If you found this article to be of value, at least “like” it or the website. INTRODUCTION Financial management is based on building on a business’s strengths while striving to overcome its weaknesses. Financial analysis helps answer questions such as: Is the business improving from year to year? Have we borrowed too much? Are we making a decent return for our shareholders? There are a huge number of ratios that can be calculated from a set of financial statements, but fortunately there are only a few that are really meaningful. Ratios are based on the principle that patterns and trends emerge in business, which can be measured, interpreted, and used as guides for action. One should also be aware that in order to compare the ratios of different companies with other companies, with their own history and with the industry averages, the ratios should be calculated in the same manner. It is therefore important to ascertain how the ratios have been calculated. It is not so much the detailed manner that is important in the calculation of ratios than it is the trend of a specific ratio. The return on investment ratio One ratio ranks far above all others in significance. This is the return on investment (ROI) ratio, which measures the return earned by the shareholders of a business on the money they invest. This investment which is sometimes referred to as TOTAL SHAREHOLDERS FUNDS consists of share capital and retained earnings. This ratio measures the all-important business factor, earning power. Analysts may use various other acronyms when referring to this measure: Return on capital(ROC) Return on net assets (RONA) Return on shareholders’ funds(ROSF) Ratio analysis requires comparison against trends. Standards of comparison are: Comparisons of historic performance against current performance. Comparison against budgets or forecasts. Comparison with other firms. Comparison with industry or national averages. We do not have many published benchmarks for industry ratios in South Africa. A good source is the Bureau for Financial Analysis attached to the University of Pretoria Business School. THE DIFFERENT KINDS OF RATIOS Ratios are classified under five headings: Profitability ratios, which measure the returns generated on sales and investment Liquidity ratios, which judge whether a business is likely to run out of cash in the short term Activity ratios, which measure how well the business is using its assets Leverage ratios, which measure the extent to which a business is using borrowed money Growth ratios, which measure the business’s rate of growth and assess the potential for future growth GENERAL PRINCIPLES APPLICABLE TO THE USE OF RATIOS Before calculating any ratio, consider what you would expect from the company being analysed, e.g. a company selling perishable commodities should have a rapid stock turnover. Then match expectations to actual performance. This may identify a company which is performing better than it was, but worse than it should be. Look for a trend. A comparison of two years is inconclusive; at least 3 years should be analysed. Bear in mind the purpose for which the analysis is being done. Directors, bankers, creditors, and shareholders have different perspectives and use different ratios. Ratio analysis is a theoretical exercise, often done without complete knowledge of trading conditions, company policy, etc. As such, there are dangers to ratio analysis if it is done mechanically. Some of these are: Ratios can only isolate a problem; they cannot identify the cause. Analysis is an historical exercise. It is meaningless unless it can give pointers to future performance. Accounting policies can have a material influence on financial statements. When in doubt, ask for expert advice. However, you must first understand your own company’s accounting policies. Changes in accounting policies could materially affect comparisons from year to year. Financial statements often show historical values for fixed assets such as property. Take the possibility of re-valuation of assets into consideration. There should be different expectations for ratios such as return on assets for companies, which have re-valued property opposed to those companies which have not valued property. The financial year-end may coincide with a period of low activity. This may not be a true reflection of a company’s business. PROFITABILITY RATIOS This section discusses the different measures of corporate profitability and financial performance. These ratios, much like the operational performance ratios, give users a good understanding of how well the company utilized its resources in generating profit and shareholder value. The long-term profitability of a company is vital for both the survivability of the company as well as the benefit received by shareholders. It is these ratios that can give insight into the all important “profit.” Bear in mind though, that profit does not equal cash, given your understanding of the cash flow statement. In this section, we will look at four important profit margins, which display the amount of profit a company generates on its sales at the different stages of an income statement. The last three ratios covered in this section – Return on Assets, Return on Equity, and Return on Capital Employed – explain how effective a company is at generating income from its resources. Profitability ratios tell us how well a firm is being managed. The ultimate measure of a business’s success is the rate at which it makes profits from its activities. Profitability is measured in three ways: Relative to investment (i.e. for every Rand of shareholders’ money invested in the business, how much profit did we make?) Relative to assets (i.e. for every Rand of assets of the business, how much profit did we make?) Relative to sales (i.e. for every Rand of sales, how much profit did we make?) In the income statement, there are four levels of profit or profit margins – gross profit, operating profit, pre-tax profit and net profit. The term “margin” can apply to the absolute number for a given profit level and/or the number as a percentage of net sales/revenues. Profit margin analysis uses the percentage calculation to provide a comprehensive measure of a company’s profitability on a historical basis (3-5 years) and in comparison to peer companies and industry benchmarks. Basically, it is the amount of profit (at the gross, operating, pre-tax or net income level) generated by the company as a percent of the sales generated. The objective of margin analysis is to detect consistency or positive/negative trends in a company’s earnings. Positive profit margin analysis translates into positive investment quality. To a large degree, it is the quality, and growth, of a company’s earnings that drive its share price. In order to calculate the ratios, we will be using the financial statements of Pick ‘n Pay for the year ending 28 February 2007. Formulas: Gross Profit Margin = Gross Profit / Net Sales (Revenue) Operating Profit Margin = Operating Profit (EBIT) / Net Sales (Revenue)Pre-tax Profit Margin = Profit Before Tax / Net Sales (Revenue) Net Profit Margin = Profit After tax / Net Sales (Revenue) Components: Gross Profit Margin = 6 893.9 / 39 337.1 = 17.53% Operating Profit Margin = 1 328.8 / 39 337.1 = 3.38% Pre-tax Profit Margin = 1 205.3 / 39 337.1 = 3.06% Net Profit Margin = 675.6 / 39 337.1 = 1.72% All the Rand amounts in these ratios are found in the income statement of 2007 of Pick ‘n Pay. As of February 28, 2007, with amounts expressed in millions, Pick ‘n Pay had net sales, or revenue, of R39 337.1, which is the denominator in all of the profit margin ratios. The numerators for Pick ‘n Pay’s ratios are captioned as “gross profit”, “operating profit”, “profit before tax, and profit for the year, respectively. By simply dividing, the equations give us the percentage profit margins indicated. It is important to remember that these ratios by themselves mean very little. You need to calculate the ratios for previous years as well and compare them, as well as against the budget figures set for the company, the industry averages, and the ratios for the competitors.