Week 2 - Financial Statement Analysis

Week 2 - Financial Statement Analysis

1. Categories of Ratios

   • 1. Profitability Ratio
     • Success of managers in a company for generating profit 
     • ROCE
       • Overall profitability  OP = profit before tax CE = SHE + NCL
       • Operating profit /Capital employed x100
     • Gross profit margin
       • How well production costs have been controlled to other costs
       • Gross profit / Sales x100
     • Operating or net profit margin
       • Operating profit Sales x100
     • EBITDA: Capital employed
       • EBITDA / Capital employed x100
     • Net asset turnover
       • Guide to productive  efficiency = how well assets have  generated sales 
       • Sales / Capital employed
   • 2. Working capital ratios
     •  show how efficiently a company has managed short-term assets and liabilities    
     • Inventory days = Inventory/COS x 365
       • This ratio shows how long it takes for a company to turn its stocks into sales. The shorter the stock days ratio, the lower the cost to the company of holding stock.
     • Trade receivable days = TR/Sales or Credit sales x 365
       • Gives the average period of credit being taken by customers compared to allocated credit period
     • Trade payable days = TP/COS or credit purchases x 365
       • Gives the average time taken for suppliers of goods and services to receive payment
     • Cash conversion cycle = ID + TR - TP
       • It indicates time needed for financing working capital. The longer the cash conversion cycle, the higher the investment in working capital.
   • 3. Liquidity ratios
     • Current ratio = CA/CL
       • Ability to meet your financial obligations. Should be normally around 2.
     • Quick Ratio = (CA – Inv)/CL
       • Wether or not the company can pay off its current liabilities if they were due today!
       • Similar to current ratio but excludes inventory. should be normally around 1.
   • 4. Gearing ratios
     • How a company is financed with respect to debt and equity and can be used to assess the financial risk that arises with increasing debt     
     • Capital gearing = Long term debt (NCL)/CE
     • Debt/Equity = LTD/SHE
       • Higly geared if >100%
     • Interest cover = OP/Interest payable
       •   The interest coverage shows how many times the company can cover its current interest payments, indicates whether servicing the debt may be a problem. IC>7 is usually regarded as safe, while IC>3 is acceptable.    
   • 5. Investor - earnings ratios
     • Price earnings (P/E) ratio
       • How much an investor is prepared to pay for a company’s share. Valuing of company in a takeover     
       • Market price per share / Earnings per share
     • Earnings per share (EPS)
       •  Asses the effect of proposed financing. Key ratio by stock market investors    
       • Profit attributable to shareholders / Number of ordinary shares
     • Investor - Dividends Ratios
       • Dividend yield
         • How much an investor expects to gain    
         • Dividend per share / Market price per share x100
       • Payout ratio
         • Is used to analyse the dividend policy    
         • Total dividend paid/ Profit attributable to SH x100
       • Dividend cover
         •  Indicates how safe a company’s divindend payment is. The higher, the more likely the company can maintain or increase in future dividends    
         • Earnings per share / Dividend per share = times
       • Total shareholder return
         • Measures purely the financial return for shareholders – no relation to the financial statements     
         • The increase in share price (market price y1 - y2 ) + dividend received / yr 2 = a percentage of the opening share price’
     • Return on Equity (ROE)
       • Profit attributable to shareholders / Shareholders’ equity x 100
     • Earnings yield
       •  Ratio of potential return to shareholders    
       • Earnings per share (EPS) / Market price per share x 100

2. Why ratios?

   • A financial ratio is an index that relates two accounting numbers and is obtained by dividing one number by the other.
   • Absolute numbers indicates the size of business
   • Relative numbers are essential for assessing performance because ratios enable comparison
   • problems with ratios analysis
     • Imperfect and imprecise
       • SOFP - can be taken on 1 day of the year or prepared 3 months earlier - different picture might have different values.  EX. missing out dividends or tax payable. 
       • tends to be performed on historical data
         • Not accurate quite to current position or future value. 
     • reliability of ratios, depend on reliability of accounting information
     • Difficult to find similar company for 'intercompany comparison'
       • No two companies are same or identical - this needs to take care
     • Just the beginning and needs other information to support and explain them

3. Useful numbers derived from the financial statements

   • Capital Employed =
     • = Shareholders’ Equity + Non-current Liabilities
     • = Non-current Assets + Working Capital
   • Working Capital
     • Current Assets – Current Liabilities
   • EBITDA = Earnings before interest, taxation, depreciation and amortisation
     • = Operating Profit + (Dep’n + Amort’n)
     • EBITDA is a measure of cash-flow that excludes financing and capital expenditure & indicates trends in profitability
     • issues -
       • ignores earnings & revenue
       • ignores contribution to cash flow made by changes in working capital

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