Understanding Accounts
Different people need annual reports: investors, lenders, managers, contributors, managers and employees. Their form vary from country to country with the two main categories being the Angle-American (giving a ‘fair’ view) and the Franco-German model (precedence of creditors’ interests; profits entered when realized, losses/expenses immediately). Concerns about the accuracy of accounting statements have among others pushed new legislature like the Sarbanes-Oxley Act (passed July 2002), requiring CEOs and CFOs in the US to certify financial statements. It also addresses:
\- non-audit services of auditors (We’ll say the report is great or we loose the 100 million consulting contract)
\- authority increase of audit committee
\- less loans to officers and directors
\- faster disclosure
Contents of the annual report
Compulsory section:
\- the directors’ report (linked to corporate governance)
\- the auditors’ report (appropriate accounting consistently applied and adequately disclosed, fair view, accounts prepared in accordance to relevant legilastion; Franco-German model often does not require auditing as reports “audited” by the tax authority)
\- the income statement (summary of productivity)
\- the balance sheet (summarises positions at the end of the financial year)
\- the cashflow statement (summary of sources of cash during year)
\- notes to the accounts
Voluntary sections
\- the chairman’s statement
\- the chief executive’s review
\- the operating and financial review (OFR)
\- the environmental report
Analysts put things into special spread sheets like the OUFS to look at several years of data in a standard way. Before you start, clarify your objective to analyse the right data, profit before tax if you lend money for example.
When you use ratios, consider the economy at the time and the industrial environment. There are four phases for ratios:
\- assessing operating efficiency
\- assessing financial structure
\- observe consequences of foregoing in profitability
\- evaluate cash flows
Three questions need to be asked:
\- Change in ratios, why
\- Compare ratios to similar companies
\- Do the ratios make sense
Consolidated group accounts
100% of shares: subsidiary wholly-owned
20–50%: related or associated company
Analysis in Context
You need something to structure the segment of the market you are looking at. SWOT, STEEP and Porter’s five forces are models to use here. You have three important numbers here:
sales show if their market share increases
return on capital if there is a competitive advantage
net operating margins show the competitive pressure
How you define the market will be critical to the evaluation, as always with STEEP, Porter’s five forces of SWOT.
Operating Efficiency
Here the ratios come in. You are looking at the cycle of production, from Cash to (supply) raw materials, (production) work in progress, (demand) finished goods, (collection) trade receivables and back to cash.
_supply phase_
(Remember, assets included in the balance sheet might not be those that are used in the income statement)
* Raw material days = Raw material / (Cost of goods sold / 365)
Very useful if you look at different components of inventory seperately
* Trade creditor days = Trade creditors x 365 / Cost of goods sold
This is about the payment terms that suppliers are granting.
_Production phase_
* Work in progress days = Work in progress x 365 / Cost of goods sold
The small the more efficiently the raw materials are progressed.
* Net property, plant and equipment turnover = Sales / Property, plant, equipment
Remember: Sales are in relation to current market values but assets might be included at a lower value as they are written off.
* Plant life
Expected life = historic cost of plant and equipment / depreciation charge for year
Life used = Accumulated depreciation of plant and equipment / depreciation charge for year
Life remaining = Net book value of plant and equipment / depreciation charge for year
Remember: if fully written off the balance sheet does not show it, but it might still be used in the production cycle
_Demand and collection phase_
* finished goods days = finished goods x 365 / cost of goods sold
If this rises, some sales that were expected might not have materialised or there is an upcoming promotion or ad campaign for which the company stocks up.
* Receivable days = receivables x 365 / Sales
_Net operating assets_
Part of the funding comes from the cycle of production and via supplier’s credit terms, which is very attractive. Minimum inventory holds down costs, then collect money quickly and pay suppliers late.
Net operating assets = accounts receivable + inventory + prepaid expenses — trade creditors — accrued expenses
_Service organisations_
also have a cycle of production in relation to Collection of cash, supply of raw materials and (demand) trade receivables. This means that these ratios are important here too. You might also want to look at things like occupancy rates for hotels for example.
Financial Structure
The main point here are liquidity (short-term) and solvency (long-term) ratios.
Management needs to make sure that there are good sources of finance, taking into account maturity, flexibility and stability while minimising costs. They need to keep a balance between dept and equity, where dept has certain clear rules to it like repayment times, first payment in case of liquidation, … and equity offers a higher return or rather has to due to the great risk it carriers for the providers of this finance.
Equity is therefore more expensive but it allows for more flexibility. Managers should match economic lives of assets with maturity of financing.
_Liquidity_
* Current ratio = Current assets / current liabilities
This can be smaller than 1 in case the company is a going concern, meaning it can finance the liabilities through trading revenues.
* Quick (acid test) ratio = Current assets — Inventory / Current liabilities
Uncertainty with the inventory is addressed here. It might not be worth anything and the liabilities must still be paid for.
* working capital = current assets — current liabilities
again, looking at liquidity here. If the company is very trustworthy this can be a high minus though.
_Solvency_
The riskier the business, the greater the dependence on equity rather than dept. Shareholders can be thought as as an equity cushion. They provide money that will not have to paid back in liquidation. The liquidation process of assets must only stay above the book value of the assets minus the invested amount for all senior creditors to be paid. A company is worth $100m in total with $30m in equity. In liquidation the assets need to bring $70m not 100 for all senior creditors to be paid.
* gearing = short- and long-term dept x 100 / equity
the more uncertainty about cash generated, the lowe this number should be, meaning the mor the company should rely on equity.
dept/equity ratio = short- and long-term dept / (short- and long-term dept + shareholders’ equity)
net gearing % = (short- and long-term dept — cash and marketable securities x 100) / equity
This is done as marketable securities and cash are not really important in the cycle of production and can repay dept at once
* leverage = long-term liabilities / equity
This presents a broader view beyond dept
* leverage (tangible) = total liabilities / (equity — intangible assets)
you might also want to include contigent liabilities here, that just might occur in the future.
Capital employed = short-term dept + long-term dept + long-term liabilities + long-term provisions + shareholders’ equity
When looking at dept you might also look at the average dept over several years to see if there is some seasonal pattern in interest expenses (Interest expense / average dept).
Profitability
Here we look at the income statment and profitability ratios. The income statments looks at the activities of a company on an accrual basis, meaing that revenues and expenses might appear in the income statement before the cash is collected.
Sales
\- cost of goods sold
\- selling and distribution expenses
\- administration expenses
= Net operating profit
\- interest expense
\+ interest income
\+ equity income
\+ dividend income
= Profit after financial items
+/- sundry income/expense
+/- gain/loss on sale of assets
+/- gain/loss on sale of investment
+/- exceptional income/expense
= Pre-tax profit
\- Tax
= Net profit after tax
+/- Extraordinary income/expense
\- minority interests
\- dividends
In the Anglo-American the fair view is employed and the Franco-German model takes a very prudent view, including revenues only when they are realised and expenses as soon as anticipated. In the long run, the result in the same, but the short term my vary.
* net operating profit = net operating profit / sales x 100
We can also look at:
cost of goods sold / sales x 100
and:
selling and distribution expenses / sales x 100
* interest cover (times interest earned) = net operating profit / interest expense
We also have some other relations
pre-tax profit / sales x 100
effective tax rate = taxes / pre-tax profit x 100
Very low tax rate should make you wonder how they come about. In the Anglo-American model the published account are different from the tax accounts.
* net profit after tax / sales x 100
Tells us what of sales is left over to give to shareholders. For dividends, we look at:
* payout ratio = dividends / net profit after tax x 100
One should also be aware of core (resulting in NOP) and non-core earnings.
_Market-Related Ratios_
earnings per share = net profit after tax / average numbers of shares issued
price / earnings ratio = markte price of share / earnings per share
You can also look at the prospective ratio by taking expected earnings per share into account instead.
Book value shows the historic cost or current market value of assets.
price/book = market share price / shareholders’ equity per share
price/book = market capitalisation / sharehoders’ equity
You can also take a look at other indicators sometimes called output-related performance indicators (ORPIs) but these are complex to define in a meaningful way, can deliver very high information on a companies performance though.
Inappropriate ORPIs can lead to (Peter Smith, 1993)
\- Tunnel vision
\- Sub-optimisation
\- Myopia
\- Convergence
\- Ossification
\- Gaming
\- Misrepresentation
Ratio Analysis
This part covers core ratios, of which two kinds exist.
_Dupont Pyramid_
Return on Capital Employes = Asset utilisation x Return on sales
Net operating profit / Capital employed = Sales / capital employe x Net operating profit / Sales
This does not consider the financial performance of the company, and for this we need to look at the
_Core Ratios_
Return on equity = Operating efficiency x Financial structure x Profitability
Return on equity = Asset turnover x Asset leverage x Return on sales
NPAT / Equity = Sales / Total assets x Total assets / Equity x NPAT / Sales
Haveing looked at these, you can continue by looking into more detail, but these give a good overview. To interpret the core ratios, you need to keep the sector and the economy in mind.
The level of asset turnover is related to the amount of technology used in the sector. The asset leverage should be inversely related to the volatility of cash flows, as said before. Profitability needs to be looked at with the help of Porter’s five forces model.