4 Interpretation of Accounts Richard OCallaghan Importance of

4. Interpretation of Accounts Richard O’Callaghan

Importance of Financial Ratios • Ratios show important relationships between financial figures in the financial statements • Compares business’ performance over several financial periods • Compare the business’ performance with that of other businesses within the same industry

Financial Statement Contents Income Statement Balance Sheet Cash Flow Statement Revenue / Income - Sales, Grant Amortisation, Interest received Expenses - Purchases for resale, materials, salaries, interest payable, overheads Profits / Losses Assets - Current – Stock, Debtors, Bank, Prepayments | Non-Current – Buildings, Land, Equipment Liabilities - Current – Creditors, Accruals | Non. Current – Loans, credit exceeding one year Equity - Share Capital, Retained Earnings Operating Investment Financing

Why Ratio Analysis? ●To examine the profitability of the firm ●To find out the ability of the firm to meet it’s debts (liquidity) ●To see how efficiently the managers of the firm uses its resources ●So that investors in the firm can see the returns on their investment ●Trends rather than individual figures

Horizontal and Vertical Analysis Richard O’Callaghan

Horizontal and Vertical Analysis Sales Cost of Sales Gross Profit 2016 2015 € € 200, 000 170, 000 (150, 000) (130, 000) 50, 000 40, 000

Horizontal Analysis Horizontal analysis helps financial statement users recognize important changes unfolding over time. 31/12/15 Gross Profit in 2015 € 40, 000 Trend Analysis • Δ in Gross Profit € 31/12/16 Gross Profit in 2016 € 50, 000 Δ in Gross Profit € and/or % from 2015 > € 50, 000 - € 40, 000 = € 10, 000 • Δ in Gross Profit % > € 10, 000 / € 40, 000 = 25%

Horizontal Analysis

Horizontal Analysis 1, 587 – 1, 670 = (83) [(83) ÷ 1, 670] × 100 = (5. 0)%

Horizontal Analysis 14, 492 – 14, 883 = (391) [(391) ÷ 14, 883] × 100 = (2. 6)%

Trend Analysis – Adidas Using 2009 as the base year we will get the following trend information: Examples of 2013 Calculations for Net Sales: 2009 is base year. Set to 100% 2013: (14, 492 ÷ 10, 381) × 100 = 139. 6%

Trend Analysis We can use the trend percentages to construct a graph so we can see the trend over time.

Vertical Analysis Vertical analyses focus on important relationships between items on the same financial statement. 2016 Amount Sales Cost of Goods Sold Gross Profit € 200, 000 150, 000 € 50, 000 Percent 100% 75% 25%

Vertical Analysis Statement of Financial Position (1, 587 ÷ 11, 599) × 100 = 13. 7% (1, 670 ÷ 11, 651) × 100 = 14. 3%

Vertical Analysis Income Statement (7, 352 ÷ 14, 492)× 100 = 50. 7%

Ratios and their Uses Richard O’Callaghan

Ratio Types • Profitability Ratios • The capacity of the company to make and maintain profits • Liquidity Ratios • Cash generation and the ability to pay • Efficiency Ratios • How well the assets of the company are being used to generate income • Investment Ratios • Returns for shareholders and those deciding on investment • Gearing • Financing via share capital or credit

Profitability Ratios Richard O’Callaghan

Profitability Ratios • Help to assess the profitability of the business by giving an indication of the level of return the owner is getting. • Gross profit margin • Net profit margin • Return on Capital Employed

Gross Profit Margin • Gross Profit as a percentage of sales / turnover Gross Profit Turnover Expressed as a Percentage

Gross Profit Margin • Absolute Builders Limited has provided the following information from their accounts for 2016 and 2017: • Turnover (Sales) • Cost of Sales 2017 € 590, 000 € 240, 000 2016 € 520, 000 € 220, 000

Gross Profit Margin • Using 2017 figures: • Turnover (Sales) • Cost of Sales • Gross Profit Margin € 590, 000 € 240, 000 = = = 590000 – 240000 = 350, 000 350000 / 590000 59%

Gross Profit Margin 2017 € 590, 000 € 240, 000 • Turnover (Sales) • Cost of Sales 2017 • Gross Profit Margin 2016 € 520, 000 € 250, 000 = = = 590000 – 240000 = 350, 000 350000 / 590000 59% = = = 520000 – 250000 = 270, 000 270000 / 520000 52%

Gross Profit Margin - Interpretation • Gross Profit Margin 2017 59% 2016 52% The increase in the gross profit margin is a good. It means that the company has increased the amount that it is directly generating from the sale of its goods or services.

Net profit margin: Net profit as a % of sales • Net Profit as a percentage of sales Net Profit Turnover Expressed as a Percentage

Net Profit Margin • Absolute Builders Limited has provided the following information from their accounts for 2016 and 2017: • Turnover (Sales) • Cost of Sales • Operating Expenses 2017 € 590, 000 € 240, 000 € 250, 000 2016 € 520, 000 € 200, 000

Net Profit Margin • Using 2017 figures • Turnover (Sales) • Cost of Sales • Operating Expenses • Net Profit Margin € 590, 000 € 240, 000 € 250, 000 = = 590000 – 240000 - 250000 = 100, 000 = 100000 / 590000 17%

Net Profit Margin 2017 € 590, 000 € 240, 000 € 250, 000 • Turnover (Sales) • Cost of Sales • Operating Expenses 2017 • Gross Profit Margin 2016 € 520, 000 € 250, 000 € 200, 000 = = = 590000 – 240000 – 250000 = 100, 000 100000 / 590000 17% = = = 520000 – 250000 - 200000 = 70, 000 70000 / 520000 13. 5%

Net Profit Margin - Interpretation • Gross Net Margin 2017 17% 2016 13. 5% The increase in the net profit margin is a good. It means that the company has increased the amount that it is generating from the sale of its goods or services after all of its expenses are taken into account.

Return on Capital Employed (ROCE) • Measures the return generated by the total resources invested in the firm • Capital Employed = Fixed Assets + Current Assets – Current Liabilities Net profit before Tax & Interest Capital Employed X 100%

Return on Capital Employed (ROCE) • • Fixed Assets Current Liabilities Net Profit 2017 € 2, 450, 000 € 285, 000 € 212, 000 € 100, 000 2016 € 2, 100, 000 € 245, 000 € 200, 000 € 70, 000 • Capital Employed will usually appear on the Balance Sheet. It it is not it can be calculated from: Fixed Assets + Current assets – Current Liabilities

ROCE • Return on Capital Employed using 2017 figures • Capital Employed • Net Profit • ROCE = = = 2450000 + 285000 – 212000 2523000 € 100, 000 = = 100000 / 2523000 4%

ROCE 2017 • ROCE 2016 • Capital Employed • Net Profit • ROCE = = 100000 / 2523000 4% = = = 2100000 + 245000 – 200000 2145000 € 70, 000 70000 / 2145000 3. 2%

ROCE – Interpretation • ROCE 2017 4% 2016 3. 1% The increase in ROCE is good. That said, a return of 4% is not that great. Compared with the return on a bank account would not be that different from the return being generated.

Liquidity Ratios Richard O’Callaghan

Liquidity Ratios • Measure of the firms ability to pay its bills as they fall due • Particularly focused on the short term and on the working capital of the business • “Working Capital” is the value of the resources available to the firm for trading in the short term • In particular, it excludes amounts invested in Fixed Assets (i. e. assets held over multiple accounting periods) • Presented as ratios rather than percentages e. g. 3. 2 : 1, 0. 74 : 1 etc.

Current Ratio • Measures the ratio of Current Assets to Current Liabilities Current Ratio = • • Current Assets Current Liabilities Do the Current Assets exceed the Current Liabilities Does the cash held, and the assets that can be relatively easily converted into cash cover the amounts due in a year or less Current Assets = Stock, Debtors, Bank and Cash, Prepayments Current Liabilities = Creditors, other short-term debt (overdrafts etc)

Current Ratio Example • Current Assets • Current Liabilities 2017 • Current Ratio 2016 • Current Ratio 2017 € 234, 000 € 115, 000 = 234000 / 115000 = 2. 03 : 1 = 200000 / 110000 = 1. 8 : 1 2016 € 200, 000 € 110, 000

Interpreting the Current Ratio • Rule of thumb 2: 1 – but in modern business, particularly in the service industry, this has a very broad latitude • Low Current Ratio – overtrading (can’t pay suppliers as they fall due) • High Current Ratio – Suggests the firm is not making full use of its current assets (e. g. cash sitting in the bank) • An increase in the Current Ratio from 1. 8 to 2. 03 is a good improvement year-on-year and shows the business as being better able to pay its bills as they fall due

Quick Ratio • Limitation of the Current Ratio – Stock can be sold quickly when required • Obsolescence • Deterioration • Therefore it is considered useful to know what the position of the company is when the inventory / stock is excluded from the calculation – measures the ability to quickly raise cash Quick Ratio = Current Assets – Stock Current Liabilities • Sometimes referred to as the “Acid Test” ratio

Quick Ratio Example • Current Assets • Current Liabilities • Stock 2017 • Current Ratio 2016 • Current Ratio 2017 € 234, 000 € 115, 000 € 160, 000 2016 € 200, 000 € 110, 000 € 130, 000 = (234000 – 160000) / 115000 = 0. 64 : 1 = (200000 – 130000) / 110000 = 0. 63 : 1

Quick Ratio Interpretation • Rule of Thumb =1: 1 • There is very little change year-on-year for the firm (2017: 0. 64, 2016: 0. 63), so little to derive from the trend • 0. 64: 1 implies that the firm is not currently bringing in sufficient resources to pay its bills as they fall due

Efficiency Ratios Richard O’Callaghan

Efficiency Ratio • Help assess efficiency in the use of business assets/resources • Management of inventory (stock) • Debtor management • Creditor management • An important measure of the performance of the management of the company • Can be interpreted as “we have given resources to the company management to invest in assets so as to give us a return, how good a return are they getting? ”

Stock Turnover and Stock Days • Stock Turnover • Knowing how many times you turn over your average stock in a year can be very useful in measuring efficient stock management and sales performance Stock Turnover = Cost of Goods Sold Average Stock Expressed as “Times” i. e. the stock turned over 10 times in the year

Stock Turnover and Stock Days Absolute builders Cost of Sales and Stock Figures • Cost of Sales • Stock 2017 € 240, 000 € 160, 000 2016 € 250, 000 € 130, 000

Stock Turnover • Cost of Sales • Stock 2017 € 240, 000 € 160, 000 2016 € 250, 000 € 130, 000 2017 • Stock Turnover = 240000 / 160000 = 1. 5 times 2016 • Stock Turnover = 250000 /130000 = 1. 9 times

Stock Turnover Interpretation • The amount of times that the stock held by the firm is “turned over” in the year • A decrease from 1. 9 times in 2016 to 1. 5 times in 2015 implies that the firm is finding it more difficult to sell its products

Stock Days • The average period of time an item is held in stock by the firm 365 Days Stock Turnover or Average Stock x 365 Cost of Goods Sold

Stock Days • Using the same figures as the Stock Turnover Calculation we get: 2017 • Stock Days 2016 • Stock Days = = 365 / 1. 5 243 days = = 365 / 1. 9 192 days

Interpretation of Stock Days • First consideration is the industry that the company is involved in, 200 days would be really bad for a supermarket, but could be really good for a development company • The increase in the stock days from 192 days (2016) to 243 days (2017) means that the firm is taking longer to move its inventory along

A Word on Stock Valuation • Businesses carry out a physical stock-take ie. count the goods not sold • Physical stock-take is important to many businesses because close stock may be a main component current assets • Incorrect valuation will affect value of the assets of the business • Incorrect valuation closing stock will affect cost of sales of the business, in turn affecting the gross profit and net profit current year as well as the subsequent year since the closing stock of the current year is taken as the opening stock of the following year

Basis of Stock Valuation • Cost or Net Realisable Value whichever is LOWER. • Cost • purchase price an all other expenses incurred in bringing the current location goods to • Net Realisable Value • amount receivable from the sale of stock after deducting expenses incurred in their sale • Example: If the cost price of the stock is € 50, 000 and the current market price for the stock is € 42, 000 the sock will be valued at € 42, 000

Debtor Days • A measure of the average time it takes a debtor (credit customer) to pay us Trade Debtors x 364 Sales* * Credit Sales if Available, otherwise use the sales / turnover figure from the Profit and Loss Account

Debtor Days • Absolute Builders Ltd 2017 Financial Statement show the following: 2017 € 125, 000 € 590, 000 • Debtors • Sales 2017 • Debtor Days 2016 € 100, 000 € 520, 000 = = ( 125000 / 590000 ) x 365 77. 3 days = = ( 100000 / 520000 ) x 365 70. 2 days

Debtor Days Interpretation • Debtor days is a measure of how long it takes us to collect the money that is owed to us from our customers • 30 days credit is typical in business, but may not be the norm in the business you are looking at • In the case of Absolute Builders their Debtor Days has increased from 70. 2 days to 77. 3 days, and increase of approximately 7 days • This implies that the firm is finding it more difficult to collect the amounts that are due in

Creditor Days • Measures the average period of time it takes our firm to pay our suppliers and other creditors Trade Creditors x 365 Purchases* * Credit Purchases if available, otherwise either the Purchases or Cost of Sales figures may be used

Creditor Days • Absolute Builders Ltd 2017 Financial Statements: • Trade Creditors • Cost of Sales 2017 • Creditor Days 2016 • Creditor Days 2017 € 75, 000 € 240, 000 2016 € 85, 000 € 220, 000 = = ( 75000 / 240000 ) x 365 114 days = = ( 85000 / 220000 ) x 365 141 days

Creditor Days Interpretation • The number of days that the firm takes to pay its bills • An increase is considered good within limits • Generally 114 days or 141 days is really bad for the firm and implies that it is really struggling to pay its bills • It is so high that it is likely to result in the firms suppliers withdrawing credit facilities

Investment Ratios Richard O’Callaghan

Investment Ratios • These are Ratios that help a current investor (shareholder) understand how their investment is doing • They also help potential investors to make their decision as to whether or not they should buy shares in the company • Also often used in the financial media to explain how a company is doing

Earnings Per Share • Measures the amount of profit the company generates for each share that is in issue: Net Profit Available to Ordinary Shareholders Number of Ordinary Shares Issued • If the EPS is increasing this means that the company has made a higher amount of profit for each share / investor • The market often has “expectations” that are based on a projected EPS and if the company does not meet this its share value can go down 62

Earnings Per Share • Absolute Builders Plc 2017 financial statements show the following: • Net Profit • Authorised Share Capital • Issued Share Capital 2017 • Earnings Per Share 2016 • Earnings Per Share 2017 € 100, 000 1, 000 400, 000 2016 € 70, 000 1, 000 400, 000 = = 100000/400000 € 0. 25 per share = = 70000 / 400000 € 0. 175

Earnings Per Share Interpretation • The amount of earnings that the firm is generating for its shareholders is a key issue for most investors • The an increase in the earnings per share is generally considered to be a very good thing • Often a key measure of performance, particularly to investors and the media

Dividend Per Share • While the profit of the company shows how much it has generated, it does not reflect the amounts that a shareholder will actually receive from the company • Rather, a company usually makes a payment to its shareholders of an amount that is considerably less than it profit • It needs resources to keep operating • The amount a shareholder actually receives is directly related to the number of shares received • This amount is called a “dividend”

Dividend Per Share • Measures how much dividend will be paid for each share held: Dividends Paid to Shareholders Number of Ordinary Shares Issued • Dividends are a key indicator of management confidence • An increasing dividend is a sign that the management believe that the company will continue to be successful • A decreasing dividend (or worse stopping a dividend altogether) is a sign that management are not confident of the future success of the company 66

Dividend Per Share • Absolute Builders Plc 2017 accounts show the following: • Total Dividend Paid • Number of Shares Outstanding 2017 • Dividend per Share 2016 • Dividend per Share 2017 € 38, 000 400, 000 = = 38000/400000 9. 5 c per share = = 33000/400000 8. 25 c per share 2016 € 33, 000 400, 000

Dividend Per Share Interpretation • This means that for each share held, the shareholder received a payment of 9. 5 c • If a shareholder holds 60, 000 shares then they will receive a total dividend payment of: 0. 095 x 60000 = € 5, 700 • The dividend per share is also considered to be an indicator of the future expectation of the management • Increase implies optimism, decrease implies pessimism • A decrease in the dividend per share is a significant issue for a company and would likely lead to a decrease in the share price

Dividend Yield • This is a measure of the percentage return received based on the current share price Dividend per Share Current Share Price • A higher dividend yield means a higher return if I were to invest now • If the dividend yield is growing, this is likely to make the company a more attractive investment • Assuming there are no fundamental problems with the company

Dividend Yield • Absolute Builders Plc have previously calculated the companies Dividend Per Share as being € 0. 095 per share • The website of the Irish Stock Exchange shows that the companies closing share price on 31 st December 2016 was € 5. 35 • Dividend Yield = = 0. 095/5. 35 1. 8% • A simple question would be whether your money would be better of in the bank? • Compare to other companies and ask are better returns available?

Dividend Cover • The number of times that the profit earned could cover the dividend that is being paid Profit Attributable to the Shareholders Dividend per Share • Generally the higher the better • A low value indicates that the company has little scope to increase the amount to be paid to the shareholders

Dividend Cover • Absolute Builders Plc 2017 accounts show the following: • Total Dividend Paid • Profit Attributable to the Shareholders 2017 • Dividend Cover 2016 • Dividend Cover = = 80000/38000 2. 1 times = = 60000 / 33000 1. 8 times 2017 € 38, 000 € 80, 000 2016 € 33, 000 € 60, 000

Interpreting Dividend Cover • The scope for increasing the dividend is indicated by a higher dividend cover • The increase from 1. 8 times to 2. 1 times is a comfort for the company • It provides a scope to increase the amount of dividend being paid

Price Earnings Ratio Share Price Earnings Per Share • Price-to-earnings ratio (PE or P/E) is the price that the shares are selling for on the open market divided by the Earnings Per Share • This is particularly important as it is often the first figure that a potential investor or other interested party will examine when considering the performance of a company • Particularly useful as it can be used to compare performance between companies and between industries

Price Earnings Ratio • Absolute Builders Plc has reported Earnings Per Share of € 0. 095 per share for 2017 and € 0. 0825 for 2016 • The website of the Irish Stock Exchange shows that the companies closing share price on 31 st December 2017 was € 1. 35 and on 31 st December 2016 was € 1. 10 2017 • P/E 2016 • P/E = = 1. 35/0. 095 14. 2 times earnings = = 1. 10 / 0. 0825 13. 3 times earnings • The higher the P/E ratio the more confident the market is that the company will grow

Gearing Richard O’Callaghan

Gearing and Leverage • Examines how the company is financed • Two main sources: Share Capital (referred to as equity) Long-Term Debt • Debt is considered riskier than equity – one missed loan payment can put a firm out of business • Shareholders are unlikely to wind up a company because of one missed dividend – they would likely suffer the most

Gearing • Can be calculated in one of two ways: Either: Debt Equity or Debt + Equity • It doesn’t matter which one you use, but once you start to use one of these it is important to stay consistent • I usually use Debt / Debt + Equity

Gearing Example • Absolute Builders Ltd Balance Sheet for 2017 shows the following: 2017 2016 • Shareholders funds € 650, 000 € 550, 000 • Long-term Loan € 225, 000 € 215, 000 2017 • Gearing 2016 • Gearing = = = 225000 / (225000 + 650000) 225000 / 875000 0. 26 or 26% = = = 215000 / (215000 + 550000) 215000 / 765000 0. 28 or 28%

Gearing Interpretation • The general view is that debt is higher risk than equity • One missed payment could put the firm out of business • Therefore a highly geared company (60%+) is more risky than a lower geared company

Other Terminology used for this Ratio • There are lots of different terms used in this area: • Types of Loans: • • • Long-term loans Debentures Mortgages Preference Shares / Preference Capital Bonds

Other Terminology used for this Ratio • There are lots of different terms used in this area: • Equity can be referred to as: • • Shareholders funds Ordinary Shares + Retained Reserves Ordinary Shares + Retained Profit Ordinary Shares + Share Premium + Retained Earnings • As you can see above the amount of profit not distributed by the company can be referred to as: • Retained Earnings • Retained Profit • Might just state “from Profit and Loss Account”

Interest Cover • Measures the ability of a company to meet its interest payments Interest Cover = Profit before Tax Interest Expense • The higher the interest cover, the less likely it is that the company will struggle to pay if there is an increase in Interest Rates

Interest Cover Example • Absolute Builders Ltd accounts for 2017 show the following figures 2017 2016 • Total interest expense € 22, 500 € 20, 000 • Net Profit before Tax € 100, 000 € 70, 000 2017 • Interest Cover 2016 • Interest Cover = = 100000 / 22, 500 4. 44 times = = 70000 / 20000 3. 5 times

Interest Cover Interpretation • A low interest cover 1. 5 – 2. 5 means that the company is susceptible to an increase in interest rates, i. e. a they might not be able to meet a significant increase • An increasing interest cover means that the risk from an interest rate increase is not so significant • In this case the increase from 3. 5 times in 2016 to 4. 44 times in 2017 is good for the company

The Trend is your Friend Richard O’Callaghan

Using Ratios • Calculating a single ratio is of limited use • Calculating them over a number of years, or comparing ratios between companies is a lot more useful • Understanding what a ratio means also helps with interpreting them • A ratio going up can be good or bad, it is only when you understand what the ratio means that you can assess whether the ratio is good or bad in the context you are examining it

Company Immediate Competitors Wider Industry Current Ratio 1. 77 2. 44 1. 52 Quick Ratio 1. 47 2. 08 1. 23 61 days 50 days 73 days 6. 25 6. 01 5. 66 Fixed Asset Turnover 4. 37 1. 58 6. 24 Total Asset Turnover 0. 86 0. 61 0. 90 Debt to Equity Ratio 1. 77 0. 52 1. 82 Gross Profit Margin 32. 76% 37. 49% 29. 52% Net Profit Margin -9. 31% -3. 00% -1. 24% Return on Investment -7. 98% -1. 82% -1. 11% -22. 11% -2. 78% -3. 14% 2. 77 1. 52 2. 82 Average Collection Period Inventory Turnover Return on Equity Assets / Equity

Cash and Cash Equivalents Short-term Investments Accounts Receivables Inventories Other Current Assets Total Current Assets Overdraft Accounts Payable Accruals Total Current Liabilities Current Ratio Quick Ratio Net Working Capital 2017 6, 507 59 4, 437 2, 869 3, 262 17, 134 2016 6, 082 80 4, 583 2, 756 3, 648 17, 149 2015 3, 301 354 7, 092 5, 242 3, 896 19, 885 2014 3, 537 699 5, 627 3, 707 4, 015 17, 585 1, 524 2, 268 5, 913 9, 705 870 2, 434 6, 394 9, 698 6, 391 3, 492 6, 374 16, 257 2, 504 3, 285 7, 117 12, 906 1. 77 1. 47 1. 77 1. 48 1. 22 0. 90 1. 36 1. 08 7, 429 7, 451 3, 628 4, 679

Long Term Debt Shareholders Funds Gearing (Debt/Equity) 2017 2016 2015 2014 7, 779 8, 857 4, 778 3, 573 11, 239 13, 691 18, 612 18, 693 0. 69 0. 65 0. 26 0. 19