Chapter Financial Analysis 18

Chapter

18 Financial Analysis

Financial analysis

The objective of financial statements is to provide information to all the users of these accounts to help them in their decision-making. Note that most users will only have access to published financial statements.

Interpretation and analysis of financial statements involves identifying the users of the accounts, examining the information, analysing and reporting in a format which will give information for economic decision making.

Types of users

Investors ? look at the risk of their investment, profitability and future growth. Managers / employees? have access to more information and will want to know the stability of the company and profitability. Creditors ? are interested in the liquidity, as they just want to be paid on time. Banks ? are interested in the performance and liquidity of organisations for lending purposes Government departments - have various uses.

Other groups including the local community on green issues, jobs etc.

18.1

Analysing performance through ratios

Ratios are an effective way of analysing the financial statements. A ratio is 2 figures compared to each other, and can either be in % terms or in absolute terms.

When analysing performance through the use of ratios it is important to use comparisons. A single ratio is meaningless and is only of use when compared with other ratios, competitors, and over time.

Ratio uses

To compare results over a period of time To measure performance against other organisations To compare results with a target To compare against industry averages

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Ratios can be grouped into 3 main areas:

1

Performance -

how well the business has done (profitability)

2

Position

-

short term standing of the business (liquidity)

3

Potential -

what the future holds for the business

Exam technique for analysing performance

The following steps should be adopted when answering an exam question on analysing performance:

Step 1 Step 2

Review figures as they are and comment on them. Calculate relevant ratios according to performance, position and potential (if possible)

1 Performance (profitability) ? how well has the business done

Return on capital employed (ROCE) Profit before interest & tax (PBIT) X 100% Capital employed (CE)

Operating profit margin

PBIT X 100% Turnover

Asset turnover

Turnover

(number of times)

Total assets

(Operating profit margin x asset turnover = ROCE)

Return on equity (ROE)

Profit after tax________ x 100% Shareholder funds (capital + reserves)

2 Position (liquidity)? short term standing of the business

Current ratio

Current assets__ (number of times) Current liabilities

Quick ratio

Current assets ? inventory (number of times) Current liabilities

Gearing - equity

Debt capital ____ Equity (shareholders funds)

X 100%

Gearing ? total

Debt capital________ Debt + equity (total capital)

X 100%

Interest cover

Profit before interest & tax (PBIT (number of times) Interest paid

Trade payable days

Trade payables______ x 365 days Cost of sales (or purchases)

2

Inventory days

Inventory_ x 365 days Cost of sales

Trade receivable days Working capital cycle

Trade receivable x 365 days Sales

Trade receivable days + inventory days ? trade payable days

3

Potential (investor) ? what investors are looking at

Earnings per share (EPS)

Profit after tax__ Number of shares

P/E ratio

Share price___ Earnings per share

Dividend yield

Dividend per share X 100% Share price

Dividend cover

Earnings per share Dividend per share

The above is not the complete list, but are the main ratios.

Step 3

Add value to the ratios by:

Interacting with other ratios and giving reasons a) State the significant fact or change (i.e. increase or decrease) b) Explain the change or how it may have occurred by looking at the business activities and

other information. c) Explain the significance of the ratio in terms of implications for the future and how it fits in

with the user's needs. d) Limitations of the ratio analysis. Look at the 2 figures used to compute the ratio and

criticise them. Also look at other factors which may distort the information (creative accounting, seasonal fluctuations etc.)

Another way of at discussing the ratio's is to adopt the 3W's for each ratio calculated:

WHAT What has happened to the figures or ratios? Have they increased or decreased?

WHY Explain why the changes may have occurred by giving examples (think creatively!).

WOW How do these changes affect the user of the information ? WOW that's great or not so great!

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18.2

Ratios in detail

We shall now look at some of the ratios in detail explain how they can be interpreted.

Performance ratios

1 ROCE

Return on capital employed (ROCE) = Profit before interest and tax (PBIT) x 100% Capital employed

The ROCE measures profitability and shows how well the business is utilising its capital to generate profits. Capital employed is debt and equity. Equity is shareholders funds (share holders'funds) and debt is non current liabilities. Capital employed can be found from the statement of financial position by taking the shareholders funds (share capital and reserves) and long term debt.

The ROCE can be broken down into 2 parts, operating profit margin and asset turnover.

A low ROCE is either caused by a low profit margin or high capital employed. A high ROCE is either caused by high profit margin or low capital employed. It is therefore important to look at the profitability, assets, liabilities and share capital when trying to give reasons for the change in ROCE.

2 Operating profit margin

Operating profit margin

=

PBIT x 100%

Turnover

This is the ratio of operating profit to sales or turnover. A high operating profit margin is due higher sales prices or low costs. Other factors to consider include inventory valuation, overhead allocation, bulk discounts and sales mix.

Low profit margins are not normally good news as it suggests poor performance. But there may be other factors to consider relating to the business activities and industry. For example the company may be entering a new market which requires low selling prices.

Other profit margin ratios can also be calculated:

? Gross profit / turnover ? Profit after tax / turnover ? Advertising costs / turnover ? Distribution costs / turnover ? Cost of sales / turnover

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