1 Financial Analysis
• Eliciting information from the financial statements of a firm. • Type of information sought depends on the person or firm
involved.
• Who is interested ?
- Management for planning and evaluating.
- Credit managers to estimate the riskiness of potential borrowers.
- Investors to evaluate corporate securities.
- Managers to identify and assess potential merger candidates. - Etc….
Financial Analysis
• Specific questions may be answered by financial analysis: - How liquid is the firm ? (Can they pay their bills)
- How are investments and capital expenditure financed ? - Is cash being generated to meet interest and/or debt repayments?
- Are stockholders receiving a sufficient return on their investment ?
3 Financial Analysis
• Data is used in a relative sense.
• An absolute value may have little relevance, whereas a relationship between two or more figures may tell a story. EG: The fact that a figure has changed may be
more important than the absolute size of the change. The trend is key.
• Beware of the source: - External auditor.
- Generally accepted accounting principles. - Inflation / Foreign Currency issues.
- People pose for a picture like a corporation poses for a financial statement.
4 Financial Analysis
• Methods of analysing financial statements include: 1. Comparative analysis over time.
2. Working Capital Analysis.
3. Internal Analysis (used mainly to assess credit risks). 4. Analysis of sales to develop a series of operating ratios. 5. Ratio Analysis. (Most Common)
6. Cash Flow Analysis.
5 Ratio Analysis
Ratio: A measure that relates two pieces of information. • A financial ratio is a measure of a relationship between
two pieces of financial information
EG: The relationship (ratio) of current assets to current liabilities
The ratio of accounts receivable to annual sales.
Ratio Analysis Ratios allow us to :
1. Make a comparison of a firms financial condition over time.
2. Standardise uniformly for inter-firm comparisons. • Successful financial ratio analysis requires that one keep
in mind the following points:
· A discussion is likely to include only a representative sample of possible ratios.
· Financial ratios are only "flags" that may indicate a potential "strength" or "weakness".
7 Ratio Analysis
• Other data may also need to be considered. • Consider both figures in a ratio.
A low ratio may be caused by a low numerator or a high denominator. Examine both before drawing your conclusion.
• The ratio is only meaningful when compared to some standard - eg : Industry standard, mgt objective. • Beware of differences in accounting techniques when
comparing ratios of two firms.
Do not become a slave to the figures - the mathematical nature of ratios implies a precision that may not really be there !
8 Liquidity Ratios
• To remain a viable business entity you must have enough cash on hand to pay bills as they fall due.
i.e. You must remain liquid.
• One way to measure liquidity is to measure the relationship between a firms current assets and approaching obligations. • Current Ratio = Currents Assets
Current Liabilities
• The higher the ratio, the higher the supposed ability of the firm to meet current payments.
• It is often suggested that a ratio of 2:1 is desirable for CR. It really depends on the circumstances of each industry
9 Liquidity Ratios
• Quick Ratio: Current Assets - Inventory
Current Liabilities
• This is a more stringent measure of liquidity sometimes called the "acid test".
• We remove inventories from the equation, as they are possibly the least liquid current asset.
• A more accurate measure of cash sufficiency would be a Cash Budget or Receipts & Payments Forecast - covered later in the course.
Profitability Ratios
• A firms profits demonstrates how well the firm is making investment and financing decisions.
• These ratios measure how effective a firm's management is generating profits on sales, total assets, and stockholders investments.
• The ratios can be divided into two groups: Profitability in relation to sales.
Profitability in relation to investments.
11 Profitability Ratios
• Gross Profit Margin: Gross Profit as a % of Sales. Gross Profit X 100
Sales
• Net Profit Before Tax Margin: Pre-tax Net Profit as a % of Sales
Net Profit before tax X 100 Sales
12 Profitability Ratios
• Net Profit After Tax Margin: Net Profit (after tax) as a % of Sales
Net Profit after tax X 100 Sales
• Total Asset Turnover : Annual Sales Net Assets
• Examines the efficiency with which the resources of the business are being used – a measure of productivity. • Take care when using this ratio for comparative purposes
EG: Depreciation policy, age of the assets, lease/buy
13 Profitability Ratios
• Return on Investment (ROI) : Net Profit (AT) Net Assets • Does the investment show a sufficient return?
• What rate of return are you making on the money invested? • The Du Pont Formula for calculating ROI reveals additional
detail (may reveal trends): Du Pont Formula
ROI = Net Profit (AT) Margin X Asset Turnover Net Profit (AT) X Sales
Sales Net Assets
Profitability Ratios
• Return on Owners Investment: Net Profit (AT) Net Worth • Another version of ROI expressing the return an owner
receives for investing his/her own funds.
Calculate and interpret the Liquidity and Profitability ratios for Ardmore Ltd., based on the financial statements
previously provided.
