Financial Statement Analysis Flashcards
Reasons for analysis
Different Users
- shareholders, bank providers, customers and suppliers, competitors
Different questions
- will they go bust before they pay
- where will they be in ten years time?
- what can we learn and apply to ourselves?
- is it a good investment/borrower?
How to answer the question?
- know about the industry and company first
- variety of techniques
- ratios
- not the only tool
- common size analysis
- comparative techniques
- credit rating methods
Where to the information?
Government statistics Industry sources Company sources Facts and truth does not mean no bias Info has value The accounts should give a true and fair view Governments also have agenda - FSA to ensure confidence in the financial system
Framework for analysis
Context - why
Overview - understanding the industry
Ratios - data issues e.g inflation rates
Evaluation - analyse ratios - answer is?
Normally use published accounts
Limited info: segments/social and environmental/ future orientated/ current values
Snapshot: seasonal factors and year end dates
Accounting polices differences
Annual or semi annual only
Need to look at trend comparators
Few ratios have universal benchmark levels
A trend can reveal the speed of change, but inflation/ impact acquisition or disinvestment, exchange rates etc
problems for comparison and assessment
Published accounts
Seasonal factors and year end dates Accounting policy choice Degree of creativity Cross border comparisons Exchange rates?
Companies can go bust quickly
If you have power in a corporate relationship, ask for a regular management accounts
The cynic would just look at whether they’ve filed and what’s the cash position
Key points in financial analysis
Always trying to learn
We don’t just produce numbers for their own sake
Analysis is flexible
-do what is appropriate
Questions in ratio analysis
Did they make a decent profit
How risky are they
Working capital/liquidity management
Issues in ratio analysis
We are trying to advise on decisions but the future is what matters
All we have is information on the past
A foundation for us to build a forecast on or to base a decision on
Tradeoff between risk and reward
Reward is meaningless without an understanding of the risk
Ratio category - performance
Has the business succeeded in making an acceptable level of profit
Profits, sales, use of assets, productivity of labour
Ratio category- working capital
Have the assets of the business been effectively used and managed?
Inventory, accounts payable, accounts receivable
Ratio category - Financial Status
Can the business meet its debts as they fall due?
Liquidity (short term)
Solvency (long term)
Ratio category - investment ratios/market performance
Is the company a worthwhile investment?
New PPE, profit retention, price/earnings ratio, dividend payout
Return on capital employed
Also return on net assets (RONA)
Key ratio
Gives the % return on the long term funds tied up in the business
How have management performed with the funds available?
The higher the risk, the higher the required return
- with large cash rich companies, handling cash may be considered a normal activity and profit after interest could then be taken.
Sales margin or operating margin
Expressed as a percentage, the margin means how many pence in each £ of sales is profit.
The trend over time would show whether the sales price has been increased more or less than costs.
Different industries will have very different ratios.
Gross margin refers to gross profit (after only allowing for certain direct costs) divided by sales.
Asset turnover
Expressed as a multiple
Shows the number of times the capital “turns over” in a year or how many £s of sales is generated by every £ invested in the business in a year.
Capital intensive companies have a low turnover, however companies using heavily depreciated equipment can have quite high multiples. Retailers can have high multiples.
Working capital
A key area of management performance
Companies go bust because they run out of cash
Companies often run out of cash because of poor working capital control.
Liquidity ratios are also working capital ratios
As little as possible working capital needed
Inventory ratios
Expressed as number of days of inventory held. Multiplying by 52 instead would give inventory weeks.
An alternative is the number of times the stock turns over in a year: this is “cost of sales/inventory”
Includes raw materials, work in progress and finished goods. If this information is available, then analysing these individually may be interesting too.
Can use average inventory.
Debtor ratios
Expressed as days outstanding
A long debtor ratio may be due to long payment terms (e.g. export sales) or to poor collection.
A falling ratio is usually a sign of improving financial management, but it might also imply a shortage of cash with discounts being offered for early payment.
Debtor payment periods are part of the pricing negotiation.
Trade creditor ratios
Expressed as the number of days between the receipt of goods and payment for them.
The ratio should only include those elements of current liabilities where the company has some control over the timing of payment.
Trade creditor ratios
Expressed as the number of days between the receipt of goods and payment for them.
The ratio should only include those elements of current liabilities where the company has some control over timing of payment.
Meaning considering the current liability note rather than taking the balance sheet figure.
If purchases is not available use cost of sales.
- consider including admin costs
A rising ratio may imply a cash shortage. There is an obvious cash advantage to late payment, but there are also downsides
Liquidity is crucial
Liquidity trends and inter-company comparisons can highlight a deteriorating cash position.
Solvency
Looks longer term at debt and its effect on profit.
Beware of forming naive views on subsidiaries
Foreign subsidiaries in the U.K. often have high debt levels- borrowing from their parent due to tax efficiency of debt/ hedging to reduce exchange risks.
Check if the accounts have a holding company liability clause.
Liquidity - current ratio
Expressed as a multiple
Can the company meet all current liabilities with its current assets.
Food retailer will have a ratio of 0.3.
The liquidity of the current assets is a key question. How quick can they be turned into cash.
Acid test- liquidity
As current ratio, but the stocks are assumed to be too illiquid to be included in the current assets figure.
Also called quick ratio.
The type of activity will affect the point at which concern might be expressed. The better approach would be to examine the trend over time.
Solvency- interest cover
Expressed as a multiple measuring the number of times interest payable is covered by profit.
Gives the degree to which the company is vulnerable to being unable to meet interest payments from profit.
The greater the proportion of capital from debt, the lower the ratio.
Consider whether preference dividends (often termed non-equity) should be treated as interest.
Solvency - gearing
Expressed as a multiple.
A ratio of 1 would imply capital being employed being equally sourced from loans and shareholders
Alternative methods of calculations e.g debt/debt + shareholders funds
A low ratio would imply a company could easily borrow funds if required and therefore have more options available to it.
Take care of treating preference (non-equity) shares as debt.
The shareholder perspective
Concerned about return:
Dividends
Share price
And risk:
Dividends cover
Level of debt
Some prefer:
Income growth stocks or
Capital growth stocks
Return on shareholders funds
The shareholders return on their money invested in the company
Also known as return on equity or return on investment
Differs from return on capital earned as it concerned with the performance of the shareholders investment rather than the management.
Earnings per share
Profits attributable to each share in pence. A published accounts requirement.
Can also be computed on a diluted basis where all share portions are assumed to have been converted into shares.
Will not rise in line with profits if more shares are issued in the year.
Some think that the method in the reporting standard is too liable to volatility, so there is also the headline eps figure.
Other ratios
Sales per employee Profit per employee Sales per square foot Growth rates Continuing vs discontinued business Segment ratios
Choice of ratios
You only compute a ratio to gain knowledge
Different reasons for analysis imply different ratio sets
Short term decisions, may only need liquidity (credit control ) assessment
Long term decisions may require weeks of analysis
Structure for appraisal
Why am I doing it Understanding the industry and the company Overview Data issues Compute and analyse ratios Conclusion? Recommendation