The long-term price-earnings ratio

This course work (Understanding and interpreting financial statements) will be consisting of 6 parts which are " reasons for using analysis", "brief description and justification of the ratios", "Calculations of the ratios", "Findings including conclusions and reccomendations", "critical evaluation", and "references".

  1. Reasons for using ratio analysis: Financial statements such as balance sheet or income statement are like blueprint of the company. These statements show us the current general sittuation of the company as a picture. Though, there are number of questions to be asked before beleiving into these pictures such as "do they really reflect the real sittuation or the pictures we are looking are 'photoshoped' " or "how can we interpret these pictures by only seeing them". At this point financial ratios also known as ratio analysis come. Being not very old, financial ratios are being used by lots of users in lots of areas of business. " It began with the development of a single ratio, the current ratio. Today ratio analysis involves the use of several ratios by variety of users- including credit lenders, credit-rating agencies, investors and management. " (Beaver 1966) As stated by beaver, these ratios are used by variety of users and their main duty is to assess a companies financial position relative to its industry. " The gauge of a financial ratio is the company's accounting information, which can befound in the company's main financial statements such as Income Statement and Balance Sheet. " (Muresan 2004). Besides all, the reasons are summerized as ;
    • They provide a quick and relatively simple means of assessing the financial health of business
    • Can be helpful when comapting the financial health of different businesses.
    • Good picture of the position and performance of business.
    • Help to highlight the financial strengths and weaknesses of a business

    ( Atrill 2008)

  2. Brief description and justification of the ratios that are decided to be used:
  3. As Muresan suggests " financial ratios are useful measures to provide a snapshot of a company's financial position. There are so many of them, making it difficult to decide and memorize which one(s) would be the most appropriate to be used for getting the overall financial picture about a company. " (Muresan 2004) The selection of appropriate ratios are very important because they will draw you a new picture using the old one. You have to choose, calculate and interpret the right ratios. If you put the wrong input, whatever the process is, you get the wrong output. I am planning to use number of ratios that I think they are crucial for all companies and some spesific ratios that should be used in order to interpret the financial sittuations of supermarkets. I will start with using PALMS theory which identifies and uses the five most useful categories of financial ratios to obtain the overall picture of acompany's financial position. The letters P.A.L.M.S. stems for Profitability, Asset utilization, Longterm solvency, Market value, and Short-term solvency. "PALMS help analysts to better organize their process of analyzing a company's financial position to arrive at a comprehensive and accurate conclusion about the company." (Muresan 2004) PALMS systems follows a top-down approach that an investor will be using when analyzing the company starting from the end results of the company which is profit. The logic is profit is a result of efficient management of assets, and in order to have some assets the company needs some funding. Then comes the companies longetivity in business. For example, if a company uses to much debt to make business it may end up having to pay the interest and principal of the debts extensively, resulting in reduced profit from its business activities. This fact will not make owners and shareholders happy which are very crucial for the companies future. Though, debts are lest costly and riskly then equity and the company has to make the right allocation of debt and equity usage in projects. PALMS lastly investigates the ability of the company's ability to manage its short-term ordeals, managing its current assets and liabilities during one period of financial activities. As it considers the all process of business I decided to use PALMS system as a basis for my report with some other ratios that I think which will be helpfull when analyzing the company. To add, I chose PALMS because I wanted to use another method than the textbook of Atrill in order to learn another system besides it.

  4. Calculation of Ratios
  5. Findings including conclusions and reccomendations
  6. Inventory Turnover : All else equal, higher inventory turnover is better. Morrisons has a 13,25 inventory turnover which reflects the companies ability to manage its inventories. When compared the last year (2008- 13,78), there is a 0,25% decrease in inventory turnover which does not reflects trouble. However, its competitor Sainsbury has a higher inventory turnover of 14,07. We may come up with Morrisons is worse in inventory managing or selling its products but we also know that Sainsbury's inventory turnover is decreased by nearly 5% from last year. You need to keep your inventory levels low because of costs related to having and holding high levels of inventory. Atrill summerises these costs as;

    • Storage and handling costs
    • Financing costs
    • The cost of pilferage and obsolesence
    • The cost of opportunities forgona in tying up funds in this form of asset

    (Atrill 2008)

    A solution for higher inventory levels can be applying Just-In-Time model for you inventory management. Increasing the risk a bit, JIT model suggests supplies to be delivered to business at the time that they will be used or sold. In order to succeed in JIT model you have to have an efficient supply chain management and a good inventory management system.

    Day of Sales Inventory: The sittuation is the same in day of sales inventory. The average days of selling inventory of Morrisons is higher that Sainsbury where lower rate is better. Morrisons also faced with a little increase in this ratio when compared to Sainsbury's %5 increase. As a result, in a market which is faced a recession and crisis in near past, Morrisons inventory management can be considered as average.

    Current Ratio : It signifies a company's ability to meet its short-term liabilities with its short-term assets (Feroz 2008). The higher this ratio is better for the company. Normally, to conclude that a company is healty, you expect to see a current ratio above 1 Though, in retail industry this average is much more lower. Morrisons has an average current ratio of 0,52 with a %7,25 increase compared to last year which is a good indicator. But its again in a slightly worse position when compared to Sainsbury which has a current ratio of 5,37. Morrisons has a upward trend in Current ratio when there is a downward movement in Sainsbury, though 2 years is not enough to conclude that what will be in future.

    Acid Test Ratio: When acid test ratio is considered which eliminates certain current assets like inventory, Morrisons experienced %12 increase when Sainsbury is experiencing nearly %15 decrease . "This is done because inventories are often the least liquid of the current assets and their liquidation value is often the most uncertain".(Michigan 2009) Eliminating inventories gives us a clearer vision and more accurate figure about the liquidty of company, because sometimes you may have difficulties when selling your products and diminishing inventories. "That is, even though a supermarket has thousands of people walking through its doors every day, there are still items on its shelves that don't sell as quickly as the supermarket would like."(Williamson 2009) The fact that the differences between the current and acid test ratios are large tells us that the Morrisons stocks are large either.

    Debt to equity ratio: This ratio measures how much of the company is financed by debt compared to its owners. Normally, a lower debt to equity ratio is favorable, and less risky but the balance should be sustained because using someone else's money is lest costly and less riskly in terms of our company. Morrisons has 0,37 debt to equity ratio which can be considered a a low value. Sainsbury has a debt to equity ratio two times bigger than Morrisons which makes Morrisons less risky in this manner. Both companies has more than %15 increase in this rate compared to 2008 which states that companies are relying more on debt than last year.

    Operating Profit Margin: I choose to interpret operation margin over 'Gross profit margin' because it reflects the companies sittuation better. According to Davis, operating profit margin is a much more complete and accurate indicator of a company's performance than gross margin, since it accounts for not only the cost of sales but also the other important components of operating income we such as marketing and other overhead expenses. (Davis 2005). As can be seen from the table 4 on page 7, Morrisons has a operating profit margin of 4,62 which can be considered as good when compared to Sainsbury's 3,56. No need to say the higher this ratio the better for the company.

    Sales per Square Foot of Selling Space: This ratios helps us to evaluate trading intensity per square foot and can be considered as an efficiency ratio for supermarkets. Morrisons has 21,41 pounds sales per square foot of selling space. This space excludes storages, inventories and other places that are not open to public shopping. Sainsbury's trading intensity per square is 20,01 for 2008 which is lower than morrisons figure indicating that Morrisons is using its selling space more efficiently.

  7. Critical Evaluation
  8. I did some parts of my critical evaluation under 4th section (Findings including conclusions and reccomendations) The reason for this is I thinks it is more accurate and easy to analyze and evaluate under some figures. But I would like to highlight some crucial points and indicators about 2 companies for 2 years period. When the overall performances of both companies are analyzed for two years, we can conclude that Sainsbury has better rates in some ratios but they are in declining phase for two years. On the other hand, we can interpret that Morrisons, despite the recession and global crisis, moves on and closing the gap between itself and supermarker sector leaders. The figures are getting better and better for Morrisons when compared to last decade. For example; the figure below presents the divident yield rates from 2002 and it is obvious that there were a huge gap between Morrisons and Sainsbury, and it is also clear the the gap is closing as years pass.

    • It can be seen from the tables 8 & 9 that Morrison has a increasing market share in a growing market which gives them a very good opportunities and strengths.
    • When table 5 is investigated deeply we can see that there is a little decrease in operating profit margin, though when we check some other indicators such as acid-test ratio, asset turnover or divident yield, we see that Morrisons is getting better year by year. Some other crucial information that should be considered in evaluation of the business are:

    • The Group's pace of investment picked up, with capital expenditure in the year increasing to £678m following the opening of nine new stores and the acquisition of the freehold of our new distribution centre at Sittingbourne, in Kent.
    • Cash generation was strong - with cash from operations of £964m, a year-on-year increase of £208m, or 28%.
    • Total divident 5.8p, +21%
    • Net debt 642 M, 99M +, net debt has only slightly increased in the year despite increased capital investment of £678m.
    • Group Turnover 14.5 billion +12%
    • Underlying profit 636 M +13 %
  9. References:
  • (Blakney and Ware ; Conroy ; Shari ; Beaver 1966; Lev 1969; Bruce 1996; Nissim and Penman 1999; Halsey 2000; Velez-Pareja 2000; Netherlands 2001; Muresan and Wolitzer 2004; Anderson and Brooks 2005; Davis, Freedman et al. 2005; Alexander and Hanley 2007; Debra 2008; Feroz, Kim et al. 2008; Finch 2008; Michigan 2009; Velez-Pareja 2009; Williamson 2009)
  • Alexander, C. R. and K. W. Hanley (2007). "Regulatory Monitoring Under the Sarbanes-Oxley Act." SSRN eLibrary.
  • Anderson, K. P. and C. Brooks (2005). "The Long-Term Price-Earnings Ratio." SSRN eLibrary.
  • Beaver, W. H. (1966). "Financial Ratios As Predictors of Failure." Journal of Accounting Research 4(ArticleType: primary_article / Issue Title: Empirical Research in Accounting: Selected Studies 1966 / Full publication date: 1966 / Copyright 1966 Accounting Research Center, Booth School of Business, University of Chicago): 71-111.
  • Blakney, J. and R. Ware "Efficiencies Analysis for Retail Sector Mergers." European Competition Journal, Vol. 2, No. 2, December 2006.
  • Bruce, J. (1996). "FINANCIAL ANALYSIS: RATIOS AND OTHER FINANCIAL MEASURES."
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  • Davis, E. E., M. Freedman, et al. (2005). "Product Market Competition and Human Resource Practices: An Analysis of the Retail Food Sector." SSRN eLibrary.
  • Debra, C. J., McTaggart (2008). "The 75th Annual Report of the Grocery Industry." Progressive grocer(April 15 2008).
  • Feroz, E. H., S. Kim, et al. (2008). "Financial Statement Analysis: A Data Envelopment Analysis Approach." <a href=http://www.palgrave-journals.com/jors/journal/v54/n1/pdf/2601475a.pdf> Journal of the Operational Research Society, Vol. 54, pp. 48-58, 2003 .
  • Finch, N. (2008). "Summary of Financial Ratios." SSRN eLibrary.
  • Halsey, R. F. (2000). "Using The Residual-Income Stock Price Valuation Model To Teach And Learn Ratio Analysis." SSRN eLibrary.
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  • Michigan, S. U. o. (2009). "CHAPTER 5. RATIO ANALYSIS, FINANCIAL PLANNING AND FINANCIAL ANALYSIS." Course ABM 435 from www.msu.edu/course/abm/435/chapter5.pdf.
  • Muresan, E. R. and P. Wolitzer (2004). "Organize your Financial Ratios Analysis with PALMS." SSRN eLibrary.
  • Netherlands, S. (2001). " Corporate Social and Financial Performance: An Investigation in the U.K. Supermarket Industry " Journal of Business Ethics 34: 299-315.
  • Nissim, D. and S. H. Penman (1999). "Ratio Analysis and Equity Valuation." SSRN eLibrary.
  • Shari, W. "Measuring Retail Performance and Productivity." Retrieved 25 November, 2009.
  • Velez-Pareja, I. (2000). "The Weighted Internal Rate of Return (WIRR) and Expanded Benefit-Cost Ratio (EB/CR)." SSRN eLibrary.
  • Velez-Pareja, I. (2009). "Financial Analysis and Control - Financial Ratio Analysis (Slides in Spanish)." SSRN eLibrary.
  • Williamson, D. (2009). "Financial Ratio Analysis." Retrieved 27/11/2009, 2009, from http://www.bized.co.uk/compfact/ratios/index.htm.

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