TOOL E7
The “Revenues and Profitability” component of financial risk analysis provides insight into a client’s ability to generate profits, which in turn ultimately drive cash flows. Profits are driven by a company’s sales and revenues; the cost efficiency of its operations; its overall operating expense management; its financial cost management; and the extent to which the company retains profits or turns them over to its owners. This tool will help you understand and interpret the non-financial reasons that drive the metrics associated with “Revenues and Profitability”; identify one-off factors; consider accounting policies that impact the reported numbers; and be mindful of internal spreading errors that may distort these metrics.
Sales / Performance / Expense Management Ratios
| Typical Ratio | Interpretation | One-off Factors | Accounting Policies | Internal Spreading |
|---|---|---|---|---|
SALES (ABSOLUTE; RELATIVE TO INDUSTRY) | • May reflect market position and may indicate competitive position vis-à-vis suppliers, buyers, etc • May indicate diversification (geography, products, customers, etc) | • Income recognition • Incidentally high sales • Acquisition/ divestments | • What is accounted for as sales? • Has there been a change in the income recognition policy? • Impact of foreign exchange rates? | • Check if ‘interest income’, ‘other income’ or “extraordinary income’, has been included in the sales figure? |
| % SALES (GROWTH) [(Sales Y 2– Sales Y1) x 100] / Sales Year 1 | • Can we separate impact of volume and price? • Slowing growth may be due to tough competition or a declining market • What stage of the product life cycle are the company’s goods in? • If there is strong growth— is the company ‘buying’ market share? This may be indicated by a squeeze on gross margins. | • Income recognition • Incidentally high sales • Change in relationship between volume and price • Acquisition/ divestments | • What is accounted for as sales? • Has there been a change in the income recognition policy?(check for a change in the income recognition policy? • Impact of foreign exchange rates? Tool: Accounting Policies Tool: Creative Accounting | • Check if ‘interest income’, ‘other income’ or “extraordinary income’, has been included in the sales figure? |
| GROSS PROFIT MARGIN Gross Trading Profit x 100 / Turnover | • Reducing margin may indicate – Pressure on sales price from competition – Rising raw material prices – Discounting of old inventory – Exchange rates • Care if an improving margin is due to a build up of inventory • Less reliable if protection depreciation is not included | • As in sales growth above • Change in product mix • Rise in raw material prices not passed on to client • Build up of inventory • Foreign exchange rate movements | • Check what is included in the sales figures (see turnover growth above) • How is inventory valued? Does value of WIP include indirect costs? • Has there been a change in the inventory valuation method? • Does the cost of goods sold include production depreciation or not | • Check what is included in the sales figures (see sales above) • Have production wages and depreciation been included in COGS? • Be careful how depreciation is treated in the measurement of all performance ratios. |
| OPERATING MARGIN Earnings before Interest & Tax x 100 / Sales | • Are the trend in Gross Profit Margin, or changes in expenses below Gross Profit Margin, a major influence? • Check Expenses Management ratio below • A reducing margins may indicate: – gross profit margin problems or rising fixed cost – Poor control of overheads or excessive spending – If the operating margin is increasing, check whether staff numbers have been reduced? • The trend is less reliable if EBITDA is used in the definition (EBITDA margin), especially in high fixed asset companies, except for peer comparison | • As above in gross profit margin • Unusual annual impairment of goodwill/intangibles • Incidentally high overhead/operating costs • Large operating provisions • Book gains / losses • Derivate gains / losses | • As above in gross profit margin • Has the depreciation policy changed? • Are intangible assets subject to annual impairment or regular amortization charge? • Are stock options included? • Is extraordinary income included? • Have operating costs been reclassified as extraordinary? • What is the impact of operating provisions? • Is adjustment needed for minority interests? Tool: Accounting Policies Tool: Creative Accounting | • Have any extraordinary costs / income been included? • Have any ordinary costs been booked as extraordinary costs? • Have any costs been taken directly to reserves? |
| EXPENSES MANAGEMENT Selling, Gen & Admin x100 / Sales | • A deteriorating metric indicates poor overhead control • Has a key costs (e.g. research & development, marketing pensions) been reduced to improve efficiency or as a cutback to essential activity? • Is individual expense analysis required? Compare individual expenses to sales (e.g labour / sales) | • Care there is no revenue item set off against the cost, e.g. net provisions • Care how depreciation and leasing costs are treated • Check: are there one-off expense reductions because of increased efficiency or harmful cut backs like R&D? | • As above • Take particular care with respect to the capitalization of costs | • As above • Check where depreciation and operating leases are spread • Check netting of costs and revenues, especially provisions |
Financial Cost Management
| Typical Ratio | Interpretation | One-off Factors | Accounting Policies | Internal Spreading |
|---|---|---|---|---|
| INTEREST COVERAGE RATIO EBT / Gross Interest + Capitalised Interest | • Answers whether the business is efficient enough for its funding structure – Check leverage – Use of EBITDA instead of EBIT makes the trend look artificially better. • A volatile ratio indicates high sensitivity to changes in interest rates. • It is preferable to use gross interest expense rather than net interest: – If net interest is being used, check that interest received does not relate to restricted cash. • The ratio should be interpreted in line with the client’s hedging policy • Check if this metric impacted by foreign currency debt • A deteriorating ratio could indicate: – Pressure on profits, leaving the company in losses after its interest bill; – Higher interest rates; – Poor interest rate risk management. – Higher debt levels without corresponding improvements in profits | • See issues under operating margin hedging activity • Large increase or decrease in debt near year-end not reflected in the interest figure | • See items related to operating margin • What is included in financial costs – is there consistency? • Capitalised interest? • Interest on off-balance sheet debt will not be included • Treatment of interest rolled up onto principal • Treatment of payment in Kind(PIK) interest Tool: Accounting Policies Tool: Creative Accounting | • Has capitalized interest been separately identified? • Has interest received been netted with interest paid? • What is included in “Financial Costs”? Is there consistency? Be aware that this ratio is not an indicator of whether the company can actually pay its interest bills (as EBIT is not cash). |
Profit Share Allocated to 3rd Parties
| Typical Ratio | Interpretation | One-off Factors | Accounting Policies | Internal Spreading |
|---|---|---|---|---|
| TAX RATE Income Tax Expense (Benefit) x 100 / Pre Tax Profit | • If tax benefit or ratio is much lower than the average rate in the country, be clear whether this is due to: a) Government incentive b) Recovery of tax losses c) Poor quality earning (see accounting policies) d) High level of offshore earnings e) Good / legal tax planning |
• Capital gains / losses on divestments • Settlement of tax disputes • Change in tax rate • Use of previous tax losses • High tax refund |
• Impact of Deferred Tax on later years tax charge to the Income Statement • The revenue authorities set their own accounting policies in areas such as depreciation, inventory valuation and provisions • Any large difference with the average rate in the country may indicate creative accounting | • Is it clear what the difference is between Tax Charge and Tax Paid? |
| NET PROFIT MARGIN Turnover-Total costs x 100 / Turnover |
• What is the impact of gross and operating margins—are they stable or improving? • A falling net profit margin could indicate: • Volatile items in the income statement (between EBIT & Net Profit) makes trend analysis of little value (See comment under ICR and Tax rate above) • The percentage gives an indication of the wealth created by the business – either to be paid to the shareholders or retained in the business. See Dividend Payout ratio below | • See issues under Gross Margin Operating Margin, ICR and Tax rate | • See issues under Gross Profit Margin Operating Margin, Interest CR and Tax Rate | • See issues under Gross Profit Margin Operating Margin, Interest CR and Tax Rate |
| DIVIDEND PAYOUT RATE Dividend Declared / Net Profit |
• Indicates the extent to which a company is retaining profit or distributing to shareholders. • The level of retention should be compared to the level of growth in the company. |
• See issues under Net Profit above • Unusually high or low dividends | • Are dividends declared in the income statement or in the note to the accounts | • Have mandatory dividends i.e. preference shares been included in financing costs? |
