16.
How can reported data be used?

16.1 Introduction

This unit considers how and why users of financial statements might seek to analyse them to gain insights into the performance and financial structure of different businesses. Many interested parties rely on published financial information to make decisions, for example, on whether to invest, to lend or to trade. They may even use ratios to predict company failure.¹

The process of analysis starts with understanding the company operationally and reviewing the financial information available. Ratio analysis builds on this by showing the relationship between linked figures within the financial statements and by providing a basis for relevant comparisons. This unit will explain the process of analysis with a particular focus on applying it to published financial statements.

We will use the fictional example of Umbrella S.A. to illustrate the calculation process.

You will also follow the Dr. Martens plc video case study to demonstrate the application of ratio analysis to a real company.

16.2 Analysing financial performance

This section will discuss the steps in undertaking a financial analysis of a company using published information.

Step 1: Understanding the company

The first step in any financial analysis is to gain an understanding of the company being analysed. It is useful to identify the following:

• the industry it is operating in
• its main product(s) or service(s)
• the impact of sustainability on its business policies and practices
• its key customers or sources of revenue
• its key suppliers
• its key competitors
• key issues impacting the industry during the period of analysis.

This information can come from several sources, including the annual report (particularly the narrative sections), the company website, reliable financial press, and industry reports.

Our fictional example company, Umbrella S.A., manufactures and sells umbrellas to retailers, who then sell them to the general public. It has recently expanded into the manufacture of parasols (sun umbrellas). They are currently researching more sustainable materials to be used in the manufacturing and packaging of the umbrellas.

Watch the video, which carries out Step 1 in the case of Dr. Martens plc.

Step 2: Review of financial statements

In addition to understanding the company, and before beginning any ratio analysis, it is a good idea to first look at the specific numbers in the financial statements and how these have changed compared to the previous year.

Ratios show the relationship between two groups of numbers, for example profit to sales. Looking at the component parts individually first will help you explain what the ratio is seeking to measure and understand the absolute values. Useful financial figures to compare to previous periods to identify where there has been significant change include:

• sales
• key cost categories such as cost of sales and operating costs
• asset and liability categories as detailed on the statement of financial position.

Useful analysis does not just present figures and movements but explores why these figures have moved. Your understanding of the company, generated in Step 1, will help you understand what these numbers represent. You should then research the company and/or the industry to find out why these may have moved. There are various helpful sources of information.

• For larger companies, the annual report will contain a financial review which may provide useful insights and more information can often be found in the corresponding notes to the financial statement’s figures.
• Some industries have adapted measures designed to provide better insights into their underlying performance. For example, retailers often supplement financial statements with a like-for-like analysis to reflect the underlying growth of the business, adjusted for store openings and closings during the year. It is helpful to review competitor financial statements to compare such measures.
• Consider how inflation during the accounting period may have impacted the financial statements. Was the business able to pass on any cost increases? How might demand have been impacted? Is it realistic to compare to prior years? Is it realistic to compare to competitors operating in different markets?
• The financial press can be a useful source of information about a specific company or the industry. Consider if this information is consistent with the movement in figures from the financial statements’ numbers.

Watch the video which carries out Step 2 in the case of Dr. Martens plc.

Step 3: Ratio analysis

After developing an understanding of the company and the key financial figures in the financial statements, we can use ratio analysis, which compares two or more numbers to help identify relationships between them. It is important to remember that the figures in the financial statements are composed of different judgements, including depreciation policies and valuation approaches, which can affect comparative analysis.

Individual ratios in isolation do not provide very useful information; they need to be compared with something. Useful comparatives can be:

• prior years’ ratios for the company in question
• ratios for a competitor
• an industry average.

Company targets, including budgets, also make good comparatives, but these will usually only be available to internal analysts. Large, quoted companies often provide a wealth of information and guidance in their investor presentations. See for example, the L’Oreal investor relations site.

When making comparisons, it is important to go beyond describing the difference between a ratio and its comparative and look at why a ratio is different to a comparative and consider the implications for the company being analysed. This will draw on the knowledge of the company (Step 1) and the review of the financial statements (Step 2) as well as any additional relevant information which may be gained from the financial statements and supporting notes.

When making these comparisons, it is important to keep the focus on the company and period of analysis, using the comparative to add to this analysis rather than analysing the prior year performance or the competitor’s performance. It is also important to consider other non-financial goals which may impact on the ratios. For example, a company may choose or move to a more sustainable material, which results in higher cost and lower profit but is in line with the ethos of the company.

While some ratios are more commonly used than others, it is important that any ratios selected add to the analysis of the organisation.

We will now look at the different groupings of ratios in more detail.

Profitability ratios

Profit can be measured in different ways which include or exclude various costs. Different profitability ratios show the relationship of these profit measures compared to other figures in the financial statements.

Profitability calculations

Gross profit margin and operating profit margin both calculate a profitability measure (gross profit or operating profit) as a percentage of sales.

Gross profit margin shows the relationship between sales and cost of sales and how these move relative to one another. For Umbrella, we can see that the gross profit margin declined, despite the overall increase in revenue. This might be due to the change in sales mix as the company expanded into parasols. It could also be due to discounts being offered to boost sales of the new product line. We do not have sufficient information to know for certain and these would be questions we would ask management.

Operating profit margin represents the relationship between sales and all operational costs, including cost of sales and any overhead costs. We can see that while gross profit margin for Umbrella declined year-on-year, the operating profit margin increased. This is attributable to salaries and other operating expenses not growing at the same rate as sales. It could be because the investment in non-current assets has contributed to increased manufacturing efficiency.

Excluding, or including, different elements in a profit measure can be really useful, but non-standard measures can also be more easily manipulated. A number of companies have been reported to show adjusted earnings which exclude costs in order to present their company more favourably.² This demonstrates the importance of taking the time to understand what is included, or excluded, in adjusted calculations.

Financial analysts often focus on adjusted measures of operating profit, commonly referred to as earnings before interest, tax, depreciation and amortisation (EBITDA). They do this to better understand the underlying performance of the business given the variations in depreciation policies and impairment assessments from organisation to organisation. Lease costs are increasingly also adjusted for to address the potential variation in performance resulting from lease/buy decisions. This creates the measure EBITDA-AL (EBITDA after leases (right of use assets)). See for example, Vodafone and Orange annual reports.

Return on shareholder funds (ROSF) and return on capital employed (ROCE) both describe the relationship between a profitability measure and the long-term funding of the company.

ROSF compares profit for the year, representing the profit available to shareholders, with the funds invested by the shareholder, which is known as equity.

ROCE compares the operating profit, representing the profit after all the operating costs have been paid and therefore the profit available to cover all funding costs, with the investment by all long-term funding providers.

For Umbrella, we can see that both measures increased, reflecting the comparatively faster increase in profitability measures. This is partially due to the increases in revenues, driven by sales volume.

We can also see that operating profit × net asset turnover = ROCE (allowing for rounding).

Specific points for analysis

• Gross profit margin analyses the direct cost of making the products or supplying the service. A decreasing gross profit margin means cost of sales are becoming a bigger percentage of sales. This could be explained by a decreasing sales price and/or an increasing cost of sales. Analysis should always try and identify specific reasons for this.
• The operating profit margin includes the overhead costs. If you have discussed cost of sales in gross profit analysis, the operating profit margin analysis can focus on the additional impact of overhead costs.
• ROSF uses profit for the year, which is the operating profit less any finance and tax costs. The profit for the year is compared to the equity, which is a measure of investment by shareholders in the company. It is important to also identify any movements in the elements of equity, such as a new share issues, which will impact the return on shareholder fund ratio. Often analysts will use an average measure for the year, but you may not be presented with this data.
• ROCE uses operating profit as the profitability measure, so analysis in relation to operating profit margin is also relevant here. Capital employed comprises equity and non-current liabilities. Movements in equity from the return on shareholder funds will also be relevant here as well as movements in non-current liabilities.

Considerations when calculating profitability ratios from published financial statements

The equity figure you use should comprise all investments by shareholders. This includes share capital, share premium, and any other reserves such as retained earnings or a revaluation reserve.

Watch the video which looks at the profitability ratios for Dr. Martens plc.

Efficiency ratios

Efficiency ratios measure how well a company is managing its operating resources, specifically their inventory, accounts receivables and accounts payables.

Efficiency calculations

The inventory turnover period (inventory days) measures how long the company, on average, holds inventory for. This will very much depend on the type of company; for example, one would expect a much shorter turnover for a company that sells fresh food compared to a company that sells jewellery. Average inventory may differ from year-end inventory, depending on the nature of the business and where the year-end lies within that annual cycle.

For Umbrella, we can see that inventory days have reduced from 44.1 days to 33.0 days. This may reflect the higher sales volume combined with improved inventory control, perhaps through selling into new markets. A business like Umbrella would be considered seasonal. For example, if it sold umbrellas into just one market, one would expect sales to fluctuate during the year in line with the wetter seasons. Umbrella might offset this risk by expanding into other countries where the weather patterns differ, or by expanding into a new product area, for example sun parasols.

It is normal business practice in many industries to offer credit to customers and expect credit from suppliers. The period of credit is the number of days after the date of sale or purchase, to the date payment is expected. The length of this credit period will vary depending on the industry and can be different for individual customers.

The accounts receivable collection period (receivable days) calculates the number of days, on average, it takes to receive money from customers the company has sold on credit to. For Umbrella, it has increased substantially from 43.8 days to 58.6 days. This may be due to new customers being granted special terms to drive sales, or it could be a sign of weak credit control. Further information that would be helpful might include details of the company’s standard credit terms.

The accounts payable payment period (payable days) measures the number of days, on average, it takes a company to pay the suppliers from whom it bought on credit. Again, this has increased for Umbrella and could be a sign of liquidity problems. Companies can use trade payables as a means of financing their business, particularly where the cost of borrowing is high. There may, however, be an alternative explanation. For example, Umbrella might have been granted extended credit terms from new suppliers of components for the parasols. It is important to consider all potential explanations in the context of the scenario presented rather than jumping to conclusions.

Read the article ‘When it makes sense to pay suppliers late’.

The working capital cycle (days) measures the number of days, on average, it takes to convert current assets and liabilities into cash. It is simply the sum of the inventory turnover period, accounts receivable period and the accounts payable period. For Umbrella the reduction from 51.3 days to 33.5 days reflects the reduction in inventory days and the increase in the payable days.

Specific points for analysis

• Keep analysis specific to the company being analysed. What kind of inventory does it hold, who are its suppliers and customers, and what are the implications of this? For example, if a company has inventory which quickly loses value (such as food or fast fashion), long or increasing inventory turnover days will be particularly concerning.
• Competitor or industry comparisons are useful here as competitors should have similar inventory, customers, and suppliers; this can help identify how the company is performing and areas for improvement.

Ratio analysis should also consider the trade-offs involved with optimising working capital ratios and running the organisation. A summary of some of the trade-offs for each working capital ratio is shown in Figure 16.5. It is important to consider both sides of this trade-off in your analysis.

Considerations when calculating efficiency ratios from published financial statements

• Financial statements will not specify which sales and purchases are made on credit and which are cash; you typically use the sales and cost-of-sales figures from the financial statements as an approximation.
• If the company does not make sales or purchases on credit, there will not be an accounts receivable/payable balance. An example of this may be a retailer who does not give customers credit. Equally, some companies may not have inventory, such as a service company.
• Some analysts prefer to use averages rather than the year-end balance, and some calculate purchases instead of cost of sales for the trade payables payment period. These are all acceptable variations, and your ability to calculate them consistently may depend on the data you have.

Watch the video, which covers the efficiency ratios of Dr. Martens plc.

Liquidity ratios

Liquidity calculations

The current ratio compares the company’s cash and items expected to become cash in the next year (current assets), with amounts expected to be paid in the next year (current liabilities). This gives an indication of the ability of the company to service its short-term financial commitments. Umbrella’s current asset ratio has deteriorated year-on-year due to the increase in trade payables and is consistent with the increase in payables days noted above.

The quick ratio is very similar but excludes inventory because it is viewed as less liquid (less easily converted to cash) and hence excluding this can sometimes give a truer picture of how the company can service its short-term financial commitments. Umbrella should now be monitoring its quick ratio carefully as it can only just meet its current liabilities as they fall due. This indicates that, despite its growing profit, the company may need to think about refinancing to inject further liquidity into the business.

Specific points for analysis

• Be cautious about ideals; liquidity ratios are industry-specific. Some companies can convert their inventory and trade receivables much more quickly to cash and therefore can successfully operate with a lower liquidity ratio.
• The relevance of the quick ratio is determined by the type of inventory a company holds. If their inventory is readily convertible to cash, there is less value in this as an additional calculation. Normally a ratio of below 1 indicates liquidity issues.
• Look at the component parts of current assets and current liabilities (which may be on the statement of financial position or within the notes) and identify what is causing changes from the previous year and consider the implications. Often the largest items within current assets and current liabilities are inventory, accounts receivable and accounts payable, which were discussed above. The efficiency ratios will therefore help you explain the liquidity ratio movements and your analysis should incorporate or refer to these if appropriate.

Watch the video, which looks at the liquidity ratios for Dr. Martens plc.

Financial gearing ratios

Financial gearing calculations

Companies need to be funded to be able to conduct their operations and this funding generally takes two forms: debt and equity.

Gearing reflects the long-term funding of the company and particularly the percentage of the company which is funded by long-term debt. The gearing ratio has many variants, so it is important to be clear on how you are calculating this ratio. Long-term debt is often viewed as higher risk as it needs to be repaid and bears interest. This compares to equity, which does not need to be repaid and where dividends might be paid instead of interest. Dividends are generally flexible; if a company underperforms one year, they are likely to have the flexibility not to pay a dividend that year.

Some companies prefer to show a net debt calculation but this may not reflect the availability of cash to pay long-term debt. See for example, Shell’s annual report’s use of the term ‘gearing’.

Umbrella has taken on a long-term loan during 20x4 which has increased its gearing. Despite this, it has a relatively low level of gearing and is predominantly reliant on equity funding. This may be a choice that the company has made, or it may not have access to debt finance. Start-ups often struggle to borrow as they do not have a track record to enable lenders to evaluate the prospects of the business. It can be easier for founders to give away part of the business in exchange for investment rather than borrowing. Investors are willing to invest their funds in the hope that the business becomes successful and they can share in a subsequent sale or initial public offering.

This contrasts with mature organisations that have stable cash flows and high levels of non-current assets and would be able to support a higher level of gearing, for example, utility companies.

Where a company is listed, it will also need to consider shareholders’ requirements to attract and retain shareholders. This may include financial returns, such as a high dividend or share price growth. Or there may be non-financial incentives, such as supporting a more sustainable future; oil and gas companies, for example, are under significant pressure to invest in developing greener products.

The interest cover ratio calculates how many times a company can cover its interest commitments from available profits. Interest cover should be considered in conjunction with the debt position as this gives an indication of how well the company can service their debt. For example, a company that is increasing their debt but still has a high interest cover ratio is much less concerning than a company that is increasing their debt but have a low or decreasing interest cover ratio. This is the case for Umbrella which has an interest cover ratio of 11.6 times in 20x4.

Specific points for analysis

• Long-term debt is a good starting place – has this increased or decreased? Increasing debt comes with increased financial risk as both the interest and capital need to be repaid as agreed. However, it is important to also look at why the company is increasing its debt. Is this to fund growth of the company which could be very positive for the future or is it because the company are in financial difficulty?
• Explanations for significant changes in finance can often be found in the narrative sections of the annual report, particularly in the financial review.

Considerations when calculating financial gearing ratios from published financial statements

• Long-term debt now comes in many forms and is not limited to long-term loans. This could include, for example, loans, bonds or debentures or long-term financing, such as a long-term lease. You will need to look through the non-current liabilities and identify long-term debt from here.
• When selecting which interest figure to use, this should include interest which needs to be paid on long-term debt. You may get this information from the income statement or you may need to go to the relevant note to get the required detail.

This video looks at the financial gearing ratios of Dr. Martens plc.

16.3 Investment ratios

This group of ratios is helpful for those considering investment in a business.

We now assume that Umbrella is a quoted company and that Umbrella’s share price was €2.50 on 31 December 20x3 and €2.75 on 31 December 20x4.

The dividend payout ratio measures the extent to which the company is paying out its profit to shareholders rather than retaining it for investment in the business. It can also be expressed as dividend cover (profit for the year/dividend announced). The Umbrella payout is high, given it also borrowed and issued additional shares during 20x4.

The dividend yield reflects the return on the investment in shares. This is often industry-specific with wide variations being identified.

Earnings per share (EPS) is a ratio that is widely used by investment analysts as it facilitates trend analysis and comparisons with other potential investments. We can see that Umbrella has an increasing EPS despite having issued more shares during 20x4.

The price–earnings (P/E) ratio is a measure of confidence in the business. The higher the P/E ratio the greater the future earnings that are expected. This measure is often used to compare to other opportunities that are available. Umbrella’s P/E ratio has fallen, which may indicate that the shares are undervalued or that the market does not anticipate rapid growth in earnings.

16.4 Limitations of financial analysis

There are several limitations of financial analysis:

• Financial ratios are based on financial information, often mainly from the financial statements. If used in isolation, this can encourage a limited view of the company being analysed. A more rounded analysis of performance will combine this financial analysis with other elements, such as environmental and social measures.
• Analysis based on financial statements is limited by the underlying rules of financial statement preparation. For example, internally developed brands and employees don’t meet the definition of assets and are therefore not included in the financial statements as assets despite being, for many companies, one of their most valuable sources of future revenue and profits. It is therefore important to consider, alongside analysis, relevant information which cannot be gained from the financial statements.
• When working with comparator companies, consider the impact of differences in accounting policies, year-end dates, and how corporate domicile impacts the corporate tax charges.

Bear in mind that if you are analysing a company which you are external to, you will not have sufficient detail to allow a full analysis and while you might gain some useful insights, these are generally limited to what is in the public domain. Companies may wish to put a positive slant on publicly available information, often using adjusted metrics (or management performance metrics). This can skew analysis, particularly when the source of adjusted metrics is not clearly disclosed.

We have included commonly used formulas and their interpretations. There are, however, many acceptable variations of formulae which can affect the outcome of calculations. The key is to be consistent and when making a comparison, ensuring you are comparing like with like.

16.5 Summary

• Financial analysis should start with developing an operational and financial understanding of the company being analysed.
• Ratio analysis can provide a useful tool to show the relationship between two or more figures in the financial statements and can provide a good basis for comparisons.
• Useful analysis goes beyond describing changes in ratios to understanding why they have changed and the implications for the company going forward.
• Ratios can, if used in isolation, result in the dominance of a financial focus in performance evaluation. It is important to combine these with other measures, such as environmental and social measures.

16.6 Self-test

Self-test questions 1 to 5 below are based on the following accounts of ABC Ltd.