Financial Analysis and Decision Making

Introduction to Ratio Analysis

Steps in Financial Analysis

1. Determine what it is you are trying to measure. 2. Select appropriate figures 3. Consider and appropriate benchmark

EXTERNAL USERS OF FINANCIAL INFORMATION

Investors

Government

Lenders

Financial Statements
Employees Suppliers

Competitors

Customers

NEEDS OF USERS
If you were a shareholder, what are the key things you would look for in the financial statements?
Profit which profit? Dividends Return what is meant by this?

If you were a holder of debentures, what would you look for?

Ability to pay interest Ability to repay debentures Liquidity Security

What is the objective of golf ?

I play golf , how can I judge my performance?

Can only judge performance if we compare score with something Compare my score with
Previous rounds
COMPARISON OVER TIME (T)

My playing partner
COMPARISON WITH COMPETITORS/INDUSTRY(I)

Par score for course

COMPARISON WITH EXPECTATION(E)

Can only judge performance if we compare results with a BENCHMARK.

Benchmarks
Time
To establish trends

Industry Averages
To compare performance against competitors

Expectations
To see if targets have been met

Which student will obtain higher marks in their coursework ?

INTERPRETATION OF ACCOUNTS
Interpretation of accounts is a detailed explanation of the financial performance of any entity incorporating the information contained within a set of financial accounts (Dyson, 2004)

BASIC PROCEDURES
Data collection
Historical data of 3 5 year period Economic, financial, political and social national and international environment

Data analysis
Horizontal analysis Trend analysis Vertical analysis Ratio analysis

COMPARISON TO PREVIOUS YEARS

All published accounts show comparatives Putting current year in context (trend analysis) Where are the major increases and decreases from previous years to the current year? What areas should you be investigating further?

COMPARISON TO PREVIOUS YEARS

How do you compare figures to previous years in a useful way? Example (figures in m) Yr 2 Yr 1 Profit 250 235 Profit increased by 15m Yr 1 to Yr 2 useful? Much more meaningful to give % increase Profit increased by 6%

HORIZONTAL ANALYSIS
A line-by-line comparison of the company accounts for each accounting period chosen for investigation For example: 2010 2009 2008 Revenue 133M 114M 95M
+16.7% +20.0%

TREND ANALYSIS
Similar to horizontal analysis The first set of accounts in the series (i.e. the earliest period) is given a base of 100, subsequent accounts are then related to that base For example: 2007 2006 2005 Revenue 133M 114M 95M Trend analysis 140 120 100

VERTICAL ANALYSIS
All the P&L items and B/S items are to be expressed as a percentage of their respective totals For example: 2007 2006 Inventory 112k (32%) 60k (30%) Trade receivables 168k (48%) 88k (44%) Other receivables 35k (10%) 26k (13%) Prepayments 14k (4%) 16k (8%) Cash at Bank 21k (6%) 10k (5%) Current assets 350k (100%) 200k (100%)

RATIO ANALYSIS
Profitability ratios
Evaluate the profitability of the company

Efficiency ratios
Examine the ways in which various resources of the company are utilised and managed

Solvency and liquidity ratios

Indicate whether the company is able to meet its financial obligations and raise enough cash when needed

Investment ratios
Help investors to assess the returns on their investment

PROFITABILITY
Most users interested in profitability Ability of a business to provide returns to investors and lenders dependant on profits Ability of a business to generate cash ultimately dependant on profits Ability of a business to generate profits depends also on the management of resources

RATIO ANALYSIS
Profitability ratios
Return on capital employed (ROCE) Gross profit margin Net profit margin Asset Turnover Rate

Return on Capital Employed (ROCE) ON CAPITAL EMPLOYED

ROCE = Profit before interest and tax (PBIT) Capital employed x 100

ROCE is a fundamental measure of business performance It compares the profit before interest and tax (PBIT) with the overall capital used to generate that profit There are many other ways of calculating ROCE

RETURN ON CAPITAL EMPLOYED

What is PBIT?
Gross profit? Operating profit/ Profit before interest and tax ? Profit before taxation? Profit for the year?

RETURN ON CAPITAL EMPLOYED

ROCE = Operating profit Capital employed

x 100

RETURN ON CAPITAL EMPLOYED

What is capital employed?
Equity shareholders funds?
Equity shareholders funds + non-current liabilities?

RETURN ON CAPITAL EMPLOYED

ROCE = Operating profit x 100 Equity shareholders funds + Non-current liabilities (interest-bearing borrowings)

NET PROFIT MARGIN

Net profit margin

= Operating profit Revenue x 100

Net profit margin shows the proportion of sales that resulted in a profit after all overheads (other than interest) have been deducted Net profit can be improved by reducing overheads but a balance has to be achieved between cost reduction and business efficiency

ASSET TURNOVER
= Asset turnover Revenue Total assets less current liabilities Revenue Capital Employed

Asset turnover examines how effectively the assets of the company are being used to generate sales In general, a higher ratio is preferred to a lower one However, a very high ratio may suggest that the company is overtrading on its assets

RELATIONSHIP OF PROFITABILITY RATIOS

ROCE = Profit from operations Capital employed

Net profit margin = Profit from operations Sales

Asset turnover = Sales Net assets

Gross Profit Margin

ROSS PROFIT

Gross profit margin =

Gross profit Revenue

x 100

Gross profit margin shows the proportion of revenue that resulted in a gross profit to the company It is affected by various factors:
Changing price levels Sales mix Marketing strategy Stock valuation

RELATIONSHIP OF PROFITABILITY RATIOS

ROCE = Profit from operations Capital employed

Net profit margin = Profit from operations Sales

Asset turnover = Sales Net assets

Gross profit Sales

Expenses Sales

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