Analysing financial statements

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Analysing financial statements

  1. 1. Analyzing Financial Statements Dr. Jatin Pancholi Website: http://www.jatinpancholi.com Dr. Jatin Pancholi has compiled and prepared this teaching note from various sources, as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The handling of a management situation requires personal guidance by a professional. To obtain copies, request permission to reproduce and to send feedback, please contact on website http://www.jatinpancholi.com . Those wishing to co-author next edition of this handout may also contact.
  2. 2. Financial Statement Analysis (1) <ul><li>Stakeholders get information from a company’s Published Accounts: </li></ul><ul><ul><li>Level of sales </li></ul></ul><ul><ul><li>Amount of cash available </li></ul></ul><ul><ul><li>Value of debtors and creditors </li></ul></ul><ul><ul><li>Level of Debt and Equity </li></ul></ul><ul><ul><li>Revenues generated </li></ul></ul><ul><ul><li>Costs and Expenses </li></ul></ul><ul><ul><li>etc </li></ul></ul><ul><li>This information is available for the last and for previous years </li></ul>
  3. 3. Financial Statement Analysis (2) <ul><li>But: </li></ul><ul><ul><li>Sales of £1,000,000 is good or bad? </li></ul></ul><ul><ul><li>Debtors of £500,000 is good or bad? </li></ul></ul><ul><ul><li>Revenue increase of 15% is good or bad? </li></ul></ul><ul><li>Absolute values are difficult to judge </li></ul><ul><li>Even an increase or decrease rate may be misleading </li></ul>
  4. 4. Financial Statement Analysis (3) <ul><li>In order to achieve meaningful conclusions on a company’s performance, there is a need to make comparisons: </li></ul><ul><ul><li>vs. previous years </li></ul></ul><ul><ul><li>vs. projected </li></ul></ul><ul><ul><li>vs. competitors </li></ul></ul><ul><ul><li>vs. industry averages </li></ul></ul><ul><ul><li>vs. known good performers (benchmark) </li></ul></ul><ul><ul><li> Ratio Analysis </li></ul></ul>
  5. 5. Ratio Analysis (1) <ul><li>Functions: </li></ul><ul><ul><li>Aids understanding of accounts </li></ul></ul><ul><ul><li>Indicates relationships </li></ul></ul><ul><ul><li>Allows for comparisons </li></ul></ul><ul><ul><li>Shows trends over time </li></ul></ul><ul><ul><li>Provides additional information to the Financial Statements </li></ul></ul>
  6. 6. <ul><li>Is a three step process: </li></ul>Ratio Analysis (2) Calculate appropriate ratios Identify users and their information needs Interpret and evaluate results
  7. 7. Categories of Ratios Profitability Efficiency (activity) Liquidity Gearing Investment
  8. 8. Profitability Ratios Return on ordinary shareholders’ funds Return on capital employed Net profit margin Gross profit margin Formula Net profit after taxation and preference dividend (if any) x 100 Ordinary share capital + Reserves Net profit before interest and taxation x 100 Share capital + Reserves + Long-term loans Net profit before interest and taxation x 100 Sales Gross profit x 100 Sales
  9. 9. ROCE – Main Elements Sales Long-term capital employed Return on capital employed multiplied by equals Net profit before interest and taxation sales
  10. 10. Efficiency Ratios Average stock turnover period Average settlement period for debtors Average settlement period for creditors Fixed Asset Turnover Formula Average stock held x 365 Cost of sales Sales per employee Trade debtors x 365 Credit sales Trade creditors x 365 Credit purchases _______ Sales _______ Number of employees _______ Sales __________ Fixed Assets
  11. 11. Liquidity Ratios Current ratio Acid test ratio Operating cash flows to maturing obligations Formula Current assets _______________ Current liabilities (creditors due within one year) Operating cash flows Current liabilities Current assets (excluding stock) Current liabilities
  12. 12. Gearing Ratios Gearing ratio Interest cover ratio Formula Profit before interest and taxation_ Interest payable Long-term liabilities _______ Share capital + Reserves + Long-term liabilities
  13. 13. Effect of Financial Gearing Profit before interest and tax
  14. 14. Investment Ratios Dividend per share Dividend payout ratio Dividend yield ratio Earnings per share Formula Dividends announced during the period Number of shares in issue Dividends announced for the year x 100 Earnings for the year available for dividends Dividend per share/(1-t) x 100 Market value per share Price/earnings ratio (P/E) Earnings available to ordinary shareholders Number of ordinary shares in issue Market value per share Earnings per share
  15. 15. Source : Constructed from data appearing in the Financial Times , 18 January 2003 Average Dividend Yield Ratios 0 1 2 6 5 4 3 Oil and gas Construction and building materials Chemicals Engineering and machinery Pharmaceuticals and biotechnology Tobacco Food and drug retailers Electricity Real estate Transport Leisure and hotels Banks 3.67 4.35 4.42 5.15 2.85 4.52 3.98 4.29 3.35 6.32 3.16 4.83
  16. 16. Average Price/Earnings Ratios Source : Constructed from data appearing in the Financial Times , 18 January 2003 0 5 10 30 25 20 15 Oil and gas Construct. and building materials Chemicals Engineering and machinery Pharmaceuticals and biotechnology Tobacco Food and drug retailers Electricity Real estate Transport Leisure and hotels Banks 22.86 8.45 16.77 12.87 18.62 12.54 18.83 12.93 14.06 22.63 23.18 12.67
  17. 17. Ratio Comparisons <ul><li>In isolation ratios’ benefits are very limited, as with absolute numbers </li></ul><ul><li>Conclusions can be drawn by comparisons against: </li></ul><ul><ul><li>The company’s budget / forecast </li></ul></ul><ul><ul><li>External observers prior expectations </li></ul></ul><ul><ul><li>Previous years ratios </li></ul></ul><ul><ul><li>Other companies ratios (current and prior year) </li></ul></ul><ul><ul><li>Industry averages </li></ul></ul>
  18. 18. Limitations of Ratios (1) <ul><li>Ratios don’t give you answers, they give you clues </li></ul><ul><li>These clues need to be investigated to find the reasons </li></ul><ul><li>For example: stock days have doubled. Is that a problem? </li></ul><ul><ul><li>Yes, if they went from 50 to 100 </li></ul></ul><ul><ul><li>No, if they went from 2 to 4 </li></ul></ul><ul><ul><li>Yes, if obsolete stock is the cause of the increase </li></ul></ul><ul><ul><li>No, if the company is about to open a number of new shops </li></ul></ul><ul><li>Trying to take conclusions from the ratios alone, may lead to the wrong decisions being made </li></ul>
  19. 19. Limitations of Ratios (2) <ul><li>Ratios may also have intrinsic problems: </li></ul><ul><ul><li>They are calculated from accounting data, and if there are mistakes in this… </li></ul></ul><ul><ul><li>The comparisons may be made against the wrong benchmarks </li></ul></ul><ul><ul><li>Ratios (as the Balance Sheet) are calculated at a point in time and significant changes may occur within a short period </li></ul></ul><ul><ul><li>Relying only on ratios when analysing a company’s performance is dangerous </li></ul></ul>
  20. 20. Thank you… Dr. Jatin Pancholi Website: http://www.jatinpancholi.com Dr. Jatin Pancholi has compiled and prepared this teaching note from various sources, as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The handling of a management situation requires personal guidance by a professional. To obtain copies, request permission to reproduce and to send feedback, please contact on website http://www.jatinpancholi.com . Those wishing to co-author next edition of this handout may also contact.

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