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Comprehensive Ratio Analysis

Methods and notes to the calculation of ratios

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- 1. Comprehensive Ratio Analysis Financial Ratio Analysis A useful framework for ratio analysis is that developed by the Dupont company. Dupont used this to control their subsidiary companies Their framework followed the principle that the source of the % Return on Equity ( Shareholders Funds ) came from three elements: PROFITABILITY EFFICIENCY LEVERAGE (Net Profit as a % of Sales) (Sales Divided by Assets) ( The English Term for this is GEARING) (Borowings as a % of Net Assets) Called Asset Turnover If Shareholders cannot finance assets from their own Funds they can Borrow at fixed interest rates and acquire more assets. If the returns they obtain on these assets are greater than the interest cost any margin over the interest costs flow directly to Shareholders. The Dupont General Formula is: RETURN on EQUITY is equal to Profitability X Efficiency / ( 1 - Leverage % ) Or Return on Equity = (Net Profit / Sales) X (Sales / Net Assets) / (Equity / Net Assets ) Profitability Ratios The usual method for analysing Profitability is with a "Common Size Income Statement". In this statement each line of the Income Statement (Profit and Loss Account) is expressed as a percentage of Sales. In this way any source of improvement or deterioration in Profitability can be identified. Another form of analysis of the Common Size Income statement which can be used is called "Horizontal Analysis". In this type of analysis the % growth of each line on the profit and loss account from one year to the next is calculated, again to identify the source of any problem. The most frequently calculated PROFITABILITY RATIOS are: RATIO CALCULATION METHOD NOTES Gross Profit Ratio (Gross Profit Gross Profit / Sales Sales can be called Sales Turnover, Sales Income, Sales Revenue, Gross Margin) Revenue Gross Profit is Sales minus Cost of Sales. Cost of Sales can be called many different things, but the best way to identify it is that it will be situated in the rows between Sales and Gross Profit on the Profit and Loss Account. Operating Profit Margin Operating Profit / Sales Alternative terms for Operating Profit are "Profit before Interest and Taxation" or "Earnings before Interest & Taxation". It is usually the Sub-total row on the Profit and Loss Account befor the Row entitled Interest. 1 Maroof Hussain Sabri
- 2. Comprehensive Ratio Analysis Financial Ratio Analysis Profitability Ratios (Continued) The most frequently calculated PROFITABILITY RATIOS are: RATIO CALCULATION METHOD NOTES Profit Before Tax Margin Profit Before Interest & Tax / Sales Sales can be called Sales Turnover, Sales Income, Sales Revenue, Gross Revenue Profit before interest & tax can also be called "Earnings before Interest & Tax". It is the row on the Profit and loss Account before the row entitled Taxation. Net Profit Margin Net Profit / Sales Alternative terms for Net Profit are "Profit after Taxation", "Earnings after Tax" or "Net Income" . It is usually the last row on the Profit and Loss Account before the Row/s entitled Dividends. 2 Maroof Hussain Sabri
- 3. Comprehensive Ratio Analysis Financial Ratio Analysis Efficiency Ratios Efficiency ratios deal with the efficiency with which Management has used the assets employed in the business. Various Asset Turnover ratios can be calculated and any improvement or deterioration in performance can be identified Commonly Calculated Efficiency Ratios are: RATIO CALCULATION METHOD NOTES Total Asset Turnover Sales / Net Assets Sales can be called Sales Turnover, Sales Income, Sales Revenue, Gross Revenue Expressed as a number of times eg 2.5 Net Assets = Fixed Assets + Net Current Assets (Net Current Assets = Current times Assets - Current Liabilities) Current Assets = Stocks ( Inventories ) + Debtors (Receivables) + Cash Current Liabilities = Creditors (Payables) + Overdraft Fixed Asset Turnover Sales / Fixed Assets Expressed as a number of times eg 2.5 times Stock (Inventory) Turnover Cost of Sales / Stocks Cost of Sales can be called many different things, but the best way to identify it is that it will be situated in the rows between Sales and Gross Profit on the Profit and Loss Account. Expressed as a number of times eg 2.5 times Can be expressed as a number of Days This is done by dividing the number of Times Stock is turned over into 365 Debtors (Receivables) Turnover Sales / Debtors Expressed as a number of times eg 2.5 times Can be expressed as a number of Days This is done by dividing the number of Times Stock is turned over into 365 Creditors (Payables) Turnover Total Annual Credit Purchases / This is not usually disclosed in Published Accounts Creditors Expressed as a number of times eg 2.5 times Can be expressed as a number of Days 3 Maroof Hussain Sabri
- 4. Comprehensive Ratio Analysis Financial Ratio Analysis Combining Profitability and Efficiency Ratios Profitability and Efficiency Ratios can be combined together to calculate RATIO CALCULATION METHOD NOTES Return on Net Assets Net Profit / Net Assets Net Assets = Fixed Assets + Net Current Assets (Net Current Assets = Current Assets - Current Liabilities) Current Assets = Stocks ( Inventories ) + Debtors (Receivables) + Cash Current Liabilities = Creditors (Payables) + Overdraft Return on Capital Employed Operating Profit / Net Assets Alternative terms for Operating Profit are "Profit before Interest and Taxation" or "Earnings before Interest & Taxation". It is usually the Sub-total row on the Profit and Loss Account befor the Row entitled Interest. Net Assets = Capital Employed Capital Employed is the total amount invested in a business by Owners who have claims on Equity ( Share Capital + Retained Profits) and Providers of Loans who have claims on the business for the amounts of their loans and who receive interest. Neither of these ratios is theoretically perfect. Return on net assets is calculated after deduction of interest and Operating Profits are subject to Taxation after interest has been deducted. Operating profit flows to three destinations: THE GOVERNMENT ( Taxes on Profits); LENDERS (Interest) and SHAREHOLDERS (Dividends plus Retained Profits). Net Profit only flows to SHAREHOLDERS though a part of the NET ASSETS are Financed by LENDERS. Therefore a further Ratio has been suggested as being the true measure for a combination of Profitability and Efficiency Ratios RATIO CALCULATION METHOD NOTES NOPAT : NET ASSETS (Operating Profit minus Taxes) / Net NOPAT is Net Operating Profit After Taxes Assets NOPAT only flows to two destinations: LENDERS and SHAREHOLDERS who have financed NET ASSETS through LOANS and EQUITY 4 Maroof Hussain Sabri
- 5. Comprehensive Ratio Analysis Financial Ratio Analysis Leverage or Gearing Ratios If Shareholders cannot finance assets from their own Funds they can Borrow at fixed interest rates and acquire more assets. If the returns they obtain on these assets are greater than the interest cost, any margin over the interest costs flow directly to Shareholders. RATIO CALCULATION METHOD NOTES Debt to Equity Ratio Long Term Debt / Equity Shareholders Equity Shareholders Funds is comprised of Share Capital plus retained Profits Funds % Debt to Net Assets Ratio Long Term Debt / Net Assets Net Assets = Fixed Assets + Net Current Assets (Net Current Assets = Current Assets - Current Liabilities) Net Assets = Capital Employed Capital Employed is the total amount invested in a business by Owners who have claims on Equity ( Share Capital + Retained Profits) and Providers of Loans who have claims on the business for the amounts of their loans and who receive interest. RATIO CALCULATION METHOD NOTES Return on Equity Net Profit / Equity Equity Shareholders Funds is comprised of Share Capital plus retained Profits Also Known as Return on Shareholders Funds REMEMBER RETURN on EQUITY is equal to Profitability X Efficiency / ( 1 - Leverage % ) Or Return on Equity = (Net Profit / Sales) X (Sales / Net Assets) / (Equity / Net Assets ) Liquidity Ratios These are of use to those who have lent money to the company or are supplying goods on credit to the company. They are a measure of how easily current assets can be turned into cash to pay lenders or suppliers RATIO CALCULATION METHOD NOTES Current Ratio Current Assets / Current Liabilities Current Assets = Stocks ( Inventories ) + Debtors (Receivables) + Cash Current Liabilities = Creditors (Payables) + Overdraft Quick Ratio or Acid Test Ratio (Cash + Debtors) / Current Liabilities Debtors should be able to be converted into cash quickly to pay current liabilities 5 Maroof Hussain Sabri
- 6. Comprehensive Ratio Analysis Financial Ratio Analysis Ratios and Other Statistical Data which can be used by POTENTIAL INVESTORS in a Company Before an investment in a company is considered a thorough analysis of the data pertaining to the company should be undertaken. Financial Analysts refer to this as Fundamental Analysis. It comprises of a calculation of the ratios outlined above as well as additional calculations outlined below. The investors may be Providers of Loans, for which they will receive returns in the form of interest payments. Or these investors may wish to purchase Ordinary Shares in the Company. In this case returns they receive will be in the form of Capital Gains from increases in the share price plus Income from Dividends. Additional Ratios for Lenders RATIO / STATISTIC CALCULATION METHOD NOTES Interest Cover Operating Profit / Interest The higher this ratio the more likely it is that a company will be able to meet its interest payments in the event of a deterioration in its trading situation Usually expressed as a Number of Times The level of interest cover also determines the Interest Costs a company will (US Terminology Times Interest Earned) pay for loans. Lower levels of Interest Cover mean that the Company is more risky to lend to, so if it is more risky the lenders will require higher returns. Additional Ratios for Investors in Ordinary Shares RATIO / STATISTIC CALCULATION METHOD NOTES Current Share Price Market Quotation Prices are quoted in the "Serious Press" and on Bloomberg.co.uk or http://www.finance.yahoo.co.uk Earnings per Share Net Profit / Number of shares in issue Will be quoted on Bloomberg & Yahoo Finance. Also shown prominently in Companies' Published Accounts Price / Earnings Ratio Curent Share Price / Earnings Per Price Earnings (PE) Ratios are quoted in the serious press and on Bloomberg Share & Yahoo Finance. PE Ratios tend to be similar for companies in a particular Industrial sector. Companies with higher PE ratios tend to be in favour with investment fund managers who control large investment funds for pensions, Insurance companies and Investment trusts. A low price earnings ratio may also indicate that the Company is undervalued, and an investment in its shares may yield possible capital gains. Dividend per share Annual Reported Dividend per Share Will be quoted on Bloomberg & Yahoo Finance. Also shown prominently in Companies' Published Accounts Dividend Cover Net Profit after tax / Dividends or Gives some indication of certainty of dividend, but note that companies can Earnings per share / Dividend per still pay dividends when they are making losses share Dividend Yield % Dividend per Share / Current Share Will be quoted on Bloomberg & Yahoo Finance. Also shown prominently in Price Companies' Published Accounts 6 Maroof Hussain Sabri
- 7. Comprehensive Ratio Analysis Financial Ratio Analysis Ratios and Other Statistical Data which can be used by POTENTIAL INVESTORS in a Company Additional Ratios for Investors in Ordinary Shares RATIO / STATISTIC CALCULATION METHOD NOTES Market Capitalisation Current Share Price Multiplied by Market Capitalisations for companies are quoted in the "Serious Press" and Number of shares in issue on Bloomberg.co.uk or http://www.finance.yahoo.co.uk Total Shareholder Return The increase in value of an investment Data for this calculation can be obtained from Yahoo Finance, share price in a company's ordinary shares over a history. period of years (Usually 3 or 5 Years) assuming that all dividends are reinvested in the company at the share price on the date when dividends are received Book to Market Ratio Market Capitalisation / Equity The book to market ratio is important, since studies have shown that Shareholders Funds Companies with low book to market ratios provide greater long term returns than those with higher Book to Market Ratios in the same industrial sector Price Earnings Relative A measure of the relationship between the Price Earnings Ratio for a Company and the P.E. Ratio for the Market as a whole. Published in Bloomberg and Yahoo Finance. Dividend Yield Relative A measure of the relationship between the Dividend Yield for a Company and the Dividend Yield for the Market as a whole. Published in Bloomberg and Yahoo Finance. Retentions Percentage Retained Profit / Net Profit Sustainable Growth Rate Retentions Percentage Multiplied by The theory is that companies retain profits to invest and in doing so should Return on Equity (Return on obtain at least the same level of Return on Equity for the profits retained for a Shareholders Funds) year as it gets on what it has invested previously. BETA Published on Yahoo Finance & BETA is a statistical measure which indicates how individual share prices Bloomberg.com move up and down as the market as a whole moves up and down. Company shares with a BETA of 1 move up and down exactly as the Market Moves up and down. Company shares with a BETA of less than 1 move up less than the market when the market is going up and move down less than the market when the market is going down. These are known as DEFENSIVE SHARES. Company shares with a BETA of more than 1 rise more than the market when the market is rising and move down more than the Market when the market is falling. These are known as AGGRESSIVE or SEASONAL Shares 7 Maroof Hussain Sabri
- 8. Comprehensive Ratio Analysis Financial Ratio Analysis Share Valuation Methods Investment fund managers are looking for two things when they decide to make investments. Firstly they are looking for income from dividends and secondly they are looking for potential share price growth. They assess potential share price growth by calculating an INTRINSIC VALUE for a share. One of the most frequently used methods is to calculate the required return for a share using the CAPITAL ASSET PRICING MODEL. The Capital Asset Pricing Model (CAPM) is a financial theory which states that the required return for a share should be equal to a RISK FREE RATE plus BETA multiplied by the MARKET RISK PREMIUM. The MARKET RISK PREMIUM is the difference between the MARKET RATE OF RETURN and THE RISK FREE RATE. The RISK FREE RATE is generally assumed to be the rate of return on short term government bonds such as Treasury Bills. At 1.1.2005 this rate is approximately 5% per annum. Over a period of years the MARKET RATE OF RETURN has been 10% per Annum, thus THE MARKET RISK PREMIUM is 5% (10% - 5%). For a share with a BETA of 1.5, the required rate of return would this be 5% + 1.5 (10% - 5%) = 12.5%. The REQUIRED RATE OF RETURN is then plugged into a formula for calculating the INTRINSIC VALUE of a share, which is based on the assumption that CURRENT DIVIDENDS will grow at a percentage GROWTH RATE determined by SUSTAINABLE GROWTH. This is known as THE DIVIDEND DISCOUNT MODEL. The formula for this model is : INTRINSIC SHARE VALUE = (CURRENT DIVIDEND) Multiplied by (1 + Growth Rate) / (REQUIRED RATE OF RETURN - GROWTH RATE) Thus if a share had a dividend of 20p per share, a Growth Rate of 5% pa and a Required Rate of Return of 12.5% the Intrinsic Value would be: 20 X 1.05 / (12.5% - 5%) = 280p The INTRINSIC VALUE is then compared with the Current Share Price. If the INTRINSIC VALUE is substantially greater than the Current Share price BUY, if it is substantially less then SELL. Financial Ratio Analysis A word of warning Financial ratio analysis is useful in highlighting potential problems with a company, but it cannot provide all the answers for an Investment Decision. Before investing a full analysis of the Economy, Market and Company's competitive position should be also examined. 8 Maroof Hussain Sabri

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