Interpretation of Financial Statements Flashcards
What different comparisons may be made with financial stmts?
- with previous financial periods
- with similar businesses
- with industry averages
What would the benefits of ratio analysis be for shareholders/potential investors?
- value of currently owned shares
- is it worth buying/selling shares
- is company growing/declining
What would the benefits of ratio analysis be for Bank and other capital providers?
- can see cash/resources/liquidity
- should they lend money?
What would the benefits of ratio analysis be for Employees?
- job security, wages, bonus
What would the benefits of ratio analysis be for Management?
- help to run the business with long term planning
- identify strong/weak areas
What would the benefits of ratio analysis be for Suppliers?
decide whether/how long to offer credit facilities for
What would the benefits of ratio analysis be for Government?
- statistics for industries
- grants
- to inform policies
What should you look at first when presented with set of accounts to analyse?
- obvious trends/ changes before any calculating
- think what these may mean with realistic reasons
- give significance
What does ratio analysis allow for?
- summarise and present financial info in more understandable form
- then be interpreted to indicate performance/ position
- only useful when can compare with another one
What are the categories of ratio analysis?
- Profitability
- Liquidity
- Efficiency
- Position
What is the purpose of profitability ratios?
- measure company’s use of assets and control of expenses to generate rate of return
Gross Profit Margin
- category
- formula
- what it measures
- what change may be due to
- Profitability
= Gross Profit/ Revenue x 100 - how well core operations running as compares price with sales price
- should be similar each yr
- sales price change
- product mix change
- inventory valuation wrong
- change in CoS
Operating Profit Margin
- category
- formula
- what it measures
- what change may be due to
Profitability
= Profit before interest & Tax (PBIT) /Revenue x 100
- avoids distortions between companies when one of financed by loans and other by share Cap
- how well overheads being controlled
- changes affecting GP Margin
- control over admin/distribution costs
- one off expense (advertising)
Return on Capital Employed (ROCE)
- category
- formula
- what it measures
- what change may be due to
Profitability
PBIT/ Capital Employed x 100
Capital Employed =
Total Equity + NC Liabilities OR
Total Assets - current Liabilities (TALCL)
- how efficiently capital used to generate profits
- new assets acquired not yet running at capacity
- assets ageing
- revaluations
Return on Equity (ROE)
- category
- formula
- what it measures
- what change may be due to
Profitability
= Profit after tax & preference dividend / Total Equity x 100
T Equity = equity shareholders funds
- focuses just on return for ordinary shareholders
- changes in interest paid and gearing
- assets ageing, revalue, new not at capacity
What is the purpose of Liquidity Ratios?
measures availability of companies cash to pay its short term debts
Current Ratio
- category
- formula
- what it measures
- what change may be due to
Liquidity
aka Working Capital Ratio
= Current Assets/ Current Liabilities as X: 1
- ability to pay current liabilities out of current assets
- finance day to day trading- inventories, offer credit, pay suppliers when due
- operate too low = can’t cover debts when due
- operate too high = can be seen as wasteful/ sitting on lots of cash
Quick Ratio
- category
- formula
- what it measures
- what change may be due to
Liquidity
aka Liquid Capital Ratio/ Acid Test
= Current Assets - Inventories/ Current Liabilities = X: 1
- omits inventories as least liquid current asset
- less than 1:1 suggest will be difficult to pay debts when due
What is the purpose of efficiency ratios?
- measure how well company uses its assets to generate profit, revenue and cash
Inventory Turnover Period
- category
- formula
- what it measures
- what change may be due to
Efficiency
- in days
= Inventories/Cost of Sales x365
- measures number of days inventories are held by company
- will change depending on type of goods
- ideal to have inventory days low whilst still being able to meet customers demands
- type of inventory
- different controls
- popularity
Receivables Collection Period
- category
- formula
- what it measures
- what change may be due to
efficiency
- in days
= Trade Receivables/Revenue x 365 - how long it take for TR to settle account
- average credit term should be taken into account
- see how efficient credit control function is
- credit term changes
- mix of cash/credit customers change
Payables Payment Period
- category
- formula
- what it measures
- what change may be due to
Efficiency
- in days
= Trade Payables/Cost of Sales x 365
- technically should be purchases but not usually in face of accounts so CoS used instead
- time takes to settle TP balances
- provide valuable short term finance
- must ensure operational issues not caused
- credit terms changes
- inc/dec cash
- management of PL
Working Capital Cycle
- category
- formula
- what it measures
- what change may be due to
Efficiency
= Inventory days + Receivable days - Payable days
- difference between time taken to get Cash in and Cash going out
- longer cycle = more financing required and higher risk of bankruptcy
- balance with inventory days not being too low as could run out of stock
- not asking too much from TP/TR and annoying
Asset Turnover Ratio
- category
- formula
- what it measures
- what change may be due to
Efficiency
= Revenue/Total Assets - Current Liabilities = x times
- efficiency of use of net assets in generating revenue
- should ideally be increasing
- could be affected by timing issue of assets bought late in the year and not have time for them to generate revenue
What two factors related to sales revenue can be looked at when analysing ROCE changes and the formula this means exists?
- Profit Margin - high or low margin, higher = bigger return
- Asset Turnover, assets generate x times their value in annual turnover
Operating Profit Margin x Asset Turnover Ratio = ROCE
(PBIT/Revenue) x (Revenue/TALCL) = PBIT/TALCL
What is the purpose of Position ratios?
- Consider company’s long term solvency and capital structure
- long term financial position
Interest Cover
- category
- formula
- what it measures
- what change may be due to
Position
= PBIT/Finance Costs = x times
- number of times a company could pay its interest payment using operating profit.
- ensure company does not have so much debt finance that risks nor being able to settle debt when due
- considers paying interest back not whole capital amount
Gearing
- category
- formula
- what it measures
- what change may be due to
Position
= Non Current Liabilities/ Total Equity + NCL x 100
- long term financial stability
- how much the company is financed by debt
- debt is cheaper than equity as interest is tax deductible
- but higher gearing is less secure financing/future is
What are some limitations of Ratio Analysis?
Can be limited by distorting factors
- inflation
- accounting policies
- lack of info
- seasonal trade
- year end accounting adjust
- related party/ group transactions
- different ratio/ formulas used
- newer vs older companies
- stmts been manipulated
- new so no comparative
