Analysing accounts
Analysing accounts is...
Using an organization’s accounts (balance sheet and income
statement – see financial accounting) to
evaluate its performance in four areas:
1. Profitability
Is it making enough profit?
Profit is increased by:
- increasing sales revenue (or turnover – goods sold x their price) and/or
2. Liquidity (or solvency)
Does it have enough cash to pay off its bills?
See also cash flow management.
3. Capital structure
How does it raise capital e.g. loans and shares?
Is it overly dependent on loans?
The level of its borrowing is called gearing (or leverage in America).
4. Investment
Is it making enough money for its owners or shareholders?
The main problem is balancing liquidity and profitability - Why?
Liquidity comes from...
Current assets that are either cash or can be easily turned into cash.
Profitability requires
Fixed assets like property and equipment that are held in the organization for a longer
period of time:
So...
1. If you spend too much on fixed assets for profitability, you won’t have enough cash.
2. If you have too much cash, you won’t be investing enough in fixed assets and new profitable business
opportunities.
Sales (and so profits) aren’t always the same thing as cash, because...
Some customers may delay payment by buying on credit (called debtors, or accounts receivable).
How to analyse a company’s accounts
You must do four things:
1. Find out sales, profit, assets and
liabilities
From the company’s Annual Report and Accounts find out
a)sales and profit (from the company's income statement)
b)assets and liabilities (from its balance sheet) –
- current and fixed assets (see above)
- long-term liabilities (loans and shares)
- current liabilities (short-term debts).
2. Calculate key performance indicators
These are financial ratios that measure the company’s profitability, liquidity, capital structure and
investment (see below).
If the company sells abroad ,the profitability of different countries or continents should be analysed.
3. Compare these key performance indicators with those of
competitors
This is called inter-firm comparison.
4. Analyse changes in the company’s key indicators in the last five
years
Use the five year summary of the company’s financial results in its Annual Report and Accounts.
We will now look at the key financial performance indicators for a public limited company
that can raise money by selling its shares to the public (usually big institutional investors like pension
funds).
We shall use the British supermarket, Tesco as an example.
Key profitability indicators
1. Percentage changes in turnover (or sales revenue)
Annual percentage increase/decrease in turnover (or sales revenue –
goods sold x their price) – the bigger increases the better!
For 2010-14 Tesco had lower percentage increases (average 4.5% p.a.) than its competitor,
J. Sainsbury (average 5.0%) - sales include VAT:
|
2010 |
2011
|
2012 |
2013 |
2014 |
Tesco |
5.2 |
8.1
|
7.4 |
1.3 |
0.3 |
Sainsbury |
5.1 |
7.1 |
5.6 |
4.5 |
2.8 |
Tesco's sales growth has fallen badly since 2012 due to tougher competition.
2. Profit margin
Operating profit
x100%
Sales
Operating profit is the company’s profit (sales less expenditures) before the deduction of tax and loan
interest.
The expected profit margin will vary from industry to industry – for example, because of
its high sales volume, Tesco (a big supermarket) will have a smaller margin than a small grocery store.
Tesco had a higher profit margin (average 5.1%) than Sainsbury (average 3.8%) from 2010-14
(sales include VAT):
|
2010 |
2011
|
2012 |
2013 |
2014 |
Tesco |
5.5 |
5.6
|
6.5 |
3.7 |
4.1 |
Sainsbury |
3.3 |
3.7 |
3.9 |
3.8 |
4.2 |
Tesco's profit margin has fallen badly since 2012 due to tougher competition.
3. Return on capital employed (ROCE)
Operating profit x100%
Capital employed (total assets, current and fixed, less current
liabilities)
This should be increasing because this shows that the company is making more profit from
its assets. For 2010-14 Tesco had a higher ROCE (average 9.0%) but Sainsbury (average
8.3%) did better in 2013 and 2014:
|
2010 |
2011
|
2012 |
2013 |
2014 |
Tesco |
11.5 |
12.9
|
9.4 |
5.4 |
5.9 |
Sainsbury |
8.8 |
10.1 |
7.8 |
7.7 |
7.1 |
Tesco's ROCE has fallen badly since 2012 due to tougher competition.
4. Sales/profit per employee
Sales (or operating profit)
Number of employees
This indicates employee performance – obviously the higher the better!
For 2010-14 sales per employee (£) for Tesco and Sainsbury were:
|
2010 |
2011 |
2012 |
2013 |
2014 |
Tesco |
132,467 |
137,349
|
138,748 |
139,511 |
138,887 |
Sainsbury |
220,154 |
231,047 |
240,540 |
244,686 |
246,290 |
Operating profit per employee was:
|
2010 |
2011 |
2012 |
2013 |
2014 |
Tesco |
6,718 |
8,021
|
8,127 |
4,700 |
5,154 |
Sainsbury |
7,297 |
8,570 |
8,577 |
8,400 |
9,430 |
Sainsbury's has done better in both!
Key liquidity indicators
1. Current ratio
Current assets
Current liabilities
For most companies this should be between 1.5 and 2.
But a supermarket like Tesco will have a much lower figure, because it buys good on
credit (shown as creditors, a current liability in the accounts) and sells in
cash (so it has virtually no credit customers, or debtors, an important current
asset for other companies).
Tesco's and Sainsbury's current ratios were
|
2010 |
2011 |
2012 |
2013 |
2014 |
Tesco |
0.73 |
0.67 |
0.64 |
0.67 |
0.65 |
Sainsbury |
0.66 |
0.58 |
0.65 |
0.61 |
0.64 |
Tesco's average was 0.67 and Sainsbury's was 0.63 - both highly satisfactory
liquidity positions for a supermarket business.
.
2. Acid test (or quick) ratio
Current assets less stocks
Current liabilities
This should be around one for most companies. But again
Tesco will be able to operate with a much lower figure, because of its low
debtors, high creditors (unpaid suppliers) and high levels of cash.
Tesco's and Sainsbury's acid ratios were:
|
2010 |
2011 |
2012 |
2013 |
2014 |
Tesco |
0.56 |
0.49 |
0.46 |
0.47 |
0.47 |
Sainsbury |
0.41 |
0.31 |
0.35 |
0.29 |
0.5 |
Tesco's average was 0.49 and Sainsbury's was 0.37 - both satisfactory liquidity positions.
3. Stock turnover
Stocks x 365 days
Sales
This shows how long it takes for a company to sell and replace its stocks of goods (the
goods Tesco has in its stores and depots).
This figure will be high for a high volume business like Tesco – in 2014 its stock
turnover was only 18 days.
4. Debt collection period (or debtor turnover)
Debtors x 365 days
Sales
Debtors are included in trade and other receivables in the balance sheet
This shows how quickly debtors (credit customers) pay their bills.
This doesn’t apply to Tesco or Sainsbury whose customers pay by cash.
5. Interest cover
Operating profit
Interest paid on loans (called finance costs in the
income statement)
This indicates the company’s ability to pay off loan interest from its profits. If this
gets very low, it will be difficult to pay interest, particularly if there is an increase in
interest rates.
For 2010-14 both Tesco (average 6.7) and Sainsbury (average 6.1) had enough
profit to pay its loan interest:
|
2010 |
2011 |
2012 |
2013 |
2014 |
Tesco |
6.0 |
7.9
|
10.2 |
4.6 |
4.7 |
Sainsbury |
4.8 |
7.3 |
6.3 |
5.8 |
6.3 |
Key capital structure indicator
Gearing ratio (or debt-to-equity ratio)
Total borrowings (short- and long-term) x 100%
Capital employed (total assets less current liabilities)
If this gets very high (e.g. above 50%), the company is said to be highly geared
(or leveraged) and paying interest on its loans will be more difficult.
|
2010 |
2011 |
2012 |
2013 |
2014 |
Tesco |
44.2 |
37.6
|
37.3 |
34.8 |
40.0 |
Sainsbury |
8.8 |
23.7 |
24.6 |
24.2 |
19.7 |
Tesco is more highly geared with
a sharp increase in borrowing in 2014.
Key investment
indicators
1. Earnings per share (or EPS)
Profit (after deducting tax and loan interest) less
dividends paid to preference shareholders
Number of ordinary shares issued
Shareholders will get a higher return (from a higher dividend, the shareholders’ share of
the profits, and share price) if the EPS is high.
2. Price/earnings ratio (or P/E ratio)
Market price per share
Earnings per share
A high P/E ratio indicates that a company’s shares are over-priced and may fall.
Earnings are the company's dividends and how much profit it’s reinvesting back into the business.
Key quotes
explained
“Profit is not a cause. It is the
result of the performance in marketing, innovation and
productivity”.
- Peter Drucker (in
his 1954 book, The Practice of Management, pictured right).
Profit comes from customer satisfaction and innovative and productive employees. So these should be a company’s
main objectives, not profit.
“Increase the value of the whole pie,
not merely the size of each person’s slice”.
- Richard Brearley, pictured right above,
and Stewart Myers, pictured right below, (in their
textbook, Principles of Corporate Finance).
Increase the profit of the whole organization (through customer satisfaction) and then there will be a
bigger cake and bigger slices for employees and shareholders.
“The investor of today
does not profit from yesterday’s growth”.
- Warren
Buffett (American share investor,
pictured right)
An organization’s success depends on its future, not its past. Buffett says that profit margins and return on
capital are the best indicators of success.
Best books
Kenneth Andrews
(pictured right), The Concept of Corporate Strategy
(1971)
Financial analysis of company accounts may encourage short-term thinking (e.g. cost cutting) at the expense of
long-term strategy (e.g. creating lasting relationships with customers and employees).
Robert Kaplan
(pictured right above) and David Norton (pictured right
below), The Balanced Scorecard (1996)
The Balanced Scorecard emphasizes the importance of non-financial objectives like customer
satisfaction, employee motivation and learning (see balanced
scorecard).
|