Financial Management 244
CHAPTER 3
Week 1
Please listen to the voice narrations
to refresh your memory regarding
the ratios’ equations. During the
synchronous lectures we will focus
on the application (calculation
and
interpretation)
of
ratios.
Economic and Management Sciences | EyeNzululwazi ngoQoqosho noLawulo | Ekonomiese en Bestuurswetenskappe
Ratios
Introduction
Why do we do ratio analysis?
• Provide more information in format that is comparable over time and
between companies and/or industries
• Ratios are more understandable than the financial figures in financial
statements
• Meaningful relationships between items from the financial statements
are investigated
Requirements for financial ratios
• Primary objective:
 Simplify the evaluation of the financial performance and position
•
Requirements:
1. Meaningful
 Logical comparison between items from financial statements
2. Relevant
 True indication of financial performance
3. Comparable
 Across industries and over time
 Ratio calculated in a consistent manner
Norms of comparison
Ratios should not be interpreted in isolation
• Conventions
 Norms developed over time (e.g. Current ratio 2:1)
 May differ between firms/industries
• Comparison over time
• Comparison between similar companies
 Determine the competitive position of the company relative to its
competitors
Types of ratios
1.
2.
3.
4.
5.
6.
7.
Profitability ratios
Profit margins
Turnover ratios
Liquidity ratios
Solvency ratios
Cash flow ratios
Investment ratios
Profitability ratios
• Evaluates efficiency of a company utilising its capital to
generate turnover/revenue
• Possible to calculate the profitability of different capital items
• The higher the return on a capital item, the more efficiently it
has been used
Profitability ratios
Return on assets (%)
• Measures how efficiently total assets are utilised to generate
turnover
 Compares profit after tax with total assets
Profit after tax
ROA =
x 100
Average total assets
How can we improve ROA?
Profitability ratios
Return on assets (%)
•
•
Higher ROA = using assets more efficiently
Careful not to reduce assets too much – negative effect on
activities in the future
• ROA steadily declines for 5 years
• Profit margin stayed more or less the same, but investment in assets
increased.
• What might it imply?
Profitability ratios
Return on equity (%)
• Indicates return generated on total equity
• Total equity includes ordinary shareholders’ equity, preference share
capital and minority / non-controlling interest
Profit after tax
ROE=
x 100
Average equity
Profitability ratios
Return on equity (%)
•
The higher the ratio the better for equity providers/investors
•
Increase in equity could lead to a decrease in ROE if profit after
tax remains the same
•
Compare to other firms in the same industry
Profitability ratios
Return on shareholders equity (%)
•
Shareholders equity includes ordinary shareholders’ equity and
preference share capital
Profit after tax −non−controlling interest
ROSE=
x 100
Average shareholders′ equity
Note that non-controlling interest is withdrawn from profit
after tax, as we now only consider a part of equity (namely
average shareholders’ equity)
Profitability ratios
Return on ordinary shareholders’ equity (%)
•
Ordinary shareholders’ equity includes ordinary share capital and
reserves
ROSHE=
Profit after tax −non−controlling interest −preference dividends
x 100
′
Average ordinary shareholders equity
Profit margins
• Indication of the percentage of turnover that reflects as profit
after deductions are made
• Profit margins could influence profitability ratios
 Higher profit margins should increase profitability levels
Profit margins
Gross profit margin (%)
•
Portion of revenue that is realised as gross profit after cost of
sales has been subtracted
Gross profit
GP =
x 100
Turnover
Please note: Turnover and revenue are synonyms
•
Higher = better
•
GP>industry = could hold a competitive advantage
•
GP could decrease should competition increase
Mark-up
NB to distinguish between mark-up % and gross profit %
Gross profit
Mark-up =
x 100
Cost of sales
Note that gross profit margin is determined as a % of revenue while
mark-up is determined as a % of cost of sales
Profit margins
Operating profit margin (%)
•
Portion of revenue that is realised as operating profit after operating
expenses have been subtracted
OP =
Operating profit
x 100
Revenue
•
Increasing OP margin = positive sign
•
Investors should be looking for strong, consistent OP margins
Profit margins
Earnings before interest and tax margin (%)
•
Profit made by a company’s operating and investment
activities excluding finance cost
EBIT =
Operating profit + Investment income
x 100
Revenue
OR
Probit before tax + Finance cost
EBIT =
x 100
Revenue
Profit margins
Net profit margin (%)
• Portion of turnover available after tax is paid
• Important to the equity providers
 Indication of portion of the turnover that belongs to non-controlling
interest holders, which can be paid out as ordinary or preference
dividends or can be reinvested as part of the company’s reserves
Profit after tax
NP =
x 100
Revenue
Turnover ratios
• Indicates speed with which an investment in assets is converted
into turnover
 Higher
more times per year
turnover
higher total profit
•
Factors influencing turnover ratios:
 Type of products
 Nature of industry
Turnover ratios
Total asset turnover ratio (times)
•
Indicates efficiency with which total assets are utilised to
generate turnover
Turnover
TA =
Average total assets
•
If a company improves the TA ratio while maintaining the same
profit margins, its return on assets should increase
Turnover ratios
Property, plant and equipment turnover ratio (times)
•
Evaluates the utilisation of a company’s investment in PPE
Turnover
PPE turnover =
Average PPE @ carrying value
Carrying Value = Cost price – Accumulated depreciation
Turnover ratios
Current asset turnover ratio (times)
•
Number of times per year that the investment in the current
assets is converted into turnover
Turnover
CA turnover =
Average current assets
Turnover ratios
Trade receivables turnover ratio (times)
• Number of times per year that investment in trade receivables is
converted into turnover
Turnover
Trade receivables turnover =
Average trade receivables
A decrease = TR are being used less efficiently, which could
also lead to a decrease in the CA turnover ratio.
Turnover ratios
Inventory turnover ratio (times)
• Cost of sales is determined by the amount of inventory that is sold
Cost of sales
Inventory turnover =
Average inventory
•
•
High = less resources are tied up in inventory
Very industry specific (e.g. flower shop vs jewellery store)
How could efficiency be improved?
Recap: Cost of sales calculation
Recap that you can use the following equation to
determine the cost of sales:
Opening balance of inventory + purchases – closing
balance of inventory = cost of sales
You can hence use the inventory turnover ratio to work
back to cost of sales
Turnover ratios
Trade payables turnover ratio (times)
• Evaluates efficiency with which company utilises trade payables
to finance its purchases
Purchases
Trade payables turnover =
Average trade payables
Purchases = (CB of inventory + COS) – OB of inventory
Liquidity ratios
• Liquidity refers to ability to honour short-term obligations
 Adequate liquidity: sufficient current assets to cover current
liabilities
 If liquidity is consistently at insufficient levels = solvency
problems could occur
Liquidity ratios
Current ratio
• Compares all current assets and current liabilities
 Conventional norm of comparison 2:1
 Value less than one: less than R1 of current assets to cover R1 of
current liabilities – this could indicate insufficient liquidity
Current ratio =
Current assets
Current liabilites
• NB: keep in mind the nature and type of business
Liquidity ratios
Quick (acid-test) ratio
• Not all current assets are included (remove “less liquid” CA)
 Takes time to sell inventory
 Prepayments cannot be reclaimed
•
Value of quick ratio more conservative estimate of current assets
available to cover current liabilities
Quick ratio =
Cash + short−term investments + trade receivables
Current liabilities
OR
Current assets − inventory − prepayments
Quick ratio =
Current liabilites
Liquidity ratios
Cash ratio
• Focus is solely placed on cash and cash equivalents available
 Cash ratio indicates if sufficient cash is available to cover current
liabilities
Cash
Cash ratio =
Current liabilites
•
•
Most conservative liquidity ratio
Cash and marketable securities = most liquid
Turnover times
• Also provide an indication of the liquidity of a firm
• Turnover times of current assets provide indication of time
(days) it takes to convert investment into turnover
• Longer turnover times: weaker liquidity
• More efficient management of working capital components
could result in improved liquidity
• 360 days
Turnover times
Trade receivables turnover time (days)
• Average time it takes to convert investment in TR into turnover
 Average collection period of trade receivables
Average trade receivables
Trade receivables turnover time =
x 360
Turnover
•
Increase in the value of ratio over time could be:


A sign of decreased liquidity;
An indication that credit terms are too lenient
Turnover times
Inventory turnover time (days)
• Average time it takes to convert inventory into turnover
Average inventory
Inventory turnover time =
x 360
Cost of sales
• Increase in inventory turnover time = negative effect on liquidity
Danger of long inventory turnover time period?
Turnover times
Trade payables turnover time (days)
• Average payment period of trade payables
 Prefer longer or shorter period?
Average trade payables
Trade payables turnover time =
x 360
Purchases
•
Trade payables turnover time decreases: trade payables are repaid
earlier = negative effect on liquidity
Turnover times
Cash conversion cycle (CCC)
• Indication of the time it takes from when cash is spent on
purchase of inventory until it is received back again
CCC = Trade receivables turnover time + Inventory turnover
time – Trade payables turnover time
 Inverse relationship between CCC and profitability; could
improve profitability by reducing CCC
Solvency ratios
• Company’s ability to cover its obligations when it closes
down its operating activities
• Comparison between total assets and total debt capital
 Assets > Liabilities = solvency is sufficient
 If this is not the case: long-term survival of the company may be
at risk
Solvency ratios
Debt to assets ratio
• Provides an indication of the portion of the total capital
requirement that is financed by means of debt capital
 The higher the value of this ratio, the weaker the solvency
position
Total debt
Debt : assets ratio =
Total assets
Solvency ratios
Debt to equity ratio
• Compares amount of debt capital with equity capital
• Higher ratio?
Total debt
Debt : equity ratio =
Total equity
•
DE = 1?
Solvency ratios
Financial leverage ratio
• Average amount of total assets is compared with the average
equity capital included in the company’s capital structure
 Higher ratio?
Average total assets
Financial leverage ratio =
Average total equity
• Increase in the ratio reflects an increase in the use of debt capital
Coverage ratios
Finance cost coverage (times)
• Finance cost payable on debt capital = legally enforceable
obligation
 If finance cost is not paid debt capital providers can take legal
action to collect it
 FCC ratio indicates if sufficient profits are available to pay finance
cost
EBIT
Finance cost coverage = Finance cost
Coverage ratios
Fixed payments coverage ratio (times)
• Fixed payments: obligations that company always needs to
honour
• Usually consist of finance cost and lease payments
Profit before tax + finance costs + lease payments
FP coverage =
Finance costs + lease payments
• Less than 1: insufficient profits, solution?
Coverage ratios
Preference dividend coverage ratio (times)
• Indicates if sufficient profits are available to pay preference
dividends
 Preference dividends can only be paid after provision has been
made for all other obligations
Preference dividend coverage =
• Lower or higher ratio?
Profit after tax − non−controlling interest
Preference dividends
Investment ratios
• Of importance to existing and potential shareholders
 potential benefits
 if the investment in the shares of the company is expected
to increase or decrease in value over time
Investment ratios
Earnings per share (EPS) ratio
• Indication of the attributable earnings that was earned per
ordinary share during the year (cents)
Profit after tax −Non−controlling interest −Preference dividends
EPS =
Average number of ordinary shares issued
Attributable earnings
EPS =
Average number of ordinary shares issued
Possible manipulation?
Investment ratios
Dividends per share ratio
• Indicates the amount that investors receive per share in the form
of ordinary dividends (cents)
 Only a portion of the EPS is declared as an ordinary dividend
 Portion not paid out reinvested as retained earnings
Ordinary share dividend
DPS = Average number of ordinary shares
Investment ratios
Price earnings ratio (P:E)
• Indication of how many Rands investors are prepared to pay for
each R1 EPS that is earned
 If P:E ratio is greater than one, it is usually an indication that investors
expect company to continue to grow in future
Price per share
P:E ratio =
Earnings per share
Investment ratios
Dividend payout ratio
• Represents portion of attributable earnings that is paid to investors
• Remaining portion is reinvested as part of retained earnings
Ordinary dividends declared
Dividend payout ratio =
Attributable earnings
• Low dividend payout ratio = more reinvestment which could lead
to value creation
Investment ratios
Ordinary dividend coverage ratio
• Ordinary shareholders have last claim on profits
Attributable earnings
Ordinary dividend coverage =
Ordinary dividends declared
• Focus is placed on attributable earnings
 Dividends usually only declared if sufficient profits are available
 If ODC < 1, reserves from previous years used or additional debt
capital obtained
Investment ratios
Market-to-book-value ratio
• Compares market capitalisation of shares with book value of
shareholders’ equity
Market capitalisation of ordinary shares
Market-to-book value =
Book value of ordinary shares
•
•
Market capitalisation = MP per share x number of ordinary shares
Indication of the price investors are willing to pay in relation to
the book value
Financial gearing
• Effect that the use of debt capital has on ROSE
• Two important factors to consider when evaluating financial
gearing:
 ROA
 Cost associated with debt capital (RD)
Financial gearing
• If company is able to generate ROA in excess of RD:
 Return on capital will be higher than its cost;
 Surplus profit will be transferred to shareholders increasing
ROSE
 Company experience positive financial gearing
Financial gearing summary
• Positive:
 ROA>RD and ROSE>ROA
• Negative
 ROA<RD and ROSE<ROA
• No financial gearing
 ROA=RD and ROSE=ROA
DuPont analysis
ROE:
Profit after tax
Average equity
ROA:
Leverage:
Profit after tax
Average total assets
Average total assets
Average equity
Net profit margin:
Total asset turnover:
Profit after tax
Turnover
Turnover
Average total assets
Tax burden:
Interest burden:
EBIT Margin:
Profit after tax
Profit before tax
Profit before tax
EBIT
EBIT
Turnover