(166)-ACCOUNTING RATIO ANALYSIS

Accounting Ratio Analysis

Return on Capital Employed (ROCE)

It is impossible to assess profits or profit growth properly without relating them to the amount of funds (capital) that were employed in making the profits. The most important profitability ratio is therefore return on capital employed (ROCE), which states the profit as a percentage of the amount of capital employed.

ROCE = Profit on ordinary activities before interest and taxation / Capital employed

Capital employed = shareholders’ funds plus creditors: amounts falling due after more than one year’ plus any long term provisions for liabilities and charges

The underlying principle is that we must compare like with like, and so if capital means share capital and reserves plus long term liabilities and debt capital, profit must mean the profit earned by all this capital together. This is profit before interest and taxation (PBIT), since interest is the return for loan capital.

What does a company’s ROCE tell us? What should we be looking for? There are three comparisons that can be made.

• The change in ROCE from one year to the next can be examined
• The ROCE being earned by other companies, if this information is available, can be compared with the ROCE of this company.
• A comparison of the ROCE with current market borrowing rates may be made.
  1. What would be the cost of extra borrowing to the company if it needed more loans, and it is earning a ROCE that suggests it could make profits to make such borrowing worthwhile? 2. Is the company making a ROCE which suggests that it is getting value for money from its current borrowing?
  3. Companies are in a risk business and commercial borrowing rates are a good independent yardstick against which company performance can be judged.

However, it is easier to spot a low ROCE, than a high one, because there is always a chance that the company’s fixed assets, especially property, is undervalued in its balance sheet, and so the capital employed figure might be unrealistically low.

(165)-PROFITABILITY AND RETURN ON CAPITAL RATIOS

Profitability and Return on Capital Ratios

Profit on ordinary activities before taxation is generally thought to be a better figure to use than profit after taxation, because there might be unusual variations in the tax charge from year to year which would not affect the underlying profitability of the company’s operations.

Another profit figure that should be calculated is PBIT, profit before interest and tax. This is the amount of profit which the company earned before having to pay interest to the providers of loan capital. By providers of loan capital, we usually mean longer-term loan capital, such as debentures and medium-term bank loans, which will be shown in the balance sheet as “creditors: amounts falling due after more than one year”.

Profit before interest and tax is therefore:

1. The profit on ordinary activities before taxation
2. Plus interest charge on long-term loan capital

Published accounts do not always give sufficient detail on interest payable to determine how much is interest on long-term finance.

(164)-ACCOUNTING RATIO ANALYSIS

Accounting Ratio Analysis

Importance of Ratio Analysis

If we were look at a balance sheet or profit and loss account, how would you decide whether the company was doing well or badly? Or whether it was financially strong or financially vulnerable? And what would be you looking at in the figures to help you to make your judgment?
Ration analysis involves comparing one figure against another to produce a ratio, and assessing whether the ratio indicates a weakness or strength in the company’s affairs.

The Broad Categories of Ratios

Broadly speaking, basic ratios can be grouped into five categories:

1. Profitability and return
2. Long-term solvency and stability
3. Short-term solvency and liquidity
4. Efficiency (turnover rations)
5. Shareholders’ investment ratios

Within each heading we will identify a number of standard measures or ratios that are normally calculated and generally accepted as meaningful indicators. Each individual business must be considered separately, and a ration that is meaningful for a manufacturing company may be completely meaningless for a financial institution. Try not to be too mechanical when working out ratios and constantly thinks about what you are trying to achieve.

They key to obtaining meaningful information from ratio analysis is comparison. This may involve comparing ratios over time within the same business to establish whether things are improving or declining, and comparing ratios between similar business to see whether the company you are analyzing is better or worse than average within its specific business sector.
It must be stressed that ratio analysis on its own is not sufficient for interpreting company accounts, and that there are other items of information which should be looked at, for example:

• Comments in the chairmen’s report and director’s report
• The age and nature of the company’s assets
• Current and future developments in the company’s markets, at home and overseas;
• Any other noticeable feature of the report and accounts, such as post balance sheet events, contingent liabilities, a qualified auditors report, the company’s taxation position, and so on

In case, consider also who you are advising, a creditor will not be interested in shareholder’s investment ratios.

(163)-SUMMARY FOR CONSOLIDATED ACCOUNTS

Summary for Consolidated Accounts

In our previous posts we discussed about consolidated accounts, you need to know following things about consolidated accounts.

• The concept of a group and introduced several important definitions.
• The principle regulations governing the preparation of group accounts.
• The machines of preparing simple consolidated balance sheet. And procedures have been described for dealing with cancellation, calculating of minority interests, calculating of goodwill arising on consolidation.
• A three stage drill has been described, the stages are,
  1. Cancel items common to both balance sheets
  2. Minority interests
  3. Goodwill

(162)-A TECHNIQUE OF CONSOLIDATION

A Technique of Consolidation

In our previous posts we have now looked at the topics of cancellation, minority interests and goodwill arising on consolidation. It is time to set out an approach to be used in tacking consolidated balance sheets.

The approach we recommend consists of three steps.

1. Step one - Cancel items common to both balance sheets.
2. Step two – Produce working for minority interests.
3. Step three – Produce a goodwill working. Then produce working for capital and revenue reserves.

(161)-GOODWILL AND INTANGIBLE ASSETS

Goodwill and Intangible Assets

• Goodwill must be amortized if it is expected to last less than 20 years.
• Otherwise, goodwill is to remain in the balance sheet.
• Navigate goodwill is shown as a credit in the balance sheet just below positive goodwill.

If goodwill is amortized the consolidation adjustment required each year is as follows.
Debit – Consolidated profit and loss account
Credit – Provision for amortization of goodwill

The unamortized portion will be including in the consolidated balance sheet under fixed assets.
Financial reporting standards contain a presumption that the useful life of the goodwill is less than 20 years. The presumption may be rebutted. If it is greater than 20 years, it must still be amortized. If it is indefinite, it should not be amortized, but a full impairment review should be performed each year. An impairment review should, in any case, be performed at the end of the first full year after acquisition.

(160)-GOODWILL AND PRE-ACQUISITION PROFITS

Goodwill and Pre-acquisition Profits

Assuming instead that S Ltd has earned profits of 8000$ in the period before acquisition, its balance sheet just before the purchase would like as follows.

Net tangible assets 40000$
Share capital 40000$
Reserves 8000$

If H Ltd now purchases all the shares in S Ltd it will acquire net tangible assets worth 48000$ (share capital + reserves) at a cost of 60000$. Clearly in this case S Ltd’s intangible assets (goodwill) are being valued at 12000$ by the parent company must be incorporated in the cancellation process so as to arrive at a figure for goodwill arising on consolidation. In other words, not only S Ltd’s shares capital, but also its pre-acquisition reserves, must be cancelled against the asset “investment in S Ltd” in the accounts of parent company. The unconcealed balance of 12000$ appears in the consolidated balance sheet.

The consequence of this is that any pre acquisition reserves of a subsidiary company are not aggregated with the parent company’s reserves in the consolidated balance sheet. The figure of consolidated reserves comprises the reserves of the parent company plus the post-acquisition reserves only of subsidiary companies. The post-acquisition reserves are simply reserves not less reserves at acquisition.

(159)-GOODWILL ARISING ON CONSOLIDATION

Goodwill Arising on Consolidation

When a company X Ltd wishes to purchase shares in a company Y Ltd it must it must pay the previous owners of those shares. The most obvious form of payment would be in cash. Suppose X Ltd purchases all 40000$ 1 shares in Y Ltd and pays 60000$ cash to the previous share holders in consideration. The entries in X Ltd’s books would be:

Debit – Investment in Y Ltd at cost 60000$
Credit – Bank 60000$

However, the previous shareholders might be prepared to asset some other firm of consideration. For example they might accept an agreed number of shares in X Ltd. X Ltd would then issue new shares in the agreed number and allot them to the former shareholders of s Y Ltd. This kind of deal might be attractive to X Ltd since it avoids the need for a heavy cash outlay. The former shareholders of Y Ltd would return and indirect interests in that company’s profitability via their new holding in its parent company.

(158)-GOODWILL ARISING ON CONSOLIDATION

Goodwill Arising on Consolidation

In the group accounts we have looked at so far the cost of shares acquired by the parent company has always been equal to the nominal value of those shares. This is seldom the case in practice and we must now consider some more complicated examples. To begin with, we will examine the entries made by the parent company on its own balance sheet when it acquired shares.

Suppose when a the directors of XYZ company agree to pay for 120000$ for a 100% investment in ABC limited they must believe that, in addition to its tangible assets 80000$, ABC limited must also have intangible assets worth 40000$. This amount of 40000$ paid over and above the value of the tangible assets acquired is called goodwill arising on consolidation (sometimes it called premium on acquisition).

(157)-RECOMMENDED TECHNIQUE FOR DEALING WITH MINORITY INTERESTS

Recommended Technique for Dealing with Minority Interests

In more complicated situations the following technique is recommended for dealing with minority interests.

• Cancel common items in the draft balance sheets. If there is a minority interest, the subsidiary company’s share capital will be a partly cancelled item. Ascertain the proportion of ordinary shares and the proportion (possibly different) of preference share held by the minority.
• Produce a working for the minority interest. Add in the amounts of preference and ordinary share capital calculated in step 1: this completes the cancellation of the subsidiary’s share capital.
  Add also the minority’s share of each reserve in the subsidiary company. Reserves belong to equity shareholders; the proportion attributable to minority interests therefore depends on their percentage holding of ordinary shares.
• Produce a separate working for each reserve (capital, revenue etc) found in the subsidiary company’s balance sheet. The initial balances on these accounts will be taken straight from the draft balance sheets of the parent and subsidiary company.
• The closing balances in these working can be entered directly onto the consolidated balance sheet.

(156)-MINORITY INTERESTS IN GROUP ACCOUNTS

Minority Interests in Group Accounts

It was mentioned earlier that the total assets and liabilities of subsidiary companies are included in the consolidated balance sheet, even in the case of subsidiaries which are only partly owned. A proportion of the net assets of such subsidiaries in fact belong to investors from outside the group.

Financial reporting standards (FRS) defines minority interest in a subsidiary undertaking as the “Interest in a subsidiary undertaking included in the consolidation that is attributable to the shares held by or on behalf of persons other than the parent undertaking and its subsidiary undertakings”.

In the consolidated balance sheet it is necessary to distinguish this proportion from those assets attributable to the group and financed by shareholders’ funds.

The net assets of a company are financed by share capital and reserves. The consolidation procedure for dealing with partly owned subsidiaries is to calculate the proportion of ordinary shares, preference shares and reserves attributable to minority interests.

(155)-PART CANCELLATION IN GROUP ACCOUNTS

Part Cancellation in Group Accounts

An item may appear in the balance sheets of a parent company and its subsidiary, but not at the same amounts.

• The parent company may have acquired shares in the subsidiary at a price grater or less than their nominal value. The asset will appear in the parent company’s accounts at cost, while the liability will appear in the subsidiary’s accounts at nominal value.
• Even if the parent company acquired shares at nominal value, it may not have acquired all the shares of the subsidiary (so the subsidiary may be only partly owned).
  • One company may have issued loan stock of which a proportion only is taken up by the other company.

(154)-CANCELLATION AND PART CANCELLATION

Cancellation and Part Cancellation

The preparation of a consolidated balance sheet, in a very simple form, consists of two procedures.

1. Take the individual accounts of the holding company and each subsidiary and cancel out items which appear as an asset in one company and a liability in another.
2. Add together all the uncancelled assets and liabilities throughout the group.

Items requiring cancellation may include the asset “shares in subsidiary companies” which appears in the parent company’s accounts will be matched with the liability share capital in the subsidiaries accounts.

(153)-REQUIREMENTS TO PREPARE GROUP ACCOUNTS

Requirements to Prepare Group Accounts

Size Criteria

Any of the following size criteria for small and medium sized groups must me met.

• Aggregate turnover
  Small- Less than 5.6 million $
  Medium sized- Less than 22.8 million $
• Aggregate gross assets
  Small- Less than 2.8 million $
  Medium sized- 11.4 million $
• Aggregate number of employees
  Small- Less than 50 million $
  Medium sized- 250 million $

The qualifying conditions must be met:

• In the case of the parent’s financial year, in that year
• In the case of any subsequent financial year, in that year and the preceding year

If the qualifying conditions were met in the preceding year but not in the current year, the exemption can be claimed. If, in the subsequent year, the conditions are met again, the exemption can still be claimed, but if they are not met, then the exemption is lost until conditions are again met for the second of two successive years.

When the exemption is claimed, but the auditors believe that the company is not entitled to it, then they must state in their report that the company is in their option not entitled to the exemption and this report must be attached to the individual accounts of the company.

(152)-REQUIREMENT TO PREPARE GROUP ACCOUNTS

Requirement to Prepare Group Accounts

The companies act introduced a completely new provision exempting some groups from preparing consolidated accounts. There are two grounds.

1. Similar groups can claim exemptions on grounds of size
2. Parent companies (except for listed companies) whose immediate parent is established in some countries need not prepare consolidated accounts. The accounts must give the name and country of incorporation of the parent and state the fact of the exemption. In addition, a copy of the audited consolidated accounts of the parent must be filed with the company accounts. Minority shareholders can, however, require that consolidated accounts are prepared.

The exemption from preparing consolidated accounts is not available to:

• Public accounts
• Banking and insurance companies
• Authorized persons under the law
• Companies belonging to a group containing a member of the above classes of undertaking

(151)-CANCELLATION AND PART CANCELLATION

Cancellation and Part Cancellation

The preparation of a consolidated balance sheet, in a very simple form, consists of two procedures.

1. Take the individual accounts of the holding company and each subsidiary and cancel out items which appear as an asset in one company and a liability in another.
2. Add together all the uncancelled assets and liabilities throughout the group.

Items require cancellation may include the asset “share in subsidiary companies” which appear in the parent company’s accounts will be matched with the liability “share capital” in the subsidiaries’ accounts.

(150)-SUMMARIES RELATING TO EXCLUSION OF A SUBSIDIARY

Summaries Relating To Exclusion of a Subsidiary

The following explanations are summaries the rules relating to exclusion of a subsidiary.

Reason 1

Serve long term restrictions hindering exercise of parent’s rights

Accounting Treatment

Balance sheet: equity method up to date of serve restrictions less amounts written off if permanent fall in value. Profit and loss account: dividends received only

Reason 2

Held exclusively for subsequent resale; has been consolidated

Accounting Treatment

Current asset at the lower of cost and net realizable value

Reason 3

Dissimilar activities

Accounting Treatment

Equity method

(149)-INFORMATION DISCLOSED IN THE GROUP ACCOUNTS

Information Disclosed In the Group Accounts

The following information should be disclosed in the group accounts.

• Its net assets
• Its profit or loss for the period
• Any amounts included in the consolidated profit and loss account in respect of, dividends received by the holding company from the subsidiary, writing down the value of the investment.
• The reason of exclusion
• The names of subsidiaries excluded
• The premium or discount on acquisition net written off
• Anything else required by the companies acts

If control is temporary (the investment is held purely for resale), the temporary investment should be included under current assets in the consolidated balance sheet at the lower of cost and net realizable value.

The companies act requires that when consolidated group accounts are not prepared, or if any subsidiaries are excluded from the group accounts (from any reasons given above), a note to the accounts should be given:

• To explain the reasons why the subsidiaries are not dealt with in group accounts
• To disclose any auditors’ qualifications in the accounts of the excluded subsidiaries

(148)-EXCLUSION OF SUBSIDIARY UNDERTAKINGS FROM GROUP ACCOUNTS

Exclusion of Subsidiary Undertakings from Group Accounts

Where a subsidiary is excluded from group accounts, financial reporting standards (FRS) lays down supplementary provisions on the disclosures and accounting treatment required.

Where a subsidiary is excluded on group accounts should include separate financial statements for that subsidiary including:

• A note of the holding company’s interest
• Details of intra-group balances
• The nature of its transactions with the rest of the group
• A reconciliation of the subsidiary’s results (as shown separately) with the value in the consolidated accounts for the group’s investment in the subsidiary

In the consolidated accounts, the excluded subsidiary should be accounted for by the equity method of accounting (as though it were as associated company).

Subsidiary undertakings excluded from consolidation because of serve long-term restrictions are to be treated as fixed asset investments. They are to be included at their carrying amount when the restrictions came into force, and no further accruals are to be made for profits or losses of those subsidiary undertakings, unless the parent undertaking still exercises significant influence. In the latter case they are to be treated as associated undertakings.

(147)-EXCLUSION OF SUBSIDIARY UNDERTAKINGS FROM GROUP ACCOUNTS

Exclusion of Subsidiary Undertakings from Group Accounts

Financial reporting standards (FRS) states that a subsidiary must be excluded from consolidation in the following circumstances.

• Serve long term restrictions are substantially hindering the exercise of the parent’s rights over the subsidiary’s assets or management.
• The group’s interest in the subsidiary undertaking is held exclusively with a view to subsequent resale and the subsidiary has not been consolidated previously.
• The subsidiary undertaking’s activities are so different from those of other undertakings to be included in the consolidation that its inclusion would be incompatible with the obligation to give a true and fair view.

The financial reporting standards (FRS) require the circumstances in which subsidiary undertakings are to be excluded from consolidation to be interpreted strictly.

(146)-EXCLUSION OF SUBSIDIARY UNDERTAKINGS FROM GROUP ACCOUNTS

Exclusion of Subsidiary Undertakings from Group Accounts

The companies act provides that a subsidiary may be omitted from the consolidated accounts of a group if any of the following apply.

• In the opinion of the directors, its inclusion is not material for the purpose of giving a true and fair view; but two or more undertakings may be excluded only if they are not material taken together.
• There are severe long term restrictions in exercising the parent company’s rights.
• The holding is exclusively for resale.
• The information cannot be obtained “without disproportionate expense or undue delay”.

If the opinion of the directors, a subsidiary undertaking’s consolidation is undesirable because the business of the holding company and subsidiary are so different that they cannot reasonably be treated as a single undertaking, then that undertaking must be excluded.

This does not apply merely because some of the undertakings are industrial, some commercial and some provide services, or because they carry on industrial or commercial activities involving different products or provide different services.

(145)-CONSOLIDATION

Consolidation

An undertaking S is a subsidiary undertaking of H of:

• S is a subsidiary of H, i.e. H is a member of S and either holds pr controls > 50% of the voting rights or controls the board;
• S is a subsidiary because it is a subsidiary of a subsidiary of H;
• H has the right to exercise a dominant influence over S;
• H has a participating interest in S and either actually exercises a dominant influence over S or H and S are managed on a unified basis.

(144)-IMPORTANT DEFINITIONS FOR GROUP ACCOUNTING

Important Definitions for Group Accounting

Control

Control is the ability of an undertaking to direct the financial and operating policies of another undertaking with a view to gaining economic benefits from its activities.

Interest held on a long term basis

An interest held on a long term basis is an interest which is held other than exclusively with a view to subsequent resale.

Interest held exclusively with a view to subsequent resale

An interest exclusively with a view to subsequent resale is either:

• An interest for which a purchaser has been identified or is being sought, and which is reasonably expected to be disposed of within approximately one year of its date of acquisition, or
• An interest that was acquired as a result of the enforcement of a security, unless the interest has become part of the continuing activities of the group or the holder acts as if it intends the interest to become so

Managed on a unified basis

Two or more undertakings are managed on a unified basis if the whole of the operations of the undertakings are integrated and they are managed as a single unit. Unified management does not arise solely because one undertaking manages another.

(143)-DOMINANT INFLUENCE

Dominant Influence

Financial reporting standards (FRS) defines dominant influence as influence that can be exercised to achieve the operating and financial politics desired by the holder of the influence, notwithstanding the rights or influence of any other party.

The standard then distinguishes between the two differences situations involving dominant influence.

1. The right to exercise a dominant influence means that the holder has a right to give directions with respect to the operating and financial policies of another undertaking with which its directors are obliged to comply, whether or not they are for the benefit of that undertaking.
2. The actual exercise of dominant influence is the exercise of an influence that achieves the result that the operating and financial policies of the undertaking influenced are set in accordance with the wishes of the holder of the influence and for the holder’s benefit whether or not those wishes are explicit. The actual exercise of dominant influence is identified by its effect in practice rather than by the way in which it is exercised.

(142)-THE REQUIRED TO CONSOLIDATE

The Required To Consolidate

Financial reporting standards (FRS) require a parent undertaking to prepare consolidated financial statements for its group unless it uses one the exemptions available in the standard.

Consolidation is defined as:

The process of adjusting and combining financial information from the individual financial statements of a parent undertaking and its subsidiary undertaking to prepare consolidated financial statements that present financial information for the group as a single economic entity