Dividend cover
Some shareholders buy shares for income. In such cases, the amount of the dividend is important and especially how it is covered. If the dividend is not well covered, then there is the risk that it would be lowered in the future.
2006 2005 2004 2003 2002
Earnings (£’000) 1704 1357 2530 1860 1529
Dividends (£’000) 200 173 150 135 123
Dividend cover 8.5 7.8 16.9 13.8 12.4
In this example, although the cover has been dropping, the dividend is well covered.
Dividend yield
2006 2005 2004 2003 2002
Price of share (pence) 41.0 44.0 38.0 45.0 35.0
Dividend per share (pence) 0.23 0.20 0.17 0.16 0.15
Dividend yield (%) 0.56 0.45 0.45 0.36 0.43
This example is clearly not what could be described as an ‘income share’!
Goodwill built into share
The idea here is to compare the value of the company as determined by the current share price with the value as shown in the Balance Sheet.
2006 2005 2004 2003 2002
Number of shares ‘000 86 500 86 500 86 500 84 800 82 100
Price of share (pence) 41.0 44.0 38.0 45.0 35.0
Value of company (£’000) 35 465 38 080 32 870 38 160 28 735 Asset value (£’000) 35 184 33 680 32 496 29 690 27 286
Goodwill 281 4400 374 8470 1449
Goodwill (%) 0.8 13.1 1.2 28.5 5.3
was an isolated example where the directors of the company acted fraudu- lently; accounts are usually inaccurate due to errors of judgement rather than criminal activity.
The difficulty for investors is, that while ratio analysis can draw attention to problem areas, they are not privy to the internal management accounts and therefore have to make judgements based on limited information. Nor can investors know whether a particular management team is on top of the problem or not; if they are, the problem indicated by the adverse ratio could go away. However, there are a few cases that crop up each year where the adverse ratio has predicted a major problem area before it has become a public knowledge.
The key ratios to look at with a view to spotting potential disasters are all asset management ratios and are to do with stock, debtors and cash.
Cash is king
If a company is making a profit, it should be generating cash. If it is not, this is an indicator that something is wrong. The company may spend more than it earns to buy assets to grow the company and, of course, this is accept- able, but growth must follow this expenditure. Also, this expenditure must improve cash generation in the long term, so eventually even growing compa- nies should generate cash. However, where companies are not buying assets, but merely consuming cash to fund short-term increases in working capital due to growth, this can result in ‘overtrading’ and liquidity problems. So, if a com- pany consistently, year on year, spends more money than it is generating, then it is an indicator that something may be wrong. This, of course, is especially dangerous where the company was highly indebted before the growth took place.
Jarvis plc is a prime example of what can happen when overtrading takes place.
At the company’s year end close at 31 March 2000, intangible assets accounted for 87% of equity shareholders’ funds (£179 million) and net debt stood at
£118 million. In its 2001 financial year, the company generated £42 million against earnings of £15 million, so all seemed well, except that the dividend was covered only 1.1 times. However, it was the 2002 result that should have caused readers of accounts some concern. Turnover went up by 29% compared to the previous year and although stock days and debtor days were virtually
unchanged, net debt went up to £80 million, despite earnings doubling to
£31 million. At the same time, the company was being blamed for the crash at Potters Bar and although the company denied this allegation, it came on top of a weak Balance Sheet.
Many companies suffer problems of the type faced by Jarvis plc (accusations of doing something wrong in the course of business) and no business is without risk, but when things go wrong it is the companies that are indebted that are the most vulnerable. Jarvis’s shares trading at around 334 pence in 2002 ended below one penny a few years later. So, cash is king.
The first test that needs to be carried out is the ‘Cash Test’. To do this, ‘Net Cash Inflow from Operations’ (operating activities in UK GAAP accounts) in the Cash Flow Statement is compared to the ‘Operating Profit’ in the Profit and Loss Account. ‘Net Cash Inflow from Operations’ should nearly (see exceptions below) always be higher than the ‘operating profit’, because the cash flow figure is simply operating profit plus depreciation plus amortisation plus or minus movement in working capital. If the cash flow figure is lower than operating profit, the cause may be overtrading and/or poor asset management.
The calculation of stock days and debtor days might provide the necessary clues.
This simple calculation can be illustrated from Figure 2.10 – Cash Flow State- ment for A Food Manufacturing Company:
2006 2005 2004 2003
Operating profit (£’000) 5082 5047 6708 4880
Net cash inflow from op. act (£’000) 22 848 8629 10 671 9311
As can be seen from the debtor days ratio, there was a potential problem with debtor days in 2005, yet this was insufficient to cause the above test to fail.
Accordingly, where it does fail, every effort must be made to establish the reason.
Of course, there are exceptions to every rule. A house builder’s stock days
Cash Flow Statement for: A Food Manufacturing Company 31 Dec 06 31 Dec 05 31 Dec 04 31 Dec 03
£’000 £’000 £’000 £’000
Reconciliation of operating profit to net cash inflow from operating activities
Operating profit 5,082 5,047 6,708 4,880
Amortisation of intangible assets 1,750 1,787 1,585 1,148
Depreciation of tangible assets 5,740 6,690 4,164 2,560
(Increase)/decrease in stocks 380 (1,500) (2,000) (2,658)
(Increase)/decrease in debtors 8,697 (10,220) (4,627) (4,726)
Increase/(decrease) in creditors 1,199 6,825 4,841 8,107
Net cash inflow from operating activities 22,848 8,629 10,671 9,311
CASH FLOW STATEMENT
Net cash inflow from operating activities 22,848 8,629 10,671 9,311
Return on investment 0 0 0 0
Servicing of Finance (2,503) (3,100) (3,077) (1,894)
Taxation (467) (98) (531) (581)
Capital expenditure 0 (7,194) (35,051) (28,482)
Dividends paid (173) (150) (135) (123)
Net cash inflow/(outflow) before financing 19,705 (1,913) (28,123) (21,769)
Financing – issue of shares 0 0 426 679
Financing – issue/(repayment) of loans (15,000) 0 25,000 19,991
Increase/(decrease) in cash 4,705 (1,913) (2,697) (1,099)
Reconciliation of cash flow with movements in cash
Opening cash (4,449) (2,536) 161 1,260
Closing cash 256 (4,449) (2,536) 161
Movement in cash balances 4,705 (1,913) (2,697) (1,099)
Figure 2.10 A Food Manufacturing Co. – Cash Flow Statement
Stock days
Stock days in the hotel and catering industry will be relatively low, as compa- nies operating bars, restaurants and hotels are likely to have only a few days’
stock of food and only a few weeks’ stock of drink. A review of accounts of five companies in this sector resulted in stock days being in the range 6–16 days, so when SFI plc’s accounts for the year ended 31 May 2001 came out with 32 days’ stock it could be described as somewhat surprising. However, these accounts did not really have an adverse impact on the market and the shares continued to trade at around £2. The following year’s accounts, for the year ended 31 May 2002, should have raised even more eyebrows, as stock days went out to 43 days. Months later it was revealed that stock had been overstated and the company ceased trading.
Debtor days
Debtor days will vary from industry to industry. A retailer selling largely for cash will have only a few debtor days, an industrial company may have debtors at around 60 days, while other companies have to offer longer periods of credit.
Companies specialising in computer software often have long debtor days.
A particular contract might include stage payments, but the customer is likely to hold a fair percentage of the contract price back until there is sufficient evidence that the software works. Accordingly, debtor days at around 100 days might not be too alarming for a software company.
Isoft plc is a computer software company and at its year ended 30 April 2003, their accounts showed debtor days at 106 days, a little high against the norm, but not alarmingly so. However, the calculation of debtor days from the fol- lowing year’s accounts showed debtor days up to 223 days. Now, both these figures (106 days and 223 days) were based on total debtors as shown in the accounts and would have included debtors other than trade debtors, so we cannot ascertain what the trade figures actually were. However, it was the comparison between the two years that would have caused concern.
The market was clearly not concerned as the shares continued to trade in the range of 350 pence–450 pence. However, the company announced later that it was changing the way it calculated the sales value of ongoing contracts and the share price fell back to 50 pence.