lecture 9 - financial statement analysis and corporate failure(1)
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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.
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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
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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?