7.2 - FInancial Ratio Analysis Flashcards
Balance sheet
Document describing the financial position of a company at a particular point in time.
What do balance sheets compare?
Value of items owned by the company with the amount that it owes
Income statement
Account showing the income and expenditure [and thus the profit or loss] of a company over a period of time [usually a year]
What are income statements and balance sheets based on?
Historical data-show what has happened in the recent past
Assets
Items owned by an organisation
Two main categories of assets
Non-current assets
Current assets
Non-current assets
Resources that can be used repeatedly in the production process, although they do wear out (depreciate) or lose value over time.
How long do organisations tend to own non-current assets?
More than 1 year
Examples of non-current assets.
Land
Buildings
Machinery
Vehicles
Current assets
Short-term items that circulate in a business on a daily basis and can be expected to be turned into cash within on year.
How long do organisations tend to own current assets?
Less than 1 year
Liabilities
Debts owed by an organisation to suppliers, shareholders, investors or customers who have paid in advance
Two main categories of liabilities
Non-current liabilities (long-term liabilities)
Current liabilities
Non-current liabilities (long-term liabilities)
Debts due for repayment after more than 1 year
Current liabilities
Debts scheduled for repayment within 1 year
Total equity/total shareholders’ equity (capital)
Funds provided by shareholders to set up the business, finance expansion and purchase fixed assets
Gross profit
Revenue - costs of sales
What does gross profit show?
How efficiently a business is at converting its raw materials or stock into finished products
Operating profit
Gross profit - expenses
What is operating profit?
Revenue earned from everyday trading activities minus the costs involved in carrying out those activities
Exceptional items
Items that have a one-off effect on profits
Internal users of financial documents
Managers
Employees
Owners and investors (who have already invested)
External users of financial documents
Government
Competitors
Suppliers
Customers
Local community
Investors
Why are non-current assets purchased?
To allow a business to operate continuously
What can non-current assets be classified as?
Tangible assets
Intangible assets
Tangible assets
Non-current (fixed) assets that exist physically
Intangible assets
Non-current assets that do not have a physical presence, but are nevertheless of value to the firm
Examples of intangible assets
Goodwill, which includes the value of a firm’s brand names, patents and copyrights.
Are intangible assets included in balance sheets?
The value of intangible assets are difficult to test objectively, so so it is customary to exclude them from the balance sheet
Examples of current assets.
Inventories (stocks)
Receivables (debtors)
Cash and other cash equivalents (mainly the bank balance)
Examples of non-current liabilities.
Debentures
Long-term or medium-term loans
Debentures
Fixed-interest loans with a repayment date set long into the future
Examples of current liabilities
Payables (creditors)
Bank overdraft
Corporation tax
Shareholders dividends
Two main forms of equity.
Share capital
Reserves and retained earnings
Share capital
Funds provided by shareholders through the purchase of shares
Reserves and retained earnings
Those items that arise from increases in the value of the company, which are not distributed to shareholders as dividends, but retained by the business for future use
Where do most reserves come from?
Arise cause shareholders have voted at the annual general meeting to allow the company to keep some of the profit, rather than distribute to shareholders as dividends.
6 purposes of balance sheets
- Recognising the scale of a business
- Calculating the net assets of a business
- Gaining an understanding of the nature of a business
- Identifying a business’s liquidity position
- Showing sources of capital
- Recognising the significance of changes over time
How to work out current assets?
Inventories + receivables + cash and other cash equivalents
How to work out working capital/net current assets?
Current assets - current liabilities
How to work out net assets?
Non-current assets + current assets - current liabilities - non-current liabilities
How to work out net worth?
Non-current assets + working capital/net current assets - non-current liabilities
How to work out assets employed?
Net current assets + non-current assets
How to work out total equity?
Share capital + reserves
How to work out capital employed?
Total equity + non-current liabilities
What are assets employed equal to?
Capital employed
Why does the balance sheet balance?
Assets = liabilities + equity
6 purposes of income statements
- Allows shareholders to assess whether there investment is beneficial
- Enables stakeholders to see if profit is being used in a sensible way
- Comparisons can be made over time (temporal comparisons) to see if a firm is improving its performance
- Comparisons can be made between different businesses (inter-firm comparisons) in order to measure relative performance
- Comparisons can be made within the business (intra-firm comparisons) to assess the effectiveness of different divisions or branches
- To satisfy legal requirements-the Companies Act requires companies to publish their income statements
Operating profit where there are exceptional items
Gross profit - expenses +/- exceptional items
Profit before tax
Operating profit + finance income - finance costs
Profit for the year
Profit before tax - taxation
2 uses of profit
- Retain profit in the business
- Pay dividends to shareholders
Business example of when profit was used in a different way
2018-19 = Shell used $9.5 billion of its profit to buy back shares from shareholders.
In future years this means that they will have to pay dividends to fewer shareholders
4 types of comparisons
- Inter-firm comparisons: comparisons with other businesses
- Comparisons over time-trend analysis
- Intra-firm comparison: comparisons within the business
- Comparisons to a standard-level needed to reach efficiency
4 types of ratios
- Profitability ratios/performance ratios
- Liquidity ratios
- Gearing
- Financial efficiency ratios
Profitability ratios purpose
Compare profits with the size of the firm
Liquidity ratios purpose
Show whether a firm is likely to be able to meet its short-term liabilities.
Purpose of Gearing
Focuses on long-term liquidity and shows whether a firm’s capital structure is likely to be able to continue to meet its interest payments on, and to repay, long-term borrowing
Purpose of financial efficiency ratios
Generally concentrate on the firm’s management of its working capital. Used to assess the efficiency of the firm in its management of its assets and short-term liabilities
Example of liquidity ratio
Current ratio
Examples of financial efficiency ratios.
- Inventory (stock) turnover
- Payables (creditors) days
- Receivables (debtors) days
Example of gearing ratios
Gearing ratio
Examples of profitability (performance) ratios.
Return on capital employed (ROCE)
What is ROCE?
Measures the profitability of a business by calculating its operating profit as a percentage of the capital that a business has at its disposal- that is, its capital employed
Formula for ROCE.
( Operating profit / total equity + non-current liabilities ) x 100
Unit for ROCE
%
What is a current ratio?
Measures liquidity by expressing current assets as a ratio to current liabilities
Define solvency
Measure of a firm’s ability to pay its debts on time
Formula for current ratio
Current ratio = current assets / current liabilities
Ideal range for current ratio.
1.5:1 - 2:1
Unit for gearing
%
Formula for gearing
( Non-current liabilities / total equity + non-current liabilities ) x 100
What percentage is high gearing?
Above 50%
What percentage is low gearing?
Below 25%
What does a high capital gearing show?
A business has borrowed a lot of money in relation to its total capital
What does a low gearing indicate?
A firm has raised most of its capital from shareholders, in the form of share capital and retained profits
Why do more firms tend to have high gearing ?
Take advantage of low interest rates so instead of raising money through share capital they borrow money during these periods
Benefits of high capital gearing.
- Less shareholders = More control of company
- Company can benefit from very cheap source of finance when interest rates are low
- At time of high profit, interest payments are usually much lower than shareholders’ dividend requirements, allowing a company to retain much more profit for future expansion.
Benefits of low capital gearing
- Most capital is permanent share capital, so with low gearing a company at less risk of payables forcing it into liquidation.
- Avoids problem of having to high levels of interest on its borrowed capital when interest rates are high
- Avoids pressure facing highly geared companies that repay their borrowing at some stage
What gearing level will a highly profitable company want and why?
High gearing
Its dividends payments usually exceed its interest payments on loans
What gearing level will a less profitable company want and why?
Low gearing
If interest rates are high and if a company is prepared to expand its number of shareholders
What does the payables days ratio show?
The number of days it takes a business to pay back any payables owed by a business.
Formula for payables.
(Payables / cost of sales ) x 365
Will firms want a higher payables days or receivables days figure?
Payables days
What does having a high payables figure mean for a business?
The company is likely able to hold huge amounts of cash and is holding other organisation’s money
What does the receivables days ratio show?
Number of days it takes to turn receivables into cash
Formula for receivables days.
( Receivables / Revenue (annual sales) ) x 365
For what type of business might receivables days be low?
Companies that deal mainly in cash transaction e.g., Papa John’s Pizza
For what firms might receivables days be high?
Those which offer long-term credit e.g., Freemans catalogue
What does inventory turnover measure?
How quickly inventory (stock) is converted into sales
What does a high inventory turnover figure mean?
Stock is sold quickly, thus bringing money into the business more rapidly
Formula for inventory turnover
Cost of goods sold / Average inventories held
What does the inventory turnover figure represent and give an example?
The number of times in a year that the business sells the value of its inventory
E.g., A value of 3 means a business sells its inventories 3x a year (every 4 months) so it will take 4 months on average to convert inventory into cash
Is a higher or lower figure better for inventory turnover and why?
Higher-better for a business’s cash flow
Factors influencing inventory turnover
Nature of product
Quality of management
Variety of products
