Financial Statement Analysis

Question 1

Reasons for analysis

Answer 1

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?

Question 2

How to answer the question?

Answer 2

• know about the industry and company first
• variety of techniques
• ratios
• not the only tool
• common size analysis
• comparative techniques
• credit rating methods

Question 3

Where to the information?

Answer 3

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

Question 4

Framework for analysis

Answer 4

Context - why
Overview - understanding the industry
Ratios - data issues e.g inflation rates
Evaluation - analyse ratios - answer is?

Question 5

Normally use published accounts

Answer 5

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

Question 6

Need to look at trend comparators

Answer 6

Few ratios have universal benchmark levels

A trend can reveal the speed of change, but inflation/ impact acquisition or disinvestment, exchange rates etc

Question 7

problems for comparison and assessment

Published accounts

Answer 7

Seasonal factors and year end dates 
Accounting policy choice 
Degree of creativity 
Cross border comparisons 
Exchange rates?

Question 8

Companies can go bust quickly

Answer 8

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

Question 9

Key points in financial analysis

Answer 9

Always trying to learn
We don’t just produce numbers for their own sake
Analysis is flexible
-do what is appropriate

Question 10

Questions in ratio analysis

Answer 10

Did they make a decent profit
How risky are they
Working capital/liquidity management

Question 11

Issues in ratio analysis

Answer 11

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

Question 12

Tradeoff between risk and reward

Answer 12

Reward is meaningless without an understanding of the risk

Question 13

Ratio category - performance

Answer 13

Has the business succeeded in making an acceptable level of profit
Profits, sales, use of assets, productivity of labour

Question 14

Ratio category- working capital

Answer 14

Have the assets of the business been effectively used and managed?
Inventory, accounts payable, accounts receivable

Question 15

Ratio category - Financial Status

Answer 15

Can the business meet its debts as they fall due?
Liquidity (short term)
Solvency (long term)

Question 16

Ratio category - investment ratios/market performance

Answer 16

Is the company a worthwhile investment?

New PPE, profit retention, price/earnings ratio, dividend payout

Question 17

Return on capital employed

Answer 17

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.

Question 18

Sales margin or operating margin

Answer 18

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.

Question 19

Asset turnover

Answer 19

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.

Question 20

Working capital

Answer 20

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

Question 21

Inventory ratios

Answer 21

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.

Question 22

Debtor ratios

Answer 22

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.

Question 23

Trade creditor ratios

Answer 23

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.

Question 24

Trade creditor ratios

Answer 24

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

Question 25

Liquidity is crucial

Answer 25

Liquidity trends and inter-company comparisons can highlight a deteriorating cash position.

Question 26

Solvency

Answer 26

Looks longer term at debt and its effect on profit.

Question 27

Beware of forming naive views on subsidiaries

Answer 27

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.

Question 28

Liquidity - current ratio

Answer 28

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.

Question 29

Acid test- liquidity

Answer 29

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.

Question 30

Solvency- interest cover

Answer 30

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.

Question 31

Solvency - gearing

Answer 31

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.

Question 32

The shareholder perspective

Answer 32

Concerned about return:
Dividends
Share price

And risk:
Dividends cover
Level of debt

Some prefer:
Income growth stocks or
Capital growth stocks

Question 33

Return on shareholders funds

Answer 33

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.

Question 34

Earnings per share

Answer 34

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.

Question 35

Other ratios

Answer 35

Sales per employee 
Profit per employee 
Sales per square foot 
Growth rates 
Continuing vs discontinued business 
Segment ratios

Question 36

Choice of ratios

Answer 36

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

Question 37

Structure for appraisal

Answer 37

Why am I doing it 
Understanding the industry and the company 
Overview 
Data issues 
Compute and analyse ratios 
Conclusion? Recommendation