Importance of Relative Performance & ROCE in Financial Ratio Analysis, Lecture notes of Finance

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UCL School of Management

Financial Frameworks

Workshop 5: Financial Analysis (Ratios)

Week commencing Monday 30th October 2023

Learning Outcomes

2

Calculate a range of appropriate different ratios to assess and monitor

profitability, efficiency, liquidity, working capital, gearing and investment.

Interpret those ratios to build an overview of key positive and negative

issues arising for a company.

Understand the limitations of ratio analysis.

4

Scandal time….

Core Ratios

**1. RETURN ON EQUITY (ROE) aka RETURN ON ORDINARY SHAREHOLDERS FUNDS

2. Return on capital employed (ROCE)
3. Operating profit margin
4. Sales to capital employed (Net asset turn)
5. Gross profit
6. Mark up
7. Non-current asset turn (Fixed asset turn)
8. Current ratio
9. Quick ratio (Acid test)
10. Cash generated from operations to Maturing Obligations
11. Trade receivables days
12. Trade payables days
13. Inventory days
14. Dividend cover
15. Dividend yield
16. GEARING aka LEVERAGE** And thereafter we group the ratios into FIVE categories: PROFITABILITY EFFICIENCY LIQUIDITY DEBT MANAGEMENT INVESTMENT

Make it relative…

Say, last year’s Total Capital Employed was (Equity £700m + Bank loan

£100m) £800m

But, say, at the start of this year an additional bank loan of £400m was

obtained and invested. Thus this year total Capital Employed is £1,200m

(Equity £700m + Bank loan £500m).

So … the Return on Capital Employed (ROCE) is:

Last Year This Year

£100m/£800m

= 12.5% ROCE

£120m/£1,200m

=10% ROCE

And thus the performance has declined overall…

The key steps of financial ratio analysis The three steps involve: firstly , identifying for whom and for what purpose the analysis and interpretation are required; secondly , selecting appropriate ratios and calculating them; and, finally , forming a view based on the information produced.

• Owner-managers
• Managers
• (^) Business Funders, both existing and prospective
• (^) Customers
• (^) Suppliers
• (^) Government Agencies

Liquidity – concerned with the ability to meet short-term obligations

• (^) Current ratio.
• (^) Quick/Acid test ratio.
• (^) Cash generated from operations to maturing obligations Debt management – concerned with relationship between equity and debt financing
• (^) Capital Gearing (Leverage) (External long-term funding/TCE)
• (^) Interest cover Core Investment – concerned with returns to shareholders
• (^) Dividend cover ratio or dividend payout
• (^) Dividend yield ratio
• (^) Earnings per share
• (^) Price/earnings ratio

Grouping of Ratios ctd…

10 From a statement of cash flows

11

Profitability Ratios

Profitability ratios are financial metrics used by analysts and

investors to measure and evaluate the ability of a company to

generate profit relative to revenue, balance sheet assets,

operating costs, and shareholders’ equity during a specific period

of time.

They show how well a company utilizes its assets to produce

profit and value to shareholders.

A higher ratio is better , as this means the business is

performing well.

KwikBuck Ltd Balance Sheet at end of Year X

Generating Returns to Ordinary Shareholders

The main objective of most businesses is to earn money for the owners.

One measure of this is RETURN ON EQUITY (aka RETURN ON ORDINARY

SHAREHOLDERS’ FUNDS ). For this measure to be ‘good’ the relative level of

Operating Profit must be good.

Year end figures can be used if there is not enough information i.e. there needs to be comparability using like for like (year end with year end comparisons or average with average comparisons. Do not mix & match!). ROSF aka ROE Profit available to Ordinary Shareholders % Ordinary Shareholders’ Equity

KwikBuck Ltd Balance Sheet at end of Year X

Profitability Ratios: Return on Equity (ROE)

The main objective of most businesses is to earn money for the owners.

One measure of this is RETURN ON EQUITY (aka RETURN ON ORDINARY

SHAREHOLDERS’ FUNDS ). For this measure to be ‘good’ the relative level of

Operating Profit must be good.

Year end figures can be used if there is not enough information i.e. there needs to be comparability using like for like (year end with year end comparisons or average with average comparisons. Do not mix & match!). ROSF aka ROE Profit available to Ordinary Shareholders Ordinary Shareholders’ Equity £18m £63m = 28.57%

Operating Profit %

OPERATING PROFIT

SALES

Return on Capital Employed %

OPERATING PROFIT

TOTAL CAPITAL EMPLOYED

These Ratios may be compared with targets for the year, with competitors’, and with industry averages, and when older than one year, with those of previous years

Sales Revenue to Total Capital

Employed

(Net Asset Turnover) ... SALES TA - CL Expressed as a factor £23m (NCL Loan £50m

• Equity £63m) = 20.35% £23m £150m = 15.33% £150m (£50m+£63m) = 1.33 times Note that the Total Assets £120m

- Current Liabilities £7m figure of £113m is the same as the Total Capital Employed figure of £113m Profitability Ratios: Return on Capital Employed Expressed as a %

Asset Turn and Operating Profit Margin are the drivers of the ROCE ratio Operating Profit % 15.33% Net Asset Turn 1.33 times ROCE 20.39% Allow for rounding!

X

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