Lecture 9 - Financial Statement Analysis and Corporate Failure(1)

www.bradford.ac.uk/management

Financial Accounting

Module code: MAN2907L

Investor Ratios & Corporate FailureLecture 9

Three “Pillars of Wisdom” for investors

In circumstances where the economy delivers:

• Rising corporate earnings

• Benign inflation and interest rates

• Reasonable valuations

Investment in the stock markets is likely to prove profitable

INVESTOR RATIOS

• RETURN ON SHAREHOLDER'S EQUITY net profit after tax before ordinary dividend

(EATOS) / ordinary share capital + reserves

• EARNINGS PER SHARE net profit before extraordinary items less

preference dividend / weighted average ordinary shares in issue during year

• PRICE/EARNINGS RATIO market price of share / earnings per share

INVESTOR RATIOS - cont.

• DIVIDEND COVERnet profit before ordinary dividend / ordinary dividend

• DIVIDEND YIELD %latest annualised dividend / market price of share (gross or net?)

ILLUSTRATION OF INVESTOR RATIOS

Income statement

Salesless: Costs

Less: Corporation tax

Dividends payableRetained profit for the year

10,000 (6,625) 3,375

(1,200) 2,175

(1,000) 1,175

£,000

Current market price of ordinary sharesMost recent declared dividendNumber of ordinary shares in issue

£3.0010p per share

10 million

Other information:

Earnings per sharePrice earnings ratioDividend coverDividend yield ?

EARNINGS PER SHARE

How much profit has the company made for the investors on each share?

= £2,175,000/10,000,000 = 21.75p

EPS =net profit after tax (EATOS)

average number of ordinary shares issued

PRICE/EARNINGS RATIO

P/E = Price per shareEarnings per share

i.e. - how many years of earnings you would pay for

Shows how long it will take to recover the share price out of profits at current levels

PRICE/EARNINGS RATIO

P/E = current share price / EPS

= 300p/21.75p

= 13.8 times

A high P/E compared to that of similar companies implies that earnings growth is expected

A low P/E compared to that of similar companies implies that flat earnings are expected

PRICE/EARNINGS RATIO

PE – A Measure of Market Confidence

Market price takes into account anticipated changes in the earnings arising from assessment of macro events, such as• Political factors, e.g. imposition of trade embargoes or

sanctions

• Economic factors, e.g. downturn in manufacturing activity

• Company related events, e.g. possibility of organic or acquired growth and the implication of financial indicators for future cash flow estimates.

11

PE Ratio – Implication of Financial Indicators

Statement of Financial Position:• change in debt/equity ratio in relation to prior periods

• new borrowings to finance expansion

• debt restructuring following inability to meet current repayment terms

• adequacy of working capital

• low acid test (quick) ratio in relation to prior periods indicating liquidity difficulties

• change in current ratio in relation to prior periods, i.e. higher indicating a build-up of slow-moving inventory and lower possible inventory-outs

• contingent liabilities that could be damaging if they crystallize – non-current assets being increased or not being replaced

12

Income statement:• change in sales trend

• limited product range, products moving out of patent protection period

• expanding product range

• changes in technology beneficial or otherwise to company

• high or low capital expenditure/depreciation ratio indicating that productive capacity is not being maintained

• loss of key suppliers/customers, e.g. loss of longstanding Marks & Spencer contracts

• change in ratio of R&D to sales

PE Ratio – Implication of Financial Indicators

DIVIDEND COVER & YIELD

Dividend per share £1M / 10M = 10p

Dividend Cover

EPS / DPS = 21.75p / 10p

= 2.1 times

Dividend Yield

DPS / SP x 100 = 10 / 300 x 100

= 3.3%

BELLWARD plc - SUMMARY

EPS 2,175,000 = 21.75p

10,000,000

P:E 300p = 13.8 times

21.75

Dividend cover 2,175,000 = 2.175 times

1,000,000

Dividend Yield 10/300 = 3.3%

What is it?.........

• Administration• Liquidation• Distress• Restructuring

• Refinancing• Takeover

COMPANY FAILURE

• Identification of risk and avoidance - Management• Mitigation of consequences - Investors• Identification of going concern problem - Auditors

PREDICT FAILURE…WHY?

• Study of root causes

• Identify contributory factors

• Statistical modelling

APPROACHES TO PREDICTION

Study of root causes• Business cycle• Major misjudgments• Areas of weakness• Attitudinal problems

APPROACHES TO PREDICTION

Identify contributory factors• Inherent risk• Fast aggressive growth• Youth/size• Dominant personality(s)

APPROACHES TO PREDICTION

(Statistical) modelling• Univariate (traditional)• Multivariate• Z-scores

Financial numbers; combine by ranking/weighting

• A-scores (non-statistical)Financial environment; assesses defects, mistakes and symptoms

APPROACHES TO PREDICTION

Z-scores• Altman• Taffler

A-scores•Argenti

APPROACHES TO PREDICTION

Professor E.I.Altman – 1968Identified five key factors and combined them into a composite multivariate score by using different weightings. The factors related to:

• Profitability• Efficiency/Productivity• Liquidity• Capital structure (gearing)• Asset utilisation

ALTMAN’S Z-SCORE

Z = 0.012X1 + 0.014X2 + 0.033X3

+ 0.006X4 + 0.999X5

X1 is - working capital/total assets (L)

X2 is - retained earnings/total assets (G)

X3 is - operating profit (PBIT)/total assets (P)X4 is - mkt value of equity/book value of debt (G)X5 is - sales/total assets (E)

ALTMAN’S Z-SCORE FORMULA

Over 2.7 OK – under 1.8 bad!

ALTMAN’S Z-SCORE

JJB sports, once Britain’s highest sports retailer, collapsed into administration on 1st October 2012.

Could this have been predicted??

JJB financial statements available on blackboard.

Z = C0 + C1R1 + C2R2 + C3R3

+ C4R4 (‘C’ is secret!)

R1 is - PBIT/ current liabilities (53%)

R2 is - current assets/total liabilities (13%)

R3 is - current liabilities/total assets (18%)R4 is - “no credit interval” – how long can the

company trade with no money coming in (16%)

TAFFLER/TISSHAW Z-SCORE

Over 0.2 OK – under 0.2 bad!

Argenti’s thesis is that most failed companies follow a similar 3-stage ‘path’:• Inherent defects

• company management• accounting systems• response to change

• Major mistakes• over-gearing• overtrading• ‘the big project’

• Final symptoms• poor ratios & a rise in creative accounting

ARGENTI’S A-SCORING

• lacks any underlying theory that is useful to specify the variables to be included in the models

• described as ‘brute empiricism’• is based mainly on historical cost accounts• results in self fulfilling prophecy• is ‘situation specific’• lacks post-analysis evidence• analysis is based upon a distorted balance of failed

and non-failed companies• the future is always ‘different’

CRITICISMS OF MULTIVARIATE ANALYSIS

• ANY QUESTION?