Search

If you found this article to be of value, at least like it or the website.

Financial management is based on building on a businesss strengths while striving to overcome its weaknesses.  Financial analysis helps answer questions such as:

• Is the business improving from year to year?
• Have we borrowed too much?
• Are we making a decent return for our shareholders?

There are a huge number of ratios that can be calculated from a set of financial statements, but fortunately there are only a few that are really meaningful.  Ratios are based on the principle that patterns and trends emerge in business, which can be measured, interpreted, and used as guides for action.  One should also be aware that in order to compare the ratios of different companies with other companies, with their own history and with the industry averages, the ratios should be calculated in the same manner.  It is therefore important to ascertain how the ratios have been calculated.  It is not so much the detailed manner that is important in the calculation of ratios than it is the trend of a specific ratio.

The return on investment ratio

One ratio ranks far above all others in significance.  This is the return on investment (ROI) ratio, which measures the return earned by the shareholders of a business on the money they invest.  This investment which is sometimes referred to as TOTAL SHAREHOLDERS FUNDS consists of share capital and retained earnings.  This ratio measures the all-important business factor, earning power.

Analysts may use various other acronyms when referring to this measure:

• Return on capital(ROC)
• Return on net assets (RONA)
• Return on shareholders’ funds(ROSF)

Ratio analysis requires comparison against trends. Standards of comparison are:

• Comparisons of historic performance against current performance.
• Comparison against budgets or forecasts.
• Comparison with other firms.
• Comparison with industry or national averages.

We do not have many published benchmarks for industry ratios in South Africa. A good source is the Bureau for Financial Analysis attached to the University of Pretoria Business School.

THE DIFFERENT KINDS OF RATIOS

Ratios are classified under five headings:

1. Profitability ratios, which measure the returns generated on sales and investment
2. Liquidity ratios, which judge whether a business is likely to run out of cash in the short term
3. Activity ratios, which measure how well the business is using its assets
4. Leverage ratios, which measure the extent to which a business is using borrowed money
5. Growth ratios, which measure the businesss rate of growth and assess the potential for future growth

GENERAL PRINCIPLES APPLICABLE TO THE USE OF RATIOS

Before calculating any ratio, consider what you would expect from the company being analysed, e.g. a company selling perishable commodities should have a rapid stock turnover.  Then match expectations to actual performance.  This may identify a company which is performing better than it was, but worse than it should be.

Look for a trend.  A comparison of two years is inconclusive; at least 3 years should be analysed.  Bear in mind the purpose for which the analysis is being done. Directors, bankers, creditors, and shareholders have different perspectives and use different ratios.

Ratio analysis is a theoretical exercise, often done without complete knowledge of trading conditions, company policy, etc.  As such, there are dangers to ratio analysis if it is done mechanically.  Some of these are:

• Ratios can only isolate a problem; they cannot identify the cause.
• Analysis is an historical exercise. It is meaningless unless it can give pointers to future performance.

• Accounting policies can have a material influence on financial statements. When in doubt, ask for expert advice.  However, you must first understand your own companys accounting policies.
• Changes in accounting policies could materially affect comparisons from year to year.
• Financial statements often show historical values for fixed assets such as property.  Take the possibility of re-valuation of assets into consideration.
• There should be different expectations for ratios such as return on assets for companies, which have re-valued property opposed to those companies which have not valued property.
• The financial year-end may coincide with a period of low activity.  This may not be a true reflection of a company’s business.

PROFITABILITY RATIOS

This section discusses the different measures of corporate profitability and financial performance.  These ratios, much like the operational performance ratios, give users a good understanding of how well the company utilized its resources in generating profit and shareholder value.

The long-term profitability of a company is vital for both the survivability of the company as well as the benefit received by shareholders.  It is these ratios that can give insight into the all important profit.”  Bear in mind though, that profit does not equal cash, given your understanding of the cash flow statement.

In this section, we will look at four important profit margins, which display the amount of profit a company generates on its sales at the different stages of an income statement.  The last three ratios covered in this section Return on Assets, Return on Equity, and Return on Capital Employed explain how effective a company is at generating income from its resources.

Profitability ratios tell us how well a firm is being managed. The ultimate measure of a businesss success is the rate at which it makes profits from its activities.  Profitability is measured in three ways:

• Relative to investment (i.e. for every Rand of shareholders money invested in the business, how much profit did we make?)
• Relative to assets (i.e. for every Rand of assets of the business, how much profit did we make?)
• Relative to sales (i.e. for every Rand of sales, how much profit did we make?)

In the income statement, there are four levels of profit or profit margins gross profit, operating profit, pre-tax profit and net profit.  The term margin can apply to the absolute number for a given profit level and/or the number as a percentage of net sales/revenues.  Profit margin analysis uses the percentage calculation to provide a comprehensive measure of a companys profitability on a historical basis (3-5 years) and in comparison to peer companies and industry benchmarks.

Basically, it is the amount of profit (at the gross, operating, pre-tax or net income level) generated by the company as a percent of the sales generated.  The objective of margin analysis is to detect consistency or positive/negative trends in a companys earnings.  Positive profit margin analysis translates into positive investment quality.  To a large degree, it is the quality, and growth, of a companys earnings that drive its share price.

In order to calculate the ratios, we will be using the financial statements of Pick ‘n Pay for the year ending 28 February 2007.

Gross Profit Margin = Gross Profit / Net Sales (Revenue)

Operating Profit Margin = Operating Profit (EBIT) / Net Sales (Revenue)Pre-tax Profit Margin = Profit Before Tax / Net Sales (Revenue)

Gross Profit Margin = 6 893.9 / 39 337.1 = 17.53%

Operating Profit Margin = 1 328.8 / 39 337.1 = 3.38%

Pre-tax Profit Margin = 1 205.3 / 39 337.1 = 3.06%

Net Profit Margin = 675.6 / 39 337.1 = 1.72%

All the Rand amounts in these ratios are found in the income statement of 2007 of Pick ‘n Pay.  As of February 28, 2007, with amounts expressed in millions, Pick ‘n Pay had net sales, or revenue, of R39 337.1, which is the denominator in all of the profit margin ratios.  The numerators for Pick ‘n Pay’s ratios are captioned as gross profit, operating profit, profit before tax, and profit for the year, respectively.  By simply dividing, the equations give us the percentage profit margins indicated.

It is important to remember that these ratios by themselves mean very little.  You need to calculate the ratios for previous years as well and compare them, as well as against the budget figures set for the company, the industry averages, and the ratios for the competitors.

None

First, a few remarks about the mechanics of these ratios are in order.  When it comes to finding the relevant numbers for margin analysis, readers are reminded that the terms: income,” profits and earnings are used interchangeably in financial reporting.  Also, the account captions for the various profit levels can vary, but generally are self-evident no matter what terminology is used.

Second, income statements in the multi-step format clearly identify the four profit levels. However, with the single-step format the investor must calculate the gross profit and operating profit margin numbers.

To obtain the gross profit amount, simply subtract the cost of sales from net sales/revenues.  The operating profit amount is obtained by subtracting the sum of the companys operating expenses from the gross profit amount.  Generally, operating expenses would include such account captions as selling, marketing and administrative, research and development, depreciation and amortization, rental properties, etc.

Third, investors need to understand that the absolute numbers in the income statement dont tell us very much, which is why we must look to margin analysis to discern a companys true profitability.  These ratios help us to keep score, as measured over time, of managements ability to manage costs and expenses and generate profits.  The success, or lack thereof, of this important management function is what determines a companys profitability.  A large growth in sales will do little for a companys earnings if costs and expenses grow disproportionately.

Lastly, the profit margin percentage for all the levels of income can easily be translated into a handy metric used frequently by analysts and often mentioned in investment literature.  The ratios percentage represents the number of cents there are in each Rand of sales. For example, using Pick ‘n Pay’s numbers, in every sales Rand for the company in 2007, theres roughly 17.5 cents, 3.38 cents, 3.06 cents, and 1.72 cents of gross, operating, pre-tax, and net income, respectively.

Lets look at each of the profit margin ratios individually:

Gross Profit Margin A companys cost of sales, or cost of goods sold, represents the expense related to labour, raw materials and manufacturing overhead involved in its production process.  This expense is deducted from the companys net sales/revenue, which results in a companys first level of profit, or gross profit. The gross profit margin is used to analyze how efficiently a company is using its raw materials, labour and manufacturing-related fixed assets to generate profits. A higher margin percentage is a favourable profit indicator.

Gross profit is the reverse of the mark-up, which is the percentage added to cost to obtain the selling price.

Industry characteristics of raw material costs, particularly as these relate to the stability or lack thereof, have a major effect on a companys gross margin.  Generally, management cannot exercise complete control over such costs. Companies without a production process (e.g. retailers and service businesses) dont have a cost of sales exactly.  In these instances, the expense is recorded as a cost of merchandise and a cost of services, respectively.

A company plans for its gross profit, by taking its cost of sales and adding to that, its margin.  Therefore, should it sell its goods at the determined price, it should deliver the gross profit margin as calculated.  Should this margin differ from the planned margin, various factors need to be investigated.  Reasons for these changes can include:

• Theft of stock or cash sales.
• Changes in sales mix.
• Increases in discounts given to customers.
• Stock write-offs.
• Failure to pass on cost increases to customers.
• Errors in stock count or stock valuation.

A gross profit percentage, which is consistent from year to year, may not in itself be acceptable.  Detailed analysis of gross profit by product line or by customer may indicate a dangerous bias toward unprofitable lines or exposure to a particular customer.

Irrespective of which of these factors played a role, the variance needs to be investigated, as it frequently reflects upon inventory that is stolen by customers and staff.  This happened to Shoprite a few years ago when about R100 million of inventory were stolen by management in collusion with suppliers.

Operating Profit Margin By subtracting selling, general and administrative (SG&A), or operating, expenses from a companys gross profit number, we get operating income.  Management has much more control over operating expenses than its cost of sales outlays.  Therefore investors need to scrutinize the operating profit margin carefully.  Positive and negative trends in this ratio are, for the most part, directly attributable to management decisions.

A companys operating income figure is often the preferred metric (deemed to be more reliable) of investment analysts, versus its net income figure, for making inter-company comparisons and financial projections.

Pre-tax Profit Margin Many investment analysts prefer to use a pre-tax income number for reasons similar to those mentioned for operating income.  A company has access to a variety of tax-management techniques, which allow it to manipulate the timing and magnitude of its taxable income.

Net Profit Margin The so-called bottom line is the most often mentioned when discussing a companys profitability.  While undeniably an important number, investors can easily see from a complete profit margin analysis that there are several income and expense operating elements in an income statement that determine a net profit margin.  It behoves investors to take a comprehensive look at a companys profit margins on a systematic basis.

Management Accounts

Profit management is about:

• A good system which captures. classifies and records transaction data
• Measurement and analysis of profitability by product line, customer and geographic area
• Regular and timely management reporting
• Iron fisted management review and control

How to Manage With Your Management Accounts

Top executives use the review process to spark off discussions on a broad range of related topics.  Some learning points picked up from watching leading players in action:

• Structure your management reports to show responsibility accounting
• Spend your time on the big numbers first
• Understand the key ratios, measures and benchmarks for this industry
• Distinguish clearly between the hard and the soft numbers
• Know where the fat is hidden
• Quantify the link between capacity utilisation and profitability
• Understand your breakeven economics
• Distinguish clearly between expenses of today, yesterday, and of tomorrow
• Understand your capital vs revenue policy
• Look at the bases of stock and asset valuation (why do we do it this way?)
• Distinguish between real profits and inflation (stock) profits
• Show graphs instead of figures

The start point for analysing trading profitability is called common sizing.  In order to understand a companys business model and determine trends, we restate the income statement figures relative to sales being 100, both horizontally and vertically.  For Pick ‘n Pay, such a common sized statement could look as follows (only selected figures – in practice this should be done for all the lines in the income statement):