Session 1 Advanced Financial Analysis

DT331-4 / DT370-4 Corporate Finance

Caroline Flynn

Introduction

Lecturer Caroline Flynn Email: caroline.flynn@dit.ie Room: 3053

Recommended Reading: Glen Arnold: Corporate Financial Management, Fourth Edition Denzil Watson and Antony Head, Corporate Finance: Principles & Practice, Fourth Edition
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CRH plc

Annual Report and Accounts for the year ended 31 December 2011

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Contents

Product and Geographic Spread

2011 Highlights Corporate Social Responsibility Chairmans Statement Chief Executives review Operations reviews Finance review Corporate governance Directors report Report on Directors Remuneration Statement of Directors Responsibilities Independent Auditors report Financial statements Accounting policies Notes on financial statements Shareholder Information Principal Subsidiary Undertakings Principal Joint Venture and Associated Undertakings
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Extracts from Audit Report (page 55)

We have audited the financial statements Income Statement Statement of Comprehensive income Balance Sheet Statement of Cash Flows The Accounting Policies Related notes 1-33
In our opinion the financial statements give a true and fair view.. In our opinion the information given in the Directors report is consistent with the financial statements. We read other information contained in the Annual Report and consider whether it is consistent with the audited financial statements. This comprises the Directors report, Chairmans statement, Chief Executives report, Operations reviews, finance review and the corporate governance statement. Our responsibilities do not extend to any other information
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Annual Report

Principal means of communication Produced annually by companies Publicly Available Increasing in size and importance Aimed primarily at shareholders

Needs of other users being recognised

Contains quantitative and qualitative info. Content controlled by statute, regulation

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Annual Report contd.

Narrative and financial elements: financial statements and notes chairmans, directors, auditors reports operating and financial review

Financial elements central Narrative elements increasing in range Supplemented by graphs, photos etc. Annual reports vary significantly in the level of detail provided

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Narrative content

Should supplement financial statements Required by statute: Directors Report Auditors Report Not required by statute Chairmans statement Operating and financial review Chief Executives report Other, e.g. historical summaries

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Chairmans Statement

Not legally required No mandatory content or format A forum for the Chairman to comment on the companys performance and prospects Usually a marketing document that tries to present the companys performance in the best light Usually contains such items as Strategy and Business plans General trading performance Economic climate Significant events Performance of specific businesses Other items of specific interest Corporate Governance Board and Senior Management
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Chairmans Statement cont.

Often presents a personal perspective, sometimes bland, full of management spin and over optimistic aspirations
Properly used, it can shape corporate ethos, objectives and influence shareholders Research shows the Chairmans report as the most widely read section

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Directors Report

Companies Act 1963 - requires directors of a company to prepare a report each year on the performance of the company and on transactions between the company and its directors
Not audited but auditor must report on any inconsistency between the Directors Report and the Financial Statements

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Directors Report should include

A review of the state of the companys affairs The recommended dividend A fair view of the development of the business Any changes in the nature and classes of the companys business Important events since the year end (Including going concern issues) An indication of likely future developments A statement of Principal Risks and Uncertainties Details of Directors (especially remuneration) Corporate Governance disclosure Directors Responsibility Statement (Proper Books of Account)

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Operating and Financial Review

Non Mandatory ASB Statement of Best Practice A balanced and understandable assessment of the companys position Discussion Top Down Operating Results Financial Needs Resources Key Financial Performance Indicators Financial Risk Management (financing, interest rate and Fx) Shareholders Return and Value

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Operating and Financial Review contd.

Clear and succinct Should only include matters that are significant to investors Balanced and Objective Analytical discussion (not merely numerical analysis) Discuss individual aspects of the business Relate ratios / numbers to the accounts Emphasise trends, unusual factors and uncertainties Assist users in understanding future performance Dont mislead users

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Operating Section

Operating results for the period

Dynamics of the business

Investment for the future

Returns attributable to shareholders

Comparison of profits by geography and product line

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Financial Section

Capital Structure and treasury policy Taxation Cash Flow Current Liquidity Going Concern Balance Sheet Value Accounting Policies

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Additional Stock Exchange Requirements (listed companies)

A statement from the directors explaining any significant departure from standard accounting practice
Explanation of the trading results being materially different from any published forecast Geographic analysis of turnover and contribution to trading results of those trading operations carried out by the company outside the UK and Ireland

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Additional Stock Exchange Requirements (listed companies)

Disclosure of principal country of incorporation of each subsidiary

Interests of the directors in the shares of group companies Details of substantial (3%) shareholdings in the company by any person Contracts in which a director was materially interested Many directors reports refer to issues of Corporate Governance including directors responsibility statements, audit committees, Remuneration committees

UK Corporate Governance Code Irish Corporate Governance Annex SOX

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Other elements

Some Annual Reports now include report by CEO, pg 11 CRH allows CEO to communicate with users supplements Directors Report and Operating and Financial Review
Historical summaries not required by statute usually summarise 5-year performance often tabular / graphical presentation

Human Resources / Employee Report

Corporate Social Responsibility Report (separate publication) also pg 6

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Summary

Annual Report - a principal means of communication

Narrative element: Substantial Evolving in type and range Partly controlled by statute Open to abuse / manipulation

Critical to any informed analysis

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Big Picture first

Need for an extremely inquisitive and enquiring frame of mind. Industry, Business and Strategic Analysis Profitability Growth Balance Sheet strength Investor Returns
Some issues will be quickly evident For example, that a company has made losses in the past two years; or it has a declining sales turnover or a large overdraft; or a greatly increased accounts payable figure.

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CRH 2011 Overview

2007 m Revenue 20,992.0 12.0% 1,438.0 17.5% 8,020.0 12.9%

2008 m 20,887 -0.5% 1,262 -12.2% 8,157 1.7% m

2009 m

2010

2011

17,373 -16.8% 598 -53% 9,710 19.04%

17,173 -1.2% 439 -26.6% 10,411 7.2%

18,081 5.3% 597 36.0% 10,583 1.7%

Profit after Tax

Equity / Net Assets

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Main Benefits of ratio analysis :

Data is summarised in a standardised, easily understood form They enable industry comparisons to help identify strengths and weaknesses and make investment decisions They facilitate comparison over time They downplay absolute and concentrate on relative figures (helps compare companies of different size) They allow assessment of stability, financial strength and identification of specific problems They are useful for those seeking to review business changes and overall reasonableness (auditors, financiers etc.)
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Compare like with like

Comparing current financial ratios with:

financial ratios for a preceding period;

budgeted financial ratios for the current period;

financial ratios for other profit centres within the company; financial ratios for other companies within the same sector.

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Importance of uniformity

Comparison is possible only if there is

Uniformity in the preparation of accounts; and An awareness of any differences international accounting policies

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Need to understand how ratios are defined

Implications of any given ratio requires a clear definition of its constituent parts.
Definitions of ratios may vary from source to source e.g. concepts and terminology are not universally defined.

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Use of ratios

Only one part of the process:

Calculation

Analysis
Interpretation

Decision-making

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Limitations of Ratios NB *

Only as good as the figures they are based on and they vary in accordance to the method used. Either figure can alter the ratio.
They do not themeselves provide financial control. The comparison of specific ratios only can ignore changes in magnitude/volume. They need trends to be useful and therefore limited in early stages of an organisations life cycle or where changes in accounting policies have occurred. There is a danger of ignoring qualitative factors such as business differences and market factors.
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Limitations of Ratios NB *

There is a danger of assuming that there is an ideal level to which a business must aspire.
Timing issues

Creative Accounting and Window dressing

Statistical issues: negative numbers small numbers numerator/denominator

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Ratios

Reduce information to common form Enable inter-firm comparison

Categories: Growth Profitability Liquidity/Working Capital Activity Financing Investment

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CRH 2011 - Growth

Growth (Revenue) (18,081-17,173)/17,173 5.3%

Growth (Total Assets) (21,387-21,461)/21,461 -0.3%

Growth (Total Liabilities) (10,804-11,050)/11,050 -2.2%

Growth (Net Assets) (10,583-10,411)/10,411) 1.7%

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CRH 2011 - Profitability

Gross Profit Margin (4,902/18,081)

2011 27.1%

Gross Profit Margin (4810/17173)

2010 28.0%

Net Profit (PBT) Margin (711/18,081) 3.9%

Net Profit (PBT) Margin (534/17173) 3.1%

Net Profit (PAT) Margin (597/18,081) 3.3%

Net Profit (PAT) Margin (439/17173) 2.6%

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CRH 2011 Rate of Return

2011 Return on Capital Employed (926+42)/(21,387-3,709) 5.5% Return on Capital Employed (753+28)/(21461-3739)

2010

4.4%

Return on Equity (590/10,509) 5.6%

Return on Equity (432/10328) 4.2%

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CRH 2011 Interest Cover and Dividend Cover

2011 Interest Cover (926)/(262-33) Interest Cover 4.04 times (753)/(255-37)

2010

3.45 times

Dividend Cover (590/445)

Dividend Cover 1.33 times (432/438) 0.99 times

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CRH 2011 Current Ratio / Quick Ratio

2011 Current Ratio (6,305)/(3,709) 1.70 to 1 Current Ratio (6499/3739) 1.74 to 1 2010

Quick Ratio (6,305-2,286)/(3,709) 1.08 to 1

Quick Ratio (6499-2187)/3739 1.15 to 1

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CRH 2011 Working Capital ratios

2011 Inventory Turnover Ratio (13179/2286) Inventory Turnover Ratio 5.77 times (12363/2187) 5.65 times 2010

Inventory Days (2286/13179)*365

Inventory Days 63.31 days (2187/12363)*365 64.57 days

Trade Receivable Days ((1879+417)/(18081))*365

Trade Receivable Days 46.35 days ((1700+342)/17173)*365 43.40 days

Operating Cycle (63.31+46.35)

Operating Cycle 109.66 days (64.57+43.40) 107.97 days

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CRH 2011 Working Capital ratios

2011 Trade Payable Days (1579 /13179)*365 43.73 days Trade Payable Days (1376/12363)*365 40.62 days 2010

Cash Cycle (109.66 -43.73)

Cash Cycle 65.93 days (107.97-40.62) 67.35 days

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Working Capital

Working Capital section provides important information relating to liquidity Combined with trading figures it highlights management activity/efficiency All measures relate to cash management This is a critical management function Need to be able to pay debts as they fall due otherwise leads to going concern / liquidity problems.
Cash is King!

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CRH 2011 Gearing ratios

2011 Gearing (7095)/(7095+10583) 40.1% Gearing (7311)/(7311+10411)) 41.3% 2010

Interest Cover (926)/(262-33) 4.04 times (753)/(255-37)) 3.45 times

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Financing

Manner in which an entity funds activities Long-term focus Financial structures of firms vary Financial stability a critical consideration often directly related to funding structure excessive external funding often compromises Range of long-term sources

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Equity v Debt Debate

Borrowed funds provide a firm with a tax shield, as interest on debt is tax deductible. Additionally the use of debt preserves control of the firm in the hands of the existing shareholders as opposed to an issue of new ordinary shares which dilutes control. An over-reliance on debt can jeopardise a firms survival if profits decline. Interest on debt is a fixed obligation, whereas dividends to shareholders are paid on a discretionary basis.

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Dont allow use of a ratio to obscure awareness of underlying trends

ROCE remains a constant 10% over the years 20X920X11 Net profit increased by 50% in both 20X10 and 20X11 This trend is not ascertainable in the ROCE ratio.

20X9 20X10 20X11

Net profit Capital employed 100,000 1,000,000 150,000 1,500,000 225,000 2,250,000

Return on capital employed 10% 10% 10%

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P/E a measure of market confidence

Market price also takes into account anticipated changes in the earnings arising from their assessment of macro events such as:

political factors, e.g. imposition of trade embargoes and sanctions; economic factors, e.g. the downturn in manufacturing activity; companyrelated events, e.g. possibility of organic or acquired growth and the implication of financial indicators for future cash flow estimates.

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Cash Flow Statement CRH y/e 31 December 2011

Profit before Tax Net cash inflow from operating activities Net cash outflow from investing activities Net cash (outflow)/inflow from financing activities (Decrease) / increase in cash Cash at 1 January translation adjustment Increase / Decrease in Cash Cash and cash equivalents at 31st December
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2011 711.0 1,026.0 (634.0) (838.0) (446.0) 1,730.0 11.0 (446.0) 1,295.0

2010 534.0 1,391.0 (607.0) (498.0) 286.0 1,372.0 72.0 286.0 1,730.0
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Use of Ratios

Ratios should be subject to comparison Past Performance (Current year Vs Prior years) Budgets and Forecasts (As set by management) Similar Firms Industry Averages

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Liquidity Ratios

Current Ratio Current Assets Current Liabilities

Acid Test Ratio, (Quick Ratio, Liquidity Ratio) Current Assets less Inventory Current Liabilities

Trade Receivables Ratio (Trade Receivables Days) Trade Receivables * 365 Credit Sales 1

Trade Payables Ratio ( Trade Payables Days) Trade Payables Credit Purchases * 365 1

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Efficiency Ratios / Profitability

Return on Capital Employed (ROCE or ROI)

PBIT * 100 Net Operating Assets (NCA+CA-CL) 1 OR PBIT * 100 Capital Employed ( OSC+Reserves+Long term Liab) 1

Asset turnover
Sales Capital Employed

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Efficiency Ratios / Profitability Cont.

Gross Profit Margin Gross Profit * 100 Sales 1

Net Profit Margin Profit before interest and tax Sales * 100 1 Inventory days Inventory * 365 COGS 1
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Inventory Turnover Cost of Goods Sold Average Inventory (or inventory)

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Growth Ratios

Year on year growth in

Revenue Profit before tax Non Current Assets Capital Employed

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Investment Ratios

Earnings per Share (EPS)

Earnings after tax, after pref. dividend and after MI Number of Ordinary Shares

Earnings Yield

EPS Market price per share

Price Earnings Ratio (P/E ratio) or

P/E ratio Total Market Value of Equity Total earnings on a net basis

Share Price EPS

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Investment Ratios Cont.

Capital Gearing Ratio

Long term Debt Long term Debt + Equity

Dividend yield

Gross dividend per share Market price per share

Dividend Cover

PAT and preference dividends Ordinary Dividends

or

EPS Ordinary dividend per share

Interest Cover

PBIT Interest Charges

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Cash Flow

Quality of profits Summarised Cash Flow Statement Ability to cover cash dividends Ability to cover Interest Expense Ability to cover repayments

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Perspective of Different User Groups

Managers All aspects of performance and financial position Shareholders Investment ratios Financial stability Profitability Dividend potential Growth potential Creditors Financial stability Liquidity Profitability

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Commenting on a ratio NB *

What does the ratio literally mean

What does a change in the ratio mean What is the norm Past performance Budgets and forecasts Similar firms Industry averages What are the limitations of the ratio

What further information would be required to present a fuller analysis.

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Return on Capital Employed - ROCE

Often the most important measure of profitability Shows how well an organisation is using its resources A low ROCE may indicate that the business would be better off realising its assets and investing in an interest bearing account A low return could turn into a loss if there is a small downturn Compare with Previous years Target ROCE Cost of borrowings Other companies in the same industry
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Return on Capital Employed - ROCE

Watch for differing accounting policies (eg. Revaluations) Age of Non Current Assets Operating leases Note which component of the ratio has changed Need to determine whether its due to good profits or to an undervaluation of capital employed.

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Gross Profit Margin

Margin % Would be expected to remain constant in a mature business

A change may result from Change in selling prices without a proportionate change in purchasing and production costs Changes in the sales mix Purchase costs Production costs Stock valuation issues Changes may be planned or unexpected Intercompany comparisons need to focus on same sector Always consider the industry
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Net Profit Margin

Net Margin % Affected by more factors than gross profit Need to identify what element has contributed to a change Which expense heading has increased out of proportion

Profit margin and asset turnover

It might be tempting to think that a high profit margin is good and a low asset turnover means sluggish trading, In broad terms this is so but there is a trade-off between profit margin and asset turnover and you cannot think of one without allowing for the other. A high profit margin means a high profit per euro of sales, but this also means that if sales prices are high, there is a strong possibility that sales will be depressed, so that asset turnover will be lower. A high asset turnover means that the company is generating a lot of sales, but to do this, it might have to keep its prices down and so accept a low profit margin.
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Inventory Turnover

It is a measure of how many times inventory is turned over in a year. It can also be expressed as the number of weeks /months inventory is held by a company.
Where inventory is turning over more slowly Demand may be diminishing Stock control issues Potential obsolescence, increased stock write-offs, Stock holding costs Too low an inventory level may also be bad Risk of stock outs Failure to realise bulk purchase discounts Stock turnover levels vary enormously with industry There may be unusual year end variations

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Trade Receivable Days (Debtor Days)

This ratio can be used to measure the

number of days credit given/taken

by customers.

Take industry into consideration Increasing debtor days usually implies credit control problems May be deliberate in order to win new business One or two major customers can distort the ratio Can be distorted by unrepresentative year end figures Debt factoring can distort ratio (Substance over Form) Be aware of the impact of bad debt write-offs Changes in credit control procedures will take time to have an effect on the core older debts.

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Trade Payable Days

This ratio identifies the number of days credit received (or taken) from

suppliers.

Can be difficult to calculate and interpret as the creditors figure used should relate exclusively to cost of sales Cost of Sales is used as the denominator where purchases is not known Creditors are seen as a free source of finance An increasing credit period may indicate liquidity problems Settlement discount opportunities may be missed Reputation and buying power may be suffering

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Liquidity Ratios

Liquidity is the amount of cash a company can obtain to settle its debts (and possibly to meet other unforseen demands for cash payments too). Profitability is an important aspect of a companys performance as are debt or gearing. However neither address the key issue of liquidity. A company needs liquid assets so it can meet its debts as they fall due. A company can be profitable but at the same time get into cash flow problems e.g. IS contains sales for which cash has not yet been received. Liquid funds consist of: Cash Short-term investments Fixed term deposits Bills of exchange receivable Liquid assets are current asset items that will or could soon be converted into cash, and cash itself. For certain companies this may include inventory.
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Liquidity Ratios

A figure between 2:1 and 1.5:1 would normally be regarded as an acceptable current ratio
A figure between 1:1 and 0.7:1 would normally be regarded as an acceptable quick ratio But be careful of applying such rules of thumb in all circumstances Consider the norm for the business / industry

High liquidity ratios may indicate excess funds tied up in working capital (inventories, trade receivables, cash) or that liquidity is being prioritised over the need to invest capital in the business itself.

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Liquidity Ratios

Availability of further finance might appease liquidity concerns (eg overdraft facility)
Seasonal nature of the business can distort ratios Long term liability commitments can also contribute to liquidity problems Always check for the component causes of any change in a ratio Where liquidity has changed try to identify the key causes

Inappropriate sources of finance Working Capital issues

Watch for overtrading (expanding too rapidly resulting in increased requirement for working capital which is not appropriately financed)
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Long Term Financial Stability

Correct gearing can improve profitability where ROCE is higher than borrowing costs Highly geared companies are more sensitive to fluctuation in economic conditions High gearing usually implies risk Companies with relatively stable profits can afford to be highly geared Lender covenants may restrict gearing

Interest Cover is also a good guide to long term stability and risk

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Investor Ratios

Price earnings PE ratio is the most widely used investor ratio A High P/E ratio can be due to expectation of significant growth in earnings or because it is a less risky company Enables comparison of companies in different sectors, markets, etc. Differing levels reflect the stock market expectations as to risk, growth, future performance etc. Most companies strive for a steadily increasing trend in earnings per share Dividend yield allows an investor to compare the return with other potential investment opportunities Dividend cover allows investors to predict future dividend levels (or at least try to) If interest rates go up, investors will be attracted away from shares and into debt capital. Share prices will fall and so P/E ratios will fall.
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Non Financial Performance Measures

Market Share Customer satisfaction Customer Base Manufacturing lead times Output per employee Staff Turnover Staffing levels Absenteeism Industrial unrest

Environmental performance

To the extent that these measures are unregulated and voluntarily disclosed, they may not reflect the complete unbiased picture

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Post Balance Sheet events

Post balance sheet events are those events both favourable and unfavourable which occur between the balance sheet date and the date on which the financial statements are approved by the board of directors. Examples include: Mergers and acquisitions The issue of new shares and debentures The purchase and sales of major fixed assets and investments Losses of fixed assets or stocks as a result of a catastrophe such as fire or flood A decline in the value of property and investments held as non current assets Strikes and other labour disputes

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Overtrading NB *

Overtrading occurs when a business tries to do too much too quickly with too little long term capital (Growing too fast).
Problems stem from the fact that the business does not have enough capital to provide the cash to pay for its debts as they fall due.

Symptoms: Rapid increase in turnover with no increase in long term capital Rapid increase in current assets Only a small increase in owners capital through retained earnings Increase in working capital financed by trade payables and bank overdraft Debt ratios and liquidity ratios alter dramatically Solutions New equity injection Improved control over inventory and trade receivables More controlled growth plans Financial forecasting to determine requirements
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Causes of Business Failure NB *

The main causes of business failure are as follows:

Ineffective management of resources (working capital, staff, assets).

Application of short term solutions to long term problems e.g. sources of finance (higher monthly repayments result in liquidity problems) Long term loss making situation Inadequate planning leading to inadequate resources or failure to respond to events in the marketplace Specific problems during growth periods of OVERTRADING, INFLEXIBLE COST STRUCTURE etc. OVERGEARING AND LAUNCHING A PROJECT WHICH IS TOO LARGE ALSO PROBLEMATIC
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Questions to ask (and answer) NB *

Is this business growing or contracting Are some areas growing whilst others arent Is profitability improving What is the dividend history What is the likely future dividend pattern Are there any recent acquisitions or discontinued activities What are the key segments of the business Are some segments underperforming What do we know about the economic climate for these businesses Is this company bucking the trend (Worldcom and fraud) What are the key expenditure categories (payroll, materials, depreciation, marketing) Are these well controlled
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Questions to ask (and answer) NB *

Does the business generate cash How is this cash used Is there a cash flow problem Can the business pay its debts as they fall due How well is working capital managed How is the business financed Are there any financing issues that should be addressed Any exposure to current / future risks (international economic climate, exchange risk, over-reliance on markets which are under threat) How is that industry perceived Any current opportunities Should I invest in this company Should I lend to this company Should I supply goods to this company Should I purchase from this company Should I work for this company
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Report Writing NB *

In analysing performance, always bear in mind the attributes of the reader / audience

Ratios and calculations should be clear, easy to follow and in an appendix

Both the report and the appendices should be structured, with sensible use of headings and page breaks to ease reading and enable the reader to follow the information Reports should include an introduction and a structured analysis followed by conclusions or recommendations Dont just give the information, interpret it. Present a document that you would be happy to deliver to your managing director, client, potential lender, audit partner, etc.
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Balanced scorecards Four perspectives

Financial perspective How do shareholders see us? Return on capital employed Cash flows Project profitability Customer perspective How do customers see us? Price Quality Guaranteed supply Internal business perspective How well will we compete? Staff morale New business from innovation Innovation and learning perspective What do we need to be best at? Presenting to potential customers Tendering success rate

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Review Questions
1
Explain how the reader of an annual report prepared for a group might become aware if any subsidiary or associated company was experiencing: (a) solvency problems; (b) profitability problems.

2 (a) Explain the uses and limitations of ratio analysis when used to interpret the published financial accounts of a company. (b) State and express two ratios that can be used to analyse each of the following: (i) profitability; (ii) liquidity; (iii) management control. (c) Explain briefly points which are important when using ratios to interpret accounts under each of the headings in (b) above.

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Review Question 3 As well as the (Statement of financial position) balance sheet,

(Statement of Comprehensive Income) Income Statement and cash flow statement, a companys annual report and accounts contain other useful information. Discuss the interpretative importance of the report of the directors, the chairmans statement, group structure information, employee statistics, geographical and activity breakdowns, and other supplementary information.

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