INVESTMENT EVALUATION



CHAPTER 213INVESTMENT EVALUATIONRATIO ANALYSISEDEXELCHAPTER 2INVESTMENT EVALUATIONRATIO ANALYSISIntroductionThe role of accounting as a technique of recording the performance of a business and on reporting this to its owners.These are the important functions but they are not the only ones.Accountants are also expected to evaluate performance, inform management of underlying trends, and give advice on how unfavorable trends can be arrested and favorable trends further encouraged. A set of accounts and figures do not tell the full story of a business.A key element in analyzing performance is to study relationship between key variables that may be expected to be linked to one another, such as profit to sales, and sales to net assets.The chief tool for such analysis is ratios. A ratio is simply the relationship between two variables.While telling something additional about a business, a ratio if it is to have real significance has to be compared with a yardstick to determine whether it is good or bad.This yardstick is provided by comparison to previous years, competitors (inter firm comparison), and budgets (expected performance). A few words on each follow.Inter firm ComparisonA Ltd made a net profit of 10000B Ltd made a net profit of 10000They are making equal profits; this is not to say however that they are equally profitable. We need to find out the profit in relation to capital employed. A ltd’s capital employed is 50000B ltd’s capital employed is 100000We can compute a measure of profitability through a ratio, Net ProfitReturn on Capital Employed = --------------------------- x 100 Capital 10000For A Ltd = --------------------------- x 100 = 20% 50000 10000For A Ltd = --------------------------- x 100 = 10% 100000This Calculation investors in A ltd are earning twice as much on their money as investors in B, so A to be the better investment.Ratios are relationship between two variables within the same business. Such comparisons are possible even between different countries. E.g. A large multinational company can make a direct comparison of the return on capital of its operations in India with operations in Europe. Since both figures are expressed as a parison with previous yearsIt is imported to learn how a business has performed compared to previous years.When comparing with previous years a business get more returns, the share holders will be pleased and management will concentrate on those policies which brought about the improvement.When comparing with previous periods, we should always take in to account the external economic, political and social environment which can affect the demand for a firm’s product, and we should make comparison at the same time with other firms who have sustained the same parison over a longer time period, e.g. the past 5 years, reveals trends of the direction a business is moving. These trends can be used to forecast future performance, in an exercise known as parison With a Budget.The next is comparing actual performance with expected or budgeted performance, revealing variances of both under-and-over achievements.Knowledge of significant unfavorable variances can help management focus on those aspects of the business in most need of attention.Different parties will be interested in different aspects of a business performance.While the owners are most interested in profitability. Bankers and creditors are interested in liquidity, potential shareholders is gearing and investment ratios. For this reason analysis is usually separated in to ratios which measure,ProfitabilityLiquidityWorking capital managementGearing Investment ratios. ProfitabilityIt is the aim of all private firms to make a profit. Profit provides an income for the owner or owners, enables the firm to put away reserves in case of future need, is a source of funding for investment projects and is an indicator of the health of the business.It is vital that a firm’s managers, share holders and potential investors have a reliable measure of the ability of the firm to generate satisfactory profits and to be able to compare these with profits made by the same firm in previous years, by other firms in the same industry and with the firm’s own budget and expectationsThe following are the main indicators used to assess a firm’s profitability.Return on Capital Employed. (ROCE) The ultimate test of profitability is the amount of profit a business is earning for every $ of capital invested in it. This should be compared with other returns in the same risk category, e.g. returns achieved by other firms in the same industry, to determine adequacy. The formula used is Profit--------------------------------- X 100 Capital Employed The profit figure taken to determine is usually net profit before interest and tax. Interest payable is excluded because its level is determined by the mix of finance between equity and debt, and not by the operating profitability of the Profit to Sales RatioWhat factors make for a high ROCE? Clearly the amount of profit on sales is important. This can be expressed as Net Profit---------------------- X 100 SalesGross Profit to Sales RatioThis is also known as the sales margin and shows how much gross profit on average the firm is making on every $ of sales. The higher the margin the greater the profit per unit sold but the less competitive the product will be on the market.Gross Profit to Cost of Sales RatioThis is also known as the mark up and shows what percentage the firm adds to its buying cost to arrive at the selling price. For a review of the distinction between markup and margin.Asset turnover Ratio.The level of sales is also important. A business holds assets not for the sake of it but it use them productively by gearing sales. The relationship between sales turnover and the asset base can therefore be expected to influence the ROCE. It can be measured as the asset turnover ratio, given by Sales--------------------- Net AssetsExampleWe are given the following information regarding a assets ----------- 200Sales------------------400Net Profit-------------20 Net profitNet profit on sale = --------------------------- x 100 Sales 20 = --------------------------- x 100 = 5% 400 SalesAsset Turnover = --------------------------- Net asset 400 = --------------------------- = 2 200The above ratios indicates that for every $1 of asset the business is gearing $2 of sales, and for every $1 of sales it is earning 5 pence in profit. For every $1 of asset it is therefore earning 5x2=10 pence in profit. The return on net assets should therefore be 10%. Let us see if this is so, Net profitROCE = -----------------------------x 100 Capital Employed 20ROCE = -----------------------------x 100 = 10% OR 5%x2=10% 200LiquidityThis shows the ability of a firm to meet commitments as they fall due. A firm should have sufficient liquid resources (cash and assets readily convertible in to assets) to meet all current liabilities. Two ratios are commonly used as tests of liquidity. The current ratio and the Acid test ratio.Current RatioThis is computed as Current Assets : Current Liabilities(Current Assets divided by Current liabilities)It is expressed as a ratio e.g. 2:1The difference between current assets and current liabilities is the firm’s working capital but since it is an absolute and not a relative figure, simply stating it gives no idea of how satisfactory the amount is. Simply stating it gives no idea of how satisfactory the amount is.Acid Test RatioIn businesses where stock is slow moving it is wrong to count it as a liquid asset. Stock not only has to be sold but the business also has to wait until the invoice is paid, and this can take months.Acid Test Ratio = Current Asset – Stock : Current LiabilitiesProfitability and LiquidityThere is strong relationship between these two basic financial objectives. We can say that the more liquid an asset, the less profitable it is likely to be and vice versa.Management of working CapitalThe aim here is to manage the various elements of the working capital cycle such that a minimum amount of finance is needed to sustain it. The working capital cycle is the process of converting stocks: CreditorsSalesDebtorcashStockcreditorsSale and so onThe amount of finance needed to support the cycle is determined by The length of one complete cycle, andThe time-lag between one part of the cycle and the nextPolicies should be followed which reduces the cycle.For exampleGiving preference to cash customers reduces the cycle by the period of credit normally extended to debtors. In a lot of industries, it is expected that trade will be carried out on credit terms and in these cases management accepts the need to invest some amount in debtors. Instead it pursues policies to minimize the amount of debt outstanding at any time by speeding up the debt collection period.There are other ways of boosting working capital. One of these is leasing. Many firms lease equipment, which means that they pay an annual charge for the use of machinery etc. which does not belong to them and for which they do not have to make a large capital outlay.Factoring has become increasingly popular. This is the process were by a firm sells its debtors to a factoring agency or other financial institution in exchange for a percentage of the invoices total.Rate of stock turnoverThis indicates the number of times during one year that a batch of stock is completely sold and replaced with a fresh batch. A figure of 6, for example, indicates 6 complete orders sold, meaning that each consignment was held on average for 2 months before being sold. The formula for the ration isCost of Goods Sold --------------------------------- Average Stock(Average stock – it is common to use a proxy for it by taking the average of Opening and closing stock.)E.g.: Sales160000Less cost of goods soldOpening Stock15000Purchases130000Less closing stock(25000)Cost of goods Sold(120000)40000 120000Rate of stock turnover = ----------------------------------- = 6 (15 + 25) /2The answer of 6 means that the average stock has been sold 6 times during the year. It is often useful to express the rate as the average number of days stocks are held before being sold. This is done by dividing 365(the number of days in the year) by the rate of turnover. In the above case we have365 / 6 = 60.8 days i.e. two months.Debtors Collection PeriodThis measures the average number of days debtors take to pay by relating debtors at a particular date to the average value of credit sales per day. Alternatively it indicates the number of days of credit sales tied up in debtors. The formula expressed in days, is Debtors at balance sheet date---------------------------------------------------x 365Credit sales for the yearThe period can be shortened by demanding quicker payment but this is often at the expense of reduced sales.Creditors Payment PeriodWhile a firm should try to give as little credit to customers as possible, it should take as much credit from suppliers as possible. It is useful to compute the average period of credit taken from the formula,Trade Creditors at Balance sheet date-----------------------------------------------------------------x 365Credit Purchase over the yearThus, if a supplier gives 30 days to pay it is a good idea to take the full 30 days before paying. Information about the firm’s creditor’s payment period and the debtors collection period is most meaningful when considered together- a firm whose debtors are taking 12 weeks to pay is not in a bad position if it has 13 weeks to pay its own creditors.CashA final, and important, aspect of working capital is the management of cash. The idea here is always to have some amount to finance day to day expenses such as wages, but not too much since holding cash does not earn interest and therefore incurs an opportunity cost.GEARINGCompanies finance their activities by eitherAttracting investments in their equity shares. On which returns are variable depending on the level of profit.ORBorrowing from banks and the public by issuing debentures, on which they are committed to pay a fixed rate of interest.The gearing ratio is a measure of the proportion of the capital employed to which the company is committed to fixed return payments. The formula isLong Term Liabilities + Preference Shares-------------------------------------------x 100Total Share holders’ funds + long term liabilitiesFor the purpose of the ratio, preference shares are included under long term liabilities since they command a fixed rate of return, though in the form of dividends and not interest.ExampleThe following information relates to two companiesHigh LtdLow LtdOrdinary shares150006000010% Preference shares150008% Debentures6500020000Reserves500020000Capital Employed100000100000The gearing ratio is given as follows (65000 + 15000)High Ltd = -------------------------------x 100 =80% 100000 20000Low Ltd. = -------------------------------x 100 =20% 100000High Ltd, with a large proportion of debt in its capital structure, is said to be high geared.Low Ltd which has only limited fixed interest commitments is said to be low geared. Just like a car, a company is in a safer position if it is in a lower gear.INVESTMENT RATIOSIn addition to gearing and profitability ratios, investors will be interested in a number of additional ratios applicable to public limited companies.DIVIDEND YIELDThe dividend yield is theOrdinary dividend per share----------------------------x 100Market price per shareTo the share holder this represents the immediate return on his investment. The ratio compares the actual dividend paid on each share with the market value of the share at that time. A low dividend yield does not in itself mean that a particular share is a bad investment. Dividend yield should be considered together with the pay-out ratio(dividend cover)DIVIDEND COVERThis is given byProfit Attributable to Equity------------------------- DividendProfit Attributable to equity is profit after interest, tax and preference dividend have been deducted.The dividend cover shows the relationship between the maximum dividend the directors could have declared and what they did in fact declare. A high dividend cover implies a low dividend yield and substantial re-investment of profit in the company.This will hopefully increase the future earnings.Potential share holders may then look favorably on a low dividend yield and want to invest, to share in the future larger profits. RETURN ON EQUITYThis ratio relates total equity earnings, whether they are distributed or not, to the amount of the investment by shareholders, it is found byProfit Attributable to equity--------------------------------------- x 100Investment By EquityEARNINGS PER SHAREThis relates the total equity earnings to the number of shares issued and is a more general ratio.Profit Attributable to equity----------------------------------------------- Number of Ordinary shares issued(it is expressed in pence per share)The two last ratios are often used by investors and potential investors in deciding whether the return on a particular company is sufficient for the level of risk taken.PRICE – EARNINGS RATIOA further ratio, often quoted in the financial press, is the price-earnings ratio which is a measure of the relationship between earnings per share and market priceMarket Price per share----------------------------------Earnings per shareIt represents the number of times by which current market price exceeds current earnings. Since market price changes every day so does the ratio. The lower the figure the cheaper the company is as an investment in relation to its earnings potential.ExampleQuestionThe following is a list of balances from the books of Vale plc for the year ended 31 December 1997.Tax on profit on ordinary shares85000Turnover1250000Distribution costs200000Investment income45000Interest payable30000Cost of sales470000Administrative Expenses270000Transfer to general reserve145000Proposed dividend on ordinary shares30000Undistributed profit from last year82000The issued share capital of the company is 1000000 $1 ordinary shares and the current market price of one ordinary share is $2.40REQUIREDA profit and loss account for the year ended 31 December 1997 in accordance with the minimum required by the Companies Act 1985. (10 Marks)Calculate the followingEarnings per share;Price-earnings ratio;Dividend yield;Dividend cover. (8 marks)Comment on the dividend policy of the company. (6 marks)SOLUTIONVale plcProfit & Loss Account for the year ended 31 December 1997Turn over1250000Less Cost of Sales(470000)Gross Profit780000Distribution Expenses200000Administrative Expenses270000(470000)Trading profit310000Investment income45000Interest payable and similar charges(30000)Profit before taxation325000Tax on profit on ordinary activities(85000)Profit After Taxation240000Transfer to Reserves(145000)Dividends paid & proposed(30000)Retained profit of the year65000Profit & Loss Credit balance B/f82000Profit & Loss Account Transferred to BS147000Earnings per share Profit after interest & Tax 240000= ------------------------------------------- = -------------- = $0.24 Number of ordinary shares issued 1000000Price-earnings Ratio Market price per share 2.40= ------------------------------------------- = -------------- = 10 Earnings per share 0.24Dividend yield Ordinary dividend per share (30000/1000000)= ------------------------------------------- x 100 = ------------------------ x100 Market price per share 2.40 0.03x100 = ---------------------- = 1.25% 2.404. Dividend Cover Profit After interest & Tax 240000= ------------------------------------------- = ------------------------ = 8 Dividend 30000CommentsThe price-earnings ratio is very low and the share is cheaply priced in relation to earnings potential. The dividend yield is low and the dividend cover is high, showing that the company is distributing to the shareholders only a small proportion of the profits. This indicates management’s intention to invest substantial amounts in capital expenditure and expansion in the near future. USING RATIOSQuestion rmation regarding a major advertising campaign by a firm;Increase in advertising expenditure - $10000Profit on resulting additional sales - $12000It is of interest to the firm to calculate the return obtained from the additional advertising. This can be done as Net benefitReturn = ------------------------ x 100 Cost $2000=----------------------- x 100 = 20% $10000Many different parties are interested in a set of accounts and for different reasons.Potential creditors such as suppliers and banks will examine the liquidity ratios to estimate whether the business will be able to make payments as they fall due.Owners of the business are more interested in profitability.Potential share holders are likely to be interested most in the gearing and investment ratiosA company considering a take-over bid of another company will probably conduct a detailed analysis of the potential acquisition involving all the ratios mentioned.The management and workers also interested in a set of accountsIn small single product businesses, management may be content with calculating ratios for the business as a whole.In larger companies , in addition to ratios for the business as a whole management willIn decentralized organizations, calculate ratios for each autonomous division, giving top management levels an idea of how each division and divisional manager is doing.In group companies owning subsidiaries and related companies, calculate ratios for each company.In multi product companies, calculate ratios for each product group,In multinationals, compare ratios for operations in different parts of the world.Workers and trade union leaders will be interested in the profitability ratios and their comparison to previous years as a guide to their wages claims, and the liquidity ratios to assess the ability of the firm to meet this claim.LIMITATIONS OF RATIO ANALYSISRatios focus exclusively on proportions, completely ignoring absolute values. Because of this they are unable to reveal all significant changes in a business. This is easily illustrated with an example. The following figures relate to Expansion ltd.20012002Net Assets (Capital Employed)100000200000Sales200000400000Net profit2000040000Net profit on sales10%10%Asset turnover ratio22Return on Capital Employed20%20%Looking at the absolute figures we can see that 2002 was a year of considerable growth. The business experienced a large increase in the amount of capital employed. This was used to generate additional sales, producing increased profits. In contrast, the three ratios show no change. Because the variables have increased in the same proportion (each has doubled) the change has not shown up in the ratios.While ratio analysis may be usefully conducted to analyze changes in a firm from one year to another, inter firm comparisons should be made with caution. Only if the two firms follow identical accounting policies in subjective areas like depreciation and stock valuation will the comparison have any meaning.Ratios do not take in to account the fact that the value of money changes with time. Comparison with previous years should then be made with care. The user should have an appreciation of the effect of inflation on a set of accounts.Accounts record only those aspects of a business which can be expressed in money terms. Calculating ratios from such accounts will therefore not give a complete picture of the business such as the atmosphere at the place of work, state of industrial relations and amount of goodwill. ................
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