INTERPRETATION,

PERFORMANCE ANALYSIS
AND CORPORATE
COMPARATIVES
READ: M C LANEY & ATRILL
BACKGROUND
TO ANALYSIS
 Click icon to add picture
CORPORATE COMPARATIVES

An initial analysis is required to understand

business as a whole by assessing:
Nature of business – which sector, expanding or
contracting sector, impact of technology, quality
of management?
Growth – growing, shrinking or static, if growing is
it organically or by acquisition, level of profits?
Size – small, medium or large using what criteria,
national or international, single company or part
of a group?
3
 Click icon to add picture
CORPORATE COMPARATIVES

Stability – financially well structured, mix of

debt and equity, solvent? Achievable budgets?

Wider context – economy, recession or recovery,

inflation or stagnation, availability of finance,
interest and exchange rates, fiscal policy,
reinvestment or restrictions?

4
 Click icon to add picture
CORPORATE COMPARATIVES

Performance – results business generated in year

- success or decline (statement of profit or loss)

Position – financial stability and debt

(statement of financial position / balance sheet)

Investment – items that specifically matter to

investors

5
 Click icon to add picture
ACCOUNTING RATIOS
Uses

• Help to summarise and present financial

information in a more understandable form

• Assist in assessing performance of a business by

identifying significant relationships between
different figures

6
 Click icon to add picture
ACCOUNTING RATIOS
Uses

• Enables comparisons to be made with previous

years, other companies, industry averages and
budgeted figures

• Do not provide answers but help to focus

attention on important areas, therefore
minimising chance of failing to identify a
significant trend or weakness

7
CORPORATE
COMPARATIVES
R a ti o s d i v i d e i n t o t h e
following main areas:

• Profitability
• Short term liquidity
• Activity / Efficiency
– overlap with
liquidity
• Long term solvency
• Investors’(stock
market) ratios
8
9
PERFORMANCE
PROFITABILITY
PERFORMANCE
P r o fi t a b i l i t y

 Gross profit margin

 Operating profit margin
 Return on capital
employed - ROCE
 Return on shareholders’
funds – ROSF

 Net asset (capital)

turnover
11
 Click icon to add picture
PERFORMANCE
Gross profit margin - measures margin earned on
revenue before overhead costs
Operating profit margin – measures profit margin
after all operating expenses
Return on capital employed – measures how
effectively overall resources are being employed
Return on shareholders’ funds – measures how
effectively funds provided by shareholders are
being employed
Net asset turnover - measures efficiency of
revenue generation in relation to overall
resources employed 12
 Click icon to add picture
GROSS PROFIT MARGIN
Formula

Gross profit margin %:

Gross profit x 100
Sales revenue

Put simply, a measure of profitability in buying

(or producing) and selling goods or services
before other expenses taken into account

13
GROSS PROFIT MARGIN
Analysis of Results

Gross profit margin should remain

reasonably constant. An alteration may be
due to a change in:
Selling prices – normally deliberate though
sometimes unavoidable due to increased
competition or entry into new market
Sales mix – often deliberate
e.g. discontinuing a product
Purchase cost
Production cost
14
 Click icon to add picture
GROSS PROFIT MARGIN
Analysis of Results

Why reduce selling prices?

Attract more sales and increase revenue

Why change costs?

Costs will generally increase
Some costs are fixed which don’t change as
revenue increases
Improves margin

15
 Click icon to add picture
OPERATING PROFIT MARGIN
Formula

Operating profit margin %:

Operating profit (before interest and tax) x 100

Sales revenue

Put simply, a measure of profit from trading

operations before finance charges taken into
account

16
 Click icon to add picture
OPERATING PROFIT MARGIN
Analysis of Results

Changes in operating profit margin:

• In line with changes in gross profit margin?
• In line with changes in sales revenue?
• Look at individual categories
e.g. admin expenses
• Are they one-off expenses e.g. redundancies?
• Are there likely to be ongoing future costs?

%
17
 Click icon to add picture
CAPITAL TURNOVER
Formula

Net Asset Turnover, put simply:

Sales revenue . = ‘X’ Times

Total capital used*

How much revenue capital generates

*Total assets – Current liabilities, or

Share Capital + Reserves + Non-current liabilities
Either / or = they give the same figure!
18
 Click icon to add picture
CAPITAL TURNOVER
Analysis of Results

• Net asset turnover often seen as measure of

how intensively assets are worked
e.g. higher = more efficient
• Whereas profit margin seen as indication of
quality
• so a trade off may exist between margin and
asset turnover

19
 Click icon to add picture
RELATIONSHIP TO ROCE

Operating Profit Margin

X

Net Asset (Capital) Turnover

Return on Capital Employed

20
 Click icon to add picture
RETURN ON CAPITAL EMPLOYED

Multiply formulae together

Sales revenue cancels out

Gives you ROCE ratio:

Operating profit .
Share Capital + Reserves + Non-current liabilities

21
 Click icon to add picture
BREAKING DOWN ROCE

Operating profit margin:

Operating profit
Sales revenue

Capital turnover:
Sales revenue
Capital employed

22
 Click icon to add picture
ROCE
Formula

Return on Capital Employed

Operating profit (before interest and tax) x 100

*Share Capital+Reserves+Non-current liabilities

Relationship between operating profit

generated during a period
and the long term capital invested

* Capital employed

23
 Click icon to add picture
ROCE

Return on Capital Employed (ROCE) is the key

measure of profitability which shows how much
profit is earned for every £1 invested in company

Movements in ROCE should be analysed for any

reasons why profit has moved and for changes in
long term funding such as loans or share issues

ROCE can be significantly affected by accounting

policies e.g. revaluation of assets will lower ROCE

24
 Click icon to add picture
ROCE
Analysis of Results

Change in Capital:
• Capital does not produce immediate
increases in profit
• Raise capital – expect ROCE to fall
immediately
• Will improve in later years as new capital
produces profits

Change in Operating profit:

• Same as for operating profit margin

25
 Click icon to add picture
BALANCING MARGINS AND
ASSET TURNOVER
Analysis of Results
• Low margin businesses (food retailers) usually
have a high asset turnover
• Capital intensive businesses (electrical
equipment manufacturers usually have
relatively low asset turnover but higher margins)

Operating profit margin x capital turnover = ROCE

26
 Click icon to add picture
ROCE
Analysis of Results

In order to assess company’s profitability,

compare this ratio on a like-for-like basis

Examples:
 with ROCE for previous years,
 with ROCE for competitors/industry averages,
 against return available on alternative
investments including commercial interest
rates
 cost of borrowing
27
 Click icon to add picture
RETURN ON SHAREHOLDERS’ FUNDS
Formula

Net profit (after tax) x 100

Ordinary Share Capital + Reserves*

Amount of profit available in period compared to

owners’ stake in business

* Equity

28
 Click icon to add picture
ROSF
Analysis of Results

Equity doesn’t change drastically (normally)

Any change is due to profit for year

Affected by
Tax for year
Interest on loans
Especially if borrowings have increased

29
 Click icon to add picture
ROSF
Analysis of Results

Compare to:
• Prior year ROSF
• Other companies’ ROSF in same industry

However, analysis usually focuses on ROCE, as

issue is management’s ability to generate return
from overall resources rather than how these
resources are financed

May be used by investors to assess suitability of a

company’s ordinary shares 30
ROSF

31
POSITION -
LIQUIDITY

32
SHORT TERM LIQUIDITY (AND EFFICIENCY)

Current ratio
Quick ratio
Inventory days
Receivable days
Payable days

33
 LIQUIDITY

Measures ability of organisation

to meet its short-term financial
obligations

Cash -
Where it comes from and
where it goes
 Click icon to add picture
POSITION
S h o r t t e r m l i q u i d i t y a n d e ffi c i e n c y

Current ratio measures adequacy of current

assets to meet liabilities as they fall due

Quick ratio measures whether there are

sufficient liquid resources to settle liabilities

Inventory days measures average number of

days between acquiring an item and selling it

35
 Click icon to add picture
POSITION
S h o r t t e r m l i q u i d i t y a n d e ffi c i e n c y

Receivable days measures average number of

days between making a credit sale and
receiving payment

Payable days measures average number of

days between making a credit purchase and
making payment

36
CURRENT RATIO (LIQUID RATIO)
Formula

Current assets : Current liabilities

‘X’ : 1

Current assets
Current liabilities

37
 Click icon to add picture
CURRENT RATIO
Analysis of Results

Should be looked at in light of what is ‘normal’ for business

e.g. (1.5:1)
But supermarkets (for example) have low current ratios as
have few trade receivables!

What is availability of further finance

e.g. is overdraft at limit?

A high figure may seem safe but may be due to

High level of inventory and receivables
High cash levels
Therefore poor use of funds
38
 Click icon to add picture
QUICK RATIO (ACID TEST)
Formula

Current assets - Inventories : Current liabilities

‘X’ : 1

Current assets – Inventories

Current liabilities

39
 Click icon to add picture
QUICK RATIO
Analysis of Results

A more severe test (‘acid test’) of liquidity by

omitting inventories (slow moving asset)

What is ‘normal’? (0.7:1- 1:1)

e.g. again supermarkets have very low liquid ratios

A company with a low ratio may have no problems

paying amounts due if sufficient overdraft facilities
available

40
 Click icon to add picture
INVENTORY TURNOVER PERIOD
Formula

Average inventories x 365 days

Cost of sales

Average period for which inventories are held

41
 Click icon to add picture
INVENTORY TURNOVER PERIOD
Analysis of Results
A delicate balance between:
Holding too much stock - costly as not generating
revenue and capital tied up and
Holding too little stock - not able to satisfy
customer demand
An increasing number of days may indicate
• Lack of demand
• Poor inventory control
• An increase in costs
• May not be bad if buying in bulk for discounts
or avoiding stock outs 42
 Click icon to add picture
INVENTORY TURNOVER PERIOD
Analysis of Results
A delicate balance between:
Holding too much stock –
• Obsolete, passed the sell by date
• Controls not very strong
• Holding costs

Holding too little stock –

• Controls not very strong
• Loss of future custom

43
 Click icon to add picture
RECEIVABLES COLLECTION PERIOD
Formula

Trade Receivables Settlement Period

Trade receivables x 365 days

Credit sales revenue

How long, on average, credit customers take

to pay amounts owed

44
 Click icon to add picture
RECEIVABLES COLLECTION PERIOD
Analysis of Results

Should be compared to:

• stated credit policy
• previous period figures

45
 Click icon to add picture
RECEIVABLES COLLECTION PERIOD
Analysis of Results

Increasing collection period usually bad sign as

may indicate:

• Bad debts/collection problems

• Change in settlement terms
• Change in nature of customer base
(big new customer but slow payer)
• How long credit customers are taking to pay

46
 Click icon to add picture
RECEIVABLES COLLECTION PERIOD
Analysis of Results

In short:
Too long
It’s your money not theirs
Increased bad debts
Inefficient credit control

Too short
Discourages new customers

47
 Click icon to add picture
PAYABLES PAYMENT PERIOD
Formula

Trade payables x 365 days

Credit purchases

How long, on average business takes to pay

those who have supplied goods and services on
credit

48
 Click icon to add picture
PAYABLES PAYMENT PERIOD
Analysis of Results

Should be compared to:

• previous period figures

A long credit period may be good as it represents

a source of ‘free’ finance

49
 Click icon to add picture
PAYABLES PAYMENT PERIOD
Analysis of Results

Increasing payment period usually bad sign as

may indicate:
• Liquidity problems
• Could be in danger of being refused credit
• May develop a reputation as a slow payer
• May be losing out on cash discounts

50
 Click icon to add picture
TRADE PAYABLES DAYS
Analysis of Results

In short:
Too long
Lose credit facilities
Lose suppliers
Court action

Too short
Could use your money more effectively

51
OTHER RELATIONSHIPS
Wo r k i n g C a p i ta l C yc l e ( C a s h C yc l e )

Inventories, receivables and payables days

Inventories days
+ Receivables period
- Payables period
= Working capital cycle

Length of time between incurring costs and

receiving cash returns

52
 Click icon to add picture
OVERTRADING

Arises when a company expands sales revenue

rapidly without additional long term capital
Symptoms:
• Inventory increasing
(more than proportional to revenue)
• Receivables increasing
(more than proportional to revenue)
• Cash and liquid assets declining rapidly
• Trade payables increasing rapidly

53
54
LONG TERM FINANCIAL
STABILITY
GEARING
INTEREST COVER

55
LONG TERM FINANCIAL STABILITY

Gearing
Interest cover

56
 Click icon to add picture
LONG TERM SOLVENCY

Gearing and debt to equity measure extent to

which a company’s long term funds have been
provided by lenders

A measure of risk - extent to which company is

reliant on long term borrowing to finance its
activities

57
 Click icon to add picture
GEARING
Formula 1

Debt : Equity

Borrowings (long and short term) X 100

Ordinary share capital + Reserves

Shareholders

58
 Click icon to add picture
GEARING
Formula 2

% of capital employed represented by

borrowings
Long term liabilities X 100
Share Capital+Reserves+Non-current liabilities

Lenders Shareholders

59
 Click icon to add picture
GEARING
Use:

Extent to which organisation is financed by

outside parties

Long term / non-current borrowings from

outside
= Debt

compared to funds provided by shareholders

= Equity

60
 Click icon to add picture
GEARING
Analysis of Results

In highly geared businesses

• There is a greater risk of insolvency
• Returns to shareholders will grow
proportionately more if profits are growing

In low geared businesses

• Scope to increase borrowings
• Usually borrow more easily

61
 Click icon to add picture
LONG TERM SOLVENCY
Analysis of Results

Gearing ratio in excess of 50% (UK) is considered

highly geared

Interest cover is a measure of number of times

that interest payable could have been paid out of
available profits

62
 Click icon to add picture
INTEREST COVER
Formula

Profit before interest and tax

Interest payable

• Number of times interest could be paid

• Risk high if low cover
• Sensitive to interest rate changes?

63
 Click icon to add picture
RELATED RATIO

Interest Cover

Use:
Amount of profit available to cover interest
Profits fail to cover interest?

64
 Click icon to add picture

How much profits cover interest on loans

The higher the better

Above 4 is best
Need enough profits to pay tax as well as
interest

Can’t pay interest = bankruptcy

65
 Click icon to add picture
LONG TERM FINANCIAL STABILITY
Conclusions
To suit a highly geared structure a company needs:

Relatively stable profits - loan interest must be

paid regardless of profits being earned
Suitable assets for security as loans secured on
some or all of company’s assets

A high interest cover indicates a relatively secure

position. Profits could fall substantially before
interest payments could not be met
66
67
INVESTOR RATIOS
INVESTOR RATIOS

Earnings per share

Price earnings ratio
Dividend yield
Dividend cover

69
 Click icon to add picture
EPS RATIO
Formula

Earnings available for shareholders*

Number of ordinary shares

Earnings (Income Statement)

Shares (Balance Sheet notes)

*Profit after interest and after tax

70
 Click icon to add picture
EPS SHOWS
• Level of profits available to pay dividends to
ordinary shareholders, in relation to number of
shares eligible to receive them

• Performance of their investment

• Comparison to previous years, to competitors

and to dividend per share actually received

• Whether to hold shares as investment or sell

them and invest in something else
71
 Click icon to add picture
EPS
L i m i t a ti o n s o f E P S

• Ignores growth due to inflation

• Based on historic information

• Earnings based on choice of accounting

policies, therefore inter-company
comparison difficult

72
 Click icon to add picture
EARNINGS PER SHARE (EPS)

Widely regarded as most important indicator of a

company’s performance

An earnings number which is both reliable and of

high quality is important for:
• Inter company comparison
• Company valuation
• Evaluation of performance

Thus calculation of EPS is governed by IAS 33

73
 Click icon to add picture
EPS

From analyst/investor viewpoint a high-quality

earnings number is one that:

Accurately reflects company’s current operating

performance
A good indicator of future operating performance
A useful summary measure for assessing firm
value

74
 Click icon to add picture
PE RATIO
Formula

Market price per share

Earnings per share

Earnings (Income Statement)

Most recent year’s earnings
Shares (Balance Sheet notes)

75
 Click icon to add picture
PRICE EARNINGS (PE) RATIO
Use

Common investor ratio

PE ratio reflects stock market’s opinion of

company worth based on most recent earnings

High PE =
low risk, growth expected

76
 Click icon to add picture
PE RATIO

• Market share prices can change quickly

(supply and demand)
• If higher share price in relation to existing
earnings, leads to higher P/E ratio
Reflects market’s confidence in future
performance of company
• If share price falls because market not
confident about future performance, lower
share price in relation to existing earnings
levels will produce lower P/E ratio
77
 Click icon to add picture
DATA USED IN PE RATIO

Warning:
Market price – fluctuates!

= Share price as multiple of past earnings

‘Good’ ratio = 15

Internet based companies = 50 / 60

78
DIVIDEND YIELD
Formula:

Dividend paid out to ordinary shareholders in

relation to current market value of shares

Dividends per share x 100

MPS

79
 Click icon to add picture
DIVIDEND YIELD
Analysis of Results
Return compared with:

• return available from investing in other

companies or
• different forms of investment

Can help decide whether to hold shares as

investment or sell them and invest elsewhere

80
 Click icon to add picture
DIVIDEND YIELD
Analysis of Results
Allows potential investor to assess return earned
on investment in shares in relation to current
value of investment

A low dividend yield:

• Might deter investor seeking income
• Might not deter investor seeking capital growth

81
 Click icon to add picture
DIVIDEND YIELD
Analysis of Results

A high dividend yield:

• Company paying out too high proportion of

profits as dividends

• Not re-investing in company for growth

• Indication share currently under-priced in

market and potential capital gain to be made
by holding onto share
82
 Click icon to add picture
DIVIDEND COVER
Formula

Earnings available for dividends*

Dividends

Warning:
Variations of formula
*Profit after interest and after tax

83
DIVIDEND COVER
Use:

Amount of profit available to cover

dividend

Number of ‘times’

84
DIVIDEND COVER
Analysis of Results

• Shows extent to which

a current dividend is
covered by current
earnings
• Provides information
to shareholders to
judge likelihood that
current dividend levels
are sustainable in
future
85
 Click icon to add picture
DIVIDEND COVER
Analysis of Results
• High dividend cover
indicates company is retaining substantial part
of its profits

• More likely current dividend level sustained in

future

• Dividend cover less than one:

indicates company having difficulty maintaining
acceptable level of dividend
86
87