Interpretation of Financial Statements Flashcards
What is efficiency defined as?
What does an efficiency ratio test?
Some examples, companies may use: (3)
Efficiency is defined as: work output/work input
- An efficiency ratio tests a key output against the input that produces it.
- Are resources are being used efficiently?
- Some examples companies may use:
o Profit per employee
o Profit per unit floor area (retail business)
o Turnover generated from assets
What is asset turnover?
Asset Turnover
The efficiency with which the company uses capital employed to generate sales
Revenue/Net Assets = £ or times
Where Net Assets = total assets – current liabilities
Or can be expressed as: Revenue/Capital Employed = £ or times
Where Capital Employed = equity + non-current liabilities
Non-current asset turnover
Measures the efficiency with which the company uses non-current assets to generate sales
Revenue/Non-current assets
Ratio relationships
ROCE = PBIT/Capital Employed
= Profit margin x Asset turnover
ROCE is influenced by
Pyramid approach – can drill down further
Average inventories turnover period
The number of days inventory is held on average
Average inventory = (opening inventory + closing inventory)
The quicker inventory is sold the better?
Depends on industry
Inventory turnover
A measure of the number of times the inventory is used up the period - e.g. in a year.
Expressed as ‘number of times’.
Average stock = (opening stock + closing inventory)
Higher the better.
Receivable days/ collection period
Measures the average number of days the company takes to collect payments from debtors.
Assumes all sales are on credit.
To express in terms of: months X 12 or weeks X 52
Payable days/ payment period
Measures the average number of days the company takes to pay creditors.
Taking longer = short-term borrowing from suppliers
Working Capital
Or net current assets
Working Capital = Current Assets – Current Liabilities
Working capital cycle:
= Inventory turnover + days receivables – days payables
The Working Capital Cycle (picture)
Liquidity ratios
- Measure the extent to which a business can cover its short-term obligations
- This can include short-term creditors and loan interest/ repayments
- Can a business use its liquid assets to cover its liabilities?
Current (liquidity) ratio
Assesses exposure to the need to suddenly meet liabilities.
Current ratio = current assets/current liabilities
Expressed as a ratio, e.g. 3:1
May be dangerous if less than 1?
Depends on industry
Quick (acid test) ratio
Same as current ratio but minus inventory (because it takes longer to turn stocks into cash or near cash)
Normally greater than 1? may be negative
Analysis of Financing
How is the company financed – capital structure
Companies are financed through a mixture of:
- Share capital
- Retained profits
- Loans
Gearing
- Refers to the relationship between debt and equity
- Indicates how the company’s capital is constituted between debt and equity (shareholders’ funds).
High gearing is OK when interest rates are low but not so good when they are high
Debt to Equity ratio
A measure of the borrowings as a proportion of shareholders’ funds
Shareholders’ funds includes:
All the share capital, share premium accounts, any reserves and profit and loss reserves.
Financial Gearing: Example
use ppt
Return on ordinary shareholders funds
Gearing interpretation
- Big cog : little cog effect
- Is high gearing beneficial?
Business usually makes greater returns than interest rates on borrowings
- Interest is tax deductible
Highly geared:
- relatively high levels of debt funding
- the more interest to pay before ordinary dividends paid
- could indicate more risk
Investment ratios
- Investors BUY shares in a company in order to earn a return
- There are a number of ratios that are useful for investors:
o Current shareholders
o Or potential investors
Investment ratios - definitions
- Dividend – proportion of profit after interest (earnings) and tax paid to shareholders.
o The remainder of the earnings is re-invested - Share volume – the number of ordinary shares in circulation
- Share price – as of today
- Dividend cover
- Dividend yield
- Earnings per share
- Price/Earnings ratio
Dividend cover
- Shows the number of times that the ordinary dividend can be paid out of current earnings
- How many times is the dividend covered by earnings?
Dividend Yield
- Expressed as %
- Measures the rate of return an ordinary shareholder gets by comparing the cost of their shares with the dividend payable
- Does not take into account capital growth
- Based on current price which may not be the price paid
Earnings per share IAS 33
- Used to estimate future growth which affects future share price.
- Measure of growth over time – may be manipulated
- Not all the profit has to be paid out in the form of dividends
- Allows comparison between one year’s earnings and the next because profit is related to the tangible number of shares in issue
- Share issue during the year
Price/earnings ratio
- Earnings per share = historical value compared with
- Market price = forward looking value
- The number of years earnings necessary to recover the market price of the share
- Represents the market’s view of the growth potential of the company, dividend policy and the degree of risk involved
- Compare to other companies in the sector
Price/Earnings ratio discussion points
The price / earnings ratio that can be expected depends on:
- Overall level of the stock market
- The industry
- The past record of the company
- The view of the market
Prediction and trend analysis
- May be used to predict financial distress
- May look at one ratio at a time or several ratios together
o Univariate or multivariate analysis - Ratios can be tracked over time to detect trends
- Plotted on a graph
The interpretation process
- Objectives of the analysis and the intended recipient
o e.g. Investor, management, board of directors - General overview, wider considerations
- Industry norms – may be hard to find
- Horizontal analysis – over time, >2yrs
- Vertical analysis, common sized statements
o May aid intercompany comparisons
Consideration of Internal and External Factors
- General business environment
- Industry specifics
- Management – motives, policies
- Read the narrative
Exam approach
- What format are you required to use? Be professional!
- Be mindful of the audience – internal manager, executive director, non-executive director, investor?
- Question – address the requirements given
- Brief conclusion – no new information
How to get started
- Either calculate the ratios required of you or decide on the most appropriate and calculate them
- Work your way down the statements addressing each requirement in turn:
1. State your calculated ratios
2. How do they differ?
3. So what? Can you link information?
Limitations of ratio analysis
- Lack of standard definitions – not governed by IFRS (except for EPS)
- Are two companies truly comparable?
o Accounting policy choices - Timing – SOFP shows one point in time
Explain the limitations of comparisons based on ratios
6 marks (out of 100)
In a 2-hour exam there are 1.2 mins per mark
Therefore 1.2 x 6 = 7.2 minutes or 7 minutes 12 seconds, in reality nearer 5 minutes.
Identification of the limitation with explanation and an example if appropriate
Marking guide:
◦ ½ mark for identification only
◦ Up to 2 marks per limitation identified, explained and illustrated with example.
◦ Max 6 marks.
