Share Investment
Analysing
Financial Statements
1
Using Ratios



Ratios are used to summarise the data on financial
statements in order to capture in one number a particular
aspect of operations.
These numbers usually take three forms
 Ratios (one value compared to another)
 Percentages (ratios expressed as a value out of 100)
 Amounts (in £)
In order to see whether a particular value shows a good
or a bad investment, you will need to view it in context.
The yellow post-its on
the slides try to put the
ratio in context.
2
The Different types of Ratio
We will look at three different types of Ratio
used in Financial Analysis:
1. Profitability
How successful is the business?
2. Liquidity
Is the flow of cash sufficient to meet obligations?
3. Investment
Does the company represent a good investment
for shareholders?
3
The Different Types of Ratio
1. Profitability
4
Profitability Ratios




Profitability Ratios attempt to measure whether or not the
business is financially successful.
The amount of of profit made by a company in a particular
year may give a distorted picture of the company’s
position.
A £1.5m profit generated on a turnover of £10m, can look
very good. The same profit on a turnover of £100m looks
poor.
However there may be reasons why the first company has
generated so much profit; there could be a one-off sale of
assets, for example, which have increased in value.
5
Example Spreadsheet


The Spreadsheet Ratio Analysis gives the full set of
examples and the details of the calculations carried
out.
We will look at one example of each type of
calculation
Managing Finance & Budgets - Ratio Analysis
Profitability (Activity 2)
Sales
Cost of Sales
Gross Profit
Overheads
Net Profit
Interest
Tax
Dividends
Net profit after tax and dividends
Share Capital
Reserves
LT Loans
Year 1
Year 2
2,240,000
1,745,400
494,600
252,000
242,600
24,000
60,200
40,200
118,200
300,000
197,500
200,000
2,681,200
2,072,000
609,200
362,800
246,400
6,200
76,000
60,000
104,200
334,100
301,700
60,000
Profitability (Activity 2)
Gross Margin%
Net Margin%
ROSF
ROCE
Year 1
22.1%
10.8%
31.8%
34.8%
Year 2
22.7%
9.2%
25.8%
35.4%
6
Gross Profit or Gross Margin
This is simply the percentage return that the company has
made on its sales or services, only taking into
consideration what it cost us to sell the items or to
undertake the services.
Profit made on what we have sold
Total Income for the Year
This profit is the largest that we can reasonably claim; it is
the difference between the money coming in, and the
expenditure incurred in order to make the sale or to
render the service.
7
Activity Two Solutions
Gross Margin%
In the spreadsheet:
Profit & Loss Data
Sales
Cost of Sales
Gross Profit
Overheads
Net Profit
Interest
Tax
Dividends
Net profit after tax and dividends
Share Capital
Reserves
LT Loans
Year 1
Year 2
2,240,000
1,745,400
494,600
252,000
242,600
24,000
60,200
40,200
118,200
300,000
197,500
200,000
2,681,200
2,072,000
609,200
362,800
246,400
6,200
76,000
60,000
104,200
334,100
301,700
60,000
8
Gross Margin%
The P & L Account Shows:
 Sales
 Gross Profit
£2,240,000
£494,600
(NB Gross Profit =
Turnover – Cost of Sales)
Gross Margin%
494600 x 100
2240000
=
= 22.1%
The company makes 22p
for every £1 it brings in.
This can be used to pay
overheads etc.
9
Net Profit or Net Margin
This is simply the real percentage return that the company
has made on its sales or services, this time taking into
account all operating costs . In other words..
Actual Profit made on what we have sold
Total Income for the Year
This profit is a more conservative estimate. It takes into
consideration the overheads (fixed costs) required to run
the business.
10
Activity Two Solutions
Net Margin%
In the spreadsheet:
Profit & Loss Data
Sales
Cost of Sales
Gross Profit
Overheads
Net Profit
Interest
Tax
Dividends
Net profit after tax and dividends
Share Capital
Reserves
LT Loans
Year 1
Year 2
2,240,000
1,745,400
494,600
252,000
242,600
24,000
60,200
40,200
118,200
300,000
197,500
200,000
2,681,200
2,072,000
609,200
362,800
246,400
6,200
76,000
60,000
104,200
334,100
301,700
60,000
11
Net Margin%
The P & L Account Shows:
 Sales
 Net Profit after Tax and Dividends
(NB
Net Profit
=
Net Margin%
£2,240,000
£118,200
Turnover – Cost of Sales- Overheads)
=
118200 x 100
2240000
= 10.8%
After paying all outstanding
costs, the company makes
11p for every £1 it brings in.
12
Return on ordinary Shareholders’ Funds
ROSF is the profit after tax expressed as a percentage of
the shareholder’s investment.
Actual Profit made (after tax)
Total Amount of Shareholders’ claims
This measure indicates to shareholders the growth of their
investment.
13
Activity Two Solutions
ROSF%
In the spreadsheet:
Profit & Loss Data
Sales
Cost of Sales
Gross Profit
Overheads
Net Profit
Interest
Tax
Dividends
Net profit after tax and dividends
Share Capital
Reserves
LT Loans
Year 1
Year 2
2,240,000
1,745,400
494,600
252,000
242,600
24,000
60,200
40,200
118,200
300,000
197,500
200,000
2,681,200
2,072,000
609,200
362,800
246,400
6,200
76,000
60,000
104,200
334,100
301,700
60,000
14
ROSF%
The P & L Account Shows:
 Net Profit after Tax and Dividends


Share Capital
Reserves
ROSF%
=
£118,200
£300,000
£197,500
£497,500
118200 x 100
497500
= 31.8%
The company is making
32p for every £1 invested
by shareholders.
15
Return on Capital Employed
ROCE is the profit (before tax) expressed as a
percentage of the total money invested in the company
(this includes Long Term Loans).
Actual Profit made (before tax)
Total Amount Invested
This measure indicates the extent to which all funds have
been gainfully employed.
16
Activity Two Solutions
ROCE%
In the spreadsheet:
Profit & Loss Data
Sales
Cost of Sales
Gross Profit
Overheads
Net Profit
Interest
Tax
Dividends
Net profit after tax and dividends
Share Capital
Reserves
LT Loans
Year 1
Year 2
2,240,000
1,745,400
494,600
252,000
242,600
24,000
60,200
40,200
118,200
300,000
197,500
200,000
2,681,200
2,072,000
609,200
362,800
246,400
6,200
76,000
60,000
104,200
334,100
301,700
60,000
17
ROCE%
The P & L Account Shows:
 Net Profit (before Tax & Interest)



Share Capital
Reserves
LT Loans
ROCE%
=
£242,600
£300,000
£197,500
£200,000
£697,500
242600 x 100
697500
= 34.8%
Including loans, the
company makes 35p for
every £1 invested in the
business.
18
Summary of the Profitability Ratios
We look at four ratios:
______________________________________________________________________________________________________________________________________________

Gross Margin% = Gross Profit x 100
Sales
______________________________________________________________________________________________________________________________________________

Net Margin% = Net Profit before tax & interest x 100
Sales
______________________________________________________________________________________________________________________________________________

Return on Ordinary Shareholders Funds (ROSF) =
Net Profit after tax and preference dividends x100
(Share Capital + Reserves)
______________________________________________________________________________________________________________________________________________

Return on Capital Employed (ROCE) =
Net Profit before tax and interest x100
(Share Capital + Reserves+ LT Loans)
19
The Different Types of Ratio
2. Liquidity
20
Liquidity Ratios



These Ratios seek to answer the question: ‘Can the
business pay its way?’
All of these ratios look at the flow of cash in the company,
and try to determine whether or not, at a particular point in
time, the business has enough cash to pay what it owes.
Liquidity = amount of stock, debt etc., which can be easily
converted into cash
21
Example Spreadsheet
The ratios in this section refer to the items in the
second part of the spreadsheet
Liquidity (Activity 3) Year 1
Trade Debtors
Bank Account
Opening Stock Value
Closing Stock Value
Trade Creditors
Dividends owing
Corporation tax owing
Net Cashflow from Operations
240,800
33,500
241,000
300,000
221,400
40,200
60,200
231,000
Year 2
210,200
41,000
300,000
370,800
228,800
60,000
76,000
251,400
Liquidity (Activity 3) Year 1 Year 2
Current Assets 574,300 622,000
Current Liabilities 321,800 364,800
Current Ratio
1.8
1.7
Acid Test
0.9
0.7
22
Current Ratio
The Current Ratio is simply the total current
Assets compared to the total current Liabilities.
Current Assets
Current Liabilities
In order to be solvent, a company should have a ratio
greater than 1, in other words, in the day-to-day workings
of the company, there should be enough resources
available to pay our debts.
23
Current Ratio
In the spreadsheet (Liquidity):
Trade Debtors
Bank Account
Opening Stock Value
Closing Stock Value
Trade Creditors
Dividends owing
Corporation tax owing
Net Cashflow from Operations
240,800
33,500
241,000
300,000
221,400
40,200
60,200
231,000
210,200
41,000
300,000
370,800
228,800
60,000
76,000
251,400
24
Current Ratio
Current Assets :
 Trade Debtors
 Bank Account
 Closing Stock Value
£240,800
£33,500
£300,000
£574,300
Current Liabilities:
 Trade Creditors
 Dividends Owing
 Corporation Tax Owing
Current Ratio
= 574300
321800
£221,400
£40,200
£60,200
£321,800
=
1.8
The business owns
almost twice as
much as it owes
25
Acid-Test Ratio
The Acid Test Ratio is simply the Current Assets
(minus the Stock) compared to the total current
Liabilities.
Current Assets
Current Liabilities
Some Authorities argue that if a company has to sell all its
stock to cover its debt, it has a cash-flow problem.
Therefore, this ratio too should be greater than 1.
26
Acid Test Ratio
In the spreadsheet (Liquidity ):
Trade Debtors
Bank Account
Opening Stock Value
Closing Stock Value
Trade Creditors
Dividends owing
Corporation tax owing
Net Cashflow from Operations
240,800
33,500
241,000
300,000
221,400
40,200
60,200
231,000
210,200
41,000
300,000
370,800
228,800
60,000
76,000
251,400
27
Acid Test Ratio
Current Assets excluding Stock :
 Trade Debtors
 Bank Account
£240,800
£33,500
£274,300
Current Liabilities:
 Trade Creditors
 Dividends Owing
 Corporation Tax Owing
Acid Test Ratio
= 274300 =
321800
£221,400
£40,200
£60,200
£321,800
0.9
Excluding stock,
the business owns
almost as much as
it owes..
28
Summary of the Liquidity Ratios
We look at two ratios:
______________________________________________________________________________________________________________________________________________

Current ratio =
Current Assets (Over 1 for solvency)
Current Liabilities
e.g. Current ratio of 1.5 = £1.50 owned for every £1 owed
______________________________________________________________________________________________________________________________________________

Acid test = Current Assets excluding stock
Current Liabilities
______________________________________________________________________________________________________________________________________________
29
The Different Types of Ratio
3. Investment
30
Investment Ratios



These ratios all seek to measure the value of the
shareholder’s investment in the company, and the
return on that investment.
It should be noted that the money the shareholder may
have paid for the shares, may not reflect either their
current market value, or the actual stake it represents
in the company.
For example, shares in TSB were originally sold at
£1.00 each in the 1980s. This represents the capital
invested in the company. If you had bought these
shares in 1996 you would have paid around £11.00
per share. Currently they are trading at around £6.00
per share.
31
Spreadsheet
The spreadsheet uses the figures given in sections 2
and 3 above , and the additional figures below, to
callculate and comment on shareholder value for the
two years shown:
Number of Ordinary Shares
Preference Dividends/Shares
Market Price Per Share
YEAR 1
600,000
NIL
2.50
YEAR 2
668,200
NIL
3.50
32
Dividend per Share
This is the amount in pence
that each shareholder gets for
each share that they own.
From the spreadsheets:
Profit & Loss Data
Sales
Cost of Sales
Gross Profit
Overheads
Net Profit
Interest
Tax
Dividends
Net profit after tax and dividends
Share Capital
Reserves
LT Loans
Shareholder Value Data
Number of ordinary shares
Market price per share
Year 1
2,240,000
1,745,400
494,600
252,000
242,600
24,000
60,200
40,200
118,200
300,000
197,500
200,000
Year 1
600,000
2.50
33
Dividend per Share

Dividends Announced

Number of Shares
£40,200
600,000
Dividend per Share =
40200
600000
=
£0.067
Each shareholder gets 6.7p for
each share they own.
34
Dividend Payout
This is the proportion of the
profits that has been distributed
to shareholders.
From the spreadsheets:
Here we are
assuming that
these are
ordinary, rather
than preferential
dividends
Profit & Loss Data
Sales
Cost of Sales
Gross Profit
Overheads
Net Profit
Interest
Tax
Dividends
Net profit after tax and dividends
Share Capital
Reserves
LT Loans
Year 1
2,240,000
1,745,400
494,600
252,000
242,600
24,000
60,200
40,200
118,200
300,000
197,500
200,000
35
Dividend Payout

Net Profit
Interest
Tax
£242,600
- £24,000
- £60,200

Net profit after interest/tax
£158,400

Dividends Announced


Dividend Payout =
£40,200
40200 x 100
158400
=
25.4%
One quarter of the
total profit is paid
out in dividends to
shareholders.
36
This is the rate of return that
shareholders are getting on their
investment through dividends.
Dividend Yield
From the spreadsheet and the first example in this section:


Dividends Announced
Number of Shares
£40,200
600,000
Dividend per Share = 40200
600000
=
In addition, we will be
assuming a tax rate of 20%
£0.067
Shareholder Value Data
Number of ordinary shares
Market price per share
Year 1
600,000
2.50
37
Dividend Yield

Dividend per share
£0.067

Market Price per Share
Tax Rate
£2.50
20%

NB:
Dividend Yield =
20% = 0.2
0.067/(1 – 0.2) x 100
2.50
Shareholders are currently getting a
rate of return of 3.35% on their
investment at market value
(compare Inflation ~ 2%)
=
3.35%
38
Earnings per Share
This is the amount in
pence that the company is
earning per share.
From the spreadsheets:
Here we are
again assuming
that these are
ordinary, rather
than preferential
dividends
Shareholder Value Data
Number of ordinary shares
Market price per share
Profit & Loss Data
Sales
Cost of Sales
Gross Profit
Overheads
Net Profit
Interest
Tax
Dividends
Net profit after tax and dividends
Share Capital
Reserves
LT Loans
Year 1
2,240,000
1,745,400
494,600
252,000
242,600
24,000
60,200
40,200
118,200
300,000
197,500
200,000
Year 1
600,000
2.50
39
Earnings per Share

Net Profit
Interest
Tax
£242,600
- £24,000
- £60,200

Net profit after interest/tax
£158,400

Number of shares issued:
600,000


Earnings per Share:
=
158400
600000
The company is making
about 26p for every share
that is held.
=
£0.264
40
Price/Earnings Ratio
This is the time in years it will
take to earn an amount equal
to the original investment.
From the spreadsheet, and the 4th ratio
in this set:
Shareholder Value Data
Number of ordinary shares
Market price per share

Net Profit
Interest
Tax
Net profit after interest/tax
£242,600
- £24,000
- £60,200
£158,400

Number of shares issued:
600,000



Earnings per Share:
=
158400
600000
=
£0.264
Year 1
600,000
2.50
41
Price/Earnings Ratio

Market Price per share:
£2.50

Earnings per share:
£0.264
Price/Earnings Ratio:
The market price of a share is
about 10 times the profit made by
the share. (may be better the other
way round – each share earns
about one-tenth of its current
market value in a year)
=
2.50
0.264
=
9.45
42
Comparison of
Ratios
In 2000 was a poor investment, and
the share price dropped dramatically.
In 2001 the investment improved, but
still it was not as good a bet as the
supermarkets.
Share
Price
P/E
Share
Price
P/E
Date
2/8/00
2/8/00
22/9/01
22/9/01
SAFEWAY
283.5
17.5
319
14
SAINSBURY
322
17.6
327
18.2
TESCO
221
21.9
238
19.6
MAN UTD.
321
54.4
122
20.3
43
Summary of the Investment Ratios
Dividend per share =
_Dividends announced__
Number of issued shares
_____________________________________________________________________________________________________________________________________________
Dividend payout =
Dividends announced x 100
Net profit after interest/tax/pref.dividends
.
_____________________________________________________________________________________________________________________________________________
Dividend Yield =
Dividend per share/(1-tax rate) x 100
Market value per share
_____________________________________________________________________________________________________________________________________________
Earnings per share = Net profit after interest/tax/pref.dividends
Number of issued shares
_____________________________________________________________________________________________________________________________________________
Dividend Cover ratio =
Net profit after interest/tax/pref.dividends
Dividends announced
_____________________________________________________________________________________________________________________________________________
Price/earnings ratio =
Market price per share
Earnings per share
44
Example of Analysis
Using Financial ratios
45
Analysing a Company’s Performance


The next slide shows five different ratios calculated from
the published accounts of J. Sainsbury PLC, summarising
the company’s performance over the five-year period
1996-2000
As you look through these figures, you should ask
yourself:
 What trends can be detected?
 Is the company improving its performance?
 Would you consider investing in the company?
46
Ratio Analysis - J Sainsbury Plc
TURNOVER (£ million)
PROFIT BEFORE TAX
NET MARGIN (%)
EARNINGS PER SHARE
DIVIDEND PER SHARE
DIVIDEND COVER
1996 1997 1998 1999 2000
13,499 13,312 15,496 16,378 17,414
764
651
728
755
580
5.6% 4.6% 4.7% 4.6% 3.3%
26.8p 22.0p 25.1p 29.2p 18.3p
12.1p 12.3p 13.9p 14.32p 14.32p
2.21
1.78
1.8
2.03
1.27
Figures taken from J Sainsbury Plc Website - 2 August 2000
Dividend cover is the
reciprocal form of the
Dividend Payout Ratio
47
Ratio Analysis:
J Sainsbury Plc
Axis scales have been
modified to enable
comparisons to be made
TURNOVER (£ million)
PROFIT BEFORE TAX
NET MARGIN (%)
EARNINGS PER
SHARE
DIVIDEND PER SHARE
1996
1997
1998
1999
2000
DIVIDEND COVER
48
Comparison of ratios



It can be noted from the previous slides that while the
turnover has increased steadily over the five-year period,
the profit before tax, fluctuates somewhat, with a sharp
downturn in 2000.
The downward trend is even more evident from the net
margin, which has down a steady reduction over the 5
years.
On the other hand, the dividend per share rose steadily
over the first 4 years, and maintaining this level in 2000.
However, the earnings per share shows a much less
impressive performance.
49
The Limitations of Ratios
Analyses which only use ratios only give a limited vision:
 The quality of base data in financial statements may be
suspect.
 Ratios can measure relative performance, but do not allow
for scale (see Sainsbury example).
 They give only a basis for comparison – we need to
compare like with like.
 Some ratios ( balance sheet - e.g.) measuring at a single
point in time, and not over a period.
 One off events such as disposal of assets can give rise to
major distortions.
50