Financial analysis Flashcards
Forms of financial analysis
- Horizontal
- Vertical
- Ratio
Key areas of financial analysis
- Profitability
- Liquidity
- Efficiency
- Solvency
- Investors’ returns
Profitability ratio analysis: key ratios
- Return on shareholders’ funds
- Return on capital employed
- Gross profit margin
- Operating profit margin
Profitability ratio analysis:
RETURN ON SHAREHOLDERS’ FUNDS =
= Amount of net income returned as a % of shareholders’ equity. “Return on equity”
- The higher the %, the better a company is at converting equity financing to profits.
- Shows profitability of a company + efficiency in growing these profits.
RETURN ON SHAREHOLDERS’ FUNDS formula
RETURN ON SHAREHOLDERS’ FUNDS = (profit for the year / equity) x 100 %
Profitability ratio analysis:
RETURN ON CAPITAL EMPLOYED =
= key ratio for providers of capital.
might change because of changes in operating profit or in capital employed
RETURN ON CAPITAL EMPLOYED Formula
RETURN ON CAPITAL EMPLOYED = (Operating profit / Capital employed) x 100 %
Capital employed =
Capital employed =
equity (shareholders’ funds) + long term debt (non-current liabilities)
Profitability ratio analysis: GROSS PROFIT MARGIN =
= Measure of profitability in buying/producing and selling before any other expenses are considered.
- Helps to evaluate production process efficiency.
GROSS PROFIT MARGIN Formula
GROSS PROFIT MARGIN =
(Gross profit / revenue) x 100 %
Reasons for change in GROSS PROFIT MARGIN
- Changes in revenue:
- Sales prices
- Sales product mix
- Sales volume
- Changes in cost of sales
- Purchase prices
- Inventory levels
Profitability ratio analysis:
OPERATING PROFIT MARGIN =
= Measure of profitability which shows the relationship between the company’s revenue, cost of sales and its operating expenses.
- Provides an indication of the company’s ability to maintain its selling margin and control its costs.
OPERATING PROFIT MARGIN Formula
OPERATING PROFIT MARGIN = (Operating profit / Revenue) x 100
LIQUIDITY RATIO ANALYSIS =
= refers to the company’s ability to meet its liabilities in the short term.
Look at generating/use of cash and relationship between current assets + current liabilities.
Liquidity ratio analysis: Key ratios
- Current ratio
- Quick ratio
- Can the business survive short term?
- Tells us how liquid the business is
- Higher is better. Concern if less than 1
- Expressed as a proportion (___:1.0)
Liquidity ratio analysis:
CURRENT RATIO
CURRENT RATIO =
current assets / current liabilities
Liquidity ratio analysis: QUICK RATIO
QUICK RATIO =
(current assets - inventory) / current liabilities
- Same as current ratio, just more of an “acid” test as inventory takes longer to turn into cash.
Horizontal analysis =
Compares the data in financial statements line by line over several years.
- Year 1 provides base figures, which equivalent figures in subsequent financial statements are expressed relative to.
- Starting point, 100% - subsequent years shown as a % of year 1’s figures.
Advantages of horizontal analysis
- Can readily identify relative changes over time
- Financial/economic trends can be identified
- Auditors can use this method as an initial risk assessment procedure - can see if there’s an exceptional movement in a certain figure.
- Easily graphed.
Disadvantages of horizontal analysis
- Figures less comparable if there are changes in accounting policies, judgements or financial strategy.
- Time consuming
- Making comparisons WITHIN a year is difficult.
- Which is base year? eg, financial year ending 2020/21 would generate less useful results because of Covid.
Vertical analysis =
- Compares figures within a year.
- Everything in stat. of profit/loss shown as % of revenue.
- Everything in stat. of fin pos shown as % of total assets
- Base figures = revenue and total assets. 100%.
Advantages of vertical analysis
- Relative changes over time easily identified.
- Financial/economic trends identified
- Auditors use this method to identify material balances and areas of higher-then-average potential risk.
- Easily graphed
Disadvantages of vertical analysis
- Obscures absolute balances, which may be important.
- Differences may be due to real economic factors eg, scale.
