Financial Analysis

 
Comparing Company Accounts
 

 
 
 
 
 
 
 
Introduction
 
Ratios, discriminatingly calculated and wisely interpreted, can be useful tools of financial analysis. Ratios are simply means of highlighting in arithmetical terms the ‘relationship between figures drawn from financial statements’ (Needham, D & Dransfield, R, 1994: 481).
 
Financial ratios provide a quick and relatively simple means of examining the financial health of a business. ‘Ratios can be very helpful when comparing the financial health of different businesses’ (Tyran, M, 1992:67).
 
Ratios can be grouped into certain categories, each of which reflects a particular aspect of financial performance or position. These include ‘Performance ratios, Investments ratios and financial status ratios’ (Mitson, A, 2002: 1).
 
The assignment requires an analysis of two companies, in terms of comparing andcontrasting.  One company has already been assigned to me, which is Bellway plc. The other company, which I have decided to choose to compare with Bellway, isBarratt plc. However, I was not able to obtain the latest annual reports for Bellway, as theyhave not yet been produced.  In order to make it a fair comparison, I haveanalysed 2001 figures for both Bellway and Barratt and I have had to change Bellway’s figures. Bellway has used £000’s on their financial statements whereas Barratt have used £m.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

Company Profile:

Barratt Plc (2001)

 
Barratt are Britain’s best-known house builders. They’ve been in business since 1958 and have built over 250,000 new homes and a reputation for quality, innovation and value for money.
 
For over ’25 years the Group’ (Barratt, 2001:3) has been in the house building industry. In 2001 the company demonstrated their ability to meet the changing market needs which in turn resulted in increasing ‘levels of volume and profit’ (Barratt, 2001: 2). They produce a diverse range of products to satisfy all market sectors.
 
During the year hey acquired ’14,710 plots’ (Barratt, 2001:3), 30% more than what they were using.
 
It has doubled its land bank enabling it to be on e of the largest land banks in the sector. Local market conditions in 2001 remained favourable with high levels of employment, good affordability and strong demand.
 
 
Company Profile:
 
Bellway Plc (2001)
 
They are a ‘leading house builder’ (providing quality homes and services to their customers in a manner consistent with environmental requirements for the benefit of their shareholders, employees and the community at large.
 
In the fifty years since its foundation, Bellway has developed from a local, family-run house building business in the North East of England into one of Britain’s most consistently successful house building groups. It is active in nearly every part of the country and builds across the housing spectrum: from small apartments to large detached luxury homes, offering purchasers high quality and excellent value for money.
 
 
 
 
 
 
 
 
 
 
 
 

Financial Ratios for Barratt Plc and Bellway Plc

Performance Ratios

 
There are a number of ratios that can be used to assess the financial performance of an organisation, which can be calculated, by using the profit and loss and the balance sheet of the two companies.
 
1). Return On Capital Employed
 
This ratio compares the profit earned (usually before interest and tax) to the funds used to generate sales. This ratio is the ‘best way of assessing profitability’ (Dyson, J, R, 1997:178). By calculating the return on capital employed, a far better idea of the organisations profitability is achieved. The return on capital employed is a ‘fundamental measure’ (Atrill, P & Mclaney, E, 2001: 147) of business performance.
 
The ratio is expressed in percentage terms and is as follows:
 

ROCE = Net profit before interest and taxation

Total assets less current liabilities
 
The ratio for Barratt plc 2001 is:  178.4 +12.4 = 190.8 x 100 = 26.7%
715.3        715.8
 
The ratio for Bellway plc 2001 is:  101455 + 5926 = 107381 = 10.7 x 100 = 23.2%
461227            461227     46.1
 
The findings clearly show that Barratt has a higher ROCE than Bellway therefore Bellway is in a better position but only relatively as the figures for ROCE are similar for both companies. The higher the ROCE the better the company is performing.
 
2). Asset Turnover
 
This is a measure of how ‘effectively the assets are being used to generate sales’ (Dyson, J, R, 1997: 23). It is one of the ratios that would be considered when interpreting the results of performance ratio analysis like ROCE, but is of sufficient importance to be calculated and analysed irrespective of that fact.
 
The ratio is expressed in pure numbers as follows:
 

Sales Turnover

Total assets less current liabilities
 
The ratio for Barratt plc 2001 is:  1509.1 = 2.11:1
715.3
 
The ratio for Bellway plc 2001 is: 695720 = 69.5 = 1.51:1
461227    46.1
 
Barratts asset turnover figure is higher than that of Bellway’s therefore Barratt are using the assets efficiently to generate sales. There maybe numerous reasons for Bellway having a lower figure, one being Bellway’s investment levels being high where assets are concerned. Due to this the company may choose to sell of its assets, which are creating a downfall in the business. The higher the asset turnover figure the higher the more efficient productivity is bound to be in creating revenue.
 
3). Net Profit Margin
 
This ratio shows what is ‘left of sales revenue after all the expenses of running the firm’ (Wood, F & Sangster, A, 1999: 76) for the period has been met. It should be as large as possible, provided that the company is not earning high profit margins at the expense of some other aspect.
 
The ratio is expressed in percentage terms and is as follows:
 
Before tax  + interest x 100
Sales Turnover
 
The ratio for Barratt plc 2001 is:  178.4 + 12.4 = 190.8 x 100 = 12.6%
1509.1          1509.1
 
The ratio for Bellway plc 2001 is: 101455 + 5926 = 107381 = 10.7 x 100 = 15.4%
695720             695720     69.5
 
Bellway have a higher net profit margin than Barratt with lower level of sales volumes. Factors such as the degree of competition, type of customer, the economic climate and industry characteristics will influence the net profit margins of a business. The net profit margins should be ‘as large as possible’ (Mclaney, E, J, 1997:45). They both have relatively the same net profit margins thereby shows their competitive performance. Both companies increasing the selling prices and reducing costs can improve net profit margin.
 
I have noticed that there is a relationship between the three ratios, which I have calculated. The relationship is (Net Profit Margin) x (Asset Turnover) = ROCE. This can be justified by Bellway’s ROCE, for example:
 
Bellway: (Net Profit Margin) x (Asset Turnover) = ROCE
15.4                                 1.51                23.2%
 
 
 
 
 
 
 
 
 
 
 
5). Operating Profit Margin
 
It was not possible to calculate the gross profit margin from Barratts published accounts due there being no gross profit figure on the profit and loss statement. This is due to the company using a ‘format 2 version’ (Mitson, A, 2002: 4) of the profit and loss account. Therefore I decided to use the operating profit figure to give an operating profit margin instead.
 
This ratio expresses ‘operating profit as a percentage of sales’ (Gray, R et al, 1996: 346) and is often regarded as a prime indicator of management’s ability to perform the basic activity of buying/manufacturing and selling.
 
The ratio is expressed in percentage terms and is as follows:
 
Gross Profit   x 100

Sales Turnover

 
The ratio for Barratt plc 2001 is:  186.2 x 100 =12.3%
1515.0
 
The ratio for Bellway plc 2001 is:   107331 = 10.7 = 15.4%
695,720    69.5
 
Bellway has a relatively higher operating margin than Barratt. This can be explained by a number of reasons such as the selling prices and the costs of sales implemented in both companies. As cost of sales represent a major expense for businesses, a change in this ratio for both companies especially Barratts with a lower operating margin can have a significant effect on the net profit for the year.
 
High levels of operating margin therefore the higher the operating margin the more successful the company is in terms of producing profits measure a company’s performance.
 

Working Capital Ratios

 
There are very many different types of ratios that we can use to measure the efficiency of an organisation.
 
1). Stock Turnover
 
Stocks often represent a significant investment for a business. For some types of business such as manufacturers, stocks may account for a substantial proportion of the total assets held. The average stock turnover period ‘measures the average period for which stocks are being held’ (Tyran, M, 1992: 143).
 
I am going to include the Properties held for sale figure to the total stocks for Barratt as that is part of stock.
 
 
 
 
The ratio is expressed in days and is as follows:
 

Stocks x 365

Cost of Sales
 
The ratio for Barratt plc 2001 is:  1177.6 + 4.9 x 365 = 338 days
1280.4
 
The ratio for Bellway plc 2001 is: 644,421 x 365 = 64.4 x 365 = 424 days
555,439             55.5
 
Barratt has higher levels of stock and higher cost of sales, which explains their low stock turnover period. Barratt is doing marginally better as it is able to sell houses in a shorter period of time (338 days). A low stock turnover period is preferred than to a high period, as funds tied upon in stocks cannot be used for other purposes. In judging the amount to carry the businesses must consider such things as the likely future demand, the possibility of future shortages and the likelihood of future price rises. A typical figure for UK manufacturing industries is ‘60 days’ (Mitson, A, 2002: 5), which shows both companies are doing better then average in terms of producing sales.
 
2). Trade Debtors Turnover
 
Investing in fixed assets is all very well, but there is not much point in generating extra sales if the customers do not pay for them. Customers might be encouraged to buy more by a combination of ‘lower prices and generous credit terms’ (Bendry, M et al, 2002: 167). It is important to watch the trade debtor’s position very carefully.
 
The ratio is expressed in days and is as follows:
 
Trade Debtors x 365
Sales Turnover
 
The ratio for Barratt plc 2001 is:  4.9 x 365 = 1day
1309.1
 
The ratio for Bellway plc 2001 is: 7860     = 7.8 x 365 = 4days
695720      695.7
 
The figures show Barratts trade debtors turnover is better than that of Bellway’s as this ratio produces an average figure for the number of days that debts are outstanding which is 1 for Barratts. The speed of payment can have an significant effect on the cash flow of the business therefore a shorter average settlement period is preferred to a lower one.
 
3). Trade Creditors Turnover
 
This ratio tells us ‘how long, on average, after a purchase on credit the company meets its obligation’ (Fleming, Mckinstry & S, 1998, 34) to pay for the goods or service bought. A well-managed creditor policy will lead to the company taking as much ‘free’ credit as is possible, but at the same time preserving the goodwill of suppliers.
 
The ratio is expressed in days and is as follows:
 
Trade Creditors x 365
Sales Turnover
 
The ratio for Barratt plc 2001 is:  388.1 x 365 = 111days
1280.4
 
The ratio for Bellway plc 2001 is: 53790     = 53.7 x 365 = 4days
555439       555.4
 
The ratio is higher for Barratts than it is for Bellway. A higher ratio for Barratts suggests difficulty in finding the cash to pay its creditors. As trade creditors provide a free source of finance for the business, it is important not to antagonise them. However the high ratio could mean Barratt having a longer average settlement period, which could result in loss of goodwill by creditors.
 
The conclusion I am able to deduce from the working capital management is that stock levels for Barratts are very high at 338days but are substantially financed by the trade creditors at 111 days. Bellway is also providing very high levels of stock at 424 days some of it being financed by the trade creditors at 35days. Both businesses are cash-driven showing the management of trade debtors is not a problem.
 
Investment Ratios
 
The following ratios are primarily of interest to prospective investors. These ratios are known as the investment ratios. Anyone concerned with making a decision to either buy, sell or hold shares in a particular company will base their decision on a number of factors.
 
1). Earnings per share (EPS)
 
This is an important investment ratio. This ratio enables u to put ‘profit into context’ (Tyran, M, 1992: 62), and to avoid looking at it in simple absolute terms. It is usually looked at from the ordinary shareholders point of view.
 
This figure can be found no the profit and loss accounts of both companies as ‘FRS 14’ (Mitson, A, 2002:8) requires that it be shown. Therefore it does not need to be calculated.
 
Barratt’s EPS   = 54.7p
Bellway’s EPS = 62.7p
 
It is not very helpful to compare the earnings per share of one company with those one another. ‘Differences in capital structure can render any such comparison meaningless’ (Atrill, P & Mclaney, E, 2001:167). One company’s EPS changing fortunes over time are therefore the only valid comparison that can be made.
 
2). Price Earnings Ratio (PE)
 
This is possibly the most important ratio as far as the investor is concerned. The ratio shows ‘how expensive the share price is’ (Mclaney, E, J, 1997:98) in terms of the current profits that are being generated. A high PE suggests that the market expects the company to grow and a low PE suggests has low growth expectations of the future of the company.
 
There is no need to calculate this as the figure for both companies can be find in the Financial Times Newspaper.
 
Barratts PE  = 5.5p
Bellways PE = 5.6p
 
A share with a high PE implies that investors are confident in future earnings of the firm. It will be on the basis of expectations of future profits that investors will assess the value of shares. Both companies have similar ratios, which are relatively high showing a good investment opportunity for potential investors.
 
3). Dividend Yield
 
This ratio seeks to assess the cash return on investment earned by the shareholders. To this extent it enables a comparison to be made with other investment opportunities available. It is ‘measured by the ordinary share divided by the market price per ordinary share’ (Mitson, A, 2002:9). Like the PE ratio there is no need to calculate this as it is found in the Financial Times Newspaper.
 
Barratt’s Dividend Yield = 3.7p
Bellway’s Dividend Yield = 3.6p
 
Bellway’s dividend yield is only slightly lower than that of Barratts. ‘Whether a high or low figure is to be preferred’ (Mclaney, E, J, 1997: 50) for dividend yield is dependent upon the needs and investment objectives of the shareholders of both companies.
 
4). Dividend Cover
 
This is the number of times that the dividend will go into the profit after tax. The higher the number of times, the more profit the company is retaining and the safer the dividend is likely to be in the future years. A company with a very low dividend cover will have difficulty in paying out the same amount of dividend if its profits were to decline in the future.
 
 
 
 
 
The ratio is expressed in days and is as follows:
 
Profit before ordinary dividend
Ordinary dividend
 
The ratio for Barratt plc 2001 is:  126.7= 4.2days
30.2
 
The ratio for Bellway plc 2001 is: 70673 = 70.6 = 4 days
17518    17.5
 
Both companies have a high dividend cover, which are relatively the same. The higher the figure the more profits has been retained in the business (1/ 4.2 = 24 % of profits on average are paid out as dividends to Barratts shareholders).
 
5) Return On Equity
 
This ‘measures the return on the capital employed’ (Mitson, A, 2002: 10) from the point of view of the ordinary shareholder. It is a variant on ROCE. ROE in most situations shows a similar trend to ROCE, where is does not, this could be explained by the profit and loss account.
 
The ratio is expressed in percentage terms and is as follows:
 

Profit before Ordinary Dividend

Equity Shareholder’s Funds
 
The ratio for Barratt plc 2001 is:  126.7 = 20.1%
631.1
 
The ratio for Bellway plc 2001 is:   70673 = 70.6 = 18.1%
390951  390.9
 
The return on equity is good for both companies and is similar. The trends here mirror with the ROCE.
 

Financial Status

 
Analysts to assess a company’s ability to remain solvent in the shirt term use the principal liquidity ratios. They effectively attempt to assess the sufficiency of a company’s working capital.
 
1). Working Capital Ratio (WCR)
 
This compares the liquid assets  (that is, cash and those assets held that will soon be turned into cash) of the business with the short-term liabilities (creditors due within one year). This is the ‘main liquidity measure’ (Mitson, A, 2002:11).
 
 
 
The ratio is expressed in pure numbers and is as follows:
 

Current assets

Current liabilities
 
 
The ratio for Barratt plc 2001 is:  1298.1 = 2.18:1
596.4
 
The ratio for Bellway plc 2001 is: 669971 = 66.9 = 2.91:1
230212     230.2
 
These are acceptable figures for both companies, which are very similar (indicating their levels of performance). Bellway has £2.91 of current assets for every £1 of current liabilities and Barratts has £2.18 of current assets for every £1 of current liabilities. Therefore if the creditors had to be paid, the businesses should have enough current resources to do so without having to obtain a loan or sell of its fixed assets.
Generally, if a ratio is above ‘2:1’ (Mitson, A, 2002: 11) this could indicate poor management of working capital.
 
2). Quick Assets Ratio
 
It may not be easy to dispose of stocks in the short-term as they cannot always be readily turned into cash, but in any case, the company would then be depriving itself of those very assets that enable it to make to trading profit. It seems sensible, therefore, to see what would happen t the working capital ratio if ‘stocks were not included’ (Gray, R et al, 1996: 164) in the definition on current assets. It is a better measure of the company’s liquidity position than the WCR because it excludes stocks since they cannot always be readily sold.
I am going to include the Properties held for sale figure to the total stocks for Barratt as that is part of stock.
 
The ratio is expressed as follows:

Current assets – Stocks

Current liabilities
 
The ratio for Barratt plc 2001 is:  1298.1 – 1182.5 = 115.5 = 0.11:1
596.4              596.4
The ratio for Bellway plc 2001 is:  669971 – 644421 = 25.5 = 0.11:1
230212            230.2
 
These are low figures for both the companies but within the context of the businesses the ratios are entirely acceptable.
 
Both the Quick assets ratio and the working capital ratio can be interpreted in conjunction with working capital efficiency ratios stated earlier. The very low quick assets ratios combined with a high working capital ratio are explained by high stock figures. This latter is consistent with the high stock turnover figures calculated for both companies earlier.
 
3). Gearing
 
Gearing ratios are concerned with the ‘financial structure of the business’ (Tyran, M, 1992: 187). Businesses fund their operations through investment by their owners and by borrowing from banks and other companies. Gearing refers to the proportion of debt and equity in a company’s financial structure. A company, which is highly geared, is a company, which has a high proportion of debt in relation to its equity. A low-geared company has a low proportion of debt in relation to its equity.
 
The ratio is expressed in percentage terms and is as follows:
 

Long-term debt + preference shares x 100

Total assets less current liabilities
 
The ratio for Barratt plc 2001 is:  84.2 + 0 x 100 = 11.77%
 
The ratio for Bellway plc 2001 is:  70337 +20000 = 90337 = 90.3 x 100 = 19.58%
461227            461227   46.2
 
The ratios clearly show that Barratt has a lower gearing than Bellway. The difference between the companies is due to Bellway receiving a better return on equity and also Barratt don’t have any preference shares in issue. ‘The higher the gearing a company has’ (Dyson, J, R, 1997: 325) the greater the risk to shareholders in poor economic conditions, but the higher their return if businesses are going well. As Barratts have a lower gearing it therefore has a lower proportion of debt in relation to its equity and in comparison to Bellways. However low levels of gearing for both companies means financial risk is low.
 
4). Interest Cover
 
If lenders are to have confidence in a company, then they must feel reasonably assured that they would receive their interest when it becomes due. If lenders are uncertain they will either refuse to lend money or, if they do, charge very high rates of interest in compensation for the additional risks they believe they are taking. This ratio tries to ‘measure how secure payment of interest is’ (Mclaney, E, J, 1997: 365) by comparing interest payable with the source from which it will come, that is profits.
The ratio is expressed as follows:
 

Profit before taxation and Interest

Interest Payable
 
The ratio for Barratt plc 2001 is:  178.4 +12.4 = 190.8 = 15.39
12.4                 12.4
 
The ratio for Bellway plc 2001 is: 101455 + 5926 = 107381 = 107.3 = 18.19
5926                  5926         5.9
Both companies have a relatively high interest cover which confirms the gearing ratio, financial risk is low (for both companies). The higher the figure, the more confidence lenders will have.

Limitations of Ratios

 
The main limitations of ratio analysis are as follows:
 

• There are no agreed definitions of the terms used
• Data drawn from different sources may not be comparable
• The figures you need to construct the ratios may not be available and you may have to use precise alternatives
• If there is high inflation, the figures in the financial statements maybe misleading
• The business may have used an unusual accounting treatment, the effect of which is not apparent
• Not all aspects of a business, which should be taken into account, are shown in the figures in the financial statements.

 
Despite these limitations, ratio analysis is an invaluable method for interpreting the financial statements of a company.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

Analysis

 
The ROCE and asset turnover ratios of Bellway are better than those of Barratts. However Net profit margin and operating margin for Barratts is better than that of Bellway’s. This suggests Barratts is better at converting sales into profits. The better operating margin ratio suggests either that Barratt can achieve a higher unit of sales price or that its unit cost of raw materials is lower.
 
The higher ROCE earned by Bellway suggests better management by the company of the finances entrusted to it by its shareholders.
 
The liquidity position of both the companies appears satisfactory, as the liquidity ratios for both companies are acceptable showing low financial risk.
 
An investor would be more confident in buying shares from Bellway as each share is earning its owners £0.62 whereas Barratts is lower at £0.57.
 
Bellway is performing marginally better than Barratts at creating profits (justified by the ratios), although both companies appear to have very similar performance levels and levels of efficiency. Overall better company performance and efficiency levels than that of Barratts can explain Bellway’s higher profit levels. It is therefore beneficial for investors to buy shares in Bellway.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

Bibliography

 
 
Atrill, P & Mclaney, E (2001) ‘Accounting & Finance for Non-specialists’, Pearson
 
Barratt, (2001) ‘Report and Accounts 2001’, www.barratthomes.co.uk
 
http://www.bellway.co.uk
 
Bendry, M, Hussey, R & West, C (2001) ‘Accounting & Finance in business’, Continuum
 
Dyson, T, R (1997) ‘Accounting for Non-Accounting students’, Pitman
 
Fleming, I & McKinstry, S (1998) ‘Accounting for Business Management’, Thomson
 
Gray, R, Laughlin, R & Bebbington, J, (1996) ‘Financial Accounting’ Thomson
 
Lewis, R & Pendrill, D, (2000) ‘Advanced Financial Accounting’, Prentice Hall
 
Mclaney, E, J, (1997) ‘Business Finance –theory & Practice’, Pitman
 
Needham, D & Dransfield, R (1994) ‘Business Studies’, Stanley Thornes
 
Tyran, M, (1992) ‘Business & Financial Ratios’, Woodhead –Faulkner
 
Wood, F & Sangster, A (1999) ‘Business Accounting 2’, Pitman
 
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