CHAPTER 10 – FINANCIAL PERFORMANCE AND INVESTMENT APPRAISAL

Objectives:

Identify other strategic models using ratio analysis.

Distinguish the ratios that can be used to measure profitability,
liquidity of corporate activity, and how the stock market values
the company.
Provide insights into the strategic decision-making process of the
key players within the industry or sector.

Evaluating Financial Performance

The ability to financially analyze a company is central to any strategic investigation, and
a better understanding of financial performance can be achieved if we apply certain
analytical cools. Indeed, the use of financial performance indicators are a key analytical
cool for many investors and management consultants, especially when the emphasis is
on evaluating past and current performance, and where projections on future
performance are being made.

Access to financial information is obviously necessary if you are to financially evaluate a

company, and this information is most likely to be contained within profit and loss and
balance sheet statements. These statements provide a ‘snapshot’ on the financial
health and standing of a company at a specific point in time.
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Using Financial Statements for Strategic Analysis

It is important to remember that financial statements contain data that is normally 12

months out of date. This is likely to be the most up-to-date information because
companies have to produce, by law, annual operating statements of their preceding 12
months activities.

Financial statements can be used for the following:

To support and underpin the data and information that is inputted into
strategic models (e.g. SPACE, Life Cycle Matrix SWOT analysis).

To analyze competitors who may pose a strategic threat by identifying their

financial strengths and weaknesses, and how these might influence their
strategic intent.

To support strategic acquisitions and mergers through a detailed financial

analysis of potential candidates.

To analyze key customers and suppliers in order to anticipate demand

and potential strategic activity.

To compare internal cost centers with comparable cost centers with in

competitors, to identify significant variances, and to incorporate remedial

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action into the strategic planning process.

To identify the growth potential and borrowing power of the organization.

To assess if the company is vulnerable to decreases in revenue and

possible corporate failure.

Analyzing Financial Statements Using Ratio Analysis

A financial ratio is a relationship, at a given point in time, between items on a financial

statement. If the ratio is to have any meaning then the items must be synergistic (i.e.
when put together they say something about the performance of the company). It is
important to resist the temptation of calculating all possible ratios, because like strategic
analysis in general, it should be a selective process where the emphasis is on the
selection of ratios to identify and illustrate specific strategic issues and trends.

When ratios are used to compare industries or sectors then it is important that the
companies should be of a similar size and sell similar products or services to similar
markets. Although it is always difficult to project into the future, ratios can be calculated
over several years and then plotted graphically in a time series to highlight changes
over that period, and by extending the trend, potential future performance.

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Ensuring Validity of Data Comparison: Comparisons between trading years and

other companies in the industry or sector can be made difficult in the following
situations:

Changes in accounting standards and methods – such changes can result

in material changes to ratios calculated. These changes should be
quantified if possible and their impact on the analysis explained.
Accounting for exceptional items can create anomalies, and an
assessment needs to be made as to whether they are a ‘one off’.
Companies frequently use this technique to cover a multitude of sins
(including poor performance).
Restructuring costs – like exceptional items these reduce margins and
profits. Explanations for such costs very often lack detail and care needs
to be exercised when assessing their strategic implications.
The sale or acquisition of subsidiaries can make a material difference
when assessing group structures.

These factors and situations need to be taken into account, and possibly compensated
for, when comparing companies using ratios. If these types of situations are taken into
account then they can only improve and enhance the insight that financial ratios provide.

Ratio analysis can be divided into five key areas: Profitability, Liquidity, Leverage or
Gearing, Activity analysis, and Stock market valuations.

Profitability Ratio

These ratios indicate the degree of competence with which the company allocates
the resources available to the resulting income generated. The main item used in
profitability analysis is the profit and loss account, and this can give rise to
confusion because two profit figures are given; one after interest and tax and the
other before interest and tax.

In general, using profit before interest and tax is useful because it enables us to
compare the trading performance of similar companies irrespective of borrowings that
may have been used to finance chose activities. Taking profit after interest and tax
charges provides a more thorough analysis of a company’s competitive strength, as
there is a direct relationship to gearing (leverage), and this can be important in
assessing whether the company is financially over-stretched. Profit after interest will
fluctuate in line with variations in interest rates assuming profits before interest remain
constant. The seven most commonly used profitability ratios are shown in Figure 10.1.

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Liquidity Ratios

Liquidity ratios can show whether a company can meet its short-term liabilities, which
usually revolve around the ability of a company to manage its stocks and inventories,
and the flow of cash coming into the company. This can be critically important because
a company that fails to pay its bills (for its stock) is likely to cease to function. If a
company is unable to generate sufficient cash itself, then it should have set up and put
in place the financial facilities to cover its position. Poor liquidity and the inability to
manage cash flow can lead to a loss in confidence from both creditors and financial
providers, and if such problems are not addressed quickly, exposure to cake-over or
company failure may be a reality.

In general, low liquidity ratios are associated with a stable and predictable industry and
sector environment, whilst high ratios can relate to unpredictable.

Companies having high levels of stock may be subject to increased risks, whilst a
downward trend of stock values in relation to sales may indicate improved management
practices (e.g. JIY stock management systems). There are three key liquidity ratios, and
these are shown in Figure 10.3.

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Gearing or Leverage Ratios

Gearing ratios provide insights into how much of a company’s assets are financed by
external sources of funding. The higher the ratios the greater the risk to the company,
as large borrowings will be prone to interest rate changes that are beyond the control of
management. Funds that are provided by ordinary shareholders can have a reduced
dividend payment when times are difficult, whereas borrowed funds attract a market
rate of interest that cannot be deferred or defaulted upon. Figure 10.3 shows the five
most used gearing ratios.

Activity Ratios: These ratios are useful for comparing individual companies to industry
or sector standards. Figure 10.4 shows five activity ratios, and when used sensible they
can indicate how efficient a company is in managing and generating a return from its
assets.

Stock market Ratios: Stock markets use a myriad of techniques to assess the value
of companies, and the four ratios outlined in Figure 10.5 are used extensively within
such evaluations.

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Using Ratio analysis with other strategic models

Ratio analysis can be integrated into, and be a valuable part of, the following strategic
models:

S.W.O.T analysis: Ratios can be used to identify strengths and weaknesses. This can
be integrated into future scenarios by trending the ratios forward.

S.P.A.C.E analysis: The ‘industry strength’ axis can be measured using ratios that
gauge profit potential, financial stability and capital intensity. Likewise, the axis ‘financial
strength’ can be measured using return on investment, gearing (leverage), liquidity,
capital required, cash flow, and inventory turnover ratios. The ‘competitive advantage’
axis can also be inferred from the position of the company’s products within the overall
life cycle (see product life cycle below).

Industry attractiveness/business strength matrix: Ratios can be used to weight and

rate market size and potential growth, capital requirements, and industry profitability so
that a composite measure can be arrived at for ‘industry attractiveness’. The areas for
measurement within ‘business strength’ are market share, relative profit margins and
cost differences.

Life Cycle Matrix: A company’s competitive position can be gauged using the five
types of ratios outlined above (i.e. profitability, liquidity, gearing (leverage), activity and

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stock market), whilst the industry stage in the evolutionary life cycle can be estimated by
incorporating estimates of product life cycles (see product life cycle below).

B.C.G Matrix: The industry growth rate and relative market share can be inferred from
profitability, liquidity, gearing (leverage) and stock market ratios, as each of the four
‘ideal’ positions within the matrix can be compared to each other using these ratios.

Investment Appraisal: Investment appraisal or capital budgeting can be defined as

‘the analysis of a proposed investment that is a long-term asset used by the business to
yield a return over a period of time that is greater than one year.’ Examples include the
purchase of a warehouse or a fleet of delivery vehicles.

Capital Budgeting: Assumes that funds are limited and that decision has to be made
between several investment alternatives.

Five most used techniques for evaluating investment projects are outlined in the
following list.

1. Payback.
2. Discounted payback.
3. Average rate of return.
4. Net present value.
5. Internal rate of return and modified internal rate of return.

Payback: The simplest method of calculation, and involves selecting projects on the
basis of repaying the investment amount in the shortest possible time period. The main
disadvantage is that it makes no allowance for taxation or capital allowances. This is
important because different allowances and tax benefits can be attributable to different
types of projects. It also disregards the profit screams from projects once the payback
period is over.

Discounted Payback: The main disadvantage is that it makes no allowance for

taxation or capital allowances, and this is important because different allowances and
tax benefits can be attributable to different types of projects. The choice of the
discounting rate is clearly important, for too high a rate will increase the payback period
and make the project look unviable.

Average rate of Return: Calculates the profitability of an investment by relating the

initial investment to the future annual average net cash flows. The method takes
account of profits over the whole of the project’s life, and its average profit is expressed
as the rate of return on the initial investment. This calculation should be done after tax
and capital allowances so that a more accurate profit figure is used.

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Net Present Value: Calculates the benefit of an investment project in terms of

current money assuming that a rate of return must be earned. To calculate the CPV
of an investment a discount rate is used on future payments and income.

Internal rate of return: The internal rate of return of an investment project is the
break-even return level that equates to the project’s present value of net cash flows
against the projects initial investment.

Modified internal rate of return: This is a more sophisticated form of IRR and the
calculation takes into account the re-investment of net flows. Two rates are required
for this calculation, a finance rate and a re-investment rate.

Comparison of Internal Rate of Return (IRR) and Net Present Value (NPV)

There is little difference between the two techniques, the IRR method has the
advantage that it provides a better estimate of project risk. It is also preferred by many
businesses because it focuses on the rate of return rather and not NPV values.

The IRR and NPV appraisal methods are both robust, yet neither should be used as a
panacea within investment appraisal, as many other factors and analysis tools can be
used alongside them to make the strategic decision- making more effective.

Financial analysis is an essential ingredient within strategic analysis. Importantly, the

ease with which the tools and techniques that have been outlined can be used in
strategic analysis.

To know more information about Evaluating Financial Performance

Please click the link: https://www.youtube.com/watch?v=kmb_OjxuZRg

To know more information about Financial Ratio Analysis

Please click the link: https://www.youtube.com/watch?v=MTq7HuvoGck

To know more information about Capital Budgeting Techniques – NPV,

IRR, Payback Period and PI, accounting
Please click the link: https://www.youtube.com/watch?v=CO8LDV2sO6M

Strategic Management and Business Analysis / David Williamson, Wyn Jenkins,

Peter Cooke and Keith Moreton

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