AFIN 252 Applied Financial Analysis And Management
1.Hierarchy of Ratios – Pyramid of Ratios
The six core ratios, often described as the ‘Pyramid of Ratios’, indicate the financial stability of an organization. These ratios when set out in a hierarchy, form a pyramid with the ‘Return on Capital Employed’ (ROCE) sitting at the top. The ROCE shows the return for shareholders. There are other ratios which help understand the way a business operates, but the six core ratios explained below remain key ones for owners and managers to help monitor the financial performance of their business.
1.1ROCE
The return that a business generates, i.e. net profit after tax is divided by equity i.e. the amount of money invested in a business. The ratio is usually expressed as a percentage.
1.2Leverage
Leverage is measure of money invested by the owner (or in case of a company, owners) against that of the lenders. It is calculated by dividing long term debt by equity (ordinary shared). Also known as gearing, it is generally seen as a warning signal if the leverage is high because the company would have more debt and less equity.
Importance of Leverage
One of the questions, a creditor asks before lending is ‘why should I lend more?’ Injecting more debt makes a business more risky. In the event of failure, the business will have to settle its liabilities and lenders rely on the debtor’s assets in that case. If the company’s liabilities outweigh its assets, it will be considered risky in the eyes of the lender.
Another reason to regulate leverage is the advantage of tax benefits. Since interest payments on debt are tax deductible making the company profitable (higher profit after tax), opportunity on raising debt finance should not simply be ignored altogether.
Hence, a balance between the two is important. A highly geared company indicates that the company might be in difficulty bearing high financial costs. Whereas a low geared company would be missing out on potential higher profits.
1.3Return on Investment (RoI)
RoI is calculated by dividing the return that a business generates after tax (NPAT) with the money that is invested in the business (capital). It is usually expressed as a percentage.
The ratio shows how effective the business is in utilizing all the capital there is at its disposal to generate a profit.
1.4Asset Turnover
Asset turnover is calculated by dividing the turnover of a business (sales) with the total assets of the business. It measures how efficiently a business is utilizing it's assets to generate its turnover. In other words, it measures how hard the assets are being worked. It is generally expressed as a percentage.
There is no ideal asset turnover figure. Different businesses have different asset turnovers. e.g. A construction business needs expensive machinery compared to a bank, whose assets mainly consist of computers and furniture.
The total assets figure mainly consists of debtors, cash, stock and machinery. A low asset turnover does not necessarily mean that sales are not increasing. It may be due to any number of reasons ranging from high debtor collection periods to underutilized machinery to high stock levels.
1.5Asset Leverage
Asset leverage focuses on the asset side of the balance sheet. It is similar to gearing, but instead of liabilities it deals with assets. Asset leverage is calculated by dividing total assets to equity. It is expressed as a decimal.
As mentioned, it looks at assets (similar to liabilities), the ratio provides an analysis of the asset side of the balance sheet and points out if there are any changes that can positively affect the business.
1.6Net Margin
Net margin or net profit margin is calculated by dividing Net profit (after interest and tax) to the turnover. It is purely a measure of a business's profitability. Since net profit is the bottom line of the income statement, it measures the proportion of net profit to sales. The higher the margin, the more profitable and attractive the company will be.
Reasons for net margin decline vary from lower gross margins or overheads increasing faster in proportion to sales.
Asset turnover, Asset leverage and Net Margin, set out the base of the 'Pyramid of Ratios.' Asset turnover when multiplied by net margin equates to Return on Investment. Also, if Asset turnover, asset leverage and net margin are miltiplied, the resulting fiigure will be Return on Capital Employed.
2.The Key Investor Ratios
Investor is any person/organization who wishes to provide capital either in the form of loan or equity in an organization. Investor ratios are frequently used by keen investors to analyze the performance of a company they wish to invest in.
Following are some key investor ratios that give insight to a company’s financial performance.
2.1Dividend Rate
This is the amount of dividend that a company pays over a period of time. The dividend rate is expressed as an annual figure. If a company pays dividend quarterly of .25 cents, then the dividend rate for that company would be £ 1.00 (i.e. 0.25 x 4). Similarly, if the same company starts paying a quarterly dividend of 0.30 cents, its dividend rate will increase to £ 1.20 (i.e. 0.30 x 4).
Investors preferring high dividends will incline towards investing in companies with a high dividend rate. Hence higher the dividend rate, the more attractive the company will become in the eyes of investors. Therefore companies pay particular attention to its dividend payments. A high rate will reflect that the company is thriving and a low rate will suggest that the company may be in turmoil. Although low dividend rate does not always equate to a company being in trouble,it may simply be the case that the company is paying less dividends to take on more profitable investments at that point in time.
2.2Dividend Yield
Dividend yield is a company’s dividend relative to its share price. It is calculated by dividing ‘total dividend’ with ‘market capitalization’ (share price x no. of ordinary shares) or dividend per share with market share price.
Usually expressed as a percentage, dividend yield shows the earning on investment (shares). It only considers dividends are the return on investment and not the capital appreciation as a result of increase in the share price. Dividend yield shows how much return is generated per currency unit (£, $ etc) invested. E.g. If dividend yield is say 20%, that mean means each £1.00 invested generates 0.20 cents in return.
2.3Earnings Per Share (EPS)
The earnings per share indicates a company’s profitability. It is the portion of profit that is allocated to each outstanding share. This is calculated by dividing Net income (less any dividend on preferred shares) with ordinary shares.
Earnings per share is expressed as decimal (currency). E.g. If a company’s EPS is 0.60 cents, this means that after fulfilling other obligations, the company can pay a maximum of 0.60 cents of dividend per share. This is normally higher than dividend per share. EPS is the maximum limit for dividend that the company can pay from its current year’s profits. As an investor, this ratio gives an idea of how much dividend the company can pay regardless of how much it actually does pay. Investors pay particular attention to eps since this is the main drive force (among others), that determine the share price on the stock market. Because a shareholder does not own 100% shares of the company, consequently 100% of the earnings isnot as meaningful of an indicator. Hence, eps gives a reliable figure as far as the earnings of an ordinary shareholder is concerned.
2.4P/E Ratio
Price/Earnings ratio or P/E ratio is the comparison of a company’s share price to its earnings. It is calculates by dividing market share price with earnings per share (eps). P/E ratio reflects the expectations of shareholders. A high P/E ratio would suggest that the investors are expecting higher growth in returns than a company with low P/E ratio.
P/E ratio shows how much an investor is willing to pay per pound of earnings and is sometimes referred to as a “multiple.” This means that if a company has a P/E ratio of £22, then the investor is willing to pay £22 for £1 of its current earnings. Investors looking to invest in a company need to pay particular attention to the P/E ratio. A high P/E ratio does not necessarily mean that the company is profitable. It simply means that investors are willing to pay high price for a pound of the return from that company. A high P/E ratio therefore reflects shareholder’s confidence in the company. A low P/E ratio would therefore suggest that shareholders have less confidence in the company’s ability to generate expected returns.
3.Importance of Profitability and Liquidity in context of Business Survival
There is a unique relation between profitability and liquidity. Gaining profitability usually means losing some (if not equal) liquidity. Profitability means the amount by which a company exceeds its expenditures i.e. Net profits. Whereas liquidity is having enough money (cash or cash equivalents) in order to meet the current financial obligation.
3.1Profitability
Profits are the reason businesses exist. The purpose of a company is to maximize shareholder wealth. Other reasons for maximizing profitability are providing money to reinvest in new projects, attracting new investments to raise further capital, growth in profits increase share price giving shareholders capital gains etc.
Profitability is achieved by investing in fixed assets. E.g. if a company manufactures garments and it wishes to maximize profitability, it would have to invest in fixed assets (machinery) to produce more goods and hence increase sales thereby increasing its net profits.
3.2Liquidity
Staying liquid is key to shareholder confidence. If a company faces liquidity problems, that will signal shareholders that the entity may not be able to settle all or immediate future expenditure demands. In the event of liquidation, shareholders are the last to get their share (of what’s left) of the company. Therefore, staying liquid will keep shareholder confidence intact.
Liquidity is achieved by investing in current assets. E.g. cash, debtors, marketable securities etc. Theseare liquid or near liquid assets. Which means they will take less time to convert into cash in need be. In the short term, liquidity is more important than profitability. But in the longer run, it’s importance is less because there is no point in holding on to cash if there is no need.
Liquidity ratios like current and quick ratios of a company when compared with sector average give a sense of perspective to the company whether it is headed in the right direction or not.
3.3Profitability vs. Liquidity
Comparing the two, there is a clear relationship between profitability and liquidity. Excess of either could pose a threat to the survival of the company. A company with high liquidity and low profitability will surely bankrupt in time since it will soon run out of cash to fulfill its financial obligations and profitability being low will not be sufficient to cope up with the shortfall. Similarly if profitability is high but liquidity is low, the organization will not be able to meet its obligations in the short run (paying vendors, suppliers etc). Since all the capital would be tied up in fixed assets, late payments to suppliers will make the survival of a company difficult in the short run and impossible in the long run.
4.Management of Working Capital
Working capital is the capital needed by a business to run its day to day operations. It needs to be financed, just as does the investment in fixed assets. However, it is due to the investment in fixed assets that generate returns and not the investment in working capital (current assets) that directly produce profits. But as discussed above, staying liquid is as important as staying profitable. Therefore the company faces a trade-off between profitability and liquidity.
The goal of working capital management is to ensure that the company stays profitable while staying liquid to satisfy its short term liabilities and operational expenses. It is the job of finance manager to manage cash, payables, receivables and inventories in such a way that neither liquidity nor profitability is compromised in the long run.
In order to manage working capital in such a way that the company stays liquid and the investment in working capital is not impaired, we need to explore the components which make up the working capital cycle.
4.1Cash
If a company is sufficient cash to meet its upcoming requirements, then there is no need for it to further keep adding more liquidity. Short term investments (readily tradable shares, fixed deposit accounts) can be made. Hence, if cash is needed in future, it is readily available.
4.2Inventory
If investment in inventory is high, the company runs the risk of damage, obsolesce etc. Too little investment and there is a risk of customers not being served on time. One way to determine an optimum inventory level is to use the ‘Economic Order Quantity model.’ Also, ‘Just in time’ system is highly efficient effectively cutting down storage costs and providing a ‘demand-pull’ production process.
4.3Receivables
The reason receivables need to be managed is because the business is prepared to sell to all customers on credit. If receivables are high, the extra cost to finance those receivables will be high. Business needs to ensure they are kept under a certain predetermined level. This can be achieved by regular credit checks, review of customer credit limit, stating credit terms and ensuring they are agreed and implemented. Customers are often given early settlement discounts encouraging them to pay early in the future too.
Proper management of these help ensure that the investment in working capital is neither excess not short. This in turn helps the company to keep its liquidity level at a stable level.
5.Financial analysis of Chrisitie
Calculation
Percentage increase in Turnover:
YearCalculationIncrease
2001-2002 2.5-2.0/2.025%%
2002-20032.5-2/2.5(20)%
2003-20049.9-9.6/9.63%
2004-200511.1-9.9/9.912%
2005-200611.4-11.1/11.13%
Percentage increase in Dividend PerShare:
YearCalculationIncrease
2001-2002 9.2-8.5/8.58%
2002-20039.6-9.2/9.24%
2003-20049.9-9.6/9.63%
2004-200511.1-9.9/9.912%
2005-200611.4-11.1/11.13%
Percentage increase in Earnings Per Share
YearCalculationIncrease
2001-2002 9.2-8.5/8.58%
2002-20039.6-9.2/9.24%
2003-20049.9-9.6/9.63%
2004-200511.1-9.9/9.912%
2005-200611.4-11.1/11.13%
Percentage increase in Annual inflation
YearCalculationIncrease
2001-2002 3.4-2.5/2.536%
2002-20033.4-2.4/3.4(29)%
2003-20043.1-2.4/2.429%
2004-20053.4-3.1/3.19%
2005-20063.4-3.1/3.49%
* All figures have been rounded to nearest 1.
5.1Assessment
Generally companies tend to adopt a stable dividend policy with dividend growing at a stable (if not fixed rate) over a period of time. According to dividend irrelevance theory, shareholders don’t mind whether their returns are split between capital gains from rising share price and dividends. But this theory does not hold in reality. In the real world, there are market imperfections like dividend signaling, the clientele effect, impact of taxation and liquidity requirements.
The increase in dividend per share of Chrisitie is consistent with the increase in earnings per share.It’scurrent dividend policy therefore must be to increase the dividend in proportion to the increase in profits. There are a few problems with this approach.
5.2Dividend Signaling
The dividend signaling theory suggests that when a company declares dividend, it gives a signal to the stock market. This signal is seen as a positive sign by investors that the company is profitable (because if it were not, it wouldn’t pay out dividends). Similarly if a company pays less dividends than the previous year, then the signaling effect is negative giving a potential negative impression that the company may be experiencing difficulties.
Chrisitie’s current dividend policy is to increase or decrease dividends based on profits. Profits generally tend to fluctuate over time. If Christie wants to stabilize its growth in dividends and avoid the negative effects of Signaling, it should not base its dividend payout on profits growth.
5.3The Clientele Effect
This theory suggests that a company’s share price will increase or decrease in accordance with the needs and goals of the investors. These needs and goals react to changes in dividend policy, tax and other policies. The clientele effect theory assumes that different investors are attracted to different policies within an organization and shareholders adjust their holdings according to these changes. This in turn drives the price of a share on the stock market.
In light of The Clientele Effect, Chrisitie’s dividend policy will prompt shareholders pursuing stable dividends to withdraw their holdings in the company. Since Chrisitie cannot guarantee stable growth in dividends (because it bases dividends on current year’s growth in profits) share price will also be affected. This in turn will affect shareholders pursuing capital gains.
6Conclusion
Chrisitie should form a dividend policy not solely based on profits. Dividend decision must be taken carefully ensuring stability and reliability. The institutional investors may not accept volatility at this big of a scale. Institutional investors usually attract towards steady and stable growth in dividends.
While forming dividend policy, following considerations must be taken into account.
. Profitability and Liquidity
. Legal and Contractual constraints
. Industry practice
. Shareholders expectations
Since shareholders generally expect stable dividends, Chrisitie should consider increasing its dividend at a lower but stable rate. One that it can afford to achieve even in times of low profits.
References
* Block and Hirt. Foundations of Financial Management.6th edition.Irwin, 1992.
* Brealey, Richard A. Principles of Corporate Finance. NY: McGraw Hill, 2000.
* Brigham and Gapenski. Financial Management: Theory and Practice. 6th edition. Dryden Press, 1991.
* Campsey and Brigham. Introduction to Financial Management.3rd edition. Dryden Press, 1991.
* Emery and Finnerty. Principles of Finance with Corporate Applications.West, 1991.
* Ross, Westerfield, and Jordan. Fundamentals of Corporate Finance.Irwin, 1991.
* Bear, Larry A. and Rita Maldonado-Bear. Free Markets, Finance, Ethics, and Law. Upper Saddle, NJ: Prentice Hall, 1994.
* Block and Hirt. Foundations of Financial Management.6th edition. Richard Irwin & Co, 1992.
* Bowlin, Martin, and Scott. Guide to Financial Analysis. 2nd edition.McGraw-Hill, 1990.
* Brealey, Richard A. Principles of Corporate Finance. NY: McGraw Hill, 2000.
Appendices
* Copeland, Tom, Tim Koller, and Jack Murrin. Valuation: Measuring and Managing the Value of Companies, 3rd edition. New York: John Wiley & Sons, 2000.
* Ehrhardt, Michael C. The Search for Value: Measuring the Company’s Cost of Capital. MA: Harvard Business School Press, 1994.
* Keown, Arthur, J. William Petty, David F. Scott, Jr. and John D. Martin. Foundations of Finance: The Logic and Practice of Financial Management. 2nd ed. NJ: Prentice Hall, 1998.
* Lewellen, Wilbur G., John A. Halloran, and Howard Lanser. Financial Management: An Introduction to Principles and Practice. OH: Southwestern College Pub., 1999.
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