniform
105
way and made mutually comparable. The actual normalization occurs not for each ratio individually but by calculating the correlation matrix of all ratios together.
The simple correlation coefficient between two ratios equals the sum of the products of their corresponding observations, divided by the number of
normalised observations.
T 2 T 2 C x Sz z = Z /T= Z:x x /TSx Sx ===x x / V/ :x i k t=1 it kt t=1 it t=1 kt i k t=1 it kt t=1 it kt
C2
Sz z =r i k ik Which equals the simple correlation coefficient between the ratios X and X . If i=k, then the variance of Z is
obtained, which equals one, thus 2 T S z ===Z Z /T i t=1 it it T 2 2 2 2 x /TS x = S x /S x = 1 = r t=1 it i i i
=Z:
If now, the product of the matrices of the normalised observations of the ratios under examination is determined, we get:
Z,....,Z 11 n1
Z=Z Z
Z
t=1 it it
t=1 it nt
Z,....,Z 1T nT
:=Z Z t=i nt it
,...., Z
Z ti nt nt
106
ITr
1
, 11
,Tr
I
1r
1
, 11
,r
1
1n1
.
1
1= T 1
1Tr I nl
„Tr 1 1r , nnl
ml
1n1 I= TR ,r 1 nn1
The matrix of simple correlation coefficients is equal to: R ZZ//T
As a consequence of (SZ Z =r ) the matrix R is to be regarded i k ik as a normalised matrix of variance and covariances. As a
2 consequence of (S z = 1 = r ) the element of the main diagonal i ii equal one.
Ratios should not be based only on measures of central tendency and it is necessary to consider not only the extent and direction of the deviation from the measure of central tendency but also the dispersion and shape of the distribution from which the measure of central tendency was calculated (volatile).
The following ratios are eliminated from the whole battery because of their volatile standard deviation as shown in Table 4.3.1. These standard deviations have been calculated from for about 600 different companies throughout UR. For example the minimum standard deviation for R4 in 1985 is .86 and its maximum value for 1973 is 148.
107
TABLE 4.3.1: RATIOS WITH VOLATILE STANDARD DEVIATIONS
+
II11971 'RATIOS
R4 R8 R10 R20 R22 R23 R24 R28 R33 R34 R35 R42 R47 R48 R54 R64 R76 R99 R101 R105 R106 R109 R113 3.7 293 3 4.1 5.3 67 23 404 3.7 49 12 8 29 13 356 .41 .7 1.7 3.5 17 1.3 1.6 385
1
1
1
1
1
1
1
1
1
1
1
1 1 +
172 173 174 175 176 177 178 179 180 181 182 183 184 185
+
4.3 148 9.4 2.8 53 3.8 3.4 134 66 12
5.8 3.1 6.3 1.9 10 96 5.3 6.1 23 62 5 12 283 13
2.1 5.413.81.861 88 65 142 126 1 22 13 115 1.581 5.512.612.11 5.515.712.71 116157 193
1
2.5 2.8 3.8 3.1 6.6 4.7 3.5 11 4.7 79 139 64 14 .9 18 3.2 3
3.9 3.3 2.7 2.9 3.1 4.2 26 5 4.1 3.9 3.9 5.1 26 48 63 159 65
4.5 4.7 5.6 249 44 13 10 50 9
378 46 10
9.1 8.5 8.4 8.7 12 2
25 112 15•71 .761.8911.51 12 110 1.751 16 154 16.31 24 123 121
1
.67 1.7 .45 11
.61 .29 1.3 100 3.3 4 34 25 5.2 12 17 34 16 33
3.1 3.9 4.7 3.8 4.2 24 55 20 58 13 31 28 27 22 30 19 51 26
7.9 8.1 11 15 56 16 25 14 18
170 47 43 17
6.1 120 39 27 14 81 12
5.3 20 27 17
5.3 17 23 51
8.8 21 124 111 22 48 124 129
1
109 25 13 15
1
9.3 3.2 3.6 4.4 5.5 6.5133 11.61
.68 .66 .98 .43 10 .91 .7 3.6 .46 33
.55 .28 1.2 100 3.2 1.9 .711.8411.21 .83 .3 1.3 1.5 3.8 2.1 .781.8911.61
.58 .51 .71 .43 12 1.2 18 37 2
1.1 1.4 3.3 1.6 6.2 8.2 1.415.41.551
1.2 1.9 1.8 1.5 1.7 1.6 1.8 1.8 8.3 48 158 11.31 33 14 7.5 5.9 34 215 73 22 9.8 67 11 15 58 29 18 19 15 125 18.51 61 119 127
1
5.6 16 37 84
.97 22 1.3 23
1.9 1.4 1.9 1.5 .94 3.9 1.3 1.6 10 2.5 1.6 2.2 1.8 1.3 10 1.6 1.9 10
1.711.41.731 1.912.11 1
1
166 404 106 267 173 185 217 183 184 145 116 81 168 145
1
+
+
108
When all the interdependence correlation between ratios have been calculated and the correlation coefficient matrix has been obtained, then the next step is to identify those ratios with high correlations. These ratios can be used as surrogate for each other and therefore many of them can be eliminated. For example as shown on table 4.3.2, R1 has the
highest correlation with R2,R6, R11,R12,R63,R91,R94 and R95, it means that all these ratios are nearly identical with R1 and they all contain almost the same information. Therefore
they can be replaced by each other and we can keep R1 and eliminate the others from the whole battery and from the model. By the same way we can eliminate the other identical
ratios and come up finally with 27 ratios which are almost independent to each other and have the lowest correlation.
109
TABLE 4.3.2: RATIOS WITH THE HIGHEST CORRELATION COEFFICIENT
+ + 1 1 1 1 1 RATIOS !YEAR 1N0 COI R2 R6 R11 I R12 I R91 R63 IR95I R94 1 + + 1 1 R1 11971 339 .79 I .62 I .78 .98 .92 I .67 .76 I .67 1 1 1 R1 11972 j 607 II .71 I .14 I .26 I .94 I .33 I .54 I .47 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 +
R1 R1 R1 R1 R1 R1 R1 R1 R1 R1 R1 R1 R1 11973 I 562 III 11974 I 561 I .68 .49 I .96 I .93 I .46 I .62 I .52 1
.79 I .56 I .90 I .91 I .62 I .72 I .58 1 .65 .92 .88 J .69 .75 I .64 1
11975 I544I .75 I .73
11976 I 541 I .77 I .71 I .69 11977 I 574
.94 I .85 I .71 I .72 I .65 1 .59 I .72 I .70 1 .62 1
.66 I .65 I .56 I .94 J .87
11978 I 548 I .67 I .66 I •57 I .91 11979 11980 11981 I
.89 I .60 I .63
517 I .72 I .28 I .65 I .92 I .91 I .64 I .72 I .69 1 490 .82 I .79 I .77 I .93 .87 I
I .74
.71 1
I .79 I .76 I .74 I .93 I .90 I .74 I .70 I .68 1
.81 .81 I .76 I .92 .88 I .66 I .66 .64 1 .65 1
11982 I 496
11983 I 509 I .72
.75 I .67 I .93 I .89 I .69 I .67
11984 I493I .77 I .80 I .70 I .91 11985 I 142 I .65 .93
.89 I .71 I .65 I .60 1 .68 1
.54 I .91 I .89 J .62 I .80
1
+
The remaining ratios are as follows:
R = NI/SALES 1 R = NI/SF
2 R = NI/(TASF) 5 R = NI/FA
7 R = SALES/(TASF) 26
110
R
 (PD+CD)/(NI+DEPRE+EI) 29 R  CD/ SF 30  (DEPRE+TI+TT)/(PS+0C+DC) R 33 R = INVENT/CA 46 R  CL/TA 50 = (TL+PS)/TA R 51 R  OC/SF 57 R  FA/SF 58 = FA/(TASF) R 59 . CASH/CA R 73 R = TI/TA 75 R = TT/NI 77 R = CA/CL 80 R  CA/SALES 82 R  CA/SF 83 R  (CAINVENT)/TA 84 R  CASH! (TACL) 87 R = (CACL)/INVENT 98 = (CACL)/(NI+DEPRE+EI) R 101  (CACL)/SF R 103  CL/(CAINVENT) R 105 = DEPRE/TA R 121
4.4 THE MODEL OF FACTOR ANALYSIS
Factor analysis is based specifically on intercorrelations. It examines the effect of the general factors which are present in more than one ratio at the same time.
111
According to Schilderinck (1977), the factors which the ratios can influence will be classified into three categories.
a) Common factors. F (j=1,2,3,
,n) factors which
i
influence several ratios Z (i=1,2 ....
i
. ,n)
simultaneously.
b) Specific factors. S (i=1,2,3,
i
,n) factors
which influence only one ratio at a time.
C) Error
factors. e (1=1,2,3,
i
,n) factors to
which errors in the observation material are related.
There are two differences between the common factor and the other two categories of factors.
1) a common factor affects several ratios Z (i=1,2
i
n) at
the same time  thereby producing one special pattern of relations among the ratios a specific and an error factor affect only one ratio at the same time. 2) a ratio Z can at the same time be dependent on more than one
i
common factor, but only on one specific and one error factor.
Taking account of the three categories of factors the model of factor analysis expressed in normalised observations Z of it ratio Z  may be written as follows:
i
Z it
+aF +....+aF +bS+C e = aF il it i2 2t im mt i it i it
(5)
112
(i = 1,2,3, where a ij
,n), (t = 1,2,3,
,T)
(j=1,2,3 ,....,m), b and c are the coefficients
corresponding to the three separate categories of factors. The factor f , S and e can be regarded as the new, theoretical
i
i
mutually satisfy the
ratios. There are assumed to be normalised and independent of each other so that they must conditions:
T
j 2 s f j t=1 T
f it
/T = 0
2 f /T = 1 jt
a
t=1
sf f = )/T = 0 (f f j j' t=1 jt j't
i b=
2 Ss
=s /T = 0 t=1 it 2 T =s /T = 1 t=1 it i
Ss s i
=
t=1
(s
)/T = 0 s it i't
e IT = 0 E(e ) = t=1 it i T 2 e IT = 1 Var(e ) = t=1 it i
( e e )/T = 0 Cov(e e ) = t=1 it i't i
113
Sf s = E(f s )/T = 0 j i t=1 jt it
Sf e (f e )/T = 0 t=1 jt it i i Ss e ii :•(s e )/T = 0 t=1 it it
2 From (SZ = 1 =r ), considering (Z =af +af+....+ i ii it lilt i2 2t af +bs +ce) and (a), (b), (c), (d), it follows that im mt i it i it for finite sums 2
S Z =Z:(Z
Z )/T =1/T(Z:(a f +a f +...+ a f + b s + t=1 ii it i2 2t im mt i it i t=1 it it
2 T 2 2 T 2 2 m2 T2 C e ) ) =a (==f /T) + b ( S /T) + c (==e /T) + i t=1 it i t=1 it j=1 ij t=1 jt i it m m a a (Z:f f /T) + 2b Z:a (==f s /T) 2Z: i j=1 ij t=1 jt it j1 j 1 =1 ij ij' t=1 it j't + 2c Z:a (Z:f e /T) + 2b c (17. e e /T) = i i t=1 it it i j=1 ij t=1 jt it 2 2 +b +c i i j=1 ij m2 (i=1,2,3 ,....,n)
so that 2 Sz 2 2 2 h +b +c =
i
i
where 2 a) h represents that part of the total variance which
114
associates with the variance of other ratios. This part of the variance belonging to the common factors is known as common variance or communality. 2 b) b is the part of the total variance, which shows no the
association with the variance of other ratios,
this part
belonging to the specific factor is the specific variance uniqueness.
or
2 c) c is the part of the total variance which is due to
errors in the observation material or to the ratios relevant to the examination which have not been taken into
consideration, this is called disturbance term or error factor.
In factor analysis, little attention is paid to specific and error factors so that the applied factor analysis is
concerned exclusively with common factors and the corresponding coefficients, which indicate the degree to which Z is related to the factor f .
However, the neglect of specific or errors in applied factor analysis is not always justified. The presence of a variable with a high specific or error variance component can be an indication that this variable is probably related to variables not yet involved in the study.
If, however, the variable with the high specific or error variance component proves to be important, then other, new, variables should be added.
115
As mentioned previously, factor analysis aims in fact at the analysis of the common factors f and their corresponding
coefficients, which we call factor loading. working model of factor analysis expressed observation is therefore: Z a f +a f+ it il it i2 2t + a f im mt
The practical in normalised
(i1,2,3,. ..,n)
Where b and c of model (5) are assumed to be zero.
In matrix notation this is Z = AF or in detail
IZ I 11 1 , ,Z 1
1TI 1
la 11
„a
(I
f
,
,f
I
iml „a
I 11
iTI
1
1=1 1
11
12 , nl
1
,
Z
la nTI nl
1
lif , nmll ml
If
1
mT1
Where Z = The matrix of the normalised ratios Z (i=1,..,n, t=1,..,T) it A = The matrix of factor loadings a ij F = The matrix of factors f with elements f (j=1,..,m,t=1,..,T) (i=1,.. ,n, j=1,..,m)
Substituting (Z=AF) in (R=ZZ / /T) gives us the relation between the correlation matrix R of the normalised ratios Z it and the matrix of the factor loadings A. R = ZZ 1 /T = AF(AF) / /T = A(FF / /T)A 1 = AA/
The
product
FF I /T is a matrix of the correlation
coefficients between the factors themselves. As these factors are also in normalised form the productmatrix is:
116
FF 1 = Z:f f l = TRf fi t=1 jt jt According to condition (a) the factors f are not correlated
thus Rf f i becomes an identity matrix so that
ii
FF / TI and FF / /T I
Equation (R=AA 1 ) shows that the product of AA / again reproduces a correlation matrix.
4.5 FACTOR EXTRACTION
After the correlation matrix R has been computed, the next step in the factor analysis is to determine how many factor constructs are needed to account for the pattern of values found in R. This is done through a process called 'factor
extraction' which constitutes the third major step in a factor analysis. This process involves a numerical procedure that
uses the coefficients in the entire R matrix to produce
a
column of coefficients relating the ratios included in the factor analysis to a hypothetical factor construct variable. The procedure usually followed is to "extract" factors from the correlation matrix R until there is no appreciable variance left, that is, until the "residual" correlations are all so close to zero that they are presumed to be of negligible importance. There are many methods of extracting a factor but they all end up with a column of numbers, one for each ratio, that represent the "loading" of the ratios on that
117
factor. These loadings represent the extent to which the ratios are related to the hypothetical factor. For most factor extraction methods, these loadings may be thought of as correlations between the ratios and the factor. The most well known factor extraction are Thurston's (1947) centroid method, Hotelling's (1933) iterative procedure and more recently by Francis (1965) known as Q. R. method. If a ratio has an extracted factor loading of .7 on the factor, then its correlation is to the extent of .7 with that hypothetical factor construct. Another ratio might have a substantial
negative loading on the factor, indicating that it is negatively correlated with the factor construct.
To reproduce the R matrix exactly with real data ordinarily requires as many factors as there are data variables. It is
usually possible, however, to reproduce approximately the R matrix with AA' where A has a number of common factors m such that m is considerably smaller than n, the number of ratios in R. For example .16 .32 .28 .24 .32 .64 .56 .48 .28 .56 .49 .42 .24 .48 .42 .36 = .41 .81x[.4 .8 .7 .6] •71 .61 A
Methods of factor extraction, designed to produce the A matrix, usually seek to account for as much of the total extracted variance as possible on each successive extracted factor. That is, a factor is sought at each step for which
the sum of squares of the factor loadings is as large as possible. 118
The total variance extracted in a factor analysis is represented by the sum of the computed communalities m2 that is
il
where m is the number of common factors. All the data ij
variable variance is not ordinarily extracted. In our case each ratio has a variance of 1, so the total ratios variance that
could theoretically be extracted is n x 1, or n, where n is the n2 a represent the sum of i=1 ik
number of ratios. If
squares of
loading on factor k, the proportion of the total
extracted
variance due to factor k is obtained by dividing this total by the sum of the communalities.
Since n is the total variance for all ratios combined, that is, the sum of the diagonal elements of R, then dividing the sum of the communalities by n gives the proportion of the total variance that is accounted for by common factors.
After the first factor has been determined,
its
contribution to reproducing the R matrix is removed from R by the operation R RA A i , where A represents the first factor 1 11 1 vector (a ,a ,....,a ) and A l is the transpose of A , R is 11 21 1 1 1 n1 called the residual matrix after extraction of factor 1 the first residual matrix. or
It contains the residual
correlations after the contribution to those correlations by factor 1 has been removed. If one factor is insufficient to
119
reproduce the correlations in R, then R will 1 values which are substantially different from zero.
have same
If this
is the case, another factor will be extracted from the first residual matrix by the equation R =R A A l . Thus, the second 2 1 22 extracted factor is removed from the first factor residuals.
In general, this process is continued, extracting the mth factor from the residuals left after taking out factor m1, until the residuals are too small to yield another factor. Since at each step as much variance is extracted as possible, the successive factors become smaller and smaller from first to last as shown by the sum of squares of the loadings in the successive column of A. This initial A matrix does not These factors
represent the final factor solution, however.
are "rotated" from their original positions by methods which are explained in the following section.
4.6 FACTOR ROTATION
Factor analysis in general and factor extraction methods in particular do not provide a unique solution to the matrix equation R AA'. One of the reasons is that the R matrix is only approximately reproduced in practice and experimenters may differ on how closely they feel they must approximate R. This will lead to their using different numbers of factors. Also, different methods of determining A may give slightly different results. An even more important reason for lack of unique solutions, however, is the fact that even for A
120
matrices of the same number of factors, there are infinitely many different A matrices which will reproduce the R matrix equally well. Comrey (1973) considered the following:
a 11 a
a 12 a sin a cos a
1 I= I
V
v 11 12 v 21 22 v 31 32 v 41 V 42
'cos a 21 22 xl a a 1sin a 31 32 a a 41 42 A
V V V
The schematic matrix operation may be expressed as a matrix equation
If RAA I , then it is also true that R=VV • since if we transpose the product AV, it may be rewritten as (AV) 1 =V 1
Since the transpose of a product is the product of transpose in reverse order, then  V/ VV 1 = A
A Al Ai
But ISM, included in the middle of the matrix product gives an identity matrix, as follows: cos a sin a
1
xlcos a sin al isin a cos al
=
11 01
10 11
sin a cos a
The reason for this is that the diagonal terms of the product
121
2 2 matrix are equal to cos a+sin a, which equals 1 for all 'a' and the offdiagonal elements are equal to sin a cos a sin a cos a which equals zero. As a result the above equation simplifies to R = AA'
Since multiplying by an identity matrix does not alter the matrix, that is AIA I = AA'
As long as the matrix is of such a form that ACV= I, then A A will reproduce the R matrix as well as A itself. Since the value of 'a' is not specified, this means that there are as many "matrices that will do this as there are value of 'a'.
This particular A matrix was of size 2 x 2, or order 2, because only two factors were involved in the A matrix. If there had been three factors the A matrix, the
A
matrix
required would be of size 3 x 3. In general, if there are m factors in the A matrix, the
"matrix will be of size m x m.
Any such (\matrix must meet the following requirements. 1) the sums of squares of the rows must equal 1 2) the sums of squares of the co umn must equal 1 3) the inner product of one row by another row must equal zero for all pairs of non identical rows 4) the inner product of one column by another column must equal zero for all pairs of nonidentical columns.
If these conditions are met, then An , . I = CV A.
If
122
these conditions are not met, then AA' is not equal to the identity matrix and A A will not substitute for A in reproducing the R matrix in the same way that A will. The values in a given column of A will be different from those of A itself. involved. This means that different constructs are
Matrix A represents one set of constructs for
accounting for the data. Matrix A A represents a different set of constructs which account for the data equally well in the mathematical sense that both reproduce the R matrix equally well. The rotational process in factor analysis
involves finding a matrix A such that AV will represent an optimum set of constructs for scientific purposes. "Since what is optimum for one investigator may not be optimum for another, this particular phase of the factor analytic process provides a fertile source of differences among investigators in the way they view the data. But, just as the artist, the engineer,
the geologist, and the farmer may all describe a given piece of real estate accurately in very different ways, so can various transformations of 'A' provide equally accurate but different
descriptions of a body of data."
With the advent of high speed computers analytical solutions for the rotation problem were made feasible. The Quartimaxtype methods were firstly developed by Saunders (1953) in which the focus was on simplifying the rows of the pattern matrix A. Each variable would have high loadings on the fewest possible factors and zero or close to zero loading
123
on the others. Several other methods were suggested by Mulaik (1972) involving oblique as well as orthogonal rotation.
4.7 THE KAISER VARIMAX METHOD
The Varimax (1959) method is based on the idea that the interpretable factor has high and low but few intermediatesized loadings. Such a factor would have a large variance of the squared loadings since the values are maximally spread out. Using the square of the formula for the standard
deviation, the variance of the squared loadings on factor j may be symbolised as follows:
2 n 2 2 2 n 2 2 Sd = 1/nZ:(a )  1/n (==a ) i=1 ij i=1 ij
The variance should be large for factors, so an orthogonal solution is sought where V is a maximum, V being defined as follows:
V =
m 2 Sd j=1 j
In practice, V is not maximised in one operation. Rather factors are rotated with each other systematically, two at
a
2 2 time in all possible pairs, each time maximising Sd +Sd . After i j each factor has been rotated with each of the other factors,
completing a cycle, V is computed, and another cycle is begun.
124
These cycles are repeated until V fails to get any larger. The fundamental problem, then, is to find an orthogonal
transformation matrix A that will rotate two factors such that 2 2 Sd +Sd for the rotated factors will be
as large as possible.
i
j
Consider the following: x x x
y
11
X 'cos asin al x I 1= 'sin a cos al
y
22
y
33
x n
y
n V1 A
Y ii X Y 22 X Y 33 . . X Y n n V2
Where V1 is a matrix of factor loadings to be rotated to 2 2 maximise Sd + Sd, V2 is the matrix of factor loadings for which
2 2 Sd +Sd is a maximum, and A is the orthogonal transformation ii matrix that will accomplish this desired rotation. in V1 are known. The values in V2 are not. The values The values in V2,
however, are functions of the angle 'a' and the values in V1 as follows: X = x cos a + y sin a
Y = x sin a + y cos a
2 2 2 2 tan 4a = 2[n::(x  y )(2xy)  7_1(x  y ) 2 22 2 22 2 6::[(x  y )  ( 2xY) ]}  {[:— ( x  y )]
( 2xy)]/n
2 [(2xY)] }
The value of 'a' must chosen such that the above equation
125
is maximised. To ensure that the value of 'a' gives a maximum rather than a minimum or a point of inflection, however, requires that the second derivative of above equation with respect to 'a' shall be negative when evaluated at 'a'. The angle of rotation that will accomplish this result may be determined as follows: tan 4a = sin 4a/cos 4a = num/denom
The angle 4a will be in the first quadrant if both numerator and denominator of above equation are positive, and the angle of rotation will be 'a' itself. If both numerator and denominator are negative, the tangent will still be positive but the required angle of rotation is 1/4(1804a) = (45a)
Since the sin and cos are both negative in the third quadrant. If the numerator is negative and the denominator is positive, the angle 4a will be in the fourth quadrant and the angle of rotation will be a. Finally, if the numerator of the above equation is positive and the denominator is negative, 4a will be in the second quadrant and the angle of rotation will be 1/4(1804a) = (45a)
If we assume that:
2 2 A  (x  y ) 2 2 2 B = [(x  y )] C = 2xy 126
2 D = (2xy) then we can provide Table 4.7.1 as follow Table 4.7.1 varimax rotation of two(x,y) factors
A
AC
A D
1
.578 .531
.562 .344
.0182 .1636 .2939 .8267
.6497 .3653
.0003 .0268
.4221 .1334 .3362 .5483
.0118 .0598 .1704 .2509
.4218 .1066 .2498 .4251
1 1
.687 .422 .765 .484
.5798 .0864 .7405 .1232
1
1
67 1.8 26 7 1.30531.2367 11.440
.3587
I
1.2033
1
Tan 4a = 2[4(.3587)(.8267)(.3053)]/4((1.2033)}{(.8267) (.3053) } = .47374
The absolute value of tan 4a is .47374 giving an angle of 25 2 / for 4a. The angle 'a' is 6 20'. With a negative a denominator, the angle of rotation will be (45  a) or 38 41/ 0 which is rounded(39) numerator and denominator negative, the transformation matrix is as follows: .578 .56201 .531 .34401 1.7771 .62931 1= l x 1 .687 .4221 1.629 .77711 .765 .4841 .10 .80 .20 .60 .80 .10 .90 .11
0 ,
Where Cos 39 = .7771 and Sin 39 = .6293
0
The varimax rotation tends to possess invariance property. This fact is pointed out by Harman (1970) when he states that, although varimax factors do not have a greater explanatory meaning than those obtained from other methods, those:
"obtained in a sample will have a greater likelihood of portraying the universe of varimax factors".
So in our case, if we want to analyse and verify the remaining ratios by factor analysis, and to find out the most wanted and the most significant ratios among the whole 27 ratios, we should compute their Varimax rotated factors. This has been done by using the Fortran computer language tother with the Statistical Package for Social Sciences (SPSS).The following tables show the highest rotated factors for each ratio.
128
TABLE 4.7.2 RATIOS WITH THE HIGHEST VARIMAX ROTATED FACTORS AFTER ROTATION WITH KAISER NORMALIZATION
1
1
I
I
I
I
I
I
I
1
I
'RATIOS
11971 172 173
I
174
175
176
177 178
179
180
181 182 183
184
185
1
I
I
I
I
I
I
I
I
I
I
R1 R2 R5 R7 R26 R29 R30 R33 R46 R50 R51 R57 R58 R59 R73 R75 R77 R80 R82 R83 R84 R87 R98
I I
.84 .76
.641.481.7 1.811.751.851.741.851.911.831.781•721•921•951 .771.91.841.91.61.81.71.991.91.91.71.711.791.791 1.7 1.511.8 1.811.861.731.781.811.881.851•931•881•681.691
I
.7 .76 .9 •79 .47
1
.431.711.431.601.601.321.291.341.351.591.3 1.791.881.651 .811.841.831.8 1.851.741.831.831.831.841.861.681.761.71 1.691.611.921.551
I
J I
I.99L 6 1.651.981•771.711.831.081.311.8 .651.881.8
1•431.5 1.731.731.351.461.411.791.451.361.821
.741.31.341.331.611.481.461.081.121.121.081.131.171.771 1.91.81.81.7 1.81.81.71.711.61.61.8 1.861.781.8 1.841.891.9 1.8 1.81.91
.9 .84 .3 .5 .6
 .8
1
1.941.741.891.911.811•871.831•971 1.21.21 1.351.61
1
1.31.21.21.21.21.21.111.141.21.21.11.1 1•31•9 1.21.731.821.791.681.91.811.881.741.5
1
1
1.61.971.91.71.811•561.591.81.721.771.951.61.861.71 1.71.81.7I51.817171.61.51.81.71.51.61.81 1.791.881.881.891.891.851.851.851.821.851.851.871.861.941 1.331.791.41.41•41.41•441.451
I
1
.52
1
.41 1.371•351.31.41.51.3 .17 .79 .6 .66 .71 .93 .35
1
1.241.11.11.11.111.191.3 .131.091.11.171.051.211.291 1.821.871.951.81.721.7 1•761.8 1.651.6 1.721.551.931.831 1.721.641.431.461•591
1
1
1.71.71.71.811.71.61.51.51.6
1
1.841.991.571.571.511.631.671.831.831.551.971.891.881.771 1.721.8 1.791.71.761.821.871.81.871.861.
1
71
.8 1
.7
1.691
1
1.881.831.9 1.281.3
1.891.861.821.821.851.831.821.8 2 1
.89 1
.9
1.91(
1
1.281.661.321.311.351.31.331.321.221.71.281.651
129
1
R101 R103 R105 R121
1
.74 1.971.471.041.941.71.441.6 1.231.251.8 1.741.351.
1.411
1
1
.83 1.791.91.651.7 1.711.831.831.981.761.811.91.761.931.881 .6 1.51.6 1.61.761.51.51.41.621.41.51.651.481.51.61 .3 1.31.51.31.41.41.251.41.41.41.31.31.41.511.41
1 1 1 1 1 1 1 I 1 1 1 1
1
1
1
1
1
1
If we assume that A = 1.00  .90 B = .90  .80 C = .80  .70 D  .70  .60 E  .60  .50 F= .50 .00
Then we can illustrate the above table as follow
Table 4.7.3 Transforming the Table 4.7.2
+
1 1 1 1 1 1 1 1 1 1 1 1 'RATIOS 11971 172 173 174 175 176 177 178 179 180 181 182 183 184 185
I I
+
R1 R2 R5 R7 1 1 I 11111111 1 BIC BIA BIC FICIBIC I B ID BIC AIA BIC AIBIAID I C IC I B IC EIBIBIB CIFIDID BIB BIB CIB FIF CIB BIB FIF BIB BIA EIF B B C B F CIAIA CIBB BICC BIAD D CC
I C IF
R26ICIB
PAl DID III C I B FIFI B R30 R33 R46 I BID I AIB F1C A FIF FIE I CIC I FIF I F FID FIF FIF CID CIA F F F
D lAPE FIFB FIFC BA
BBB
CIBIBIC
DIBIB
R50 I B I BBB lBIAIAIA R51 F FFF FIFIFIF
AIBIB I BA F FIF FF
R57 I E IFAFICIBBIDABBCEFD R58 R59 R73 R75 R77 R80 R82 R83 R84 R87 R98 R101 I I I I D B E F F DABICIBEIDBCCADBC D B CIE1B C DIE E DID EDD
I B I ABIBIA F F F F FIFIE FIFIF
B I BIB I B I BIB I B I BA F F FIB FIFIF F F FIF FIF
FIFIFIFIF
BIB I B IIICI CI C1BID IDI C I E IAIB DIC D C A F C C CIBIC E EIEID CID FIFD
IB I AIEIEIE I DIDIBIB I EIA I AIAB IC BIBICIC BIBIBIBIBICIBICC
I BIBIBIBIBIBIAIAA IAI BIAIA1B IF IA FIFIDIF FIFIAIC FIFIFIFIFIFICIFD FIDIFIFIBICIFIFIF
131
I
R103 R105
1
B D F
IBIAIDICI
C
IBI
B
I
A
I
C
I
B
I
A
I
C
1
1A1
1
I
IEIDIDICIEIFIFIDIFIEID1F1E1E1 IFIFIFIFIFIFIFIFIFIFIFIFIEIF1
1 1 1 1 1 1 1 1 1 1 1 1 +
I 1 +
R121
1 1
After subtracting the ratios with low rotated factors from the whole ratios we have the following ratios which can be considered as significant ratios with high reliability and high stability.
R = NI/SALES 1 R  NI/SF 2 R = NI/(TASF) 5 R = SALES/(TASF) 26 R = INVENT/CA 46 R = CL/TA 50 R = CASH/CA 73 R = CA/CL 80 R = (CAINVENT)/TA 84 R = CASH/(TACL) 87 R = (CACL)/SF 103
4.8 INTERPRETATION OF FACTOR ANALYTIC RESULTS
The usual procedures followed in factor iterpretation are deceptively simple. Those ratios with high factor loadings
are considered to be "like" the factor in some sense and those with zero or near zero loadings are treated as being "not
132
like" the factor, whatever it is.
Those ratios that are
"like" the factor, that is, have high loadings on the factor, are examined to find out what they have in common that could be the basis for the factor that has emerged. High loading in both the positive and negative direction are considered. If a ratio were to correlate perfectly with a factor, it would ordinarily be considered identical with the factor in what it measures. Since ratios are not perfectly reliable, they can
not correlate perfectly with a factor, of course, but with a factor loading of .90 would indicate a total overlap in true variance between the ratio and the factor.
A question that frequently arises is how high the correlation between a ratio and a factor must be before it can be regarded as significant for interpretive purposes? There
can be no answer to this question in any precise statistical sense since there is not available at the present time any statistical test that can establish the significance level of a rotated factor loading. The loading of a given ratio on a factor can be altered easily by rotating the factor a little closer to or a little farther away from the particular ratio vector in question. A crude index of the sability of a given ratios for interpretive purposes is the square of the correlation between the factor and the ratios.
A fairly commonly used cutoff level for orthogonal factor loadings is .30, that is, no ratio with a factor loading below .30 is listed among those ratios defining the factor. A squared value (.30) gives .09, which indicates that a ratio correlating with the factor less than .30 has less than 10
133
percent of its variance in common with the factor. The other 90 plus percent lies elsewhere, in specific and common factors plus error. Whereas loadings of .30 and above have commonly been listed among those high enough to provide some interpretive value, such loadings certainly can not be relied upon to provide a very good basis for factor interpretation. Table 4.8.1 Scale of ratiofactor correlation
1
ORTHOGONAL FACTOR LOADING 'PERCENT OF VARIANCE'
RATING
.71 .63 .55 .45 .32
50 40 30 20 10
EXCELLENT VERY GOOD GOOD FAIR POOR
4.9 CONCLUSION
Courtis (1978) and Laurent (1979) have looked at ways of reducing the number of ratios in use without losing significant amounts of information. One of the important
result of these studies was that there is a significant degree of correlation between different ratios and that one or two ratios selected from each area should be sufficient at least for the initial review of the firm's performance. One of the best techniques which can be used to study the correlation between the ratios is factor analysis that enable management
134
to choose the most significant and reliable ratios among the others.
This chapter has described the prime difficulty of using ratios which is deciding which ratio to use. However, it has been established that this problem is overcome by the use of factor analysis.
135
CHAPTER 5 DEVELOPING A FINANCIAL MODEL
o
COMPADIES'
waymmInn
136
CHAPTER 5: DEVELOPING FINANCIAL MODEL OF COMPANIES' PERFORMANCE
5.1 FACTOR SCORE ESTIMATION
There are different methods of factor score estimation using multivariate analysis which were described in detail by Anderson (1958), Duckworth (1968), Goodman (1970), overall & Klett (1972), Dunn & Clark (1974), Harvis (1975), Afifi & Azen (1979) and Linderman, Merenda & Gold (1980).
Comrey (1973) has employed multiple regression methods to estimate factor scores, using the following basic equation:
4112 +1)2+ Zf =b2 22i 33i 1 li i where
b n ni
Zf is a standard score of factor f for subject i
Z ii 2 2i
is a standard score of ratio 1 for subject i
is a standard score of ratio 2 for subject i
b is the standard regression coefficient for ratio i
The standard scores on the n ratios (in our case 27) used to predict the factor scores are known, these ratios could consist of all the ratios in the factor analysis, in which case many of the bi weights would be very low because their loadings on the factor would be low, or the ratios included could be a subset of these, restricted to only those with
137
loadings above a selected cut off point.
This development,
however, will presume that all ratios are being used.
Equation (5.1.1) is like the standard multiple regression equation where
n ratios are being used to predict a single
To obtain the bi weights for this
criterion variable.
equation, it is sufficient to know the correlations among the ratios and the correlation of the ratios with the criterion, that is, the validity coefficients. In the application to the problem of estimating factor scores, the factor scores become the predicted criterion scores, the ratios in the factor analysis are the predictors, and the orthogonal factor
loadings or oblique structure coefficients, are the validity coefficients. The unknown bi weights are obtained through the solution of the following normal equations derived using the principle of least squares:
b 1
+br +br + 313 212
+ b r =r n ln if +br =r n 2n 2f + b r =r n 3n 3f +b =r n nf (5.1.2)
br +b+br+ 121 323 2 br +br +b + 131 232 3 br +br +br+ 1 n1 2n2 3n3
The above equation may be expressed in matrix form as Rb = rf (5.1.3)
Where R is the matrix of known correlations among ratios 1 through n in Eq.(5.1.2), b is a column vector containing the unknown bi weights, and rf is a column vector of correlations
138
between the ratios and the factors, that is, orthogonal factor loadings of oblique structure coefficients. Provided the matrix R has an inverse, Eq.(5.1.3) and hence Eqs.(5.1.2) may be solved as follows:
b
1 R rf
(5.1.4)
Thus, the column of bi weights to be used in Eq.(5.1.1) for predicting the factor scores from the ratio scores is obtained by multiplying the inverse of the matrix of correlations among the ratios by the column vector of correlations of the ratios with the factors.
In our case, the factor score coefficients(b) are computed by the SPSS(1975) for all the 27 ratios (n =27) for each of 530 companies and 14 years of activities (7420 cases) as follows:
139
TABLE 5.1.1 FACTOR SCORE COEFFICIENTS
I.
I I I I 1 I I I I I 1
1R
1
Fl
1
F2
1
F3
1F4
I
F5
1
F6
1
F7
1
F8
1F9
F10
1
Fll
1
V
I I I I I I I
1R1 1R2 1R5
.04411.12011.04851.44811.0481.04391.0671.1811.09491.0941.0591 .0831.08971.3771.30961.0211.11021.0351.00521.03711.66511.0131 .00551.0651.04031.51201.0171.08431.0171.17361.2461.09301.0031
1R7 1.0011.02751.0011.01671.00181.0251.00871.0141.1791.0051.05801 1R261.0431.1011.0241.04101.01091.11991.0311.5110i.1561i.061i.024i 1R291.0001.0051.0021.00841.00551.01061.0181.00011.0101.03251.31411 1R301.00481.00731.00121.04151.0011.01631.0011.0061.01281.10111.01501 1R331.00481.00791.00561.0001.0041.0071.02971.0031.0121.10311.0091 1R461.06531.37691.0131.00091.0041.29501.38121.10721.0721.01471.03641 1R501.0201.45101.0301.08791.05141.49841.4201.03331.13821.13391.0181 1R511.0031.0031.00511.0091.0061.0151.0141.04701.00641.1241.0431 1R5711.121.13611.6571.25341.0041.11621.11031.0891.2261.62931.0041 1R581.0121.1351.22161.00131.0441.0091.0481.0041.23661.67261.04001 1R591.0161.1011.01681.01751.0001.0391.0751.15361.18861.1871.02941 1R731.0151.0061.0451.0241.54021.04151.03381.0291.02871.05961.0211 1R751.00101.00311.00021.0091.0061.0111.00581.0111.0071.03021.0121 1R771.0001.00281.00111.0011.0001.0041.0021.00501.0061.0141.00191 1R801.01451.01071.02361.0511.01641.19831.54781.07131.18801.20571.07131 1R821.0221.0021.0101.06591.00451.14261.01991.3461.36611.1481.08071 1R831.1721.19481.56871.11181.01891.00961.20881.0381.3411.2761.0011 1R841.09531.61241.05801.08041.1251.8341.23351.32441.28751.0071.04581 1R871.01421.0161.00611.0321.49221.14541.03451.0241.0791.0331.0081 1R981.00191.0261.0041.00521.0001.05451.0181.0051.17811.00601.0081 11011.0031.0011.00011.0031.00501.00261.0131.00291.0341.0241.36291
140
11031.0701.09111.1891.0601.02131.03601.19001.1371.3371.1014
00311
11051.0091.03001.00721.05541.01241.10481.0371.06681.15801.0131.00061 11211.0111.0281.00561.0001.0171.0291.01531.00991.04241.22601.0441
I + I I I I I I I I I I
+
5.2 BUILDING COMPOSITE FACTOR SCORES FROM THE FACTORSCORE COEFFICIENT
After the final solution is obtained we may wish to have composite scales built that represent the theoretical
dimensions associated with the respective factors. The factor scores for the individual data cases are calculated from the factorscore coefficient matrix.
As SPSS specified, the factorscore coefficient matrix (F) is: F = (A IA) A (5.2.1)
Where A is the rotated factor pattern matrix and A i is the transpose of A. In our case the factorscore coefficient
matrix F has been calculated from the: F = S R (5.2.2)
Where S is the rotated factor structure matrix and R is the correlation matrix. A composite scale (factor score) is then built for each factor in the final solution. case a vector of factor f is calculated: f = Fz (5.2.3) For each data
Where F is the factorscore coefficient matrix and z is the vector of standardised values of the ratios which have been factor analysed.
141
For example, from the factorscore coefficient matrix in Table (5.1) we may construct a case's factorscore fl, which is a composite scale representing Factor 1, as follows:
+ f = .0441z  .0371z + .0055z  .001z  .043z  .000z 7 26 29 1 2 5 1  .003z  1.12z .0048z + .0048z + .0653z  .02z 51 57 46 50 33 30 .012z 58 .022z 82 .07z 103  .009z 105  .172z 83  .011z 121  .016z 59  .015z 73 + .0953z 84 + .001z 75 + .0142z 87 .000z 77 + .01145z 80
+.0019z  .003z 98 101
Where z represents the standardised values of ratios, or z = (R  mean of R )/standard deviation of R 1 1 1 1
Note that the composite factorscore variables produced by SPSS include a term for each variable in the factor analysis. It has been customary to build factor scores employing only those variables that have substantial loadings on a given factor. By this shorter method we can modify the above equation to:
f 1 f 2 f 3 f 4
=  1.11449z 57 = .61235z 84 = .568742 83 = .44807z 1 + .512z 5
142
f 5 f 6 f 7 f 8 f 9 f 10
= .54025z 73 = .49844z 50 = .38124z 46 = .51104z 26 = .17859z 7 = .66508z 2 .03017z 75  .31409z 11 29
+ .49215z 87
+ .54781z 80
+ .19001z 103
+ .18855z 59 + .67259z 58 + .10307z 33 + .30982z 101
+ .36611z 82 + .10113z 30  .124z 51
+ .15803z 105 + .22604z 121
+ .17812z 98
+
 .0144z 77
f
By adding all the above equations together we will have: f 1 +f+f+f+f+f+f+f+f+f +f= 4 5 6 8 11 7 9 10 3 2 + .66508z 1 .10113z 30 .672602 58 .36611z 82 .19z 103 + .15803z + .56874z 83 +.10307z 33 + .18855z 59 2 + .512z 5  .17859z 7 + .51104z 26 + .31409z 29 +
.44807z
+.38124z + .49844z  .12400z  1.1145z + 57 46 50 51
+ + .5403z + .0302z  .0144z + .5478z 80 73 75 77 + + .6124z + .49215z + .17812z  .3098z 101 98 87 84
+ .56874z 105 121
Let Y be the name of the total values of factor scores (f) and substitute the standardised score of ratios (z) with their initial and original values, then we have:
Y = .44807(R  .04)/.0537 + .66508(R  .1063)/.5458 + .512 1 2
143
(R  .1116)1.1209  .17859(R  .2196)/3.0873 +.51104(R 3.0922) 26 7 5 /1.7032 + .31409(R  .1534)15.8897 + .38124(R  .4517)/.1749 + 47 29 .49844(R  .3785)1.1413 + .67259(R  .7736)/.7898 + .18855(R 59 58 50 .7355).6126+.54025(R .0631)/.0978+.54781(R  1.7276)/.7931 + 80 73 .3661(R  .4456)/.2759+.56874(R  1.5767)/6.2481+ .61235(R 83 82 84 .319)/.1273+.19(R .468)/1.1866+.30982(R 3.412)/28.862 1.1145 101 103 (R .2585)/2.2488+.10113(R .0398)/.0571 +.22604(R  .0322)1 57 30 121 .0221+.49215(R .06)1.112  .0144(R  1.2021)/22.951 + .15803 87 77 (R 1.4809)/2.1847+.17812(R .983)14.5205+ .03017(R  .0207) 98 105 75 .0755 + .10307(R 33 Or simply Y = 8.344R +1.218R +4.235R .0578R +.300R +.0533R +1.77R + 1 2 5 7 26 29 30 .014R +2.18R 2.969R 5.188R .496R +.852R +.308R + 33 50 46 51 57 58 59 5.524R +.4R 73 75 .0006R +.691R +1.327R +.091R +4.81R + 77 80 82 83 84  1.4741)/7.2896  .124(R 51  1.0119)/.0239
+.072R +10.23R 1.989 4.394R +.0394R +.011R +.16R 98 101 103 87 105 121 By eliminating the ratios with low loadings which have been discussed in Chapter 4 (Table 4.3) from the above equation then we have: Y = 8.344N1/SALES + 1.218NI/SF + 4.235NI/(TA  SF) + .3SALES/ (TA  SF)  2.969CL/TA + 5.524CASH/CA + .691CA/CL + 4.81(CA  INVENT)/TA + .16(CA 
144
CL)/SF +
4.394CASH/(TA

CL)

1.989
(5.2.4) Where NI = NET INCOME SF = SHAREHOLDERS' FUND TA = TOTAL ASSETS CA =, CURRENT ASSETS CL = CURRENT LIABILITIES INVENT = INVENTORY
5.3 TESTING THE EFFECTIVENESS OF THE MODEL
From initial 600 UK companies, 53 companies have been chosen randomly to test the effectiveness of the model. First of all it should be noted that the mean value of Y is zero. It means that all the companies with Y score above and higher than zero are classified as the going concern or well performing companies, and those with Yscore lower than zero are classified as the poor performing group of companies some of which are actually failing.
One of the simplest ways of testing th model is to find out how well the model can classify those companies whose data were used to construct the model, then doing the same test for the other companies as well and finally compare the results or testing both groups simultaneously. This can be done by
computing the Yscores for all the 53 companies which include 20 of initial 600 companies under investigation and 33 companies out of the model constructing companies, then
145
classify them according to their Yscores. On the other hand the companies with positive Yscores are classified as the going concerns and those with negative Yscores as failed or poor performing companies, then compare the results with the actual cases. The results are shown below: Table 5.3.1 Classification of companies performance
1 1
CLASSIFICATION
1 1
FAILED
I I
I
1
+
NO OF 1 COMPANIES
1
GOING
1
1
+
RECEIVERSHIP
I
1 OTHERS
I
I
1 1
I
1
FAILED GOING
I
18
35
1 1
13 o
2 0
31 35 1
+
1 +
One of the 2 "others" had a sort of compulsory liquidation and the second one had a voluntary liquidation, the 3 going concern in failed group had some other drastical changes because of the financial difficulties. As it can be seen from the above table the results are quite good and it can be said at this stage the model has a high and considerable
effectiveness in measuring the companies' performance.
The second method and one of the import nt ways of testing the effectiveness of the model is to plot the Yscore against time and compare it with actual profitability, working capital, and liquidity of the companies. We can classify the ten ratios comprising the model into three separate groups as follows:
a) profitability ratios
146
1) NI/SALES 2) NI/SF 3) NI/(TASF) 4) SALES/(TASF) b) working capital ratios 5) CA/CL 6) CL/TA 7) (CACL)/SF C) LIQUIDITY RATIOS 8) CASH/CA 9) CASH/(TACL) 10) (CAINVENT)/TA
By multiplying the coefficient of the above three group ratios by their mean values then dividing the total values for each group by the total values of the three groups, we can identify the total variance of each group in the whole model. The results of above computation are 1) profitability 2) working capital 3) liquidity 30% 37% 33%
This means that the model almost contains the same percentage of variance for each of the three important factors of the company's performance.
The model was applied to all 53 companies selected from the Exstat tape accessible at computer centre of University of Bradford and the 'Yvalue' for all of them was computed for each year (for which data was available) and plotted against
147
time.
In the following pages, we have compared the 'Yvalue'
as a performance index with three main factors; profitability, working capital, and liquidity(cash position) for each of the 53 companies, using Simple Plot(1985) which is available at University of Bradford. The aim of this exercise was to demonstrate the effectiveness of the model in measuring performance, and to see how it responds when changes occur to these three important financial dimensions. This sort of
comparison can be done for well, fair and poor performing companies separately as follows:
5.3.1 DEMONSTRATION OF THE MODEL'S EFFECTIVENESS ON WELL PERFORMING COMPANIES
The General Electric Co is well known, and accepted as a well performing company. Figure 5.3.1 comprises four graphs. The top left graph is a plot of General Electric's 'Yvalue' from 1973 until 1984. The top right graph is a plot of the same company's profitability over time, while the bottom left graph shows the company's cash position and the bottom right graph the company's working capital position. All these financial dimensions are plotted over the same time period as the 'Yvalues'. The 'Yvalue' as well a profitability, and
cash position is rising while the working capital is static. This means that in General Electric Co the performance (Yvalue) is responding quickly to any changes occurring in companies cash position and profitability if working capital remains unchanged.
5.3.2 DEMONSTRATION OF THE MODEL'S EFFECTIVENESS ON FAIR PERFORMING COMPANIES
According to the classified performances in Chapter 6 (6.1), the Anglia Television Group is generally accepted as a fair performing company for which the relevant graphs are presented in Figure 5.3.17. As it can be seen from
performance graph, it was well performing from 1972 to 1978 and then rapidly deteriorates from 1978 to 1984. At the same time the three other financial dimensions are falling as well. This means that the performance of Anglia Television Group is declining when companies' profitability, cash position and working capital are falling. But still its performance is above the safety level.
5.3.3 DEMONSTRATION OF THE MODEL'S EFFECTIVENESS ON POOR PERFORMING COMPANIES
Burrell
& Co is one of the failed companies whose
performance has been analysed. The relevant graphs are shown in Figure 5.3.46. Its 'Yvalue' as well as its profitability, cash position and working capital is falling. This means that Burrell & Co was failing because its profitability ,cash position and working capital were declining which is affected its 'Yvalue'. In fact this assumes a negative value in 1979 indicating that the company has a failed company financial profile. Burrell's historic performance led to
a receiver
being appointed on 4th of August 1980.
The same sort of evaluation can be applied to the other companies and the results demonstrate the effectiveness of the
149
model. The main conclusion is that in most well performing companies, the performance model is rising and all of them are well above the ideal level. In fair performance companies the performance model is going up and down but they all are above the safety level. And in poor performing companies the performance model for all of them is declining and its overall performance is below the safety level.
150
0.22 0.200 0.175 0.150 E4.5 4.0 3.5 3.0 1974 1976' 197EI 198d YEAR 1982r 1984' 0.100 /' 0.075 0.050 19741976 1978 1980 YEAR 1982 1984
6.0 5.5
0.401
1
2.0
N.
0.35
0.30
// n\
\\ /
0.1
//.
4
1.5
\\
(_) z: cc
1.0
•••••
_
0.5
1974' 0.10 1974 '. 1976 1978' 1980' 1982' YEAR 1984'
19b
1978' 1980 YEAR
1982t.
1984'
GENERAL ELECTRIC CO
Figure 5.3.1 Testing the Effectiveness of the Model
Y VALUE NI/SFILES NI/SF NI/TASF CASH/SF CASH/TACL CA/CL {i1C/SF CL/TA
151
0.40
6
0.35 0.30*L• 0.25 j
1/4 1/4 1/4
tz
ilf\f
\
2 0.10 0.051974 1976 1978 1980 YEAR 1982: 1984' 1974' 1976 1978 1980 YEAR
\)
\/\
1982 1984
0.2
0.20 2.0 // FT 'E 1.5
I
'' 1 . 0 /
0.5 0.05 1974 1974 1976 1978 1380 YEAR 1982 1984
NI/SF NI/TASF CRSH/SF Y VALUE
1.976
1.978 1980 YEAR
1.982
1984
COALITE GROUP
Figure 5.3.2 Testing the Effectiveness of the Model
CRSH/TACL CF1/CL
WC/SF
CL/TA
152
4.5 w
V,
0.06
0.04 1.0 , 1972.
1974
1976 '
1978' YEAR
1980
1982. 1984
1972
197.4 . 1976
1978 YEAR
1980
1982
1984
0.1 0.14 0.12 0.10
0111 0..
3.5 3. 2.T
0.
cc
1.5 1.0 0.5
r0.08 tr) cc 0.06 0.04
972. 1972. 197.4 1976 1978 YEAR 1980 1982 198.4
1.974
1976 1978 __YEAR
1980
1982
1984
ALLIED TEXTILE CO PLC
Figure
5.3.3 Testing the Effectiveness of the Model
VALUE NI/SALES NI/SF NI/TASF CASH/SF CASH/TA CL CA/CL WC/SF CL/TA
Y
153
7. Q 6.5 6.0 0.40
0.35"
./ •
0.30 0.25a. 0.200.15
1.0 13 4.5
4
7\\
,\
.0
0. 3.0
0.
10
051974' 1976 1978' 1980' 1982' 1984' YEAR
1974
1976' 1978 1980 YEAR
1982
1984
0.5 ./
2.5" 0.4
\
/I
/ / ILi
1.5
\
E
tr10.30.2
I
/
I I \\ Jj
11 1974 1976
//"/
°
1.0 0.5
S. S.
0.1
1976' 1980. 1982 YEAR
1984'
1574
1976
1978. 1980 YEAR
1.982
1984
BRITISH HOME STORES PLC
Figure 5.3.4 Testing the Effectiveness of the Model
VALUE NI/SALES NI/SF NI/TASF — —CASH/SF CASH/TACL — — CA/CL WC/SF      
154
0.30
fN, i, \
6
,f
\‘‘
%
0.25 5
I
I \/' "i ,
I
, ,i) , 0.z,, , , c. , , , 0.15 /......_..,
o / \
0.10 \ .
i n\
A !
1
\\L/
/
/\ \
2 0.05 ii 1972 1974 1976 197d YEAR \
, ,,,.. s„,„,‘ / 1978 YEAR 1980
, , • _. _ ,. . „. _, , , ,
198 1984
mid 19E4 1984' 1972: 1974' 1976
0.18 0.16 0.14 g0.12
4.54.0 3.5 3.0
cm „
(I) 0.08
L_1
0.06 0.04 0.02 1972 1974 1976 1978 YEAR 1980 1982 1984 1.0 • 1972 1974 1976 197d YEAR 198d Figure 5.3 . 5 Testing the Effectiveness of the Model 1982: 1984'
BELL (ARTHUR) & SONS PLC
Y VALUE NI/SALES N1/SF N1/TRSF CASH/TAft CA/CL 112/SF
155
0.14'
0.12
In
r
AJ/
‘‘:
/ ,, 1 \,
I
v\
...
s n t \
\
.
n ...
i 0_04'
".
n
\
\,1
1972 1974 1976
1978 YEAR
1980 1982 1984
1972. 1974 1976 1978 YEAR
1980
19821 1984
0.200" 0.175' m0.150" '417) o_ nt
&10 .125
E 0.100
0.075 0.050 0 025 972 1974 1976 1976 YEAR 19ed 1982
196.4'
9
0.5
972
1.974
1976
1978 YEAR
1980
19821 1984
V_
WELLCOME FUNDAT I ON
Figure 5.3.6 Testing the Effectiveness of the Model
Y VALUE NI/SALES NI/SF NI/TASF CASH/TACL CIA/CL WC/SF CL/TA
156
F
0.40 0.35 0.30 :1125
0.15
4.0 0.10' 3.5 1972 1974 1976' 1978' 198d 1982 1984 YEAR 0.05 97 1974 1976k 1978' 1980 YEAR 1982 1984
0.00f1 0.007
/ tr\
/ / /‘
\J /
\,/
0.006 20.005
co
20.004'
in cc
'O.003 0.002
1972 1974 1976 1978 1980 1982 1984 YEAR
1974 1976' 1978' 198d YEAR
1982 1984
BENFORD CONCRETE MACHINERY PLC
Figure
5.3.7 Testing the Effectiveness of the Model
Y VALUE NI/SALES NI/SF NI /TRSF CASH/SF CASH/TACL   CA/CL IC/SF
157
5.5'"
0.250F 0.225 ' / )(\\ 20.200F.„, j:\
5.0
..7 '] 14. 0 i 1:
E 0.1503.0 0.125'
/
0.075
5.
1974
1976
1976 1980 YEAR
1982: 1984
1974
197d
1978' 198d YEAR
1982
1984
2.50/ '
0.2500.2250.20T
N
/
/ / \
N
/
/
/
.
\
\_
/
\
0.175(20.150 D A 25
0.1.00
0.075 O. 751 0.050 1974 1976' 1978' 198d YEAR
1382'
1984'
0.50 7`"Y 197d 1974
1978' 198d YEAR
1982' 1984
BEECHAM GROUP PLC
Figure 5.3.8 Testing the Effectiveness of the Model
  
VALUE N I /SFILES NI/SF NI/TASF CASH/g CASH/TACL CA/CL 1./JC/SF
158
0.356.0 0.36 5.5 5_0
t.L1
\
0.25
g4.5
:k 30.20
60_4.0 a0.15 3.5 3_0 2.5 1974 1976 1978 1980 1982 1984 YEAR 0.10
_
0.05 1974
1976' 1978' 1986 YEAR
1982
1984'
(LT
1.0 0.8
er. j
• _
 0.6
Li
CD
LE)
FL; 0.4
ct
0.2
0.2
0.1 0,2 1974. 1976' 1978' 1980' 1982' YEAR 1984'
197A
197G 1 43 1981119E1•984,' YEAR
MARKS & SPENCER
Figure
5.3.9
Y
Testing the Effectiveness of
the
Model
VALUE NI/SALES NI/SF NUTASF CASH/SF CASWITFCL 111C/SF CUM
159
0.18'
0. 18'
0.14 n DO12 .\ t .
lr
i , " n \I\
0Z
/\
/ /
t
\ 7 \/ j/I
E
2.0
1'1On0..10
008 . 0.06'
\\ \
\ ' %1
i
‘V/ k
//
t
/
1.5 0.04972. 1974. 1976' 1978' 1980' 1982' 1984 YEAR
/
\ . 
\
/
/
1972 1974' 1976
1978' 198d 1982 19E4 YEAR
2.000.200 f'
\ i t.,.
1.
N
.
0.175
1 A1, 50  ......
1 1 ii 1 1 1.25' cc \ 'cc 1.00 / 7.17 ,\ ,,./1 t.. % ,......
t
..... ,.
6 0.150
I
0. 100 0.075
/ .I / .,: %... . 1 .. J /
IL) 1 cc
0.75' 0.50'
0.25"
'9
0.050 0.025 19 12.
0.25
972
1974' 1976
1978' 1980k 1982 YEAR
1984'
1974
1976
197B YEAR
1980
1982.
1 .984
PEARSONS
Figure 5.3.10 Testing the Effectiveness of the Model
Y
VALUE  NI/SALES NI/SF NI/TASF CASH/SF
—
CF1SH/TRCL
CA/CL 111C/SF
CUTR
160
7
0.4
0.35 0.30 :EE 0.25 cl
Lj
_ 1974:
197e
1978' 198d Y.EAR
1982:
1984: 1.974
1976
1978 1.980 YEAR
1982
1984
/
0. 25
—
0. 20:
11\
I...' 0Ct
2 .0
\
V
1.0
cn
CC
LJ
0.10 0.5 0.051974 19 4 1979. 1979 i980: 1982': 1984' YEAR
0. 5
_
1979 1978:
1980: 1982:
1984
RACAL ELECTRONICS
Figure
5.3.11 Testing
the Effectiveness of the Model
1 VALUE NI/SALES — NI /SF NI/IASF —CASH/SF  CRSII/TRCL — — — CA/CL NC/SF CL/ TA
161
F
4.0
0.3C
3.5
0.25
LL13.0 '21 _ 17;0.20
IL
ES2.5
0_ c c 0.15
2.0 0.10 1.5 0.05 1974 19767, 197d 1980' YEAR 198 1984' 1974
• • • _
/
1976' 1978' 1980' 1982' YEAR r
1984'
0.200
1.8 0.1750.150.90.125 If
Ro.100\\ /
/
\_,
n "
'0.075 0.8 0.050 0.02.5 1974 1976' 1978' 1980' 1982' 1984' YEAR 1974 1976 1978 1980 YEAR 1982 1984
BPB INDUSTRIES PLC
Figure 5.3.12 Testing the Effectiveness of the Model
Y VALUE NI/SALES NI/SF NI/TASF CASH/SF CASH/TACL CA/CL WC/SF
162
5.0 4,5 tA.1 4.0 I3.5'
'at' 3.0
\
\
0.1 1_5 1974 1976' 1978 1980 YEAR 1982 1984
\
0"
_ '
/ ,
/
/
, 
\
,
.
\
.
\
\
/
/,
/
1974. 1976' 1978 1980 YEAR
1982:
1984'
,\
/ /
a.0 /
_,L.5' ," . .....
ES ,9
/ ,... / /
\ 1 /
/
\ \
\
/
FIm
L:
z
1.0
\
115
'
1974 1976 1978 1980' 1982' 1984 YEAR
'..\
1974 1976
1978 1980 YEAR
1982 1984
0.5
ALLIED COLLOIDS PLC
Figure 5.3.13 Testing the Effectiveness of the Model
Y VALUE NI/SALES 411/SF NI/TASF CASH/TACL CA/CL WC/SF CL/TA
—
163
4.0
0.30
0.25
PE
8E
0. 15
\)/
Th
2.. d
0.10 1 .5
19721
1.974
1976' 1978' 1980 YEAR
1982
1984
19721 1974'
1976'
1978' YEAR
1988' 19821 1984'
0.05'
2_75
I\
2.50
f\
1
1
I 1
I 1 \ V 1
\
\
0.04L
2.25
E. /
i)\ cm z. / 1.50 1.25 1.00 0.75' 9721 1974 1976 . 1978: YEAR
c i=i m
a.4. 2_00
, •175' / \
I
/ \_„..•
..
/ \ .. ._
0..01
t
0.509721
1974' 1976
1978' 1980' 198211984' YEAR Y VALUE NI/SALES NI/SF NI/TASF CASH/SF CASH/TRn_ CA/CL WC/SF
ASH
& LACY PLC
Figure 5.3.14 Testing the Effectiveness of the Model
164
0.35
t
6.0
I
0.30
5.5 5.0 45 0.20 6`
SE
(
=0.25 (\
0.15
0.10
/
0.05 1974 1976 1978 1980 YEAR 1982 1984 1974 1976 1978 1980 YEAR 1982 1984
/ '. ..N.
,,
1.6
/
\ \
\
/ \ /
/
0.60.4 1974 1976 1980 1978 YEAR 1982 1984 1971 1976
N. 1978' 1980' 1982' 1984' YEAR Y VALVE NI/SALES  111/SF N I /TFESF CASH/SF CRSH/TRCL CA/CL 111C/SF
BOOTS CO PLC (THE)
Figure 5.3.15 Testing the Effectiveness of the Model
165
0.6
0.4
/  KW"
74 197 „ 978
/\ .\\
• '1980
0 .4
76
1978
1980 YEAR
1982
1984 0.6
0.05
5 0.04
i
_ 6 _. La,... cL.
0.02 /
5)
\J 0.01
l \ / I z 1 , , , , , ,
ii, (/ \\
\ f_ _,
, ... ....
1974 1976
•
,
1978
198d YEAR
1982' 1984
1974
1976' 197d
1980' 1982 YEAR
1984
BRITISH GAS CORPORATION
Figure 5.3.16 Testing the Effectiveness of the Model
Y VALUE   NI/SALES NI/SF NI/TASF CASH/SF CASH/TACL WC/SF
166
0.50
8
0.450.40
•
0.35
0.30 1E0.25 0.20
0.15
0.10
0.05 1972 1974 1976 1978 YEAR 1980 1982 1984 1972 1974
•

//\
1980 1982! 1984
1976
1.878 YEAR
0.4 0.40
2.5
/•

0.30 E0.25
0.m
0.15 0.10 972! 0.05 1972 1974 1976 1978 YEAR 1980 1982 1.984
   URLUE
___
1974
1976! 19?8 YEAR
1980
1982
1984
ANGLIR TELEVISION GROUP PLC
Figure
5.3.17
Testing the Effectiveness of the Model
NI/SRLES NI/SF NI/TASF IRSH/SF CRSH/TRCL CA/CL MC/SF CL/TA
167
0.1 97 YEAR 1978
1981
198
0 , .....„ , •
r 0 . 1

'
1
\ s   I ‘\\,
11 7
! ,.
0.3 0.4
\,._i L__/
\I
\J
I
0.5
0.050
I'
2.25
0.0450.040•
I
/
2.001 1
I , \ I I l\,
0.035c% E0.030cn o 0... _ 0.025
cut'
7
li
/I \\
1 II
i
Li0.020
0.0,5
0.010
0.005" .1.
!I_
_I
L\
_ 198d
0.75
\\ '..
972
1974
1976
1978 YEAR
, r.  0.501982' 1.972
1974
1976 1978 198d YEAR
'
'
1982'
GOODYEAR TYRE & RUBBER CO.
Figure 5.3.18 Testing the Effectiveness of the Model
Y VALUE  . NI/SALES N1/SF NI/TASF CASH/TACL CA/CL WC/SF
168
0.18 0.16 0.14 [1.12
R0.08
n
0.02 197 1974 1976' 1978 YEAR 198( 1982' 1984 197 1974 1976' 1978' 198d YEAR 19E2 1984
0.160.14
1.4
N \
\
/ ' \. /
_
__ N
z
1.2
= co
60.M 0.0 6
0.04
/ z
972' 1974 1976
/
1978' 198d YEAR
7
0.4
198
1984
1972' 1974
1976' 1978 YEAR
1980' 1982'
1984
BABCOCK INTERNATIONAL PLC
Figure
5.3.19 Testing
the Effectiveness of the Model
VALUE NI/SALES NI/SF NI/TBSF CRSH/SF CASH/TACL CA/CL WC/SF
169
1972 1974 1976
1.918 YEAR
1980
1982 1984
972 1974 1976 1978 YEAR
1980 1982 1984
0.12
2.0` /
NJ
0.04
972
1974
19/6
1978 YEAR
1980
1982
1984
1972
1974
1976
1978 YEAR
1980
1982:
1984' Y VALUE NI/SALES NI/TASF
APV HOLDINGS PLC
Figure 5.3.20 Testing the Effectiveness of the Model
—
CRSH/TRCL ClitCL WC/SF CL/TA
17 0
2.5
0.2000.175 >_ 0.150
2.0
iTa.1250.1000.0750.50.050 0.0251972 1974 197d 1978 YEAR 198 • 1982. 198.4 972. 197.4 1976 19714 YEAR 1980 1982. 198.4
0.07
0.061.6
0.05z:
in 0.04 Li
A / 
/ \._ _ /
/
I I
!
\
\
3 0.03
0.020.8 0.60.010.41972 1974 1976 197d YEAR 1980 1982. 1984' 1972 1974' 1976 1978' 198d YEAR 1982' 198.4
, ", / \
X %
I
AULT & WIBORG GROUP PLC
Figure 5.3.21 Testing the Effectiveness of the Model
Y VALUE NI/SALES N1/SF NI/TASF — —CASH/SF CASH/TACL — — — — CA/CL WC/SF
171
0.2000.1750.150LU
:1
0.125(7.1 LJ
PE

fa
N.100
0.075 0.050'1972 1974 1976' 197 g. 1980' 1982' 1984' YEAR 0.025 172 1974 1976' 1978' 1981 YEAR ,,„ 1982. 1984
0.25
3.0 2.. 5
0.20
/
•• n•
0.5 0.051974 1972. 1974 1976' 1978 YEAR 1980' 1982' 19841 1973 1976 —YE 1980 1982.
1984
AL.BR.IGHT & WILSON LTD
Figure 5.3.22 Testing the Effectiveness of the Model
VALUE       +11/SALES — NI/SF NI/TASF — —CASH/SF CASH/TACL CR/CL — — WC/SF CL/ TA
172
0.200 0.175 0 150 '6E1 '0.125 FE
V \
\\
‘K) \j
'60.100
0.0750.050 0.025972 1974 1976 1978 YEAR 1980 1982 1984 972 1974 1976 1978 YEAR 1980
/
\\.
1982 1984
0.250
I
1.8 1.6
I
0.2250.2002,0.175 E2
!=.0.150
I
I I/11 II \II
1.4
1
_t
FE1.2 co 1.\
ir
0,_
C)
co
ml1125 (r,
m
It
Ii \\ tI
III
c..)
_
0.100 0.075
t
0.6Ii
, I/
•,..._.../...,"
,
) / j
\ 11
t
9
0 .4 •
0.2 \,/ 97 1974 1976' 1978' 198d YEAR 1982' 1984
0.025 972 1974 1976' 197d 198d 1982 YEAR 1984
BARROW HEPBURN GROUP PLC
Figure
5.3.23 Testing the Effectiveness of the Model
Y VALUE NI/SALES NI/SF NI/TASF CASH/SF CASH/TACL
cripa
WC/SF
173
F
0.5 0.45
i
i
,
,
' .____J.
,/ \
1 I I
0.40 ›.0,35 .IEd F E 0.30 C 20.25 / 0.20
./ i /i
7' f
1 1
\I
 I / \
/
I
4
/
7 ./
.. 
/
\ , .
1972 1974
1976
1978 YEAR
1980
1982 1984
1.972
1974
1976
1978 YEAR
1980
1982
1984
0.9 0.8
1\
/ /
/ / I I I
\ 1 /'' \
0.6 D r(.710.5 en' 0.4
Li
0.3 0.2 0.1 1972:. 1974
fj
972!
1974
1976,...1478.
1980
1982'
19E14'
\J 0.501976' 1978' 1980 YEAR 1982 1984 Y 'VALUE NI/SALES NI/SF NI/TASF —CASH/SF CASH/TACL
•
PLEASURAN4 PLC
Figure 5.3.24 Testing the Effectiveness of the Model
WC/SF —CL!TA
174
0.1
97 97 1974 1976 YEAR 197 1980 198
1974
1976 744... 1980
198
/Th\) e. 1
0 .4
0. 5
0.06
1.4 1.2 \
0.05
6
7). .L 0.04
_ j 1.0
m 1
N
,.__. /— \ /— — N N\s) \J
i\
ji
I
\ / s,
eff 0.8 p
m F., 0.6
'60.03
C) 
0.4 0.2 972
0 .2
0.02
0. 011972 1974 1976 1978' YEAR
19
1976
197e 4380 EA
182
1.980' 1982
BRITISH RAILWAYS BOARD
Figure
5.3.25
Testing the Effectiveness of the Model —
Y VALUE NI/SALES NI/SF NI/TASF CASH/g CASH/TACL — CA/CL 41C/SF
175
1
.6.40.20
1
1.21 . 0
0.8 0.6 0.4 0.05 0.2 972' 1974' 1 76' 1.978' YEAR 0.2 1988 1.982 1.98.4 372 1974 1 . 978 YEAR 1980 1982. 1984'
/
1
0.12 I\ 0.10
1.50  
'
•••.
•
I`, I I!
()\ I \
i
V\1
%
I.
Lou0351 0.50
n0.08
L71
It i t
iIi
i
\ e ....
CM Z
\ ()
1"0.06
Gul
/r\
()\ )
.E. 0.25 cz, 972' 1974' 1976 0..25 1978 YEAR 198d 1982'. 1984'
0.04
j 0.02 _!/\j /
0.50
1972. 1974' 1978
1978' 1980' YEAR
i.se
18841 Y UFLUE NI/SALES NI/SF t'11/TASF CASH/SF CASH/TACL  CA/CL WC/SF CL/TA
ANCHOR CHEMICAL GROUP PLC
Figure 5.3.26 Testing the Effectiveness of the Model
176
0.250
3. 0.2253.0 0.2000.175!]0.1502'0.125u_ I
I
/e\
I I I
E0.100
1.5
0.075 0.0511
1.0 0.0251974 1976 1978 1980 YEAR 1982 1984 1974
./
1976
1978' 1980 YEAR
198
1984
0.07 ,' 0.06
z / 1
I\
2.0
—\ \
\  /
I' I \
\
I 1 \ 1 1
\ ...... 1
/
\ k
‘.....„\
o
1
ro.o5
0.03
0.02
c, / / \ = C), i /
2
Il i :
I\
i
//1 1/1
0.80.61974 1976' 1978 198d 1982 YEAR 1984
\
74r
1978 1980 YEAR
1982
1984
BAKER PERKINS HOLDINGS PLC
Figure
5.3.27 Testing the Effectiveness of the Model
Y VALUE NI/SALES NI/SF NI/TASF CASH/SF CASH/TRCL CR/CL WC/SF
177
3 .02.5 2.0 1.5
0.4
0.3
_
F 0.5 .5 9 2 13 1 6 1978 YEAR 1986' 1982 1984 72  1.0  1.5 0.1 1374 1976 1978 YEAR 1980 1982 1984
0.10 / 0.09 0.08 0.07 z Q 0.06 1r r t‘ i \/ /
1
\
\
\ n \i
1.4_r acc _
ii
CL 0.05 = U) (LE, 0.04 0.03 0.02 0.01 1972
;I 1 i 11 \\
C2 60.8 0.6 0.4 0.2 1976 1978 YEAR 1980 1982 1984
\\ ‘ 1974
z
972 1974 1976 1978 YEAR 1980 1982 1984 VALUE NI/SALES NI/SF NI/TASF CASH/SF CASH/TACL CA/CL 61C/SF
FORD MOTOR CO. LTD.
Figure 5.3.28 Testing the Effectiveness of the Model
178
3.5
0.20 0.18
3.0
0.160.14
r10.08 0.06 1.5 0.04 1 01 1972. 0.02197.4. 1976 1978 YEAR 1980 1982 1984 1974 1976
1978' 1980' 1982" 1_984' YEAR
1972
0.02.00 1.75" 0.0175
/ i
\
\ /
1.50 1.25
0.0157
Z
.90.0125
I— U7
'\i
....,/
cc
1.000.750.50
20.0100(1 ' 0.0075
\ liV i" \ \ ' \
:\ ii /111 U \\
cL
CC
0.0050
0.00251974 1976 1978' YEAR
iV 1
I 11 I il
( \,
0.5 972 1974 1376 1978 YEAR 1980 1982 1984
1980' 1982' 1984'
\
0.25 0.50
ADAM & GIBBON PLC
Figure 5.3.29 Testing the Effectiveness of the Model
Y UALUE      N1fSFILES — NI/SF NI/TASF — —CASH/SF CASH/TACL — CR/CL WC/SF CL/TA
179
0.30
0.25
..2
/
1
\
%
/
1\
/
0.05 1 1972 1974 1976' 1978' 1.986 YEAR 1982 . 1.9E14 972
n .... 1976
/
/ 1982 1984
197+
1978' 1900 YEAR
0.14
2..5
I
\
\
0.12
24
\
/.•
n /
0.
8"_ m ('1. m (I) 50.06
n
1
I
0.04 /.,... t. ,
0 .02
\
,, y/ '  /
7
fi 1 \ 0.5 1978 YEAR
0
ix
C) 1.0 ,..
n n n
1972
1974' 1978
N, , 1980' 1982 1.984
1972'.
1974
1976
1978 YEAR
1980
1982
1984
ARRITAGE SHANKS GROUP LTD
Figure 5.3.30 Testing the Effectiveness of the Model
Y VALUE       NI/SALES N1/SF NI/TASF CASH/SF CASH/TACL CA/CL WC/SF
180
F
5.04.5
0.30
0.25 4.0
,I'
\
0.10
1 1
k
1
0.05
1974
1976
1978 1980 YEAR
1982.
1.984
197.4:
1976'
1978' 198d. YEAR
1982
1924'
3.5 ip.. \ /
k / /
/ 1\
i
\
i
1 n / ...
C n
/ . .....
0.02T
3.0.
N
\ i
i •
\
. ..
\ 1
F.0.02C
0_
2.. 5
(T)0.015
CC
1
0.
0 10
1.5
0.005
1
.0
0
.51974" 1976' 1978' 1380' YEAR 1982". 1984'
1974' 1976
1978' 19El8' YEAR
1982
1984'
ATKINS BROTHERS PLC
Figure
5.3.31
Testing the Effectiveness of the MOdel
Y VALUE NI/SALES — N1 /SF NI/TASF — —CASH/SF  CASH/TACL CA/CL WC/SF
181
0.15 1.50
0.1.0
1.25 00 >_ 0..05
17
1.
972 ° 0.50 0.05 0.25 0.10
1974
1976
1978 YEAR
nu 1'3
972 0.25
1974
1976
1978 YEAR
1980
1984
0.15
0.2502.0 0.2250.2001.5 60.175I'&10.150C)
1
II \
a_

Ei0.5 12
Lt
0.100
i
%
0.075
I/
0.050N;.'• "
—
/ \71;
•
972
1974
1.976
1978 YEAR
1980' 1982' ,38\4 ,
0.025'52 1972 1974 1974 1974 1980 YEAR 1982 1984
DUNLOP HOLDINGS PLC
Figure
5.3.32
Testing the Effectiveness of the Model
Y VALUE NI/SALES NI/SF NI/TASF CASH/SF CASH/TACL CA/CL WC/SF
182
4.03.5t;:;3.0
0.200 0.175 015T 630.125
0. 100 \ _I/ .
Ai1\
//r—\ \ I1 1k
i
0.075 1.50.050 0.025 1972 1974 1976 197d 198d 1982 1984 YEAR / .. n \\
j/
/
\ I
f
_ ...\
/ ‘ \t \ r . 1976 1978 YEAR 1980
\.__/ /
1972 1974
1982 1984
0.25
\
'•••n
0.20
_ R0.15 CT,
0.10
0.05 0.41972 1974 1976' 1978 YEAR 1981i 1982' 1984 197 1974 1976 1978 YEAR 1980 1982 1984
BARNO INDUSTRIES PLC
Figure
5.3.33
Testing the Effectiveness of the Model
Y VALUE NI/SALES NI/SF NI/TASF CRSH/SF CASH/TACL CA/CL WC/SF
183
0.14 1.6
1 .4
0.12 0.10 0.08 cc :7. 0.06 A 0.04 0.02 \
\J
rN.,/
t±j1.2
S.
0. 80 .6
2/r\\
972 1974 1976 1978 YEAR 19 982 1984
0 .40.02 1972 0.10 0.09 1.60.08 1.4=0. 07 I t,10.M ;0.05 0.04 0.03 0.02 0.01 1972 1974 1976 1978 YEAR 1 . 980
V
1974 197d 1978' 198d 1982 YEAR
1984
;\
1.8
/
/ /  \ \.1 / /
\
\ \ \ , /
/
\\
1
cc
cc
/f.\\
I
_
t
0.8
0. 6 0 . "Th
1982 1984 1972' 1974 1976 1978' 1980 YEAR 1982 1984
BBA GROUP PLC
Figure
5.3.34 Testing the Effectiveness of the Model
Y VALUE NI/SALES NI/SF 411/TASF CASH/SF CASH/TACL CA/CL WC/SF
1 84
0.30
0.25'
>0.M
n
0.10 0.05
_
1974 1976
1980 1978 YEAR
1982 1984
1974
1976
1978
1980 YEAR
1982
1984
0.1 0.14 1 0.12 n =0.10
61
1.0 0.8 0.6
/..
—
dt 0.08
1
Li
83
0.06 \\ 0.04 0.02 0.2 0.4 0,6 1974 1976 1978 1980 1982 1984 YEAR
1974
1976
1978 1980 '1982 YEAR
13 ?4
ie.
BRTLEYS OF YORKSHIRE PLC
Figure 5.3.35 Testing the Effectiveness of the Model
Y VALUE NI/SALES NI/SF NJ/TASF CASH/SF CASH/TACL CA/CL WC/SF
185
F
1.75'
0.75'
0.50'
0.25" 972: 1974' 1976: 1978' 1980 YEAR 1982: 1984
1.972
1974 1976
1978 YEAR
1980
1982
1984
0.09 1..6 0.08 0.07
\./""\
/I
g30.05
CL
0.03 0.02"
0.01
rA
1974' 1976: 1978' 1980 YEAR 1982 1984 1980 1974" 1976' 1978 YEAR 1982 1984
197
BEMROSE CORPORATION PLC
Figure 5.3.36 Testing the Effectiveness of the Model
Y VALUE NI/SALES NI/SF NI/TASF CASH/SF CASH/TACL CA/CL WC/SF
186
4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 972 1974 1976 1978 YEAR 1980 1982 198
0 1 
0.10 0.05 972 1974 1976 0.05 0.10 0.15 1978 YEAR 1980 1982 s'‘ 194
0.18' 0.16 I 0.14 P0.12' D u ' =.10 0 cn LJ = 0.00 i 1 / 0.06 I A t 1.8 FE 1 .6 ES 2 14 01 1.2`   \ \ / \., 1 \ \ / \,. / / /
, / \ \ \ \ \ \
I\
i II \ % /,\ k \ \ \
''
1 \'
Ili \; \
N
1/
V \II
. 1978 YEAR 1980
iI
\\
V\
\. Hi0.8 197i
•• •
0047 1972: 1974 1976
i 19E2
1984
1974" 1976
1.978 YEAR
1980' 1982' 1984 Y OLLIE NI/SALES • NI/SF NI (TASF CRSH/SF CASH/TACL CR/CL WC/SF
BESTOBELL PLC
Figure
5.3.37 Testing the Effectiveness of the Model
187
0.30 2.0 0.25 1.5 ,. 0.20
1=1 ,
o
Lálj_
m m
1 . 0
F
LL DI
0.15
IT
0.5
0.10
1972 1973 1974 19/5 1976 19/7 1978 19/ YEAR
0.05 1972 1973 1974 1975 1976 1977 1918 1979 YEAR
0.09 0.08 0.07
z
cp
 /
1 I ii\I
2.0
0.06
F.r.
ii
i
/
f/ 7'..\
'6;0.05
(7)
a_ ill
ai 0.04
ct
03 0. 0.02 0.01
I
// / /
//
/
\
7.
\
A
/
0 .5
1972 1973 1974 1975 1976 1977 1978 1379
1972 1973 1974 1915 1976 1.977 1978 1.979 YEAR
BROCKS GROUP OF CO LTD
Figure

`t VALUE
5.3.38 Testing the Effectiveness of the Model
USRLES 441/SF NI/TASF — —CRSH/SF CASH/TACL — — — — CA/CL WC/SF CUTR
N
188
3.5
0.15
0.05'
1.97
1974:
1976 YEAR
1978
1972
1974
1976 YEAR
1978
N
o— AT
0.180.16' \ ‘‘.
c\ I \
r • /
——
30.
II \i
\\
1972 1974 1976 YEAR 1978 1980
it/
0.02 19721 .197‘. 1976 YEAR 1978 1980 (3.5
Y VALUE
STONE PLRTT INDUSTRIES PLC
Figure
5.3.39 Testing the Effectiveness of the Model
NI/SALES NI/SF NI/TASF — —CASH/SF CASH/TACL — — CA/CL WC/SF CL/TA
189
3.5 3.0 2.5
0.3
0.2
cu 2.0
E 1.5 1972 0.5 1972 0.5 0.2 1974 1976 YEAR 1978 1980
0.1
1974
1976 YEAR
1978
1980
0.062.00.051.8_r 1 . 6
/ i
/

E, O. 04 1— cn \ /\
CC
:*:)
1.4 1.2
C)
10.03/
Ln ct (_) i
r‘`,\ 1
r ' ‘j f
g
'' cc
0.02/
0.8 0.01 197i 1974 1976' YEAR 1976' 1980' 0.6 0.4 , 1972
1974
1.976' YEAR
1978'
1986' Y VALUE NJ/SALES
BRITISH AIRWAYS
Figure 5.3.40 Testing the Effectiveness of the Model
    
NI/TASF —. —CASH/SF CASH/TACL CA/CL 11JC/SF
19 0
3.
3.0 2. b
0.25r
0.20
1.0 0.5 1972 0. 5 1.0 0 . 051974 1976 YEAR 978 1980 1972' 1974  1976' YEAR 0..05 nn
n
n
194
0.061
rN\
/ \ %
\
,.....„ ...... n ....n •n• ....n.
/
Li
\
(ct) 0..03 T
0.02
\% 1
‘
e\ ...
If
\
IS LJ
2
LO
n n ..............
ii
r\
11‘. // „,.// 0.01 197 1974
9 O. 5'
197 1974 1976 YEAR 1971i 1980
IC
0.. 5 1976 YEAR 1978'
1980
VINERS
Figure
Y VALUE NI/SALES  NI/SF NI/TASF CASH/TACL CA/CL 11.1C/SF CUM
5.3.41 Testing
the Effectiveness of the Model
191
F
0.20 uu
LJ
z
r=
I
mcc
0.15
E'
E oL
tr 0.10
22
1972
1974
19 YEAR
1978
1980°0.05   1972
0
1974
1976 Y EAR
874 , /
1980
.05
0.20 0.18
1.6
1.4
/ / / / I I
_
0.16
1.2
0.14 ;720.12 \I '6; R 0.10 u/
lt
50.08 0.0G 0.04 k 0.02 197 1972 1974 1976 YEAR 1978 1980 1976 YEAR 1978' 1980' 0.4 0.2
BLACKNAN & CONRAD
Y
Figure 5.3.42 Testing the Effectiveness of the Model
VALUE NI/SALES NI/SF NI/TASF CASH/SF CASH/TACL CA/CL WC/SF
192
0.1
0.10
0.05 0,5 197.
g
YEAR 1973 1974 1975 1976 1977 197 10
•••.
itnrs
J
/1 ;30.05 ii
F
m
, Et 0.5 L.0 1.5
L o—. Lo I
R
CL 0
'. 15 I
0.20 I 0.25 0.30
1.75
0.10
o_oe''
0 1\
i \ I ' \ 1
N,
1.50 1.25 e 1.00 0.75
...•••••
. ;::: , '..jo..136
0_
t u, ct
11( \\ II
0.
/ 0.25 . ,.../
,
,
'. 04
11
1\ '11 il
\
1976
0.02"
II
1972 1973 194 1975' 1976 1977 YEAR 0.25 0.50
19.1i
1972 197 ' 1974 1975 1976 197f 134 1.34 YEAR
/‘,...._./ 3
AP1ALGAMATED INDUSTRIALS
Figure 5.3.43 Testing the Effectiveness of the Model
Y VALUE NI/SALES NI/SF NI/TRSF
CRSH/SF CASH/TACL — — — — —CR/CL WC/SF
CL/TA
193
2.0
0.20 0.15
1.5
0.10
1
.0
e: n
0.05
I0.5
LT:
1973 1974 1975 1976 1977 19 YEAR 0.5 1979 1 80 0.05 0.10 0.15
1973 1974 1
1976 1977 YEAR
'980
0.0200 0.0175' 0.0150I‘ 20.0125 cZTri 20.0100\ //(\
1.
u)
cc (10.00750.0050' 0.0025
\
g
kt:
1973 1974 19/5 19/6 19/7 19/8 1979 1980 YEAR
0.5
1973 1974 1975 1976 1977 1978 1979 1980 YEAR
BLACKWOOD, PlORTON 8, SONS
Figure 5.3.44 Testing the Effectiveness of the Model
Y
VALUE
  —
NI/SALES  NI/SF NI/TASF CASH/SF  CASH/TACL — CR /CL  111C/SF CL/TA
19 4
0.25
0_
1972 1973 1974 1975 1976 1977 1i 1919 YEAR 0.05
0.10
1972 1973 19i+ 1915 196 12TT 19 J979
IERR .\\: ‘
0.040 0.035 0.030 0.025 A
6 8_ a
to L, '
i \
ili
_ii i :
±0.020
0.015
\
\
i
0.010
\
0.5
972 19(3 1974 1975 19/6 1977 1918 1919
YEAR
0.0(6 1972. 1974 1974 1975 1974 197i 1978 ' 1974 YEAR
BURRELL 8, CO.
Figure 3.3.46 Testing the Effectiveness of the Model
Y VALU NI/SALES NIISF
 NiansF  CASH/SF  CASH/TAa  WC/SF
195
\
\
0.05 197
_ _ _ 19 ". 74
YEAR 1976
197
198
a
0  . 05
1972
1974
1976 YEAR
1978
990 0.15 0.20 0.25
0.14 0.12
0.' 10'
r= .. t° E0.08
\2i0.6
±:
0.04' 1972T 0.02 1976' YEAR 1978 1.980 1972 1974 1976 YEAR 1978 1980
PICKLES (WILLIAM & CO.
Figure
5.3.45 Testing the Effectiveness of the Model
Y VALUE   NI/SALES NI/SF NI/TASF CASN/SF CASH/TACL CA/CL WC/SF CL/TA
196
0.1 0.10 0.05
0.15 0.20 0.25 0.30
0.02.00 0.01750.015(1 20.0125ul 20.0100
7= U/
1. (51.50
\
i\
I' It 7 % !,
1.25
( ,. \ "4 i .00' \
ES
0. 750. 50 ...." 
0. 25 ' 197,1 0 .25 197d YEAR 1978
'0.00750.00500.0025 1976 YEAR 1978..
I. I
,
11I '\\ \I '
\ _ _ __,,/
,,.
\ 1980 .
...
)1(
1980.
0. 50
.... ..._.
CAWDAW INDUSTRIAL HLDGS
Figure
5.3.47 Testing
the Effectiveness of the Model
Y VALUE  NI/SALES NI/SF NI/TASF CASH/SF CASH/TACL —••CR/CL WC/SF CL/TA
197
O. 2
0.1 1973 1974 1975 1976 1977 197 197\9 198
1973 1974 1975 1976 1977 1978 1979 980 YEAR
50.1
0.2
0.14 0.12 1. 0.10 .0.08 ( 0.06 c2 n 0.04 0.02 0. 5( 1973' 1974 1975' 1976. 1977 1978' 1974 1980) YEAR
11111.1 1 1973 1.974 1975 1976 1977 1978 1979 1980 YEAR
RIRFIX INDUSTRIES
Figure 5.3.48 Testing the Effectiveness of the Model
 
Y VALUE    N I /SALES NI/SF NI/TASF — —CASH/SF CASH/TACL — — — CR/CL WC/SF CL/TA
198
0.030
L.501.25
0.025'
1 .00'
E0.020' i=7 cz) =0.015 = Ln
ii
ii ii
0.75' 0.50"
Ir\\ 0.010'
I.
I
/
1972' 1974 1979 YEAR 1379 1986
1972
1974
JO
1979
0.005
OXLEY PRINTING GROUP
Figure
5.3.49
Testing the Effectiveness of the Model
V VALUE NI/SALES NI/SF NI/TASF CASH/SF CASH/TACL — CA/CL IC/SF CL/TA
199
4
1974
L976 YEAR
1978
1.980
0.2250.2003 6'
\ / \

/
/
. \ /
\
\
/
/
/
/
\ \
\
0.175 o r= 0.150 174 ID 0.125
ct .
'0.100F
—s cc 2.5`I
1
\
.... ___)
.
i
I
\
\
\
\
cct L5
O. 075'' 0.5 0.0500.025• 1974' 1976 YEAR 1978 1980'
_
19JEL. • YEAR
1980'
LESNEY PRODUCTS & CO.
Figure
4
5.3.50 Testing the Effectiveness of the Model
VALUE   N I /S ALES NI/SF • NI/TASF — —CASH/SF CASH/TACL CA/CL WC/SF CL/TA
200
O. 197
_ 1974 1976 197 98
0.
0.4
0.030 
r
2.0
\ _/
\ /
/
0.025 z o a..
L , 0_015' T Ct
I3
1.5 \
\ \ ..j LO
\ \ \
I
I
.
cE
p0.020
.L. 
S 0.5 .!
\
\
t
I
1 n
_1972 74 19  YE94 16
\
C\
/ ‘ \/... \ \
i
5) 0.5
1 978 _ 1 BO _ _No
0.010 • 0.005"/
\ xi 1.0
1974
• 1976' 1978' YEAR
1980 7   URLIJE  N1/511115 NI/SF NI/TRSF — —CASH/SF CASH/TACL —CA/CL 1.dC/SF CL/TA
RICHARDS & WF1LLINGTON INDUSTRIE
Figure
5.3.51 Testing
the Effectiveness of the Model
201
YEAR
1972
1974
1976 YEAR
1978
1980
.—\
0.300.25
/ \
/// /.\
/— \ 2.5 \ / \,/ N
\
\
2.0
—l ca F'; .. a
i
,T)0.15
Li
/7
\ \ %
1.5 1_0
c_)
/
\\ 0.10I \k 0.05  137E1
%
i /
1972: 0.5
198O
1974!
• 1976 YEAR
1978.
188d
1972
1974
1976 YEAR
NORVIC SECURITIES
Figure
Y VALUE NI/SF NI/TASF CASH/SF CASH/TREL CR/CL WC/SF
CL/TA
5.3.52 Testing the Effectiveness of the Model
202
0.1
/\ — — 197 —i'80
j.1 i LL, 2 `12_3
0  .1 r. 10.2 CIS cc t 0.3 1. m
0.. 5 0.6 0.7
0.12'
2.0
0.10' z.
p0.08J: 0.06
0.
uo Li
04
/— —
, •
1374! 1976
•
0.02'
YEAR
1978'
19e0'
• 1974i
1976'
YEAR
is7d
/980'
0.5
AUSTIN(F.)(LEYTON)
Figure 5.3.53 Testing the Effectiveness of the Model
Y VALUE NI/SALES NI/SF NI/TASF CRSH/SF CASH/TACL CR/CL WC/SF CUM
203
5.3.4 OVERALL EFFECTIVENESS OF THE MODEL
To evaluate overall effectiveness of the model for all 53 companies we can look at the general trends of their four graphs such as performance (Yvalue), profitability, cash position and working capital for each company and over the time which were presented by Figure 5.3.1 to 5.3.53. If the general trend over time is improving it is called 'up', if it is constant over time it is called 'static' and if it is declining then it is called 'down'. This demonstration for
all the companies is shown in Table 5.3.2, by considering that P  profitability CP = cash position WC = working capital AOP = actual overall performance
204
Table 5.3.2 Effectiveness of the Model
I
I +
Figures
P
CP
WC
I AOP IYvaluelModel Effectiveness'
5.3.1 I up I up 5.3.2 Istatic I up 5.3.3
I
Ist atic I up I up I up up up
up up I up up up I up I
very good very good good bad excellent very good bad very good excellent excellent very good I bad very good very good very good I very bad excellent very bad excellent good good excellent very good I excellent
up
down up I up
5•3•4 'static 5.3.5
I
down 'static I up I up I up I
up I I
up
up up
5.3.6 'static I up 5.3.7
I
down
up
'static 'static I
I up I I I I up I I I I
5.3.8 'static I up 5.3.9
I
j
down
down I down I up I up
down up down
down up down up
5.3.10 I up 5.3.11
I
down
down 'static
5.3.12 I up 5.3.13 'static 5.3.14 5.3.15 5.3.16 5.3.17 5.3.18
I I
down 'static 'static
down 'static 'static 'static I
I
up down up down down
'static
up
I I I I
up down down down
I 1 I I I
up down up
I
down 'static I down down down I up
I I 1 I
down down up
down I up I I
'static
I up
5.3.19 I up 5.3.20 down
I up
1 up
up up
'static 'static 'static I
I I
5.3.21 I down 5.3.22
up down up
I I
up down up
I up I
I
down I down up
I up
down I up
5.3.23 'static 5.3.24
I up
1
1
1
I up
I up
I up
205
5.3.25 5.3.26 5.3.27 5.3.28 5.3.29 5.3.30 5.3.31 5.3.32 5.3.33 5.3.34 5.3.35 5.3.36 5.3.37 5.3.38 5.3.39 5.3.40 5.3.41 5.3.42 5.3.43 5.3.44 5.3.45 5.3.46 5.3.47 5.3.48 5.3.49 5.3.50 5.3.51 5.3.52 5.3.53 +
I
up
up up down up down down down up down down down down down do down down
I
up
I
up
I
up
excellen very good excellent excellent excellent excellent excellent good excellent very good very good very good excellent excellent very good bad excellent excellent excellent exc very good excellent excellent very good excellent very good excellent excellent excellent excellent
'static down up down down down down down down I down 1 'static down down down down down down down down down down down down down down down down down
I
'static 'static 'static down up down down down down down 'static I down
up
down
up
down down down down down down
I
down down down down down down down
'static I down 1
'static 'static 'static
I
do down down
down down down Istatic down down down down down down down down down down down down down
down do down down down down down down down down down down down down down down down down
I
'static up down down down Istatic down down down down do down do down down down down
'static I down down down down down down
'static
I
down
'static
I
down
I down 1 I down 1
I
down
206
For classifying the effectiveness of the model the following computations can be done, by this assumption that the model has almost got 33% of profitability, 33% of cash position and 33% of working capital.
1) if P
+ CP
wc U =
33% 33%
Yvalue
then 33%
99%
11
So when the effectiveness is about 99% it is called 'excellent'
2) if P
CP
1t
+ WC (static) = Yvalue
II
then 33%
33Z
+ 22% = 88%
When the effectiveness is about 88% it is called 'very good'.
3) if P
CP
+ WC
= Yvalue
or P
+ CP (static) + WC (static) = Yvalue
or P
I+
CP
+ WC (static) = Yvalue (static)
then 33%
11
332
J1
11%
=
77%
J1
or 33%
22% + 22% = 77%
11
When the effectiveness is 77% it is called 'good'.
4) if P
+ CP
If
WC (static) = Yvalue
or P
CP
+ WC
= Yvalue (static)
then 33%
+ 11%
II
22% = 66%
or 22% + 22% + 22% = 66%
207
When the effectiveness is around 66% it is called 'bad'.
5) if P
+ CP
li wc 11 Yvalue
+ 11% + 11%
then 33%
if
= 55Z
fl
When the effectiveness is 55% it is called 'very bad'.
Overall effectiveness of the model is shown in Table 5.3.3. Table 5.3.3 Overall Effectiveness of the Model
Effectiveness
(1) No
(2) I'
(1)x(2)
excellent very good good bad very bad
26 17 4 4 2
99% 88% 77% 66% 55%
25.75 14.96 3.08 2.64 1.10
1 1 1 1
total
53
47.52
1
If we divide 47.52 to 53 then we have 90%, which means that the overall effectiveness of the model is 90% or its accuracy to measure the companies' performance is about 90%.
208
5.4 CONCLUSION
In this chapter a financial model has been described which was developed to measure companies' financial performance. This model was applied to a sample of 53 companies. About 83 percent of failed companies and 100 percent of going concerns were classified correctly. Of the 15 failed companies 13 have gone into receivership and the other 2 were in serious financial difficulties. At this stage it appears that the
model might be effective in measuring the companies' performances.
A second aspect of the model is that it explains 30 percent of profitability, 37 percent of working capital and 31 percent of liquidity, which means that it almost explains the same variance of the three main factors of the companies' performance.
Finally by plotting the output from the model against time for each company separately and comparing its trend with companies' actual profitability, cash position and working capital trends (pages 151203), it is possible to demonstrate the model's effectiveness in measuring the company's financial performance. The main result of this visual analysis is that the overall effectiveness of the model in identifying the companies' strengths and weaknesses is about 90 percent.
209
CHAPTER 6 PERFORMANCE CLASSIFICATION AND COMPARISON
210
CHAPTER 6 : PERFORMANCE CLASSIFICATION AND COMPARISON
Measurements
are
taken to obtain either definitive In
statements or information for the purpose of comparison.
the analysis of financial data the comparative aspect is foremost and it is the direction of trends that is important in most cases. Consequently a standard of performance can not be established in an absolute sense and in practically all the measurements taken the previous year's results are used for comparison.
6.1 CLASSIFICATION OF THE PERFORMANCES
The next step after testing the model is to use it to classify companies. If we consider the model as the following equation:
Y =a +aR +aR+ 0 11 22
+a R 10 10
and compute the Yvalue for each company and each year separately then we have for company A:
213.
• 1971 • 1972 • 1973
=b 1 =b 2 = b 3
• 1985
=b n
Where n is the number of years, and b is the Yvalue at the
end of each year. To compute the mean value of all
Yvalues
we need to divide the total value of 'Y' by the number of years for each company. mean = m = (b + b + b + 1 3 2 +b )/n
where m is the mean of Yvalues. This mean value shows the average performance of the company over the years, or how effectively they were doing in the past. This mean value can be used as a base for analysing and evaluating each year's activity. It can be said that each Yvalue above the mean
value is classified as the good and well performing an fur all the Yvalue's below the mean are classified as the poor and bad performing companies.
So if we assume D as deviation of each year performance from the mean or simply:
D = b m
Then we can classify the company's performance into three
212
different categories such as: 1) if D>0 and b >0
That such companies are classified as the well performing companies. 2) if D<0 and b >0
Such companies are classified as the fair performing companies 3) if D<0 and b <0
Such companies are classified as the poor performing companies
By applying the above classification to our 53 sample companies we have: well performing companies fair performing companies poor performing companies 20 15 18
To identify cutoff lines to distinguish areas which specify
the above three categories, we can compute Z:b /m j=1 nj group separately where m is the number of companies
for each
in each
group and b is the terminal 'Yvalue' for each company. Then
20 well performing=Z:b /20=66.486/20=3.3243 j = 1 nj
213
15 /15=28.4912/15=1.899 fair performing4 j=1 nj
b
18
poor performing
=t=b
/18=38.5746/18=2.143 j=1 nj
And the cutoff lines are calculated as follows: a) cutoff line between first and group=(3.3443+1.899)/2=2.6 b) cutoff line between second and third group=(1.8992.143)/2=.244 second
So by the above calculations we can specify the cutoff lines as follows: If Y>2.6 If 2.6>Y>.244 If Y<.244 well performing companies fair performing companies poor performing companies
The above classifications can be shown as
well performing area 2.6 fair performing area .244
poor performing area Figure 6.1.1 Classification of performing area
By applying the above classification criterion to the sample companies which have been presented in Chapter 5 we have:
214
Table 6.1.1 Applying the new classification to the sample companies
CLASSIFICATION
NO OF CO
FAILED
GOING
1
WELL FAIR POOR
16 21 16
0
16 21 1
1 1
15
1
As
we
can
see
from
the
above
table
100% of the well
performing companies are truly classified and 94% of the poor companies have gone into receivership and the other 6% are in serious difficulty. 100% of those classified as fair
performing companies are going concerns. Therefore, the model can classify 98 percent of the whole sample correctly. companies
The companies comprising the three classes are: a) WELL PERFORMING COMPANIES 1) General Electric Co. 2) Coalite Group 3) Allied Textile Companies plc 4) British Home Stores plc 5) Bell (arthur) & Sons plc 6) Wellcome Fundation 7) Benford Concrete Machinery plc 8) Beecham Group plc 9) Marks & Spencer
215
10) Pearsons 11) Racal Electronics 12) BPB Industries plc 13) Allied Colloids plc 14) Ash & Lacy plc 15) Boots Co plc (The) 16) British Gas Corporation b) FAIR PERFORMING COMPANIES 17) Anglia Television Group plc 18) Goodyear Tyre & Rubber Co (GB) Ltd. 19) Babcock International plc 20) APV Holdings plc 21) Ault & Viborg Group plc 22) Albright & Wilson Ltd. 23) Barrow Hepburn Group plc 24) Pleasurama plc 25) British Railways Board 26) Anchor Chemical Group plc 27) Baker Perkins Holdings plc 28) Ford Motor Co Ltd. 29) Adams & Gibbon plc 30) Armitage Shanks Group Ltd. 31) Atkins Brothers (hosiery) plc 32) Dunlop Holdings plc 33) Barno Industries plc 34) BBA Group plc 35) Batleys of Yorkshire plc 36) Bemrose Corporation plc 37) Bestobell plc
216
C) POOR PERFORMING COMPANIES 38) Brocks Group of Companies Ltd. (Receiver
appointed 3rd March 1981) 39) Stone Platt Industries plc (Receiver appointed 18th March 1982) 40) British Airways (On 12th March 1986, because of difficulties on renewal of the UK/US Air Service Agreement and other political reasons the Government decided to privatise British Airways. On 30th september 1986, British Helicopter Ltd.(BAHL) was sold.) 41) Viners (Receiver appointed 16th November 1982) 42) Blackman & Conrad (Voluntary Liquidation 11th February 1981) 43) Amalgamated Industrials (Compulsory liquidation 6th November 1981) 44) Blackwood, Morton & (HLDGS) (Receiver appointed 15th November 1981) 45) Pickles (William) & Co. (Receiver appointed
16th June 1982) 46) Burrell & Co. (Receiver appointed 4th August 1980) 47) Cawdaw Industrial HLDGS (Receiver appointed 22nd February 1982) 48) Airfix Industries (Receiver appointed 29th
January 1981) 49) Oxley Printing Group (Receiver appointed 17th
August 1981)
217
50) Lesney Products & co. (Receiver appointed 11th June 1982) 51) Richards & Wallington Industries (Receiver
appointed 15th July 1981) 52) Norvic Securities (Receiver appointed 15th July 1981) 53) Austin (F.)(Leyton) (Receiver appointed 31th
July 1982)
Or testing the model's effectiveness
is
classifying
companies it might be enlightening to compare its effectiveness with those of other models that exist for this purpose which is the subject of the following discussions.
6.2 FAILURE PREDICTION STUDIES
Business failures can be attributed to circumstances or conditions that were known prior to make any major financial commitments and could be easily identified. For some reason whether enthusiasm or ignorance, management simply failed to recognise the importance or existence of these failures.
The prediction of failure was stimulated in the USA by the high rate of business failures during the Depression of the 1930s. Between 1930 and 1942, five studies were undertaken,
by Fitzpatrick (1932), Smith (1930), Smith and Winakor (1935), Ramser and Foster (1931), and Merwin (1942). These studies gave a good indication of the data which appeared to be relevant to the prediction of failure. Some data were shown to indicate serious weaknesses in a company several years in
218
advance of failure. The idea was that, for example if current assets more than current liabilities, this was a sign of strength. The lower the current assets, the greater the weakness. The extremes could readily be identified, and a
cutoff point or range could be established from predictive experience. Most of the data was in the form of ratios, and
those which appeared to be useful predictors were: 1) Current ratio=current assets/current liabilities (two studies) 2) Acid test ratio=(current assetsinventories)/ current liabilities (two studies) 3) Net Worth to Fixed assets=(total assetstotal liabilities)/ Fixed assets (five studies) 4) Working capital to total assets=(current assetscurrent liabilities)/total assets (four studies) 5) Net profit to net worth=Net profit/net worth (three studies) 6) Net worth to total liabilities(total assetstotal liabilities)/ total liabilities
The first two measuring the company's ability to meet shortterm liabilities. The others measuring the overall, The ratio
long and short term position of the company.
analysis has been considered as a tool in assessing current and expected company performance, in relation to investment decisions as well as more specially in relation to the prediction of failure.
The next major study was by Tamari (1964) on Israeli data, who found that six ratios in particular were good predictors
219
of failure, in some cases up to five year ahead, and all cases in the year prior to failure: 1) current ratio, as above 6) net worth to total liabilities, as above 7) (sales+change in inventory)/inventory 8) sales/(current assetscurrent liabilities) 9) profit trend(fitting a trend line to profit figures over the recent past) 10) sales/debtors
Tamari observed that a large proportion of the successful companies in his sample had at least one weak ratio, some had two and even three. He concluded that the analyst can not rely on one ratio alone in measuring the degree of risk associated with a company.
Beaver (1966) found that the best predictor of failure was the hitherto untested longerterm ratio: 11) cash flow/total debt 12) net profit/total assets 13) total liabilities/total assets
Beaver tested the ability of financial ratios to predict failure. He found that not only the financial ratios of failed firms differ significantly from non failed firms, but they deteriorated considerably during the five years prior to failure. He also found that the mean of total debt over total assets of the failed firms was 0.79, whereas that of the non failed companies was 0.37. He should that the low ratio of net profit over total assets is one of the three major
220
characteristics of the company failure.
Horrigan (1968) showed that in the 1930s, the first attempt were made to test the utility of ratios by examining how effective they were in predicting business failure.
Altman (1968) attempted to 'assess the analytical quality of ratio analysis  a set of financial ratios was combined in a discriminant analysis approach to the problem of corporate bankruptcy prediction, by the use of multiple discriminant analysis. Discriminant analysis aims at distinguishing
between two or more distinct populations on the basis of some characteristics of their members, and the classification of individual companies into one or other of the classifications, in this case 'failing' and 'nonfailing'.
Altman, like Beaver, selected a sample (thirtythree) of solvent companies to 'pair' with companies. (thirtythree) failed
From twentytwo ratios, he selected five that
appeared to be most effective in predicting failure, and these ratios were used to discriminate between failed and solvent companies, using data from one to five years before failure. The predictive ability of his'fiveratio' model declined in proportion to the number of years prior to failure but was able to predict fairly accurately up to two years ahead.
221
Altman assigned weights to each of his ratios, as below: weights (4) working capital/total assets (14) Retained earning/total assets (15) EBIT/total assets (16) debt (17) sales/total assets 0.012 0.014 0.033
Market value of equity/book value of longterm 0.006 0.999
These ratios were drawn together, with the weights assigned to each of them to give an overall score, often called the Z factor:
Z=(4)W +(14)W +(15)W +(16)W +(17)W 4 16 15 17 14
According to Altman, a minimum Z score of 1.8 is necessary to avoid failure, but only with a Z score of 3.0 or more is the company fairly safe.
222
Table 6.2.1 The Predictive Accuracy
+ Altman's predictive accuracy + within one year within two year within three years within four or five years 95% 75% 48% 30%
Taffler (1977) has used a model to predict failure among UK companies which has the following characteristics:
Z=C +(PBT/AVCL)C +(CA/TL)C +(CL/TA)C +(No Credit interval)C 0 1 2 3 4 Where C is a constant which measures half the distance between 0 the Z score of the failed and solvent companies, C ,....,C are 1 4 the weights, (PBT/AVCL) is the ratio of profits before taxes to average current liabilities and 'No credits' interval=(cash and market securitiescurrent liabilities)/projected daily operating expenditure The weights C to C contributed 0.53, 0.13, 0.18 and 0.16, 1 4 respectively, to the models operation. cutoff point was found to be Z = 1.95. The failed/insolvent
Betts (1984) developed two models for identifying those companies which are in danger of financial failure, using published accounting data and multiple discriminant analysis.
223
On the basis of these studies, it appears that financial ratios can be used as predictors of various events, and it is likely that ratio analysis will become more useful in future.
6.3 COMPARISON OF THE MODEL WITH SIMILAR MODELS AND STUDIES
Although some studies have been undertaken to measure the overall financial performance of companies, the main problem with these studies is the proprietorial nature of the models, which makes comparison of performances of different models difficult. However, there are some similarities of the
present study with others which is presented in this section.
According to the previous studies such as Wall & Dunning (1928), Tamari ( 1964), Smith (1965), Lev (1974), Altman (1977), Hoshino (1982) and Taffler ( 1982), the current ratio is a good indicator of company's success and failure. Tamari
also found from data of manufacturing companies in Israel in 1968 that 70 percent of failed companies had a current ratio less than 1.0 whereas only 27 percent of non failed companies had similar values.
In this study, it was found that the current ratio is significantly related the company's financial performance. As described in Table 6.3.1, 88 percent of well performing companies had a current ratio in excess of the optimum liquidity ratio which is 1.5 according to Richard (1964). 75
percent of poor performing companies had a current ratio less than 1.5 which is called under liquidity and they all had payment difficulties.
224
Table 6.3.1 A comparison of current ratios with differing levels of company overall financial performance.
liquidity ratio R = CA/CL
over liquidity R>2.0
optimal liquidity 2.0>R>1.5
under liquidity 1.5>R>1.0
payment difficulties R<1.0
I
Well performing Fair performing Poor performing
57% 5% OZ
31% 48% 25%
6% 382 372
6% 9% 38%
The variation in the current ratios overtime for particular companies are depicted in the lower right graphs of Figures 5.3.1 to 5.3.53.
There are also nine studies which found that business failure is usually linked with low or declining profitability. The studies were those of Beaver (1966), Altman (1968), Haslem and Langbrake (1971), Schoeffler (1974), Tamari (1977),
Taffler (1977), Bass (1978), Belhoul (1983) and Betts (1984).
As indicated in Table 6.3.2 the present study showed that about 81 percent of well performing companies had excellent and good profitability whereas 100 percent of poor performing companies had low and deficient profitability with about 94 percent of them have already gone into receivership.
225
Table 6.3.2 A comparison of profitability ratios with differing levels of company overall financial performance
+
+
1 1 1 1 1 1
1 1
deficient I good excellent IR — NI/SFlprofitability 'profitability 'profitability I R>0.15 I 0.15>R>0.10 I 0.10>R>0.0 I
danger of failure R<0.0
1 1
well fair poor
50% 19% OZ
31% 19% OZ
19% 57% 19%
OZ 5% 81%
Another good indicator of business success or failure was found to be company's cash position. This view is shared by Beaver (1966), Blum (1969), Gonedes (1971), Deakin (1972), Martin & Scott (1974), Pinches (1975), Mao (1976) and Belhoul (1983).
Table 6.3.3 presents information on the cash position of companies for varying levels of overall financial performance. The variation of this ratio over time is shown at the lower left of Figures 5.3.1  5.3.53 for various companies. In
summary nearly 56 percent of well performing companies had a considerable margin of cash in hand to make immediate payments whereas 100 percent of poor performing companies had problems meeting immediate payments.
Table 6.3.3 The comparison of cash position ratios with differing levels of company overall financial performance
+ 1
+
'cash position lexcellent Ivery good 1 R =. cash/SF I R>0.15 .15>R>.10
1 +
good bad very bad I .10>R>.05 .05>R>.01 I R<.01
1 1
+
well fair poor +
44% 5% OZ
6% 5Z
6% 33% OZ
25% 33% 44%
19% 24% 56%
1 1
OZ
1
+
The models output is also depicted in the top left corner of Figures 5.3.1 5.3.53. This output can be simultaneously compared with the three main indicators of company financial performance, ie. profitability, working capital and cash
position, for the 53 companies analysed.
By the above analysis it was found that the effectiveness and accuracy of the model to measure companies' financial performance whose data were used to construct the model is about 91 percent which dropped to 88 percent when it was applied to companies whose data was not used in the model's construction. However, the overall effectiveness of the model is about 90 percent which can be compared with some of the other model's and studies accuracy regardless of their
specific purposes or different techniques or criterions used for their construction. Some of these studies are summarised in Table 6.3.4 as follow.
Table 6.3.4 The Classification Accuracy of Some Financial Performance Models
1
authors
1
year
area of study
'classification accuracy 2'
1
1 1
Walter Smith Altman
11959 11965 11968
& 1
financial characteristics common stock analysis failure prediction
80 72 75
1
1
Haslem
1
Longbrake 11971 Frank
& 1
bank performance analysis
86.5
1
1
Weigandt 11971 Klekowsky
1
debt characteristics analysis
90
1
1
& Petty 11973 Blum White (1974 11975
& 1
share price analysis
86 81.7 84
1
business failure analysis
shares analysis
1
1
Schick
1
Verbrugge 11975 'financial characteristics analysis Taffler 11977 company failure analysis profitability analysis
77 98.5 94.4
1
'Gillingham 11980
1
Betts
&
1
1
Belhoul 11982 Belhoul 11983 Betts 11984
company failure analysis high performing companies failure prediction analysis
97 85 90
1
1
Finally the classification accuracy of this model is compared with that of Betts' (1984) first model. Although,
228
Betts' model was designed for the restricted purpose of identifying financially failing companies within a set of going concerns, it was thought that such a comparison may be useful, because the present model ought among other things be able to identify failing companies.
The model was applied to 15 out of 23 failed companies that Betts (1984) used in his study and it was able to classify them as failed companies. It was then applied to another 6 companies which Betts defined as well known financially healthy companies and again they were classified correctly. • These companies are Allied Colloids Group Plc, Anglia Television, Coalite Group, General Electric Co, Pleasurama Ltd and Racal Electronics.
229
6.4 CONCLUSION
In this chapter the model was used to classify companies. The average performance of the company over the years was used as a base for analysing and evaluating each year's activity. The cutoff line between well and fair performing companies found to be Y = 2.6, and between fair and poor performing companies was computed to be Y = .244. These criteria were applied to the sample 53 companies. 100 percent of well
performing companies and 94 percent of poor performing companies were correctly classified.
At the end of this chapter the similarities between the present model and other models were discussed in detail.
The main result of above comparison is that we have almost used the same indicators of business success or failure as others used in their models and studies. model's By comparing the
output with these main indicators of company's
financial performance, it reveals that the accuracy of the model in measuring company's financial performance whose data were used to construct the model is about 91 percent which dropped to 88 percent when it was applied to companies whose data was not used in the model's construction.
230
CHAPTER 7 PERFORMANCE STABILISATION
231
CHAPTER 7 : PERFORMANCE STABILISATION
The goals of performance stabilisation are not simply to eliminate fluctuations in performance variables, but to force variables to follow 'ideal' paths. For example a 5% profit margin even if it is constant over time, is not acceptable. Thus the goals of stabilisation might include reaching (and then maintaining) a high rate of profitability, a high rate of working capital and a low rate of leverage. Eliminating fluctuations in the company performance is therefore a
secondary objective that becomes desirable only after the performance has reached a 'healthy' steady state.
In other words, we would like variables such as current assets, current liabilities, net income and cash as closely as possible to follow a nominal or 'ideal' path throughout the performance period.
7.1 PERFORMANCE STABILISATION
The structural model of stabilisation consists of four equations which are extracted from five different factors. The factors themselves are extracted by factor analysis available on SPSSX at University of Bradford. The variables
are R1 to R10 the main 10 variables of Ymodel and the number of cases are 7420 (530 companies multiply by 14 years of activity for each company). By applying the above package to our variables we can construct the following equations:
232
F 1 F 2 F 3 F 4 F 5
= .60132ZR 2 = .49905ZR 5 = .53485ZR 1 = 1.07767ZR 9 = .82264ZR 6
+ .4056ZR 7 + .50836ZR 8 + .4632ZR 3
+ .15715ZR 10
Where the Z is the normalised value of ratios and is equal to Z = (variable  mean)/standard deviation
By replacing the actual variables in the above equation we have
F 1 F 2 F 3 F 4 F 5
= 1.1R 2 = 5.1R 5 = 9.96R 1 = 7.627R
+ .34R 7 + 4.54R 8 + 3.83R
 .276
 .594
 .826 3
 2.887 9
= 1.04R 6
+ 1.23R 10
 2.19
And by substituting the real variables with the ratios we have F = 1.1NI/SF + .34(CACL)/SF  .276
1
F = 5.1CASH/CA + 4.54CASH/(TACL)  .594 2 F = 9.96NI/SALES + 3.83NI/(TASF)  .826 3
233
F = 7.627CL/TA  2.887 4 F = 1.04CA/CL + 1.23(CAINVENT)/TA 5 In Chapter 6 it was seen that well performing companies had D?,0 and b  140
b
Which means that for well performing companies the b score in year n should be greater than or equal to M the mean value of bn scores. So to get an ideal value we can write
b =M
or b =riff +mF +mF +mF +mF = M n 1 2 3 4 5 where mF is equal to the mean value of the factor 1 1
On the other hand the mean values of factors are equal to zero and their standard deviation is equal to one, which means that M 0 or simply 1.1NI/SF + .34(CACL)/SF .276 = 0 5.1CASH/CA + 4.54CASH/(TACL)  .594 = 0 9.96N1/SALES + 3.83NI/(TASF)  .826  0 7.627CL/TA  2.887 = 0 1.04CA/CL + 1.23(CAINVENT)/TA = 0
234
Finally the
ideal values for four important and
controllable variables such as CA, CL, CASH and NI are calculated as follows: ideal CA = OCA = .55TA + .31INVENT ideal CL = OCL = .378TA ideal CASH = OCASH = .37TACA/(3.2TA + 4.5CA) ideal NI = ONI = .826SALES(TASF)/(9.96TA
9.96SF+3.83SALES)
In this chapter the ideal path based on the above equations together with its associated actual path which is based on historical data are presented in graphical form. This is done so as to make it possible to easily observe the general form and characteristics of the ideal solution. We can consider the positive direction (+) for each actual value above or better than the ideal value and negative direction () for each value below the ideal value (except for CL). By doing
the above classifications for all the cases which are the whole set of sample companies the results can be shown in the following tables.
235
Table 7.1.1 Comparison of Ideal Path with its Actual Path
COMPANY
NET WORKING CAPITAL I INCOME
I
CASH
General Electric Co Coalite Group Allied Textile Companies plc British Home Stores plc Bell (Arthur) & Sons plc Wellcome Fundation Benford Concrete Machinery plc Beecham Group plc Marks &Spencer Pearsons Racal Electronics BPB Industries plc Allied Colloids plc Ash & Lacy plc Boots Company plc (THE) British Gas Corporation Anglia Television Group plc Goodyear Tyre & Rubber Co (GB) Ltd. Babcock International plc APV Holdings plc Ault & Wiborg Group plc Albright & Wilson Ltd. Barrow Hepburn Group plc
+ + + + + + + + + + + + + +
+ + + + +
+ +
+ + +
_ + + + + + + + + + + + + _
+
+ + +
+
+

  + + + 
+ + +
+
236
Pleasurama plc British Railways Board Anchor Chemical Group plc Baker Perkins Holdings plc Ford Motor Co. Adams & Gibbon plc Armitage Shanks Group Ltd. Atkins Brothers (hosiery) plc Dunlop Holdings plc Barno Industries plc BBA Group plc Batleys of Yorkshire plc Bemrose Corporation plc Bestobell plc Brocks Group of Companies Ltd. Stone Platt Industries plc British Steel Corporation British Airways Viners Blackman & Conrad Amalgamated Industrials Blackwood,Morton & Sons Pickles (William) & Co Burrell & Co. Cawdaw Industrial HLDGS Airfix Industries Oxley Printing Group Lesney Products & Co. Richards & wallington Industries
+ + 
+ + + 


+ +   + _  +

  





237
1
Norvic Securities
 1 1 1 1
Austin (F.)(Leyton)
 1 1 1  1
1
As the above table shows, in well performing companies 100% of working capital, 88% of the net income and 63% of the cash are above
ideal
values and in poor performing companies,
100% of working capital, 100% of the net income and 100% of cash are below their ideal paths. It means that all the companies that have gone into financial difficulties and receiverships were suffering from insufficient working
capital, lack of profit and shortage of cash and the majority of well performing companies are doing very well in the above three important dimensions.
7.1 PERFORMANCE IMPROVEMENT
From the quantitative model of the characterics of the failing company, Argenti suggested what he called three possible trajectories of failing company performance, which are illustrated below:
Exce lent a)
E
E
o
O 0
o
0
Good
m 0
a)
0
dG
clAp
41 Poor
;I
a) fa4
k
a) 1:14
Fai ..,, Time Type 1
F . s Time Type 2 Type
. "Time 3
Time Type
)1,
4
238
Type (1) failure should be preventable at the planning stage. The company never performs satisfactorily,
and should probably never have been established. Type characteristics, (2) failure exhibits 'mercurial'
with very high growth rates and other
performance measures, until some point at which the company overreaches itself and collapses equally dramatically. Oneman rule is, according to Argenti,
a major feature of such
companies, and the prevention of collapse should take the form of a moderating influence, preferably from inside the company otherwise from the company's bankers and advisers. Type (3) companies are probably typical of the longestablished business which has not 'moved with the times' and has not recruited enough professional management from outside the company. The dashed lines indicate what might happen if the company were rescued by a management change or other factor and in case of the nonfailed company what might happen if things start to go wrong.
Argenti's study is interesting because it relates a largely qualitative approach of management alongside he quantitative and statistical research studies, in an attempt to identify common themes in the behaviour of failing companies.
In our case we can not do anything about the poor companies because they have already failed to meet a certain level in their activities, but we are able to keep the fair and well performing companies at a good level or as close as possible to their ideal paths to improve their further activities. This can be effective when the other environmental factors are
239
Table 7.2.1 Performance Improvement Recommendations
COMPANY
1VARIABLESIFROM (O00)
19851
TO 1986 (E, 000)
Allied Textile Companies plc British Home Stores plc Bell (Arthur) & Sons plc Wellcome Fundation
Cash CA CA CA NI
I
1093
I
116981 156976
466500
1695 1219393.3
I
1169387.3
I
I
489621 37121.4 584 856.3 1356095 1097287 511465 284238 15253 3092.3
31600
I
I
Benford Concrete Machinery plc
NI Cash
474 116
1247800
I
I
I
Beecham Group plc Marks & Spencer Pearsons BPB
CA CA CA CA Cash
I
I
456600
I 471434
I
I
I
215500
I
3900 915 48089
I
I
Allied Colloids plc
Cash CA
I
53810.1 15904.2 767872 43307.1
Ash & Lacy plc Boots Co plc (THE)
CA CA Cash
15149 674000 9000
I
I
I
British Gas Corporation
CA Cash
J
2735500 110193209 30300 1868 261667 2310
I
I
Anglia Television Group plc
NI Cash
I
448 1097 593
1458.8 7208.1 5308.3
Goodyear Tyre & Rubber Co Ltd.
NI Cash
I
1
241
Babcock International plc
CL NI
I
349000 24800 119606 3890 816 197827 6517 11221 992
15424
1
26
54
j
I
1
50803.4
APV Holdings plc
CL NI
1104406.6
1
I
17486.6 3329.8
Ault & Wiborg Group plc Albright & Wilson Ltd.
NI CA Cash
I
1
I
1225330.1 12876.5 9333.2
I
I
Barrow Hepburn Group plc
CL NI
I
I
1642.9 67990.6 1139238
Pleasurama plc British Railways Board
CA CA NI Cash
I
I
I
859300
I
97300
I 27100
1124287.2
I
61619 4547 61614.4 10497.4 6713.2 1223208
Anchor Chemical Group plc Baker Perkins Holdings plc
CL CL NI Cash
I
6213
84139
I
I
I
I
7999
3984
I
I
I
Ford Motor Co.
CL NI Cash
I
1297000 45000 117000
I
1179715.6 1128949.1
I
Adams & Gibbon plc
CA CL NI Cash
I
6682 4617 413
6906.1 3917.6 808.3 405 59128.1 35482.5 3134.4 5307.6
I
I
I
2 45644 36837 16
I
Armitage Shanks Group Ltd.
CA CL Cash
I
I
I
I
1
Atkins Brothers (Hosiery) plc
CA NI
I
4914 169
I
I
467.6
242
Cash Dunlop Holdings plc CL NI Barno Industries plc CL NI Cash BBA Group plc CA NI Cash Batleys of Yorkshire plc CA CL NI Cash
43 808 0 7838 439 142 70644 1217 1101 18674 19087 1260 2
3
.4
396.1 81.6 5079.6 994.8 545.6 77872.8 7548.5 4445.2 20150.8 10528.4 3336.4 1111.4
+
7.3 A GRAPHICAL ILLUSTRATION OF IDEAL PERFORMANCE
As stated in pages 232235, there are four ideal equations for four important and controllable financial variables such as current assets, current liabilities, cash and net income.
In the following pages, the graphs for all the companies are listed according to their classifications such as well, fair, and poor performing companies. All the ideal paths are indicated by '0' at the beginning of the variables, for example OCA stands for ideal current assets which is plotted against CA or actual current assets. If CA is greater than OCA it is favourable but if it is lower than OCA it is not favourable. For example, this kind of evaluation can be done for three different classified companies as follows:
WELL PERFORMING COMPANIES
These companies are shown from Figure 7.3.1 to 7.3.16. If we take a look at the General Electric Co (Figure 7.3.1) on the top left hand side current assets is plotted with its ideal path, on the top right hand side is the current liabilities with its ideal path, on the bottom left hand side is net income with its ideal path and on the bottom right hand side is cash with its associated ideal path. As it can be seen the current assets and current liabilities are better than their ideal paths, which means that the working capital of the company is at a good and satisfactory level. Company's net income and its cash are both well above their ideal paths.
244
This evaluation shows that the General Electric Co is doing very well in working capital, net income and cash, and the overall performance is improving.
FAIR PERFORMING COMPANIES
These companies are illustrated from Figure 7.3.17 to 7.3.37. By looking at the Anglia Television Group plc (Figure 7.3.17) we can see that its current assets and current liabilities are nearly the same as their ideal paths and its net income and cash have gone under their ideal paths. This
means that the working capital is almost ideal and static, while the net income and cash are both declining but they are still above the safety level and overall performance is not bad.
POOR PERFORMING COMPANIES
Poor performing companies are shown from Figure 7.3.38 to 7.3.53 and we choose the Burrell & Co as an example. This company's current assets and current liabilities are worse than their associated ideal values and its net income and cash are also far below and worse than their ideal paths. This
means that this company's working capital, its net income and its cash are declining sharply and the company is in danger of failure and bankruptcy. In fact as indicated in 5.3.3 a
receiver was appointed for this company on 4th August 1980.
245
The difference between cash graph in Figures 7.3.1 to 7.3.53 and cash position graph of Figures 5.3.1 to 5.3.53 is that the first one shows the total cash held by each company at the end of each year and second one is equal to the ratio of cash over shareholders fund and the ratio of cash over total assets minus current liabilities. This is also
indicated in legend at the bottom right hand side of each graphs.
246
4.0E6 1.8E63.5EEi 3.0E6 H LL ui T. 2.5E6 / 1.6E6 /   in 1 . 4E6 LLI :1.2E6 ::j. 1.0E6/ / //'
/
/1 / ?'"1
/ '
///
E cc
1
u
2.0E6 1 . 5E6 1.0E6 1974 1976 1918 1980 YEAR .
/
,. /
LI:10.8E6a() 0 . 6 E G0.4E60.2E61982 1984 1974
/
1976
/ /' ,/
1978 198d YEAR
1982
1984'
1.2E6 4.0E5 3.5E5 3.0E5 (75 W 2.5E5Lu
1.0E6
i ;
(.Z‘..
Ln
5 0.6E6
2.0E5 1.5E51.0E5 0.5E5 1974 1976
/
!
/
0.4E6
0 .2E6 7 •   'N....." / 1978 1980 YEAR 1982 1984 / _____ •1976 1978 1974 198d YEAR
. 
 
1982
1984'
GEACJ
GENERAL ELECTRIC CO
CL —
NI • — OCASH CASH
Figure 7.3.1 A Graphical Illustration of Ideal Performanc
247
1.8E5 800001.6E5 700001.4E5 Ln 1u. 60000
E1.2E5Ln
1.0E5 Lu z' L_) 0.8E5 0.6E5 0.4E50.2E51974 1976 1978 1980 YEAR 1982' 1984'
Li
40000
a 300002000010000
1974 13 S 1378 1980 YEAR 1982 1984'
3000018000 16000 14000' 2000912000'
Li
25000
— 10000ILi 800060004000' 2000' 1974 1976
(cf, 15090
/7
710000
1978 1980 YEAR
1982
1984
1974
1976
1980 1978 YEAR
1982
1984 cn ocn
COALITE GROUP COME Figure 7.3.2 A Graphical Illustration of Ideal Performance
CL — —ON! N OCF1SH CASH
248
3500014000
30000 u) Li
U,
12000
25000 c L:2
a L=.I
a. Li
("x c. ;1• 10000',
20000
I_TJ
/
8000
Li
\I
15000
7;"\
60004000
100001972 1974 1976 1978 YEAR 1980 1982 1984 1972 1974 1976 1978' 1980 YEAR 1982 1984'
2500
t \
2250 2000
i i \ .. /...\
2250 I 2000 1750 1500
,'",
r
17501500I
:
1
1
1
s
\
I /
/
Li
,..
1
1
T I. \ \/ ...," L C 1250 ec
Li
I
\
1ZI 1250 1000 •50 500 1972 1974 1976 1978 YEAR 1980 1982 1984
000 1
v / , ......'
\ I K :
\I
I
i
750 500250 972 1974 1976 1978 YEAR 1980 1982 1984 CA OCR — —
ALLIED TEXTILE CO. PLC
Figure 7.3.3
A
Graphical Illustration of Ideal Performance
— — °CASH CASH
21+9
200000175000
1.2E5
E.11.0E5 V2150000125000 10000075000500000.2E5 250001974 1976' 1978 1980 YEAR 1982 1984 1974 1976 1978 1980' 1982' 1984' YEAR PIET
!21
tri'i 0 . 6E5
cr.
Li
=
0.4E5
I/
70000 60000
35000t 30000
/
50000 u, 25000
Ei
Li
FA 40000
—20000Ui
I
Li
30000 1500020000
10000
1000050001974 1976' 1978' 1980' 1982' 1984' YEAR
•
1974
1976
1978 1980 YEAR
1982' 1984' CA OCR — CL
BRITISH HOW STORES
Figure
7.3.4
A Graphical Illustration of Ideal Performance
 NI — — — OCFISH CASH
250
1 ,6E51,4E51,2E5LU
113
90000 8000070000
1600001,0E50. 8E5
22.
50000Li 0.8E50,4E5cc 4 0000(X Lij
,
Li
300002000010000_
rr\ J
I
\1
/
1972
1974
1976
1978 YEAR
1980
1982
1984
1974 1982 1972 19841 4 1976 1978 1980 YEAR
20000 2500017500 15000 (512500
, 5 11:
20000
Li
I 10000 g
15000
7500 5000 2500 972 1974 1976 1978 YEAR 1980 1982 1984
10000
5000— 1972 1974 1376 1978 YEAR 1980 1982 1984
BELL (ARTHUR) & SONS PLC
Figure
7.3.5
OCA — — —0N1 NI — NASH CASH
A Graphical Illustration of Ideal Performance
251
3.0E54.5E5 4.0E5
tr)
2.5E5
LU
_
,3.5E5
LU
tf'. 3.0E5 c
_
'Er3 cr.
2.0E5
1 . 5E5u.; cc
2.0E5 er
LU 1 . 0E5
1.5E5
1.0E5 1972 1974 1976 1978 YEAR 1980 1982 1984
/
0.5E5._ 1972 1974 1976 1978 YEAR 1980 1982 1984
1.0E5 35000 30000 Lu
/1
/
0.9E5 0.8E5 0.7E5
2:
E U
z
25000 ,,,i.'J 20000 1500010000 5000 1972 1974 1976 1978 YEAR 1980 1982 1984 4 • _
_... 7t._ .
.
i I
i
0.6E5
Lt.)
E9 0.5E5
/ //'./'
V
0.4E5 0.3E5 0.2E5
_
0.1E5 1972 1974 1976 1918 YEAR 1980 1982 1984 CA OCR CL — ON I NI — — °DISH CASH
WE.LLCOPIE FUNDAT ION
Figure
7.3.6
A Graphical Illustration of Ideal Performance —
252
1600014000"
80007000 tri Li ;7260005000L 400C
EV
E 12000cc
'2 /0000cr.
Booci
6000400097i 1974 ' 1976' 1978 ' YEAR 1980 ' 1982 ' 1984'
30002000 1972 1974 ' 1976 ' 1978' YEAR 1980 1982 1984
1800/
/60C
/
//
\
900 800
• \ \ • I \... 1\ .1 %
700600 tT) 500
1400
LIJ
I.
E, 12001 1000
400 800600 400 972 1974' 1976' 1978' 1980 YEAR 1982 19841 300 200 100 1972 1974
,/
/
1976 1978 YEAR 1980 1982 1984
BENFORD CONCRETE MACHINERY PLC
Nigure 7.3.7 A Graphical Illustration of Ideal . Performance
CA OCR GEL — CL — I NI — KASH CASH
2 3
F
8E5
I .2E6 7E51.0E6
c.n LI;
6E5 'i'D 5E5 fc
uE 0.8E6 c)
6 0.6E6
0.4E6
'lt 4E5
Li
/
3E5///
2E50.2E6 1974 1976 1978 1980 YEAR 1982 1984 1E51974
Ji
19761 1978 1980 YEAR
1982
1984'
1.6E5 1.4E5
2.5E5
2.0E5
w
CD
1.2E5
Z' 1.0E5
0.8E5
II
/ LT 1.5E5
/ cr
1.0E5 0.6E5 0.4E5 0.2E5 1974 1976 1978 1980 YEAR 1982 1984 1974 1976 0.5E5 '1978 1980 YEAR
1982
1984 CA
BEECHAM GROUP PLC
Figure
ocn
7.3.8 A
Graphical Illustration of Ideal Performance
CL —ON] NI — — — — OCASH CASH —
254
7E5 1.0E6 6E5
o . 8E6
(.1)
MU) I
r".". 5E5 4E5
O. 6E6
LU
ix cr
LU
IT. 3E5 0.4E6
LU
2E5 0.2E6 1E5 1974 1976 1978 1980 YEAR 1982 1984 1974' 197E: 1978 198d YEAR 1982 1984'
1.8E5 1.6E5 1.4E5 614.1.2E5
LU
80000 70000
/
U) cr
60000 50000 40000
1.0E5Lu 0.8E5 V 0.6E50.4E50.2E5 1974 1976 1980 1978 YEAR 1982' 1984
rt
••n
30000 20000 100001974' 1976' 1978' 198d YEAR 1982' 1984' CA OCR — CL —ONI NI – °CASH CASH
///
MARKS & SPENCER
Figure 7.3.9 A Graphical Illustration of Ideal Performance
255
5.0E5 4.5E5 4.0E5
E 3.5E5
v)
3.0E5
2.5E5if
21 cr.
2.0E5
r
3.0E5 11: 2.5E5 5 I..) 2.0E5 1.5E5 ,///' 1.0E5
i t!
1.5E5f' 1.0E5
0.5E5/ 0.5E5 97i 1974' 1976' 1978' 1980' 1982' 1984 YEAR 972' 1974 1976 1978 YEAR 1980 1982 1984
60000
9000080000
50000 '7000T u, 4000060000
ICi] 30000z
20000
g!.450000L)
40000 3000020000
100001972 1974 1976 1978 YEAR 1980 1982 1984'
100001972' 1974' 19761 1978 YEAR 1980 1982 1984' CA OCA — CL — —ON! N1 (KASH — —  CASH
PEA RSONS
Figure 7.3.10 A Graphical Illustration of Ideal Performance
256
8E5 7E5 6E5
cr,
4.5E5 4.0E5 I 3.5E5 .t; 3.0E5
Fi
LU a.
I.T.J
4E5 3E5 2E5 1E5 1974 1976 1978 1980 YEAR 1982 1984
..J
LT,
cr. ()
2.5E5 2.0E5 1.5E5 1.0E5 0.5E5 1974 1976 1918 1980 YEAR 1982 1984
80000 '70000
7000060000
60000
LU
1
50000/
650000
LU
40000 30000 20000 10000 1974 1976 1978 1980 YEAR
.,
40000300002000010000I.
1982 1984
1974' 1976' 1978' 198d YEAR
1982
1984' CA OCR
RACAL ELECTRONICS
Figure 7.3.11 A Graphical Illustration of Ideal Performance
— CL — ON1 NI OCASH — — CASH
257
1 .8E5
2.5E5
EGET
1.4E5
E. 1 . 2E5
E, 1.5E5
1.0E5
1.0E5 0.5E5
/0. bE5 0.4E5 0.E5 1974 1976' 1978 1980 YEAR 1982 1984' 1974 , 19761 1978 19801 YEAR 19821 1984 
\ 50000
18000 1600C1
1' ./ i
I
40000
1400012000
F.; 30000
Eil0000
.
0'. ../ t I
800020000
6000
4000 100001974 1976 1978' 1980 YEAR 1982' 1984' 1974 2000
j
1976 1978 1980 YEAR
\I
1.982
1984 Fl
  
BPB INDUSTRIES PLC
Figure 7.3.12 A Graphical Illustration of Ideal Performance
—
ON I NI °CASH CASH
258
50000
30000III
40000 f— in Lu ul Ln cc 30000
LL.I .
/
/
r
u., 25000u..1 I=• .•., .i:73! 20000cc :11 Li 15000Z cl.
cc R — 20000
a
10000
,j'
10000
50001974 1976 1980 1978 YEAR 1982 1984 1974 1979 198d 1979 YEAR 1982 1984'
3000. 120002500. 100002000 a: ir) cc () 1500
It' BOOT
LU
LT; 6000
\
40001 0 00
2000
500
ii
1974 1976
, If
I
,r •
1974
1976
1979 1980 YEAR
1982
1984
1979 198d YEAR
1982
1984 CA
—ocn
ALAFY
ALLIED COLLOIDS PLC
CL ONI Figure 7.3.13 A Graphical Illustration of Ideal Performance
•
NI — OCASH CASH
259
16000
900014000 800012000
Ui
Lr) m10000
LU
•••
226000.:1
:It
E 6000
=
5000
'40006000 3000 4000 20001972 1974 1976 1978 YEAR 1980 1982 1984 1972 1974 1916' 197d YEAR 198d 1982' 1984'
2250 2000 1750
U.1 600 51500 Li
900800 / 700
m _ "(2500 Li / /

/
. . /
/
/ 
tr\ 1 % t i t
L:1250 400 1000 300
I,•\ /
/
,1
I t

./
200'
/
\
1 t
750 500
ri\
1
i
1
% !
I
I
100
\
1984'
1!
1972 1974 1976 1978 1972 1980 1982 1984 YEAR
19741
1916
1978 YEAR
1 , 1980 1982
ASH & LAP( PLC
Figure 7.3.14 A Graphical Illustration of Ideal Performance
CA OCA 0CL — CL — 1 N1   OCRSH CASH
260
4.5E5 7E56E5 5`Cn 5E ij In =  4E 5.
/ Li
4.0E5 3.5E5 3.0E5 CO cr
I
:12.5E5 cig 2.0E5
uJ
Li
3E5
2E5
1.5E5 1.0E5 1E51974' 976' 1978' 1980 YEAR 1982 1984 1974' 1976' 1978' 1986' YEAR
A II
1982' 1984'
1.0E50.9E5 / 0.8E5 ,/ L.Li O. 7E5 tp La .F. 0 . 6E5I. 0.5E5 ,/''' 0.4E5 • ''' .......„../ /,/ ' I /
1.0E5
i i I \ I I / 1 1 / /
f n
/ 0.9E5 0.8E5
1
...../
0.7E5
7.: .va2. 0 . 6E5 / Li 0. 5E5 0.4E5 0.3E5
//.
1 1 1
I It
..."
r
I
0.3E5
0.2E5 ...„1974 1976 ,'''
/
0.2E5
. . 
,...  1974 1976
1
0.1E5 1978 1980 YEAR 1982 1984
k 1978 1980 YEAR
1982
1984 CA OCA
BONS CO PLC (THE)
Figure 7.3.15 A Graphical Illustration of Ideal Performance
— CL — —ON I I — — — °CASH CASH
261
1.0E70.9E70.8E7(MO. 7E70.6E7(cf,
7E6 6E6 5E6
cio 4E6 15
E 0.5E7a: 0.4E7
_
a:
3E6 2E6
O. 3E70.2E7_ 
1E6 1980' 1982' 1984' YEAR 1974 19(6 1978 1980 YEAR 1982 1984
0.1E71974 1976' 1976
0E4
0E4
0E4 I Z' 1 0E4
0E4
19 6
1978
1980 YEAR
1982
198:1 4
T 1
1974
19761 1978
1980 YEAR
1982
19841 OCR
BRITISH Gm CORPORATION
Figure 7.3.16 A Graphical Illustration of Ideal Performance
— —
—   EL — — ON I °CASH CASH
262
22500 20000 17500 L1115000
1600014000 tr, 12000
1..0
/
/7
,7 7
r: m cr. 10000
5: 12500
Lc110000
:11 l 8000w Ex cr a6000 4000
/ /
If
7500 5000 2500 1972 1974 1976 1978 YEAR 1980 1982 1984 2000 1972 1974 1976' 1973 YEAR
// .../ .
198d
1982
1984
3000 3500 30002500LJJ
2500
n
2000
•
2000
\
n
/ //V
,
w cr (31500
1500 1000 500 197 i
, t \
,, I,,
, ///' "
//
1000
/........„.. ___ 
500
1974
1976
1978 \ERR
1980' 1982
1984
1972
1974
1976
1978 YEAR
1980
1982 CA OCR
1984
ANGLIA TELEVISION GROUP PLC
ANAB I

Figure
7.3.17 A
Graphical Illustration of Ideal Performance
— —ON1 NI — OCFISH CASH
263
90000
6000055000
80000.Li t`l 70000ciL
5000045000
7:140000 c 35000g 50000300002500040000197 1974' 1976' 1978' 1980' 1982' YEAR 20000 1972 19741 19161— 19781 1980 YEAR 1982
I
5000 5000 YEAR 1.93 _ 1978 1.1;
o Li
z ..
19.93814___ .
1
I
40001
I I I , I 1
1
LcT.3000_ 2000
•
5000
10000 100015000
1972
• 1974
1976
1378 YEAR
1980
1987r— 2
KR
GOODYEAR TYRE & RUBBER CO.
CL —0N1 OCASH CASH
Figure 7.3.18 A Graphical Illustration of Ideal Performance

264
•
5.0E54.5E5
3.5E5
3.0E54.0E5IT w
3.5E5
2.5E5 • 
cc 3.0E5( . 2.5E5 g
n2.0E51.5E5
•
2.0E51.5E5 1.0E5 , 1972 1.0E5
r 1974 1976 1978
YEAR 1980
1982
1984
0.5E5 — 1972
194
1916' —19 (81 807 198i  19E141 19 YEAR
500004500040000/
/ .../,
5000040000
LL.,
Li
sz _
30000 2500020000
35000_./
/ /f\ / . //
\,
F
,
7 —/
•
le—
,., 5
in
1 , 1
Lt : 30000
15000 10000 5000
/ i 1972 1974
/
1982 1984
20000
1
10000
.r ,
, 1984
.—
. — ../ 1974 1972 1976 1978 YEAR 1980' 1982
197
1978 YEAR
1980
BABCOCK INFERNATIONHL PLC
Figure 7.3.19 A Graphical Illustration of Ideal Performance
OCA — —ON! NI — KASH CASH
265
1.2E5200000 1.0E5175000
LU
/
' tLU 150000 u
In
0.8E5cr.
C17.
,
125000 7:1
1 S' 100000
2
0 . 6E5
C (X
75000 50000
0.4E5
0.2E525000 1972 1974 1976 1978 YEAR 1980 1982 1984 I 1972 1974 1976 19(8 1980' 1982' YEAR 20000/ 16000 / 14000 u., 120009 c=
1984'
18000
18000 'I/ / 1600014000 i i f / . ,1 '''' / 1 6000 4000200019841 1972 /1 ' \\ _ _ _I /
,,,'
r"    '
/
u ,. 10000  L  8000
1/ / f
N., , •  \ \ =, 12000 c.n cc L' 10000
\
/
/
/I
600040001 .. ." 1974 1978 1978 YEAR 1980 1982
8000
1972
1974
1976
1978 YEAR
1980
1982
1984 CFI 0CF1
APV HOLDINGS PLC
Figure 7.3.20 A Graphical Illustration of Ideal Performance
 
— • CL —ON1  N I   • °CASH CASH
266
30000 27500 25000 in 22500
n i, cr. 1—
(r) LLI
2250020000;2175007n
20000
E, 17500
a 15000
12500 10000 7500 1972 1974 1976 1978 YEAR 1980 1982 1984
c (z () 000ci
II
750050001972 1974
• 1976 191E1' 1980 YEAR
198 2i 1984' 
3500
It
2000
3000
I II
;
Li
;
\
175015001250u' m
./
Li.:
Li
2500
2000 HLL 1500
1
1000•750500 r 250 n 1972 1974 1976 1978 YEAR 1980 1982 1984' CA OCA CL —ON 1 NI •   OCIISH CASH ,/
1000
500 , 1972
1974
1976'
1978' 1980 YEAR
1982' 1984'
AULT & WIBORG GROUP PLC
Fig ure 7.3.21 A Graphical Illustration of Ideal Performance
267
225000200000175000Ln.
1.2E5
V! 150000`n Ln
1777.1.0E5
. f / /
,
i
..11
cc
LL.1
125000
.C7
:721 0.8E5
1. = u..1 ,.
/ / i
Eg 100000=
75000 50000
E
0.6E5
/ .../
/
0.4E5 25000 972 1974 1976 1978 YEAR 1988 1982 1384' 1972
r •
1974
1976
1918 YEAR
1980
1.982
1984
40000 22500 20000
t t
35000i: C.
17500 L I. 15000 E
t_) 2::
\
1
i
30000 u, 25008
/ t 1 1 t
i
7:
12500 100007500 5000
1
!
5 20000
15000
1
1 I 1 t t j
I
/ 1982 1984
10000 5000 1972' 1974 1976 1978 YEAR 1988 1982 1984T FA 0CF1
• — • CL  ON! N1
1972
1974
1976
1378 YEAR
1980
ALBRIGHT
8,
WILSON LTD
Figure 7.3.22 A Graphical Illustration of Ideal Performance
OEFISH CASH
268
35000 32500 30000
CO
r\ 30000'
27500
tr 25000i
u
T25000
E
:D ()
22500 20000 17500 15000
520000
c
a )5000, /10000 t'
it \
\ \
1
12500 1972 1974 1976 1978 YEAR 1980 1982 1984 1972 1974
‘.*\\./\ 1976 19(8 YEAR 1980( 1982 1984'
r.
fl
4500 4000 3500
L.L.;
/ \ i \ 1
2500 2250 2000 /
/ / /
;1 ' 1 / t ._
/ \ /
B 3000
.
1
/
I
\ \
Li 2500 7 /' z
E 1500
1250 //
..
1
1750 .__.... /
/\ \
1
2000/ 1500 1000 .V'''.
I ,,i\
„.. . .n1_ 7 ____./
%v
i  , I
% %
1000/
,
750 500 7 19(2 \..../ . 19(4
/
19 (6
1
I " i ,, \ 1 s.... ...r......
i
1
1
:Th ''
',.//'' n
v
1
• /
1972
7
. 1914 19761 1978 YEAR
1980
1982
19841
,  1 1v9 116  19801— 1982 1984 E R
CA
ocn • OCL CL — —ONI
BARROW HEPBURN GROUP PLC
Figure 7.3.23 A Graphical Illustration of Ideal Performance
 °CASH CASH
269
/ 45000 6000050000 ce.12) 40000,
a.
1
Ui
40000 ,3 0005 t; 30000 Ec; cl; ..J 25000
SL . 30000 C 2000010000
E 20000 cL
Li 15000 10000 5000 1972 1974 1976 1978 YEAR 1980 1982' 1984' 1972 1974 1976 1978 YEAR 1980 1982 1984 / /
14000
7000
//I\
12000 6000 10000
/
uJ
/
5000I
8 8000 F.
1
,1
,,,, 4000.
in cr.
r
/
\
I
t../
U
L1 6000 4000 2000 .._ ..../ 1972 _ 1974 1976 1978 YEAR 1980 PLEASURAMA PLC , }
....
/ / / / ,/
3000
/
/
2000. /
,/ /
1000. _ __ 1974 1976 .... .__ .  ' ' 1y9 78 01 R 1980 ..
 1982 1984 1972
1982 CR UCF1
1984
PL ABU
Figure 7.3.24 A Graphical Illustration of Ideal Performance
• CL — —ON! NI — °CASH CASH
270
1.4E6 9E51 1.2E68E5
1.0E6 tt..; tn 120.8E6
Ui
Q:.
= (3
0.6E6
0.4E6
3E52E5
0.2E61972 1974 1976 1978 YEAR 1980 1982 19 (2 1974 1916 19(8 YEAR 198d 1982
•
60000
1
1.0E5 500000.5E5Li
Li ••
40000 972 1974 1976
/
1978 YEAR
IpicIU
19821
Li W CC
Li
n
30000 0. • .5E
5:‘.
20000
••"'
,***
1.0E5I
j
10000 1.5E51972 1974
/
1976
1978 YEAR.
1980
1982
BRITISH RAILWAYS BOARD
• Figure 7.3.25 A Graphical Illustration of Ideal Performance —
OCA CA CL —UN! NI
KASH
CASH
271
4
6000
(..r)
cc 5000
7: 11.1 CC:
Li
4000 2000
972
1974' 1976' 1978' 1980' 1982' 1984 YEAR 500 450
972
1974
1976'
1918' 1980' 1982' 1984 YEAR
800 700
400600
,tiv....„w . •=• .1 ;
350300 u) cc Li 250
500
.400
/
,
11 I / /
. ' —\ if ! ; \ ;
/‘; 1 1 1 t , ,
300200 100 972
j\
1I
/\
t 1 i I ;
1
1
1974
1976
197E1 YEAR
1980
1982 1984
1972
1974 ' 1976
1918 YEAR
1980
1982' 1984 In EICF1 — — ON! • NI  ocnsH CASH
ANCHOR CHEMICAL GROUP PLC
Figure 7.3.26 A Graphical Illustration of Ideal Performance
272
1.1E5 1.0E5 0.9E5
80000
70000
;:60000" "1n 0.8E5 (. '20.7E5
nalooT
E 0.6E5
0.5E5 30000 0.4E5 20000 0.2E5 19 ./4 1976 1918 1980 YEAR 1982 1984 1914' 1916 1918 1980 YEAR 1982 1984
10000 6000 8000 /// // 5000
./
6000
/
_4000 
4000
3000
2000 2000
1000" 1914' 1916' 1918 19801 1982 YEAR 1984 1914 1916'T 1918 1980 YEAR 1982 1984
BAKER PERKINS HOLDINGS PLC
— Figure 7.3.27 A Graphical Illustration of Ideal Performance  — —
CII
CL NI
ocnsH
CASH
273
.2.0E6. 1.8E61.6E6uJ cc
1.4E6
1.2E6
Li
172. f_l *
1 . 4E6
1.
Li
1.2E61.0E6O. 8E61 0.6E60.4E61972 1974 1976 1978 YEAR 1980 1982 1984
an :71 0.8E6 z: Lu
a,
/1'
a 0.6E60. 4E6
972
1974
1976
19(8 YEAR
1980
1982
1984'
5E4
1 .8E5
0E4
5E4
\ I \%
1 . 6E5
11
1.4E51. 2E5e2,11.0E5J/' Li
A/
I
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,
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%
0.8E50.6E5 0.4E50.2E5
1974
1976
1978 YEAR
1980
1982
1984 1972 1974 1916 YEAR 1980T 1982 19841 cn
0 CA   0CL
FORD MOTOR CO. LTD.
CL
—ON! Figure 7.3.28 A Graphical Illustration of Ideal Performance
N1 —
°CASH
cnsn
274
•
00 0
5000 4500
6000 4000
Ui
r: 5000
Cr7 J
3500E
Cr) J
30002500
_
/ /, \s/
/
E4000
Li
3000
2000
1500
2000
1 00 0
1972
1974
1976' 1978' 198d YEAR
1982' 1984
1972
1974
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1980' 1982' 1984
800
/r
400 350 300 250
700r 600 / //
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in E 200 ,." 150 100 /
z
400
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200 1972
J
1974
I. 1976 1978 YEAR
1 l'\\._,l
1980 1982 1984
50 1972 1974 1976 1978 YEAR 1980 1982 1984 C71
OCA — — •—ON I
AnAms a GIBBON
Figure 7.3.29 A Graphical Illustration of Ideal Performance
NI   •  •  °CASH CASH
27 5
35000
30000
E 25000;FO :c
"615000
10000
5000 9.? 1974 197d 4 1978' 1980' 1982' 198'1 YEAR 1972 1974 1976 1978 YEAR 1980 1982 1984
8000 3000 70002500 6000 / 2000 /**
Ili; 400030002000 //* 1000.1 1972 ..4"".".. .,,....,G,
,
i
n It / t 1 1
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u 1500 7 s \ 1000 I 500 .....\ I 1
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t
n'. ''.
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1974
1976
1978 YEAR
41 1980' 1982k 198: 1972
1974
1976
1978 Y YEAR
1980 .
1982
1984
ARMITAGE SHANKS GROUP LTD
Figure 7.3.30 A Graphical Illustration of Ideal Performance
—
CA
OCA CL — —ONI N1 — OCF1SH CASH
276
30005000 4500 2500
3000 2500 2000 1974 1976 1978 1980 YEAR 1982 1984 500 1974
1000
1976
I 198 1986 YEAR
9821 1  1984T
450 400 350
L.L.1 E:
300
250
/

•
200300 250 200 150 100 1974' 1976 1978 1980' 1982' 1984' YEAR 1974' 1976' 1978' 1980' 1982 YEAR 1984 100
I
g .
a.: 150"
1,
Ui
tf
‘
\ \
50
ATKINS BROTHERS PLC
Figure 7.3.31 A Graphical Illustration of Ideal Performance
OCR CL — —ON NI  OCRSH CASH
I
277
F
7E5 6E5wn _ i 5E5
2;
Li
Ln y' m
5E5 4E5
, 1
\
or.
a 3E5
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,r
,  ) /
t1 ill 1
%
t
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til
1984
1972
197;
1976r 19igr18811 —1982' 1984 F YEAR
8E4
80000 , 7000060000
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w 4E4 7
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u
21:
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972
1974
1976' 1978 YEAR
iseo'
1982' 1921
2E4 , 4E4 I. 1972 1974 19761 1978. 1980 YEAR 1982 1.984 10000
DUNLOP HOLDI\ GS PLC
Figure 7.3.32 A Graphical Illustration of Ideal Performance
OCA  OCL Cl —ONI  •  • NI  ocnsH
cnsH
278
9000 8000 7000
1.1/
7000 En 6000
.n
4000 3000
LU
LU
3000 2000
//
f
2000 1972 1974 1976 1978 YEAR 1980 1982 1984j 1 . °°°1972 1974 1976 1978 YEAR 1980 1982 1984
10001200900 800 700 Llj O
I 11
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LU
/ 114(
/iii I
II
Goo
tj . 500 400 300 200 . 1972 1974 1976
600
r
721 //' / r 200 /
k
400
./
1978 YEAR 1980 1982 1984' 1972 1974 1976
/
1378 YEAR 1980
\
1982 1984' CA OCR CL — —OWL NI •  OCASH — CASH
BARNO INDUSTRIES PLC
Figure
7.3.33 A
Graphical Illustration of Ideal Performance
279
H
/ 45000 70000
40000
Li) 35000
60000 IL7.1 Ln (efE' 50000 Li 640000
'&130000 cc
ra,
Li
_
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t 1000 500 / n. 1974' 197
1976
1978 YEAR
1980
1982
1984' CA
ocn
BBA GROUP PLC
Figure
7.3.34 A Graphical Illustration of Ideal Performance
— CL — —ONI NI  ocnsn —•— CASH
280
•
20000 17500 15000 r `j cci 12500 10000
/
if
18000 16000
J
E 14000'11!
2112000
:1100008000 • 7500 5000 2500 1974 1976 1978 1980 YEAR 1982 1984' u 600040002000 1974 1976 1S8 1980 YEAR 1982 1984
1200 3000 1000 2500 800
0 2000
1500 400 1000
II
200
500 1974 1976 1978 1980' 1982' 1984 YEAR 1974 1976 1980 1978 YEAR 1982 1984
BATLEYS OF YORKSHIRE PLC
Figure 7.3.35 A Graphical Illustration of Ideal Performance
— — — —
CFI
0CF1 CL —ON I
NI
•  °CASH  CASH
281
18000 25000 22500 u)20000 Ls) In cr. 17500 LcS15000LLI CY
16000
s's
14000
It
ER
12000
, /1
I
1250010000 75001972 1974 1976 197d YEAR 1980' 1982 1984
a. () 80006000" 4000 972 1974 1976 1978 YEAR 1980 1982 1984
1600 2500/ 1
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t
1
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C)
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t
t
/
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t I ,
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\
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f
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\./ 1972 1974' 1976 1978' 1980 YEAR 1982
200 z\ 19841 1972
..
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1
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1978 YEAR 1980 1982 1984 CA — •— CL N1 — ()CASH CASH
1974
1976
BEMROSE CORPORATION PLC
Figure
7.3.36
A Graphical Illustration of Ideal Performance
282
70000 4500060000
Lu tn
4000C 3500C
/
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cr.
50000 .
/ FE:
30000
(SA 40000
10 25000 c, 20000 15000
30000
20000 972 10000 1974 1976 1978 YEAR 1988 1982' 1984 972 1974 1976' 1978 YEAR 1980 1982 1984
6000
8000 7000
4000 6000g 2000 m 500C
cn
CE
•972
1974' 1976
1978 YEAR
1980
1982' 1914i
400C 3000
 20002000  40001000 1972 1974 1976 1978' 1988 YEAR
\
1982' 1984' CA OCR • — CL —0N1 NI — OCASH CASH
BESTOBELL PLC
Figure 7.3.37 A Graphical Illustration of Ideal Performance
283
80007000
I
5000 ,
4500LU
,
1
,
40006000
cc
E
. (,,
,
, 7\
,
,
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cc 3500 :71
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2000
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800
1
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n
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700
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\
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cc
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150100 50
1972 1973' 1974 1975 1976 197/ 1978 1979 YEAR
1972 197:3 1974' 1975 1978 1977' 1978 1915 YEAR 0CA CA —L — ON I NI ocnsH •  •  CASH
BROCKS GROUP OF CO. LTD
Figure
7.3.38
A Graphical Illustration of Ideal Performance
284
1 .3E51.2E5700001.1E5co 1.0E5(1) /. )
//
\
O. 9E5
glmooT
"n.....• • /
t'
cr.
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• ,
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. 1974'
•
1976' YEAR
•
1978'
It 1 i
1980'
/
•
./
1972' • 1974'. 1976 YEAR
• 1978
• 1980' OCA CA
STONE PLATT INDUSTRIES PLC
Figure
7.3.39 A Graphical Illustration of Ideal. Performance
—
— CL — I NI — OCASH CASH
285
F
1.6E5 900001.4E5Ui
80000
n7000C
cr.
_
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1— 60000
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0'.
a 500000.8E5 0.6E5 1972 1974 1976 YEAR 1978 1980
_
, ' 1/7 \* \ j/ .... .., 7
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1974 1972. '
1978 YEAR
1978
1980
20000 15000 10000
i
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\
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r .. ,
tLI 5000 c) Li 972 5000 10000 15000 20000 1974 1976 YEAR 1978 1980 1 I r
I
t
• i' • j .
4000 3000 2000
.... '
1972
1974'
197E; YEAR
1978
1980' OCA CA — CL — ON1 Ni — KASH CASH
BRITISH AIRWAYS
Figure 7.3.40 A Graphical Illustration of Ideal Performance
286
5000U7
4000Cr:
11nIl

2000
1000
1972 1974
•
1972
1974
1976 YEAR
1978
1980
1976
1978
ned
YEAR
450500 400400350300
,
•
.,/
//' 300
g.!
200/ }/ 100
n
c i 2 250
200
1972' 1974'
100
1976' YEAR
1979
1980
150
100
200
50
•
I
1972' 1974'
1976 1978' YEAR
19807
VINERS
Figure 7.3.41 A Graphical Illustration of Ideal Performance
OCA CA — • ft — owl N I  •  NASH
287
5000 3500 4500
Lu cn
3000
cr: 4000
;L:
:=;
(n u'
3500u 3000200 1500 2000 1980 1972 2000 ci
rN / , , 1 N /; '
/ / , , • \\
I \
1976 1980
1972' 1974
1976' YEAR
1978'
1974
1976 YEAR
500 400
250
200 300 Fi 200 I OT (
1972
1974
1976 YEAR
\lr
198d
10T
1972 1974 1916' YEAR 1978' 1980 OC11
BLACKMAN & CONRAD
Figure 7.3.42 A Graphical Illustration of Ideal Performance
— ON I NI —  •  — acnsH CASH
288
12000 11000 11000 1000010000 9000 9000
U.J U/
8000 8000 7000
L. .J cL a'.
7000 6000 6000 5000 4000 3000 1972 1973 1974 1975 1976 1977 1918 1979 YEAR 5000 4000 3000 1972 1973 1974 1975 1976 1977 1978 1979 YEAR
800 600 w 400 — 200LU
/
1
172 1973 1974 1975 1976 1977 1978 1919 YEAR 200 400 1972 1973 1974 1915 1976 1977 1978 1979 YEAR
AMAL1AP1ATED INDUSTRIALS
Figure 7.3.43 A Graphical Illustration of Ideal Performance
—
OCA CA — ON! NI °CASH CASH
289
14000 13000
7000 6500
(\
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/ /1/
/
12000
L now u)
tr)
cc
(.1)
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tn
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1
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uJ
10000
a 9000
8000 7000 1973 1974 1975 1976 1977 YEAR 1978 1979 1980
a
4500
4000
1973
1974 1975 1976 197? 1978 1979 1980 YEAR
1000 750
700 600
/
../
500 LL.1 2501974 1974 250 50020075010001001974 „ 1973' 1975 1976 19T? 1978 1979 1980 YEAR
I•
500 c2 ( 400 300
151976 1977 YEAR
1n978 1/979
980
BLACKWOOD,FlORTON & SONS
Figure
OCA CA — CL — —ONI NI OCFISH — — CASH
7.3.44 A
Graphical Illustration of Ideal Performance
290
•
7/ 5000" 6000 450040005000
cE
0." 300
Li.t u)
E J
3500
4000
6
3000
()
2500_
2000 1500,
2000 1972 1973 1974 1975 1976 1977 1978 1979 YEAR
loaf
1972 1973 1974 1975 1976 1977 1978 1979 YEAR
l' 400 .
/ \
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n n

350
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300
200
L.).1
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m
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I
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1972
1973
1974
w
z
1975 1976 1977 197k 1979 YEAR
‘
t
150,
t
200
100'\\ 400
t
(\\
\
\
501972' 1973 1974 1975 1976 1977 1978 1979 YEAR
BURRELL & CO.
— — Figure 7.3.45 A Graphical Illustration of Ideal Performance
OCR CA
NI OCRSH  CASH
291
60004500 5500 4000 5000 Lr) 117, 4500 nE 4000 3500300025007
1500
1.11; 3500 _ ..". FE; J 30001Z Ieti 2500rx 
I \ // 1 '.... \
I 1
/ ...',
\
...........   ...
a
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2000
/
2000 1974 1976 YEAR 600
\
1978'
 1980'
1974
197E YEAR
1978
1980'
350300
400 200 YERP
U_1 CZ11
1974,
250
7
1978,
1980,
LT) 200
 L.1200 400
Li
=
/
150
1001
600
50
800 1974
1916
YEAR
197E1
1980' OCR CR  CL — —ON! NI  °CASH CASH
CAWDAW INDUSTRIAL HLDGS
Figure 7.3.46 A Graphical Illustration of Ideal. Performance
292
30000
30000
25000
U) n I.
in
25000
Vr). 20000
LT;
r.Fc; 20000
m I 
ai m
= u 15000
z: W15000a. La
10000 10000 5000 1973 1974 1975 1976 1977 1978 1979 1980 YEAR 3000 180020001200a: U.) 1000 1974 1974 1975 1976 1977 YEAR  1006
E
1973 1974 1975 1576 1971 1978 1974 1980 YEAR
1600 1400
.: /I / (\
l
1 I / I
/
1000
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1 I
800 600400
1 !
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/./
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\
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.A,I I I
I
\
 2000200 , 1974 1974 1975 1975 19T/ 1978 1974 1.980 YEAR OCA CA — —ON] 141 OCASH CASH
AIRFIX INDUSTRIES
Figure
7.3.47
A Graphical Illustration of Ideal Performance
293
12000
11000 10000
10000
LU
9000 8000 7000   6000 Z LU 5000Li
)j 8000 L11
LU cc c a 6000
40004000 3000"
, 2000 //,
1972
1974
1976 YEAR
137Ei
EgeG
csd
{Te4
(Re6' YEAR
csee'
?see'
, 1000
• ••••".°
700 / 600 197 13 YEAR 19 1978 198 500
/
500
LU E.
6.41
Li 500

W
=1000 1500 2000 2500 1972 1974 1976 YEAR
1978 1980
OXLEY PRINTING GROUP
Figure 7.3.48 A Graphical Illustration of Ideal Performance
—
OCR CA — CL — ONI  NI °CASH CASH
29L1.
70000 40000 60000 3500011) LU LU
50000
r 30000II I
cr.
E
40000
'Er; cc 25000
.J
cuj cr. u 30000
L.T., 20000
=11."
Lj 1500020000 1000010000 1974 1976 YEAR 1978 1980 5000 1974 1976 YEAR 1978 1980
4000 2000  11374 YEAR 1976 197 19
6000
5000! !
2000  4000  6000  8000 10000 12000
a: v)
LI
4000
\1
/
I
tI
/ I 
/.....' \ \
\
3000
\ \\.." 1
\/
I1
A
2000
.
,
...• .•••
..." ..."
/
\ \,. / t
%
\
1000 1974
,
1976 YEAR 1978
1980 OCR cn OCL — CL — —ON1 OCFISH CASH
LESNEY PRODUCTS & CO.
Figure 7.3.49 A Graphical Illustration of Ideal Performance
295
.„/•••n\
3000030000
25000f1125000
_
ES.
20000
I
15000
11; c g 15000
1000010000•
, "
1972' 1974'
1976' YEAR
1978
1980
1972
1974'
1976 YEAR
1978'
140012001000
(ff. Li
IT:
/
197
1974
YEAR 1976
IN
/
800
/
600
,
400 200
 n n
1972
• 1974' 1916' YEAR
•
• 1978' 1980 OCR CFI • 0CL — CL — ON1 N1   KASH CASH
RICHARDS & WALLINGTON INDUSTRIES
Figure 7.3.50 A Graphical Illustration of Ideal Performance
296
8009 7000 6000 cri
`n cr. o. Fin' 5000
5000 4500 4000 tr)
LL.1 _
a. 4000
3000 2500 2000
1500
cr' or. 3000 2000
1000
1000 1972 1974 1976 YEAR 1978 1980 1972' 1974'
• ,
1976 YEAR
1978'
1980'
1400 500YEAB..1972, • 19 •711376, , 1978, ., 1980,
/f
1200 1000800
cr:
(1 500
IFn111
600  1000400  1500200
1972
1974
1976 YEAR
•
1978
1980
ocn CFI
NORVIC SECURITIES
Figure 7.3.51 A Graphical Illustration of Ideal Performance
—  —ON! NI  •  ocnsH
CASH
297
3000 3500 2150 :300O cr. w
Ele. 2500
250d FE, 2250:5'2'2000cr.
,
Ci
2000
17501500
1500 • 1974' 1976' 197E1 YEAR 198d
1250'7/
• 1974
1976 YEAR
1978
•
1980
250 1974,
2501 /I
250 500
=
200
n
I\
/ I/
I
1,
\ :
t
1 I
150
!
I
./.
750 1000 1250 1500 1750
V)
cc U 1001
i\
1
I I V
\
1 1 1
1 50;
\
n
n
1974
1976 YEAR
1978
1980
AUSTIN (F.)(LEYTON)
Figure 7.3.52 A Graphical Ellustration of Ideal Performance — — —ON! NI
OCFISH CASH
298
7.4 CONCLUSION
Factor analysis has been used to construct the ideal equations as presented in this chapter. There are four
equations that can be used to calculate ideal values of current assets, current liabilities, cash and net income for each company separately and at the end of each year.
By applying these equations to the sample of companies, it is found that in well performing companies about 84 percent of performance variables are above their ideal values and 100 percent of these variables are below the ideal values in the poor performing companies. This means that all the companies that have had financial difficulties and have gone into receivership were suffering from insufficient working capital (managerial performance), lack of profit ( profitability) and shortage of cash (liquidity), and the majority of well performing companies are doing very well in the above three important financial dimensions. This will also confirm the
earlier conclusion that the present model has almost explained the same variance of three significant performance factors; profitability, managerial performance and liquidity.
299
These equations could be also used to improve future financial performance, and guide managers to provide better plans. In the Marks & Spencer case (page 240), based on its past performance and comparison of its actual performance with associated ideal values, it is possible to detect that current assets should have been increased in 1985 from their present value of 456 million pounds. A more appropriate level would be over 1 billion pounds.
300
CHAPTER 8 CONCLUSIONS AND RECOMMENDATIONS
301
CHAPTER 8 : CONCLUSIONS AND RECOMMENDATIONS
8.1 MAIN CONCLUSIONS
The main conclusions of the present study can be summarised as below 1) The knowledge of financial ratios and its use as a measuring tool provides the means of a
controlling the success and stability of business. 2)
A single ratio can not reflect every aspect of a company's performance and sets of ratios are proposed to allow a better evaluation of the financial performance of company.
3) Three dimensions represented by profitability, managerial and liquidity ratios jointly measure nearly every aspect of a company's financial performance. They can and do serve as tools for detecting irregularities in managerial behaviour and company performances. They also provide a meaningful and quantitative representation of the results of decisions and the effects of external conditions.
302
4) The techniques available in the past were wholly inadequate for proper analysis, and there is a need for constructing a firm conceptual basis for financial analysis; particularly, the to
desirability of a shift from univariate multivariate financial analysis. 5)
An important result of the past studies was that there is a significant degree of correlation between different ratios and one of the best techniques which can be used to study the correlation between the ratios is factor analysis which enable management to choose the most significant and reliable ratios.
6)
The model developed using factor analysis together with regression analysis to measure companies' financial performance with the following significant characteristics: 6.1) It explains nearly 30 percent of
profitability, 37 percent of working capital and 33 percent of liquidity, which means that it almost explains the same percentage of variance of the three main indicators of the companies financial performance. 6.2) Its overall effectiveness in identifying companies strengths and weaknesses is about 90 percent. 6.3) It can correctly classify 100 percent of well performing companies and 94 percent of poor performing companies.
303
6.4) Its accuracy to measure companies' financial performance whose data were used to construct the model is about 91 percent which dropped to 88 percent when it was applied to companies whose data was not used in the model's construction. 7) The Ideal models which were constructed using factor analysis for calculating ideal values of current assets, current liabilities, cash and net income, when applied to a sample companies, it was found that in well performing companies about 84 percent of performance variables are better than their associated ideal values, whereas 100 percent of these variables are worse than their ideal values in poor performing companies. 8) These models could also be used to improve the future financial performance, and guide managers to provide better plans for their company.
Finally it appears that the model is able to measure and summarise past performance and assist in ide tifying future targets of financial performance. That is, it can be a useful tool for financial planning and control.
304
8.2 RECOMMENDATION FOR FURTHER RESEARCH: DYNAMIC ASPECT OF RATIO
Saint Augustine says that we always are in the present. The present has several dimensions, however: the present of the past, the present of the present, the present of the future. Thus, at any time our actions at every single instant depend not only on our current state but on our memory of the past and anticipation of the future. However, while there is little that can be done to affect the past, there is still time to influence the future by present actions. To do so, it is essential that we relate the past and the future i,e, construct a model of 'temporal change'. When a model of
temporal change is used for the purposes of selecting a desired future sequence of states, this is called 'planning'. Thus our ability to plan is strictly a function of our ability to reconstruct the process of temporal change as a function of discretionary acts. As it has been stated the main purpose of this section is to seek a greater understanding of how the special characters of time and change influence our ability to construct dynamic financial models and how su h models have improved our ability to cope with and manage time and change. The management of time and change is, however, a very complex task, requiring that we understand how and why change occurs over time. To do this it is necessary that we first
understand the dynamic behaviour of financial ratios. Once their behaviour over time is understood there may be a possibility of controlling them to some extent.
305
It would appear that fruitful research could be carried out into how financial ratios vary over time and into the extent that the company can control future values of these ratios. In this way it might be possible to control future company's financial performance to a limited degree. Of course
companies are exposed to considerable influences outside of their control and therefore the extent to which future performance can be endogenously controlled will be limited.
The major objective of analysing dynamic financial ratios is to predict future values of the ratios. The general
approach to such predictions is to search for dynamic patterns in the historic behavior of the ratios; knowledge of such patterns can then be used in the prediction process. This approach to the prediction of ratios rests on the assumption that the underlying process generating the ratios is stable over time, that is, the process continues to operate as it did in the past. Dynamic patterns in the behaviour of ratios can be determined by various statistical techniques, such as plotting the data on scatter diagrams, serial correlation analysis, and various transformations of the original data.
The best prediction model to be used depends on the statistical nature of the process generating the ratios. However, most processes in business and finance are very complex and, in many cases not even well understood because of the large number of factors and the complex interactions involved.
306
For example, a firm's net income is usually effected by 1) EconomyWide factors such as interest rate and
pricelevel fluctuations. 2) Industrial factors such as a change in demand for the industry's product. 3) management. Firm's factors such as firm size and quality of
Consequently the financial analyst would be interested in a set of techniques and methods which enable him to study and explain the crucial effects of these factors in order to improve the behaviour of the financial ratios.
307
APPENDICES
308
APPENDIX 1: GEOMETRIC PRESENTATION OF THE FACTOR MODEL
To understand the basis of factor analysis which is a complex statistical technique, Comrey(1973) find it helpful to employ an additional medium of representation of factor model.
In the geometric representation of factor model, a data variable may be represented as a vector in a space of as many dimensions as there are common factors(Fig.A11). In this
case, the length of the vector is h, the square root of h, the communality. It is also possible to represent the data variables in spaces of higher order, adding also a dimension for each specific and error factor. If all of these factors are included, h rises to 1.0 for each data variable and so does the vector length. Figure All Y(Rotated factorII)
1.0
P (.19.8) P (.2
6)
(.59.4)(Centroid point) P
•4
8 3 (. P ' (.1) 1) 4 ' 9 X(Rotated i°
.0
factor n I)
As an illustration, Fig.All represents four data variables as vectors in a two dimensional space. A vector is a line extending from the origin to some point in space. The
coordinates of the end points of the vector are given. There are two coordinates for each point because the vector are represented in two dimensions.
309
By the Pythagorean theorem, the length of each vector in Fig.All is given by the square root of the sum of squares of its coordinates:
2 h 1 = +(.8)
2 = \/.01+.64 = \/7E = . 806
h 2
2 2 = \/(.2) +(.6)
\0 .04+.36
=
V770T
.632
h 3
2 2 = \/(.8) +(.1)
\/74T7E— =
V7i3
. 806
h 4
2 2 = \/(.9) +(.1)
\i .81+.01 v
= V782— .906
For more than two dimensions, vector length is given by
2 h=\/a 1
2 2
2 +a 3
2
+a +a +
Where the a values are the coordinates of the vector with 3. respect to the m reference axes or dimensions For more than
three dimensions of course, it is impossible to visualise the results.
310
The scalar product of two vectors may be defined as follows: a 21 a 22 [a 11 a 12 a 13 ...a lm a 2m Where c=a a +a a +....+a a is a constant. The values a 11 21 12 22 lm 2m 11 represent the coordinates of first vector, and lm for the ] x a 23 = [c] (Al2)
a 12
, a 13
,...,a
the values a , a , a ,...,a are the coordinates 23 21 22 2m
second vector. Thus, the scalar products of all possible pairs of four test vectors in Fig.All are given as follows:
311
Pair 1,2
Row (.1 .8)
Column
Scalar product
x 1.21 =(.1x.2) + (.8x.6) =(.02+.48) =.50
I
.61 1,3 (.1 .8) x
1. 8 1 I .11
=(.1x.8) + (.8x.1) =(.08+.08) =.16
1,4
(.1 .8)
x 1.91
I .11
= (.1x.9)
+ (.8x.1) =(.08+.09) =.22
2,3
(.2 .6)
x
1
.8 1 I .11
=(.2x.8) + (.6x.1) =(.16+.06) =.24
2,4
(.2 .6)
x 1.91 =(.2x.9) + (.6x.1) =(.18+.06) =.24
I .11
3,4
(.8 .1)
x 1.91 =(.8x.9) + (.1x.1) =(.72+.01) =.73
Lets L represent the cosine of the angle between vector i and ij coordinate axis j. The value L is called the direction cosine ij of vector i with respect to coordinate (factor) axis j. If a ij is the coordinate of data vector i with respect to factor axis j, and h is the length of vector i, then
L 11 or a 11 and a 21
= =
= a /h , L = a /h , ...,L = a /h 11 1 12 12 1 lm 1 lm
hL ,a 11]. 12
=
hL , ....,a =hL lm 112 1 lm
hL ,a 221 22
=
hL , ....,a =hL 122 2m 1 2m
Substituting these values in Eq. (Al2) gives the following
312
representation of the scalar product of two vectors: h L jjl [h L h L .... h L ] x urn iii i i2 h L j i2 = [c]
h L jiff' or hhL L +hhL L + i j il jl i j i2 j2 and h h [L L + L L + ...+ L L ] = c i j il jl i2 j2 im jm (A13) ...+hhL L c i j im jm
A theorem from analytic geometry that will not be proved here states that the inner product of the direction cosines for two vectors equals the cosine of the angle between the vectors. Thus Eq. (A13) becomes
h h cos v =c ii ij
(A14)
The scalar product between vectors i and j is also equal to the correlation between them. The proof proceeds from r ij + ....+ a =aa +aa im jm il j1 i2 j2
Dividing both sides of this equation by h and h gives J r /h h =a /h .a /h + a /h .a /h +...+a /h .a /h im i jm j ij i j il i jl j i2 i j2 j = cos v + ...+LL =LL +LL il jl i2 j2 im jm ij
Or
r ij = h h cos v i j ij (A14)
313
The application of the law of cosine will show that the scalar products computed all pairs of vectors in the series of above equations are the same as the results of multiplying the length of two vectors by the cosine of the angle between them as on the right hand side of Eq. (A14). For two of the
vectors, P1 and P2, for example the law of cosines states that
2 2 2 h h cos v = 1/2(h +h c ) 12 12 1 2 Where c is the distance between the vector end points and is given by 2 2 (X c = \// X ) + (Y Y ) 12 12 Where (X ,Y ) and (X ,Y ) are the coordinates for P and P 11 1 2 22 respectively, in Fig. All. For the first two vectors
2 2 c = \// (.1 .2) + (.8.6) = \/.o1+.04 = \/7(7)3 Then, h h cos v = 1/2(.65 +.40 .05) =.50. This value is the 12 12 same as that obtained for the scalar product of vector 1 and 2.
Using the squared lengths of the vectors and scalar products for all nonidentical pairs of vectors in Fig. All, the correlation matrix with communalities, as shown in Table A15, is obtained for the four data variables.
314
Table A15 : A Centroid Factor Analysis
1 1 2 3 4
2
3 .16
4 .17 .24
I
II 1 I .578 2 3 4
(.65) .50
1 .578.562 2 .531.344
.50 (.40) .22 .16 .17
.531 .687 .765
.22 (.65) .73 .24 .73 (.82)
R
= 3 .687 .422 II .562 .344 .422 .484
4 .765 .484 A
A'
In Table A15, R is the correlation matrix; A is a factor matrix, or a matrix of extracted factors derived from R; and A is the transpose of A.
The values in parentheses along the main diagonal of R are the communalities h obtained by squaring the vector lengths h . ii i The offdiagonal elements of R are the correlations r ii the fictitious data variables, derived as scalar products of the vectors in Fig. All. among
Figure Al2
Cent oid vector
n
x
315
If the X and Y coordinates for the four vectors in Fig. All are averaged, the average X coordinate would be .5 and the average Y coordinate would be .4. locate These two coordinates Centroid factor
the centroid point Pc(.5, .4).
analysis derives the factor loadings by obtaining the perpendicular projections of the test vectors onto a line extending from the origin through the centroid point Pc as in Fig. All. The perpendicular projection of vector 1 on the
centroid vector is shown as line OA in Fig. Al2. Then
Cos v =OA/OP =a /h 1 1 1 lc Where a is the factor loading, or projection of 1 vector 1 on
the centroid vector. Using these equalities, the expression for the factor loading a becomes 1 a = h Cos v 1 1 lc Cosine v here is the cosine of the angle between 1 and the lc centroid vector. The scalar product between vector 1 and the centroid vector is: (.1 .8) x 1.51 = (.1 x .5) + (.8 x .4) = .37 = h h Cos v 1 c lc II 1.41 .37 = h (h Cos v ) = h a c 1 1 lc c a = .37/h 1 c
h
C
2 2 (.5) + (.4) = j
= .6403
a = .37/.6403 = .578 1 316
Performing this operation for the other three vectors in Fig. All gives a = . 531, a = . 687, and a = . 765
2
3
4
The contribution of factor I to the R matrix is removed by the equation R = R  A A i . R , the matrix of residuals after the 1 11 1 extraction of factor I, is reproduced exactly by the product of the second factor times its transpose. Or
(.65)
.50
.16
.17 .24
.578 .531 x [.578 .531 .687 .765]
.50 (.40) .22 .16 .17 .22 (.65) .24
R
.73 _ .687 .765
A 1
.73 (.82)
At 1
(.65) .50
=
.16
.17 .24 .73
.334 .307 .397 .442 .307 .282 .365 .402 .397 .365 .472 .526 .442 .406 .526 .585
A Al 11
.50 (.40) .22 .16 .17 .22 (.65) .24
R
.73 (.82)
(.316) .193
.237 .272
.193 (.118) .145 .166
=
.237 .145 .272 .166
R
(.179) .204 .204 (.234)
.5621 I .3441 I .4221x [.562 .344 .422 .484] I .4841
A Ai
1
1 22
2 1
2
In matrix terms, R  A A i = O. Since R is reproduced exactly
by the second factor multiplied by its transpose, no more than two factors are necessary to account for the original R matrix.
317
The sum of the original communality values is .65 + .40 + .65 + .82 = 2.52
The sum of squares of the first factor loadings 1.6737, plus the sum of squares of the second factor loadings, .8463 also equals 2.52 showing that all of the common factor variance was extracted. The first factor was approximately twice as large as the second factor since 1.6737 is roughly twice as much as .8462.
318
APPENDIX 2: FACTOR ROTATION
Factor analysis in general and factor extraction methods in particular do not provide a unique solution to the matrix equation R = An'. One of the reasons is that the R matrix is only approximately reproduced in practice and experimenters may differ on how closely they feel they must approximate R. This will lead to their using different numbers of factors. Also, different methods of determining A may give slightly different results. An even more important reason for lack of unique solutions, however, is the fact that even for A matrices of the same number of factors, there are infinitely many different A matrices which will reproduce the R matrix equally well.
a 11 a 21 a 31 a 41 A
a 12 a 22 a 32 a 42 A
I
V 11 Cos v Sin vi V 21 V 31 V 41
V 12 V 22 V 32 V 42 V
xi 1= ISin v Cos vi
AA=
V
If R = AA' then R = VV / since if we transpose the product A A as (A
6)
= V / or A IN = V/
VV I = A A A'A' but " Ai , is
319
1 Cos v Sin vi 11 01 'Cos v Sin v1 1 x 1 1 1 = 1 1 1Sin v Cos 111 10 11 'Sin v Cos v1
A
Ai
I
since multiplying by an identity matrix does not alter the matrix, that is AIA 1 = AA'
The angle between the centroid axis and the Y axis in Fig. All may be obtained as follows : The Yaxis vector terminus has coordinates (0,1). The scalar product with the centroid is given by
h h Cos v = (0 1) x 1•51 = ( 0x.5) + (lx.4) = .4 y c yc 1 1 1.41 Cos v = .4/h h = .4/(1.0 x .6403) = .625 y c
e
0
,
Hence v = 51 19 and the Sin v is .781. The angle of the centroid axis with the X axis in Fig. All is 90  511 19' or
384' 41 .
To obtain a configuration of points corresponding to those in Figure All using the coordinates of the data points from the matrix of factor loadings A in Table A15, it is necessary to reverse the direction of factor II in matrix A. This is
I
done by changing the signs of all the loadings in factor II, matrix A, Table A15. Any factor may be reversed in direction in this manner at any stage in the factor analytic process without affecting the property that AA 4 reproduces the matrix R.
320
If the signs on the loadings for factor II in Table A15 are reversed in this manner, the coordinates for the four data vector with respect to the centroid axes become P1(.578, :562), P2(.531, .344), P3(.687, .322) and P4(.765, .484). Plotting these data points with respect to centroid factor axes I and II yields Fig. A13. Only the end points of the data vectors are plotted here. This is a more useful practice than drawing in the full vector from the origin to each datavector end point.
Rotation of factor I away from factor II by an angle of 38 41 will bring it into coincidence with the old X axis (see
Fig. A13). At the same time, rotation of factor II an equivalent amount toward factor I into coincidence with the old Y axis. The matrix operations in Table Al2 show how this rotation is carried out, transforming the coordinates with respect to centroid axes (after reversing axis II) into the coordinates with respect to the original X and Y coordinate axes, respectively. Fig. A13 Rotation from centroids to original coordinate axes II
n
•
P ( . 531 e 344 )
2 '
.6 .8 1.0 381 Lfit P (.687,.422)  3 • P4(.765,.484) x
321
Table A16 : Rotation of the Centroid Axis
Unrotated factor1 Transformation
1
1
Rotated factor
1
I .578 .531
II .562 .344 x
1 1
I(X) II(Y) 1 .781 .6251
1=
.1 .2 .8 .9 V
.8 .6 .1 .1
2 3 4
.687 .422 .765 .484 A
1.625 .7811
A
322
APPENDIX 3: FACTOR EXTRACTION BY THE CENTROID METHOD
The centroid method of factor extraction (Thurstone, 1947; Fruchter, 1954) is probably the best known of all methods of factor extraction. The centroid method has the advantage of
being easily conceptualized in terms of the geometric model of factor analysis.
In Fig.
All the centroid point was located by averaging
all the data vector X coordinates to get the X coordinate of the centroid point and all the datavector Y coordinates to get the Y coordinate of the centroid point. If there had been more than two dimensions involved, the third, fourth, and other coordinates would have been averaged to get the remaining coordinates of the centroid point. Imagine a new set of coordinate axes at right angles to one another placed in such a way that one of the axes goes through the centroid point, as Fig. A13. Suppose that the coordinates of the data vectors with respect to these new coordinate axes are known (actually they are the centroid loadings given in Table Al2. With these new coordinates, it would be possible to recompute the coordinates of the centroid point with respect to the new coordinate axes. Since one of the axes, say the first one, however, the
goes right through the centroid point,
coordinates of the centroid point with respect to the new axes will be
323
in — a ,0,0, n i=1 il
E
0
(1)
That is, since the centroid point falls on the first coordinate axis, its coordinates with respect to all axes will be zero. In Fig. A13 there are only two factors, hence only two coordinates. Therefore, the coordinates of the centroid point can be found by averaging the loadings with respect to the new axes, the first of which goes through the centroid point. These loadings are given in Table Al2. Thus,
averaging the coordinates in the first column gives 1/ 4(.578+.531+.687+.765)=.64 as the first coordinate of the centroid point. The second coordinate of the centroid point is the average of the second column of the A matrix in Table A16, that is, 1/4(.562+.344 — .422—.484) =0, which is accordance with Eq.(1). in
To use Eq.(1) for deriving an
expression for the centroid loadings, Eq.(2) serves as a starting point:
r =a +a a + i2 j2 il
ij
+a a im jm
(2)
Summing both sides of Eq.(2) over i gives n n n a + ....+ a /:: a a + a r = a jm i = 1 im J2 1 = 1 12 jl 1 = 1 il i=1 ij n
E.
1:
E
(3)
Summing both sides of Eq.(3) over j gives n n n n n n r = Ea Ea + a La + ... + a (4) j=1 i=1 ij j=1 jl i=1 il J=1 j2 i=1 12 j=1 Jm i=1 im
EE
n n
La E
324
But
Z:
a a = j=1 jk i=1 ik
(5)
Since both terms in Eq. (5) are merely the sum of the entries in the kth column of the A matrix of factor loadings. Substituting (5) in (4), therefore, gives n 2 2 a ) + a ) +( r j=1 11 ij i1 ii i1 i2
=(Z:
E:
n a ) +( i=1 im
Z.:
2 (6)
By Eq. (1), however, all the sums on the righthand side of Eq (6) are zero except the first. Eq. (6) reduces, therefore, to n n ii a i=1 ) 2 (7)
r j=1 i=1 ij
Also by Eq. (1) the sums of loadings for the second and subsequent factors are zero, since the second and subsequent coordinates of the centroid point derived from these sums are zero, making Eq. (3) reduce to
a Cr = a i 1 ij j1 i=1
(8)
Taking the square root of both sides of Eq.(7) and substituting in Eq. (8) gives n n Er j=1 i=1 ij
= a i = 1 ij Solving for a gives jl j1
\
(9)
r 1=1 ij a jl =
(10)
n n r j=1 1=1 ij
325
Eq.
(10) gives the formula for a centroid loading for
variable j on factor 1. To get the centroid factor loading for data variable 1, for example, Eq. following steps: 1) Add up the entries in the first column of the correlation matrix, including the diagonal cell. 2) Divide this number by square root of the sum of all the entries in the entire correlation matrix, including the diagonal cells. (10) calls for the
For the second data variable, compute the sum of the entries in the second column of the correlation matrix and divide by the same square root term as for first data variable. Continue this for all columns of the R matrix. Thus, the computation steps involve computing the sums of the columns of the R matrix, adding these column sums to get the sum of all entries, taking the square root, and dividing this square root into each column sum.
Applying these steps to the fourvariable correlation matrix in Table All gives the results in Table A17. The contribution of factor 1 must be removed.
Table A17: Correlation Matrix
1 2 3 4 t a i
1 (.65) .50 .16 .17 1.48 .578
2 .50 (.40) .22 .24 1.36 .531
3 .16 .22 (.65) .73 1.76 .687
4 .17 .24 .73 (.82) 1.96 .765
T =
E
\J 1/\/Y—
r = 6.56 2.56125 = . 3904
326
From the correlation matrix by the operation RAlA q , as shown before. The results of this operation give the matrix R1, the matrix of first factor residuals shown in Table A18. Note that in Table A18 the columns in each case add up to zero, within the limits of rounding error. As a check, the rows should be added also, to make sure that the row totals equal the column totals as required for a symmetric matrix.
Table A18: First Factor Residuals
1 2 3 4 Sum 0
1 (.316) .193 .237 .272 .000 .316
2 .193 (.118) .145 .166 .000 .118
3 .237 .145 (.179) .204 .000 .178
4 .272 .166 .204 (.234) .000 .234
It was established in Eq. (1) that the sum of the loadings on the second and subsequent centroid factors is zero, which provides the basis for a check on the computations of the first factor residuals used above. Since the sums of the columns are zero, however, it is clearly impossible to apply the steps used for computing the first centroid factor to the matrix of residuals given in Table A18. It is necessary first to carry out a process of reflecting the residuals to get rid of as many negative signs as possible in the matrix of first factor residuals.
327
First Factor Residuals after Reflecting Variable 1
1 2 3 4 Sums without communalities
1 (.316) .193 .237 .272 .316
2 .193 (.118) .145 .166 .504
3 .237 .145 (.179) .204 .296
4 .272 .166 .204 (.234) .310
Reflected 1st Factor Residuals and 2nd Factor Calculations
1 2 3 4 t a
1 (.316) .193 .237 .272 1.018 .562
2 .193 (.118) .145 .166 .622 .343
3 .237 .145 (.179) .204 .764 .422
4 .272 .166 .204 (.234) .877 .484
T = 3.281
VT = 1.81135 1A117= .55207
1
328
COMPUTER PROGRAMS
329
COMPUTER PROGRAMS
C
This program reads 23 financial data from EXSTAT tape for all the British companies which have 14 years available data. Data 88 C2 B29 C31 C105 C114 C157 C115 C158 C49 C111 C91 C122 C43 C34 C57 C47 C48 C52 C50 C42 C123 C124 C151 C132 C106 End Select (B9 EQ EX AND B29 EQ 14) END
C
This
program reads the above data and indicates
companies which have missing values. Program MISSVAL Dimension X(23), KX(23) Character 35 company Integer date, NY Open (1, file = 'datal', status='old') DO 10 I = 1, 23 10 KX(1) = 0 20 Read (1„ END=99) Company, date, NY, (X(I), 1=1, 23) DO 30 I = 1, 23 30 If (X(I).GT.9999999999.0) KX(I)=KX(I)+1 DO 40 K= 1, NY1
330
Read (1,
) Company, date, NY, (X(I), I = 1, 23)
DO 50 I=1, 23 50 If (X(I).GT.9999999999.0) KX(I)=KX(I)+1 40 Continue GO TO 20 99 Write ( , ) (KX(I), I = 1, 23) STOP END
C This program eliminates the missing values from the extracted financial data. Program ELMISVA Dimension X(23) Character 35 Company Integer Date, NY Open (1, file='datal', status='old') 30 Read (1„ END = 99) Company, date, NY, (X(I), I=1, 23) DO 20 I = 1, 23 20 IF (X(I).GT.9999999999.0) GO TO 60 Write (2, 200) Company, date, NY, (X(I), I=1, 23) 200 Format (A35, 1X, 14, 1X, 12/14(5F15.0/)) 60 Continue DO 40 K = 1, NY1 Read (1, ) Company, date, NY, (X(I), I=1, 23)
DO 50 I = 1, 23 50 IF (X(I).GT.9999999999.0) GO TO 80 40 Write (2, 200) Company, date, NY, (X(I), I=1, 23) 80 Continue
331
GO TO 30 99 STOP END
C
This program calculates ratios for all the cases based on year by year activities from the original financial data. Program RATIOS Character Company 35 Integer date, NY Real Invent, NI Open (1, File = 'tape2', status='old') Rewind 1 Rewind 2 Rewind 3 Rewind 4 Rewind 5 Rewind 6 Rewind 7 Rewind 8 Rewind 9 Rewind 10 Rewind 11 Rewind 12 Rewind 13 Rewind 14 Rewind 15 Rewind 16 Rewind 17
332
10 Read (1, 200, END =99) Company, date, NY, Sales, Invent, CA, CL, TA, TL, RE, Cash, FA, PS, NI, PBT, TI, PD, CD, Depre, El, TT, OC, DC, Credits, SF, Debts R1  NI/TA R2 = NI/SF R3 = NI/CA R4 = NI/(TASF) R5 = NI/SALES
R6 = NI/FA
R7 = (PBT+TI)/TA R8  (PBT+TI)/SALES R9 = (PBT+TI)/SF R10 = (PBT+DEPRE)/SF R11 = SALES/TA R12 = SALES/SF R13 = SALES/CA R14  SALES/(TASF) R15 = NI/(TACL) R16 = (PD+CD)/(NI+DEPRE+EI) R17 = (DEPRE+TI+TT)/(PS+0C+DC) R18 = TI/SF R19 = TI/(PBT+TI) R20 = CD/NI R21 = CA/CL R22 = CL/SF R23 = (CACL)/TA R24 = CA/TA R25 = CA/SALES
333
R26 = CA/SF R27 = (CACL)/FA R28 = (CACL)/SALES R29 = (CAINVENT)/CL R30 = (CAINVENT)/SALES R31 = (CAINVENT)/TA R32 = (RE+DEPRE+EI)/(TACL) R33 = DEBTS/SF R34 = CASH/TA R35 = CASH/SALES R36 = CASH/CL R37 = CREDITS/SF R38 = TL/SF R39 = SF/FA R40 = (NI+DEPRE+EI)/(TASF) R41 = (NI+DEPRE+EI)/CL R42 = (NI+DEPRE+EI)/SALES R43 = (NI+DEPRE+EI)/SF R44 = (NI+DEPRE+EI)/TA R45 = INVENT/SALES R46 = INVENT/CA R47 = INVENT/TA R48 = INVENT/CL R49 = INVENT/(TACL) R50 = CL/CA R51 = CL/TA R52 = TL/CA R53 = RE/SF R54 = (CACL)/SF
334
R55 R56 R57 R58
0 RE/TA 0 CASH/CA 0 SF/TA 0 FA/SF
R59 = FA/TA R60 = RE/NI R61 (TL+PS)/TA
R62 = SF/(TASF) R63 = CL/(TASF) R64 = FA/(TACL) R65 = OC/SF IF (DATE.EQ.1971) IC = 1 IF (DATE.EQ.1972) IC = 2 IF (DATE.EQ.1973) IC = 3 IF (DATE.EQ.1974) IC = 4 IF (DATE.EQ.1975) IC = 5 IF (DATE.EQ.1976) IC = 6 IF (DATE.EQ.1977) IC = 7 IF (DATE.EQ.1978) IC = 8 IF (DATE.EQ.1979) IC = 9 IF (DATE.EQ.1980) IC = 10 IF (DATE.EQ.1981) IC = 11 IF (DATE.EQ.1982) IC = 12 IF (DATE.EQ.1983) IC = 13 IF (DATE.EQ.1984) IC = 14 IF (DATE.EQ.1985) IC = 15 WRITE (IC, 100) COMPANY DATE R1 R2 R3 R4 R5 R6 R7 R8 R9 R10 R11 R12 R13 R14 R15 R16 R17 R18 R19 R20 R21 R22 R23 R24 R25 R26 R27 R28 R29 R30 R31 R32 R33 R34
335
R35 R36 R37 R38 R39 R40 R41 R42 R43 R44 R45 R46 R47 R48 R49 R50 R51 R52 R53 R54 R55 R56 R57 R58 R59 R60 R61 R62 R63 R64 R65 N = NY DO 20 I = 1, N1 Read (1, 200, END=99) Company, date, NY, Sales, Invent, CA, CL, TA, TL, RE, Cash, FA, PS, NI, PBT, TI, PD, CD, Depre, El, TT, OC, DC, Credits, SF, Debts R1 = NI/TA R2 = NI/SF R3 = NI/CA R4 = NI/(TASF) R5 = NI/SALES R6 = NI/FA R7 = (PBT+TI)/TA R8 = (PBT+TI)/SALES R9 = (PBT+TI)/SF R10 = (PBT+DEPRE)/SF Rll = SALES/TA R12 = SALES/SF R13 = SALES/CA R14 = SALES/(TASF) R15 = NIRTACL) R16 = (PD+CD)/(NI+DEPRE+EI) R17 = (DEPRE+TI+TT)/(PS+0C+DC) R18 = TI/SF R19 = TI/(PBT+TI) R20 = CD/NI
336
R21 = CA/CL R22 = CL/SF R23 = (CACL)/TA R24 = CA/TA R25 = CA/SALES R26 = CA/SF R27 = (CACL)/FA R28 = (CACL)/SALES R29 = (CAINVENT)/CL R30 = (CAINVENT)/SALES R31 = (CAINVENT)/TA R32 = (RE+DEPRE+EI)/(TACL) R33 = DEBTS/SF R34 = CASH/TA R35 = CASH/SALES R36 = CASH/CL R37 = CREDITS/SF R38 = TL/SF R39 = SF/FA R40 = (NI+DEPRE+EI)/(TASF) R41 = (NI+DEPRE+EI)/CL R42 = (NI+DEPRE+EI)/SALES R43 = (NI+DEPRE+EI)/SF R44 = (NI+DEPRE+EI)/TA R45 = INVENT/SALES R46 = INVENT/CA R47 = INVENT/TA R48 = INVENT/CL R49 = INVENT/(TACL)
337
R50 = CL/CA R51 ... CL/TA R52 = TL/CA R53 = RE/SF R54 = (CACL)/SF R55 = RE/TA R56 = CASH/CA R57 = SF/TA R58 = FA/SF R59 = FA/TA R60 = RE/NI R61 = (TL+PS)/TA R62 = SF/(TASF) R63 = CL/(TASF) R64 = FA/(TACL) R65 = OC/SF IF (DATE.EQ.1971) IC = 1 IF (DATE.EQ.1972) IC = 2 IF (DATE.EQ.1973) IC = 3 IF (DATE.EQ.1974) IC = 4 IF (DATE.EQ.1975) IC = 5 IF (DATE.EQ.1976) IC = 6 IF (DATE.EQ.1977) IC = 7 IF (DATE.EQ.1978) IC = 8 IF (DATE.EQ.1979) IC = 9 IF (DATE.EQ.1980) IC = 10 IF (DATE.EQ.1981) IC = 11 IF (DATE.EQ.1982) IC = 12 IF (DATE.EQ.1983) IC = 13
338
IF (DATE.EQ.1984) IC = 14 IF (DATE.EQ.1985) IC = 15 20 WRITE (IC, 100) COMPANY DATE R1 R2 R3 R4 R5 R6 R7 R8 R9 R10 R11 R12 R13 R14 R15 R16 R17 R18 R19 R20 R21 R22 R23 R24 R25 R26 R27 R28 R29 R30 R31 R32 R33 R34 R35 R36 R37 R38 R39 R40 R41 R42 R43 R44 R45 R46 R47 R48 R49 R50 R51 R52 R53 R54 R55 R56 R57 R58 R59 R60 R61 R62 R63 R64 R65 GO TO 10 100 FORMAT (A35, 2X, I4/9(8(F9.4,1X)/)) 200 FORMAT (A35, 1X, 14, 1X, 12/14(5F15.0/)) 99 STOP END
C
This SPSS package reads the above ratios and analyse them by Factor Analysis technique. Run Name Data List Factor Analysis Fixed (10)/ 1 company 18 (A), year 3841/ 2 R1 TO R8 180/ 3 R9 TO R16 180/ 4 R17 TO R24 180/ 5 R25 TO R32 180/ 6 R33 TO R40 180/ 7 R41 TO R48 180/ 8 R49 TO R56 180/ 9 R57 TO R64 180/ 10 R65 110 N OF CASES UNKNOWN
339
FACTOR OPTIONS STATISTICS
VARIABLES=R1 TO R65 7,10,11 1,2,4,5,6,7
This SPSSX package reads the selected ratios and COMPUTE the Yvalue for each company. TITLE COMPANL FILE HANDLE TAPE21 DATA LIST FILE = TAPE21 FIXED (3) /1 COMPANY 18 (A), YEAR 1316/ 2 R1 TO R8 180/ 3 R9 TO R10 120 COMPUTE Y = 8.344R1 + 1.218R2 + 4.235R3 + .3R4 + 5.524R5 + .691R6 + .16R7 + 4.394R8  2.969R9 + 4.81R10  1.989 FILE HANDLE KOBRA PRINT OUTFILE = KOBRA/ COMPANY, Y (A8,F9.4) EXECUTE FINISH
C
This program reads the KOBRA file and recode it company by company. program recode character 10 comp, compl integer year, c open (3, file='kobra') open (4, file='farhood') compl = 'A. C. Cars' c= 0 5 read (3, 10, end=999) comp, year, Y
340
If (compl.NE.comp) then compl = comp c = c+1 end if write (4, 20) comp, year, Y, c Go to 5 999 close (3) close (4) stop 10 format (A10, 14, 1X, F8.3) 20 format (A10, 14, 1X, F8.3, 1X, 13) end
C This SPSSX package reads the Farhood file and plots Yvalue against years. FILE HANDLE FARHOOD DATA LIST FILE = FARHOOD/COMPANY 110 (A), YEAR 1115, Y 1623, C 2427 SORT CASES BY C SPLIT FILE BY C PLOT TITLE = 'PLOT YEAR AND RATIOS' /VERTICAL = /HORIZONTAL = YEAR EXECUTE FINISH
C This Fortran program reads the provided data and plots four different groups of data on four different scales in one page by the SIMPLE PLOT. PROGRAM PLOT14
341
DIMENSION XARR(14), YlARR(14), Y2ARR(14), Y3ARR(14), Y4ARR(14), Y5ARR(14), Y6ARR(14), Y7ARR(14), Y8ARR(14) REWIND 1 OPEN (UNIT=1,FILE='KOBRA') READ (1, ) (XARR(I), YlARR(I), Y2ARR(I), Y3ARR(I), Y4ARR(I), Y5ARR(I), Y6ARR(I), Y7ARR(I), Y8ARR(I), I = 1, 14) CALL PAGE (20.0, 29.7) CALL PICSIZ (8.0, 8.0) CALL MARGIN (1.0) CALL GROUP (2, 2) CALL SCALES (1972.0, 1985.0, 1, 28.0, 45.0, 1) CALL AXES7 ('YEAR', 'CURRENT ASSETS') CALL BRKN CV (XARR, YlARR, 14, 6) CALL BRKN CV (XARR, Y2ARR, 14, 0) CALL SCALES (1972.0, 1985.0, 1, 67.0, 78.0, 1) CALL AXES7 ('YEAR', 'CURRENT LIABILITIES') CALL BRKN CV (XARR, Y3ARR, 14, 1) CALL BRKN CV (XARR, Y4ARR, 14, 6) CALL SCALES (1972.0, 1985.0, 1, 56.0, 9 .0, 1) CALL AXES7 ('YEAR', 'NET INCOME') CALL BRKN CV (XARR, Y5ARR, 14, 5) CALL BRKN CV (XARR, Y6ARR, 14, 5) CALL SCALES (1972.0, 1985.0, 1, 238.0, 458.0, 1) CALL AXES7 ('YEAR', 'CASH') CALL BRKN CV (XARR, Y7ARR, 14, 2) CALL BRKN CV (XARR, Y8ARR, 14, 4) CALL TITLE7 ('L', 'C', 'COMPANY'S NAME')
342
CALL SET KY ('L', 'R', 8, 6) CALL LINE K7 (0, 'CA') CALL LINE K7 (6, 'OCA') CALL LINE K7 (6, 'CL') CALL LINE K7 (1, 'OCL') CALL LINE K7 (5, 'NI') CALL LINE K7 (5, 'ONI') CALL LINE K7 (4, 'CASH') CALL LINE K7 (2, 'OCASH') CALL ENDPLT STOP END
343
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