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Ufa#Ed 2#Sol#Chap 06
Ufa#Ed 2#Sol#Chap 06
6.1
A potential shareholder is interested in the future prospects of the company with regard to growth and
profitability. This is considered relative to other companies which are potential investment targets. The
use of technical analysis may be considered if the company is listed, but the most significant analysis
will be the use of fundamental analysis.
Information will be gathered with regard to the economy, both globally and locally.
Information will be gathered with regard to the industry in which the company operates
Information will be gathered with regard to competitors
Select the appropriate ratio’s. An in depth analysis will require that all aspects of the company be
considered, over a period of at least the three previous years. These would include ratio’s with regard
to:
Profitability – Margins, mark-ups and returns on assets and equity
Liquidity – Ability to meet short-term obligations from cash and near cash resources
Efficiency, notably of working capital
Financial leverage – the effective use of debt without undue increase in risk
Market performance – if listed, how well it has performed relative to other companies in the
industry.
Compare the selected ratio’, once calculated with other companies, over the time period and with
industry benchmarks
Evaluate the company and its prospects on the basis of trends or significant issues which are apparent
from the calculations
Finally, a prediction must be made. A potential shareholder is only interested in future prospects, using
past performance as an indicator of possible future prospects.
6.2
External variables, which could have an impact on the expected performance of a company would
include:
Economic factors: The global economy and the national economy, to gain an insight into whether
future growth can be anticipated, as well as the growth rate. For the local economy, factors such as
the inflation rate, exchange rates, gross domestic product and foreign direct investment would all be
significant.
6.3
There are many potential sources of information about a company, the most obvious sources are:
The Annual Report of the company, which will contain at least the following:
• The Director’s Report
• The Auditor’s Report
• The Balance Sheet with accompanying n otes
• The Income Statement with accompanying n otes
• The Cash Flow Statement with accompanying n otes
• General information about the company with a five year review
• Extensive notes of accounting policies
Reports in the financial press, such as Business Review, Financial Mail
Reports by analysts, available from large stockbroking firms
Brochures and leaflets available from the company on request
Internet services
6.4
The client has already identified the company in which he is interested. The fact that he has selected
an investment in a company rather than in a risk-free security, such as a Government or Escom bond,
indicates that he is prepared to take the risks, which accompany such investments. Risk may be
defined as the probability that the company may generate a smaller return than that which is expected.
This probability is dependent upon future events, which cannot be predicted with certainty. However,
the past record of the company is a useful starting point for the analysis.
The past record of profitability may be seen in the recent income statements of the company. One
would expect to see steady growth in turnover and net income attributable to ordinary shareholders, as
reflected in the earnings per share figure. If net income has been unstable or erratic, the likelihood of
steady future growth and profitability is lower.
The financial stability of the company can be assessed by examining past balance sheets. The client
should focus particularly on the company's liquidity and solvency history. The trends in the market
price of the share should also be studied. Once again, the investor will feel more confident in the
quality of his investment if the share price history has shown steady growth over the last few years.
Once the information relating to the company has been gathered, it must be compared with
information relating to similar companies.
6.5
Previous years: Every company would wish to increase its performance each year. Should a company
obtain results which are worse than those of the previous year, it is a clear indication that something is
wrong. Of course, it may be because the industry has suffered or the entire economy is in a state of
recession. Nevertheless, no company will survive unless it achieves growth in the long term.
Budgets and targets: Budgets and targets represent the plans which management has for the
company. If those budgets and targets are not achieved, it indicates that management has been
unable to achieve what it had intended. This failure may result from factors which were not know at the
time of planning, but, nevertheless, failure to meet budgets will be a source of concern.
6.6
A sudden drop in the value of the Rand means that it becomes cheaper for foreigners to buy Rands
with which to pay for goods and services exported by South Africa. Similarly, South Africans must pay
more for overseas currencies, which are used to pay for imports to South Africa.
A company, which specialises in the demolition of old buildings and the redevelopment of the land for
the erection of shopping complexes, is not directly involved with goods or services, which are imported
or exported. One may thus be inclined to think that a drop in the value of the Rand will have no direct
effect on such a business. There are, however, at least two reasons why this may not be so.
Firstly, it is possible that the company uses imported fixed assets for the purpose of demolition. In
such cases, the cost of these assets will rise as a result of the change in value of the Rand. Secondly,
the economy as a whole will be affected by the change in value of the Rand. The demand for space in
shopping complexes may fall, thus placing pressure on the redevelopment business.
6.7
The selection of techniques for purposes of analysis is dependent on the objective of the analysis and
the party for whom the analysis is being performed. In this case, management is the party for whom
the analysis is being performed and the purpose of the analysis is to assess the performance of the
company.
The term performance has many interpretations, but is most closely related to profitability and
efficiency. The profitability may be assessed by analysing the figures generated in the annual financial
statements and the market performance of the company, if it is listed on the Johannesburg Stock
Exchange. The efficiency is usually measured by selecting financial ratios, which are compared
against past performance and other benchmarks.
It is unlikely that management would use only one technique if it wished to perform a thorough
analysis. The use of time series techniques will assist in identifying problem areas. Once the weak
areas have been identified, financial ratios may be used for further analysis.
6.8
MOTOPASSION LTD
a) Reduction in gross profit margin
• Change in stock mix. The company could have sold more vehicles of a lower mark-up
than in the past.
• The sales price may not have increased in proportion to the cost of the vehicles, resulting
in a lower gross profit.
• The method used in valuing stock may have changed during the current year.
• The gross profit fluctuation may also be due to errors in the quantity or pricing of stock on
hand.
b) Increase in current ratio
We have analysed the sales for April and May 20.1. Our analysis confirms your impression that the
gross profit is worsening. It has in fact fallen from 36,7% in April to 35,1% of sales in May. This would
appear to be due to the change in the sales mix (the proportion of products sold) set out in Appendix
A. We are continuing to review the business records and will report back to you shortly on the other
question of the reason for the difference between your gross profit of 37% for the year and the industry
average of 40%.
The effect of the 3% difference in gross profit could be approximately R7 000 based on using cost of
sales as the base (R90 720 ö 60 x 100 - R144 000 = R7 200). That means that one would expect the
gross profit to be approximately R7 000 more than shown, based on the existing cost of sales figure.
In order to identify the precise reasons for the shortfall in gross profit, the total cost of R90 720 should
be analysed into its constituent parts (bar food, beer, etc) and the sales estimate based on that
analysis. Purchase invoices will need to be obtained for this purpose. There should also be a
reconciliation of physical stock movements to identify whether there has been any misallocation of
sales to product type.
Yours faithfully
Appendix A
Sunderland Ltd
Report to: Mr Sibanje
Prepared by:
Date:
Subject: Proposed loan to Sunderland Ltd
Proposal
A loan of R100 000 to be made to Sunderland Ltd at a fixed rate of interest of 16% per annum, the
capital sum to be repaid in five years by a single payment.
Information analysed
This report is based on the balance sheets and income statements for the three years 20.1 to 20.3
inclusive, and from the the general explanations provided to you. It has not been possible to verify the
accuracy of the financial statements or the bases on which the general explanations have been
founded.
Requirements of the lender
In terms of a fixed interest loan, the lender requires sufficient cash flow to ensure that interest is paid
at the appropriate time and that capital is repaid when due. You will therefore need assurance that
your annual interest will be met when due and that the R100 000 will be repaid in five years' time. It is
also normal for a lender to have some security in case of default by the borrower.
Analysis of the company (Supporting schedules attached)
a) The working capital of the company has barely increased since 20.1, despite the fact that the
business has expanded, as evidenced by the increase in sales volume, particularly in 20.3. The
balance sheet also highlights the increase in the overdraft from 20.2 to 20.3. There are a number
of reasons for these liquidity problems, the most important being the following:
i) Relatively high dividend per share payments in each of the years (i.e. 24%, 22% and 26%),
which has also meant that virtually no profits have been ploughed back for expansion.
ii) Debentures are being repaid at the rate of R16 000 per annum without any other finance
coming back into the business to replace this loss of long-term capital finance.
iii) There has been an increase of approximately 16% in the level of stock between 20.2 and
20.3 and an increase of approximately 9% in the level of debtors between those two years.
iv) Development costs of R7 000 per annum have been incurred in 20.2 and 20.3. When
reference is made to the balance sheets and income statements, it can be seen that all
development costs have been capitalised and there is no evidence that there is a policy of
writing off such costs against profits. It would normally be expected that some proportion of
such costs would be charged against profits each year, and thus the profits would appear to
be overstated in this respect.
v) It is likely that the rent payable under any new lease could substantially increase, thus
making the business less profitable. The current rent is R4 000 per annum, but if the same
charge per square metre is adopted as for the new adjacent factory building, the rent
payable on the renewal of the existing lease could be R36 000 per annum
(R18000/500=R36 per square metre).
vi) Plant acquisitions over the last two years have been fairly insignificant and the depreciation
charges have been calculated at 10% p.a. on a straight-line basis. It is clear that the majority
of the plant held at present is very near the end of its working life, which is why money is
urgently required for plant replacement. The business seems to have taken no steps to make
provision for the replacement of fixed assets, either in terms of charging depreciation on a
replacement cost basis, or in providing adequate cash for replacement.
* Existing debtors are allowed 2 months credit. The extra month will represent a further 50%.
ii) Management
Trading profit as % of capital employed [W3]28,4% 27,4%
Trading profit as % of sales 3,5% 3,8%
iii) Shareholders
Earnings per share [W4] 40c 37,2c
Dividend cover, EPS/DPS [W4] 2,7 x 2,7 x
i) Both the current ratio and the acid-test ratio have deteriorated slightly, but are still within
acceptable limits.
ii) Return on capital employed has improved slightly; the reasons for this are not apparent.
iii) Earnings per share has increased because earnings have increased, while the number of
equity shares has remained constant. The dividend has increased in proportion to earnings,
thus maintaining dividend cover.
Capital employed
Share capital 5 000 5 000
Distributable reserves 18 030 15 530
Shareholders' funds 23 030 20 530
Loan capital 10 000 10 000
33 030 30 530
3 Return onAssets = Net operating profit/Total Assets = 52.0% 42.7% 34.1% 34.0%
Return on Equity (based on year 54.6% 40.0% 32.4% 29.8%
4 = Net profit / Equity at year end =
end)
Return on Equity (based on beg Net profit / Equity at beginning of the 59.6% 44.5% 39.1%
equity) year
LIQUIDITY
5 Current ratio = Cur assets/Cur Liabilities = R 1.83 per R1 R 2.19 per R1 R 2.59 per R1 R 2.20 per R1
6 Acid test ratio = [Cur assets – Inv] /Cur Liabilities = R 1.10 per R1 R 1.23 per R1 R 1.63 per R1 R 1.00 per R1
EFFICIENCY
7 Fixed asset turnover = Turnover/Fixed Assets = 4.24 times 3.77 times 3.42 times 2.76 times
8 Days’ inventory = [Inventory x 365]/Cost of sales = 87 days 109 days 97 days 107 days
9 Debtors’ collection days = [Debtors x 365]/Credit Sales = 31 days 37 days 39 days 37 days
10 Creditors’ settlement days = [Creditors x 365]/Purchases = 47 days 49 days 49 days 52 days
LEVERAGE
11 Debt ratio = Total debt/Total Assets = 48.9% 41.4% 37.4% 24.4%
12 Interest cover = Net profit before Int/Interest = 13.3 times 11.8 times 12.0 times 36.2 times
MARKET
13 Return to shareholder = [SP(end-beg)+Div]/ SP(beg) = 77.0% 35.4% 66.5%
14 Dividend yield (DY) = Dividend per share/Share price (end) = 8.2% 12.5% 10.2% 10.1%
50.1% 34.7% 31.4% 25.0%
15 Earnings yield (EY) = Earnings per share/Share price (end) =
Price earnings ratio (P/E) = = 2.0 times 2.9 times 3.2 times 4.0 times
16 Price per share/Earnings per share
NOTE
The above ratio's are a selection. Other appropriate ratio's may be selected
Profitability: This company shows an interesting decline in profitability ratio's, which could mistakenly
be interpreted as poor performance. The profitability ratio's must be seen against the sales growth.
Management seem to have introduced policies which increase turnover, being satisfied with lower
margins. This had led to the RAND value of the profit margin increasing and a consistent growth in the
profit to shareholders. They will need to watch future movements carefully, as whatever policies to
boost sales are introduced, must result in continuing growth on the "bottom-line".
Liquidity: The current ratio has been relatively consistent and well within reasonable ranges to foster
confidence that this is being managed. With the increasing turnover, inventory levels have risen (giving
customers a greater selection), and this has caused the acid test ratio to show a decline. They should
not let this ration fall much below 1:1.
Efficiency: The company, in a growth phase has invested more each year in non-current assets. This
has had a negative effect on the non-current assets to turnover ratio, but is not a cause for concern.
The other 3 working capital items are all being managed well. Debtors are being given slightly longer
to settle their accounts (thus keeping them happy and attracting more customers), inventory is
reasonably consistent between 100 and 110 days, and creditors are being kept waiting just a little
longer, to make use of the free finance, without incurring any interest penalties.
Financial Leverage: The growth in the company has had positive effects on cash, and loans have
been repaid. While this reduces the opportunity to lever shareholders profits, it also reduces risk and
makes the company more attractive to investors. The interest cover at 36 times in well within all safety
limits, and could lead to further loans (if required), being obtained at very reasonable interest rates.
Market Performance: The JSE investors have responded well to the good management of the
company and confidence in this company is growing. This is reflected in the steady climb of the share
price over the last 3 years from R6.10, to a remarkable R17.85 a the end of the 20.6 financial year.
There is no reason to indicate that this growth pattern will not continue.
end
Comment
The company's liquidity position has deteriorated over the year. In 20.0 the company's current and
quick ratios were slightly above the industry averages. In 20.1, these ratios are below the industry
averages. The lower current ratio is not supported by more effective management of stock.
Stock is a significant percentage of current assets. The stock turnover ratio of 4.1 x is lower than that
in 20.0 and is substantially below the industry average. There may be significant quantities of
unsaleable or obsolete stock on hand.
The company is taking a substantially longer time than the industry in collecting its accounts
receivable. The collection period has increased slightly in 20.1. This may indicate that certain debts
All the indicators point towards a deteriorating liquidity position during the year. Moreover all indicators
are below the industry norm. The acid-test ratio is particularly significant and reflects an increase of
21% in debtors, a decline of 38% in funds at the bank and an increase of 13% in accounts payable.
Stock turnover has declined, debtor’s collection period has increased and creditors settlement period
has decreased, thus extending the cash collection period by circa 24 days. There are thus warning
signals regarding possible future liquidity problems. These can be addressed in a number of ways, but
particular attention must be paid to moving stock and collecting cash from debtors.
(b) Use of Debt
Comment
The company is relatively highly geared. The debt ratio of 58.2% compares unfavourably with the
industry. In addition, the company's debt ratio is higher than in the previous year.
The times interest earned ratio is almost half the industry average and is significantly below the prior
year figure.
The above clearly illustrate that the financial risk of the company is higher than average.
The company's increased investment in debtors and stock has been financed through the use of short-
term loans. The acquisition of Non-current assets has also been financed through the use of short-
term borrowings. Non-current asset acquisitions should rather be financed with long-term debt, than
short-term.
One basis of calculation of the debt ratio includes all debt to total assets. On this basis the company
has increased its debt component relative to equity in the financing of assets. This increases the
financial risk of the company but may also offer further leverage to shareholders. However, as 20.1
was not a growth year, shareholders have had to bear the additional interest burden. It would seem
that interest rates rose during 20.1, as the interest expense has risen by a relatively greater proportion
than the increase in interest bearing debt.
LT Ltd has achieved a significant growth in sales, which is in excess of the inflation rate, whereas the
industry has not achieved a real volume growth. They have improved on their margin, which indicates
that they have managed to obtain good selling prices for their goods and/or have obtained good cost
prices from suppliers. The other expenses, including interest have however risen and the decline in
net profit margin is a cause for concern. This has resulted in a serious decline in return on assets and
equity. This trend will have to be reversed for LT Ltd to be an attractive investment opportunity.
end
Possible reasons
Pressure on margins (competitors, wrong choice of inventory, increasing costs)
Strategic decisions to lower prices and increase turnover, which has not come to fruition
Pressure on costs for additional employees and/or salary and wag increases.
Pressure on other costs probably for advertising and marketing
Stock not moving, resulting in longer creditors settlement, which may incur interest, or refusals to
supply.
Slow liquidity leading to incurrence of more long-term debt and therefore higher perception of
financial risk and resultant higher cost of equity.
By far the most pressing issue is to move the Inventory as a matter of urgency.
END