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3. Financial Statement Analysis Interpretation- AC570 AMcM.pptx
- 1. Accounting for BusinessDecision Making AC570 Session 3 Interpretating Financial Performance
- 2. Learning Objectives • Identifythe major categories of ratios that can be used for analysis purposes • Calculate important ratios for determining financial performance and position of a business • Explain the significance of the ratios calculated • Discuss the limitations of ratios as a tool of financial analysis
- 3. Financial Ratios • Providequick and relatively simple means of examining the financial position/performance of a business • Ratio – expression of the relationship of one figure to another, e.g. Net profit : sales Sales per employee • Ratio – can be expressed as %, time (e.g. days), proportion • Usually easy to calculate – sometimes difficult to interpret (skill) • Use of ratios can build up picture of the financial performance
- 4. Financial Ratio Classification •Profitability • Determine the wealth creation (ability to generate profits) in business • Efficiency • Relates to resources used – called activity ratios – measure of management performance. • Liquidity • Measures the ability to pay short term debts as they fall due • Gearing/Risk • Relationship between finance provided by owners vs that of outside parties (% of equity vs debt financing) • Investment • Measures the returns available to shareholders
- 5. Similar businesses duringthe same periods Planned performance (i.e. Vs Budget) Past periods Ratios may be compared with: Ratios Benchmarks NB: Crucial to compare or benchmark, ratios in isolation are meaningless. E.g. consider a sports analogy, how can a Olympic sprinter know their performance is good enough without comparing to their competition/rivals?
- 6. Liquidity Ratios: Current Ratio CurrentAssets (£300) Expressed as a factor Current Liabilities £100 e.g. 3 : 1 • usually expect more current assets than current liabilities • but may depend on the type of business Acid Test Ratio (or Quick Ratio) Current Assets - Inventory also as a factor Current Liabilities • More specific than the current ratio • Most applicable for a manufacturing business, where inventory is not readily turned into cash 6
- 7. Efficiency ratios: Inventory Turnover Costof Goods Sold = No of Times Closing inventory • The greater the inventory turnover the more efficient the business • Obviously varies from business to business • Particularly applicable to retail businesses Net Asset Turnover Ratio Sales = No of Times Capital Employed (Total Assets-Current Liabilities) • Indicates how effectively the capital employed has been used to generate revenue 7
- 8. Efficiency ratios: Asset turnover Sales/Revenue= No of Times or € revenue per € of Assets Total Assets • The greater the turnover the more efficient the business at generating sales from its assets • Obviously varies from business to business Working Capital Turnover Ratio Sales = No of Times Working Capital (Current Assets-Current Liabilities) • Indicates how effectively the business generates sales for every € of working capital used 8
- 9. Efficiency ratios: Receivables CollectionPeriod Trade receivables x 365 = No of days Sales • Faster collection indicates efficiency in debt collection-cash conversion • Very much dependent on the type of business involved • Need to establish a trend Payables Collection Period Trade Paybables x 365 = No of days Cost of sales • Strike balance between paying on time, but using credit period (cash conversion) • NB to maintain good relations with suppliers, part of supply chain • Need to establish a trend 9
- 10. Risk ratios: The morelong term debt, the more interest has to be paid before the shareholders can receive a return • Gearing is also known as leverage • There are many ways of calculating this* 10 How easy is it for the company to pay its interest charges out of operating profit Debt to Capital Total Debt (short & long term) Total Capital (debt & equity) Debt to Equity Total Debt Total Equity
- 11. Risk ratios: Interestcover 11 Operating profit Interest charges How easy/comfortable is it for the company to pay its interest charges out of operating profit
- 12. Profitability Ratios 12 Gross ProfitRatio/Margin Gross Profit x 100 = X% Sales • Measures how much profit has been earned from the main trading activity • Indicates how successful the business is at trading. Operating Profit Ratio Operating profit x100 = X% Sales • Mostly used for internal comparison because the differing accounting policies applied by different businesses make external comparison difficult • Useful for establishing trends
- 13. 13 Return On CapitalEmployed (ROCE) Operating Profit x 100 = X% Capital employed (Total Assets- Current Liabilities) • HOW much profit is meaningless, unless the size of the business in known • Useful as a comparator within and between businesses Return on equity • The ultimate profit that is available to shareholders expressed as a percentage of the value they have invested in the business Profit after tax Total equity ´100 = X% Profitability Ratios
- 14. ROCE Interrelationships of ratios Operatingprofit Operating profit Sales Capital employed Sales Capital employed ROCE Profitability ratios Efficiency ratios
- 15. Investment ratios: DividendYield Dividend per Share X 100 = X% Market price per Share • Measures the rate of return and investor gets by comparing the cost of his shares with the dividend he receives Note: Dividend are usually declared as a % of the nominal (face) value of the shares 15
- 16. Dividend Cover • Profitafter tax. Paid & proposed ordinary Dividends = Number of Times • This shows the number of times the dividend could be paid out of ordinary earnings 16
- 17. Investment ratios: Earningsper Share (EPS) Profit after tax No. of Ordinary Shares in issue in year = X cent • EPS enables a fair comparison to be made between one year’s earnings and another by relating the earnings to the number of shares in issue 17
- 18. Investment ratios: Price/ Earnings Ratio (P/E) Market price per Share = X Earnings per Share • The P / E ratios allows a comparison between the EPS and the market price. • It tells you that the market price is X times earnings 18
- 19. Other Analyses Techniques •Using multi year P & L data ( 5 years) • Horizontal Analysis • Identifies the annual % change in individual items, e.g. sales, gross margins, net margins – to view performance year by year • Trend Analysis • Starts with a base year and measures subsequent performance against base year values which are given a base value of 100 – to view performance over a period from a base line • Vertical Analysis • Expresses individual expense categories as % of sales (IS) or % of capital employed (BS) – to spot trends in expenditure levels
- 20. Other Considerations Analysts shouldalso consider non-financial factors: ● the nature and size of the business ● the riskiness of the business ● quality of management and staff morale ● a company's future development plans ● geographical location ● the prevailing economic, political and social environment ● industry trends…performance of key competitors ● the impact of technological changes • Combined these help ‘set the scene’ for any subsequent financial analysis
- 21. Limitations of RatioAnalysis • Quality of Financial Statements – should • Be prudent, conservative in presentation • Not use creative / false accounting / manipulate profits • Inflation – impacts profits, values of assets. • Measures relative performance – ignores scale, size • Basis for Comparison – inter company comparison may not be on same basis due to accounting policies, year end date, financing policies • Balance Sheet Ratios – may not be representative of business over full year , e.g. seasonality • Should only be used as a guide, they do not provide the answers, only the starting point for further analysis/investigation. • Be careful about being dogmatic when making any decision based on any analysis you may do.
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- 23. Reading Recommended Atrill, P. andMcLaney E. (2019). Accounting and Finance for Non-Specialists • This session: Chapter 6 Analysing & Interpreting Financial statements or ● Collier - Chapters 6 and 7 ● O’Regan - Chapter 8
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