Company Analysis

Jelena Stanojevic

3. Business and Financial Analysis

3.2 Planning cycle

Management s key tasks:  Set the framework (Goals, objectives, strategies and company policies)  Initiate new activities (New products, markets or new sales channels)  Interpret results (Analysis of relevant information including reflection and the drawing of sound business conclusions to facilitate growth and performance improvements)  Initiate changes (Implementing new initiatives or upgrading the business infrastructure and/or operating procedures for the business to meet its objectives)

The Planning cycle

Analysis PEST, Porter, Value Chain and Financial Analysis

Data Collection Accounting, internal statistics and external data

The Plan The Business Plan and Budget

Actions Implementation of Plan

3.3 Financial analysis

Financial Analysis is conducted internally in the company to identify the company s strengths and weaknesses. Financial Analysis is used from a more external point of view for a number of reasons: 1. To assess the performance of a customer or supplier 2. To assess performance of a takeover target or a potential investor in one s own company 3. To assist in investment decisions of various kinds (buying shares in other companies)

The purpose of financial analysis

The purpose of the financial analysis is to gain an understanding of the major issues for the company: Profitability - company s ability to generate return on the invested capital Earnings Capacity - company s effectiveness in converting revenue to profit (return) Capital Adjustment - adjusting capital base in line with the changing activity levels Solvency - ability of the company to pay its debts Liquidity - company s ability to honor its short-term debts

Summarized suited P&L statement

First Step If needed, we must reorganize Profit & Loss for analytical purposes, seperating variable cost from cash period cost (fixed cost excluding depreciation)

 For a full financial analysis the financial accounts must be in (or adapted to) the right format:  Variable cost seperate (independently of which function they belong to)  Marketing fixed cost seperate  Remaining external fixed costs  Depreciations  Interest income  Interest expense  Extraordinary items

3.4 Financial Ratios

What Does Ratio Analysis Mean? A tool used by individuals to conduct a quantitative analysis of information in a company's financial statements. Ratios are calculated from current year numbers and are then compared to previous years, other companies, the industry, or even the economy to judge the performance of the company. There are many ratios that can be calculated from the financial statements pertaining to a company's performance, activity, financing and liquidity.

3.4.2 Need for comparison Past periods Planned Performance Similar businesses

 Steps for the financial analysis 1. Calculation of ratios 2. Interpretation of ratios 3. Evaluation of results While making comments we focus on: The direction of speed of the change. How large is the change? Is it positive or negative? The level of the ratio and basis for comparison The cause of the development

3.4.4 Profitability ratios

Return on investment (ROI) - Return on Assets (ROA) ROI = Profit before interest*100 Average Total Assets This ratio expresses the relationship between the profit generated by the business and capital employed. Shows the percentage of profit that a company earns in relation to its overall resources (total assets). Return on assets is a key profitability ratio which measures the amount of profit made by a company per dollar of its assets.

 Total assets can be year-end only or average of opening and closing balance, but whatever you use it must be used consistently. THIS APPLIES TO ALL THE FOLLOWING KEY FIGURES! Page #160 in the text book
ROI = Profit before interest*100 ____18,389*100______ = 12.1 % Average Total Assets (149,797 + 154,608) / 2

This tell us that the company earned $0.121 for each $1 in assets. As a general rule, anything below 5% is very asset-heavy (manufacturing, railroads), anything above 20% is assetlight (advertising firms, software companies).

Profit Margin Ratio (PMR) - Return on Sales (ROS) PMR = Profit before interest*100 Net Turnover This ratio shows how efficiently the company controls its cost. It tells us the % of the turnover left to cover net interest expenses, tax expenses and profit. P#161 in your text book. PMR = 18,389*100 = 7.2% 255,440 This tell us that 7.2% of turnover is left to cover net interest expenses, tax expenses and profit.

Return on Equity (ROE) ROE = Profit before tax*100__ Average Owner s Equity This ratio measures the return generated on the owner s level of investment in the business or the profit available to the owners Page #163 in the text book ROE = ____16,029*100______= 28.7% (56,059+55,480)/2 This means that the owners of the company get return on their investment of 28.7%.

Asset Turnover Ratio (ATOR) ATOR = ___Net Turnover___ Average Total Assets This ratio examines how effectively the company s assets are employed in generating sales. It measures the amount of net turnover generated by each euro worth of assets employed in the business. P#162 in your text book.
ATOR= _________255,440______ = 1.68 times (149,797+154,608)/2

This shows that in the course of a year the company turns its assets around 1.68 times or that each euro invested in the company creates 1.68 Euro of turnover.

Return on Debt (ROD) ROD = Interest expenses*100 Average Total Debts ATD=(Opening Total Assets - Owners Equity + Closing Total Assets - Owners Equity)/2 ROD, also called Creditors Return expresses the average rate of interest paid to the creditors. Page #164 in the text book ROD =________3,360*100____________= 3.5% (149,797-56,059+154,608-55,480) This means that the average interest cost in 2004 ran at 3.5%. The ratio should be lower than ROI. The higher the rate, the poorer the debt structure, or the higher the risk perceived by creditors/lenders.

The debt/equity ratio (D/E Ratio or Gearing ratio) D/E Ratio = _Total Debt__ Total Equity Total Debt here is Total liabilities less owner s equity This ratio defines the finding structure as divided between funds provided by the owners and funds provided by third parties such as banks and creditors. Page #165 in the text book D/E Ratio = (149,797-56,059) = 1.67 56,059 A ratio above 1 signifies growing financial risk.

Relationship betwee ROI,PMR and ATOR

DuPont equition: ROI = PMR * ATOR ROI = 7.2*1.68 = 12.1% , which is same as we calculated earlier DuPont Pyramid

ROI,ROE,ROD and Debt Equity Ratio

If ROI > Return on Debt or ROE > ROI then there will be a profit on creditors (Debt) If ROI < Return on Debt or ROE < ROI then there will be a loss on creditors (Debt) For good financial picture good ROI is needed

Ratios: A word of caution!

1. The level of ratio should be benchmarked against a relevant alternative 2. The direction over time 3. DuPont hierarchy Although ratios (key figures) are not difficult to calculate, they can be difficult to interpret . Page#168 Conslusion and tables

3.4.5 Earning Capacity

The earning capacity measures the operational performance of the business, that is company s ability to generate profit from its sales (turnover). The following ratios are used to assess company s earning capacity: 1. Profit Margin Ratio (PMR) (Already explained) 2. The Contribution Margin (CM%) 3. The Capacity Ratio

The Contribution Margin Ratio It measures the profitability in selling or procuring goods for sale, before any other expenses than variable cost are taken into account. CM=Net Turnover Variable Cost CM%=Contribution Margin*100/Net Turnover (P#171 in your text book). CMR=137,100*100=53.7% 255,440 The figure shows that 53.7% of the turnover is left to cover the fixed cost and the profit.

The CM Ratio may change because of: 1. Change in selling price 2. Changes in the cost price for the goods sold 3. Changes in the mix of goods sold (higher or lower profit margin taking a greater portion or sales) 4. Changes in the combinations of the aspects mentioned above

Gross Profit Percentage Trading companies only Gross Profit % = Gross profit * 100 / Turnover It shows the profit on goods sold and it covers: Freight, Insurance, and other costs for the goods until they are ready for sale. Sales commission is not treated as part of COGS.

Capacity Ratio Capacity Ratio= Contribution margin Fixed Cost Fixed Costs = Promotion expenses + Cash capacity costs + Depreciation + (Interest) It is factor not percentage Page#173 in your text book CR = ______137,292_______ = 1.15 4,000+104,883+10,020 Each Euro spent on fixed cost has generated 1.15 Euro of contribution margin. The higher ratio the better and should remain above 1. Below 1 the company is loosing money.

Indexes Index=The figure for the year * 100 The figure for the base year Example: Hansen A/S 2003 Turnover 100 Cash Period Cost 100 Depreciation 100 Interest 100 Example P#174

2004 85 102 98 111

3.4.6 Capital Adjustment Analysis

Capital efficiency ratios examine how company manages its resources The following ratios consider some of the more important aspects of resource management: Asset turnover (This ratio has been already explained) Stock turnover Trade debtor s turnover Trade creditor s turnover

Stock Turnover Ratio (STR) A ratio showing how many times a company's inventory is sold and replaced over a period. STR = Production Cost or Cost of Sales Stock at the end of the year This ratio expresses the number of times the stock is turned over. The higher the better Number of days on average the stock is held: Stock Turnover Period=_______360_______ Stock Turnover Ratio

(P#178 in your text book) STR = Production Cost or Cost of Sales Stock at the end of the year STR = 151,561 = 5.5 times 27,473 This means that that stock on average is replenished 5.5 times during the fiscal year The stock turnover period = 360 = 65 days 5.5 This means that average stock is equal to 65 days worth of output

Trade Debtors (Account Receivables) Turnover Ratio It measures the average number of times per year it takes for the business to collect its debts (Page#179 in your text book) Trade debtors turnover ratio = Turnover*1.25 Debtors = 255,440 * 1.25=8.8 times 36,334 Trade debtors turnover period = ______360___________ Trade debtors turnover ratio It measures the speed of payment in number of days

Trade Creditors (Account Payable) turnover ratio TCTR = ____Purchases on credit * 1.25 _ Trade Creditors at the end of the year TCTR = 73,327*1,25 = 4.4 times 20,940 This ratio measures how many times a year the creditors on average are turned over Trade creditors turnover period = 360 = 360 = 82 days TCTR 4.4 Trading company = COGS + stock end of year - stock beginning of the year (P#180 in your text book)

Cash to Cash Days (operating cycle) The time over which the company has to fund the operating cycle, covering stock, debtors less creditor days. Total Fixed and Tangible Fixed Asset Turnover The amount of sales generated for every Euro's worth of assets. It is calculated by dividing sales in Euros by fixed assets in Euros. Total Fixed = __Net Turnover_ = 255,440 = 3.3 times Asset Turnover Total Fixed Assets 76,820 Tangible fixed = Net Turnover Assets turnover Tangible Fixed Assets (P#181 in your text book)

3.4.7 Evaluation of the financial position of a firm

Risks
Operating risk exists if there are factors which could cause costs to increase. Companies are particularly vulnerable to operating risks when they have a relatively high level of fixed costs. Financial risk exists where the company has a financial structure, especially in long-term loans, where it cannot relinquish its commitment. Total risk = Operating risk * Financial risk

Solvency - Companies ability to carry losses Solvency ratio = Equity * 100 Total Assets The more capital the company has, the better ability to sustain a loss, and more creditworthy the company will be. Solvency ratio> 50% is considered to be very good. Solvency ratio = Equity*100 = 56,059*100 = 37.4% Total Assets 149,797 This means that 37.4% assets can be lost before creditors risk a loss (Page 185 your text book)

Gearing ratio Gearing ratio = Creditors = Debt__ Capital Equity A general term describing a financial ratio that compares some form of owner's equity (or capital) to borrowed funds. Gearing is a measure of financial leverage, demonstrating the degree to which a firm's activities are funded by owner's funds versus creditor's funds.

 The higher a company's degree of leverage, the more the company is considered risky. As for most ratios, an acceptable level is determined by its comparison to ratios of companies in the same industry. A company with high gearing (high leverage) is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are. A greater proportion of equity provides a cushion and is seen as a measure of financial strength.

Liquidity Liquidity is the company s ability to meet its short term debts and financial commitments (Paying the bills). Current ratio = Current Assets*100 = 72,977*100 = 100.5% Current Liabilities 72578 (P#186 in your textbook) Acid Test Ratio or = Current Assets - Stock*100 Quick Ratio Short Term liabilities =(72977-27473)*100=62.7% 72578 (P#187text book )

Cash flow statement A measure of an organization's liquidity that usually consists of net income after taxes plus noncash charges against income Shows what happens to the profit and how the company has financed its operations and how resources have been used. Shows the funds available at the opening and closing of the year. The cash flow statement shows: Sources: Sources of funds - Applications: how they were used during the period = Increase or decrease in funds for the period

 Cash flow is affected by: 1. Cash from operations 2. Cash from Investments 3. Cash from financing Operating activities are the actions of buying and selling, manufacturing goods or providing services. Investing activities are buying and selling fixed assets. Financing activities are the actions of raising and repaying the long-term finance of the company

The influence on liquidity can be illustrated like this: Liquidity Increase in stock/inventory Increase in trade debtors Increase in trade creditors Increase in other creditors + +

3.5 Business Analysis

Financial analysis alone cannot stand alone as comprehensive understanding of company s situation. External Analysis Macro environmental Factors Micro Factors PEST Analysis 1. Politics 2. Economics 3. Society 4. Technology

Micro Factors by using Porter s 5 competitive forces

MARKET STRUCTURES -Monopoly -Oligopoly -Monopolistic Competition -Perfect Competition

Internal Analysis Aims to identify the strengths and the weaknesses of a company. In this respect the following analysis can be used: 1. 2. 3. 4. A buying behavior analysis A value chain analysis A financial analysis A business structure and management review

1. A buying behavior analysis An assessment of the company s competitive capabilities for each of the business segments and distribution channels reviewed. A survey can be carried out to collect the data about: a) Customer s buying criteria b) The company s capabilities in serving each of these Buying criteria c) Competitor's capabilities in serving each of the buying criteria d) The Cost/Benefit of serving the desired criteria

2. A value chain analysis The analysis helps to identify Critical Success Factors- the key success factor to win the market. T = TR (income)-TC 4. A business structure and management review a. Technology b. Management c. Organizational structure d. Staff review e. Cultural Review f. SWOT Analysis

Assessing the Market Attractiveness of Business Opportunities

Market Potential
Selective Strategy Very Attractive

LOW

Competitive Intensity
HIGH

Not Attractive

Selective Strategy

LOW

HIGH

High Potential combined with Low Competitive Intensity signifies high attractiveness Low potential combined with High competitive Intensity signifies low attractiveness

Economics provide several tools to analyze each of two dimensions 1.Market Potential Market projections The Product Life Cycle Projection The macro environmental drivers or threat factors Profit Level (rate) of the Opportunity 2. Market Projection An assessment of the market's size; the bigger the more attractive The expected growth of the market

Product Life Cycle (PLC)

How to measure- Business, Product and Project Profitability

Profitability is a key ingredient in the most objectives and goals. (profit)= TR (sales turnover) - Production Costs - Development Costs - Distribution and Sales Cost - Administration Costs - Financing Costs - Income taxes

Profit measures
Sales Turnover - Variable Costs= Contribution Margin Sales Turnover Direct Costs - of all other costs = Estimated Profit Contribution Margin VS the Activity Based Costing Method Page # 209 in your text books Adjusting Cash tied up in stock, Debtors (Assets) Spending cash which could be used elsewhere to generate profit Opportunity cost of capital is the expected rate of return forgone by bypassing of other potential investment activities for a given capital. It is a rate of return that investors could earn in financial markets. Key measurements of profitability: ROA/ROI, ROS/PMR, ROE, ATOR, ROD,D/E ratio ; Dupont ROI=PMR X ATOR

Pricing Setting the right price

Pricing in general Finding optimum price (The Supply decision CH 3) Using Total Model The Marginal Approach

Pricing Methods
1. Target Pricing Obtaining a specified ROI Text book p#216 a. Estimated demand of 1000 Chairs b. TC is 1000 DKK per chair c. Investment in production and sales is estimated to be 500,000 DKK d. ROI=20% = 100,000DKK e. TC=1 mill. + 100,000 DKK of profit = 1.1 mill. f. Sp=1100 All costs are included and used in TC

 Target pricing- Target Costing ( Automotive companies in Japan)

2. Mark-Up Pricing Two questions: Which Cost and What Mark-Up factor? 3. Pricing to improve the market share Volume and Market share being primary objective

4. Pricing to fit into a given Price Bracket (Restaurants) 5. Pricing to attract customers towards new service ex. E-business 6. Auction Pricing (EBAY) 7. Pricing to eliminate competition or specific competitor (Predatory pricing)