# FINANCIAL ACCOUNTING TOPIC: FINANCIAL ANALYSIS

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1 SYLLABUS Compulsory part Basic ratio analysis 1. State the general functions of accounting ratios. 2. Calculate and interpret the following ratios: a. working capital/current ratio, quick/liquid/acid test ratio, b. gross profit ratio, net profit ratio and c. return on capital employed. 3. Evaluate the liquidity and profitability of a business using accounting ratios. Elective module Financial analysis 1. Calculate ratios and comment on a company s (i) profitability, (ii) liquidity, (iii) solvency, (iv) management efficiency and (v) return on investment: a. mark-up, b. inventory turnover, c. average trade receivables collection period & trade receivables turnover, d. average trade payables repayment period & trade payables turnover, e. earnings per share, f. total assets turnover, g. gearing ratio, h. dividend cover and i. price-earnings ratio. (Note: Paper 2A requires the in-depth application of the ratios in the Compulsory Part, i.e. working capital/current ratio, quick/liquid/acid test ratio, gross profit ratio, net profit ratio and return on capital employed) 2. Explain the functions and limitations of accounting ratios in financial analysis. TOPIC I FUNDAMENTALS OF RATIO Industry averages comparison Comparing (benchmarking) an item with industry averages Providing information as to a company s relative performance within the industry Intercompany comparison Benchmarking an item with one or more competing companies Determining a company s competitive position Trend analysis of the same company Compare the ratios of prior year and current year to identify movement during the year 1

2 TOPIC II RATIO ANALYSIS: LIQUIDITY Measure company s ability to meet its continuing (short-term) obligations when they arise Parties interested: short-term creditors (bankers and suppliers) Focusses on the relationship between: (1) current assets; and (2) current liabilities 1. Working capital Current assets Current liabilities 2. Current ratio Current assets Current liabilities 3. Acid-test ratio Current assets - inventories : 1 Current liabilities : 1 Measures potential excess sources of cash (from current assets) over its upcoming uses of cash (from current liabilities) Measures short-term debt-paying ability The higher the ratio, the more liquid the company appears to be Possible misinterpretation: high current ratio just due to slow turnover in inventory Measures immediate short-term debtpaying ability (more demanding) Includes only most liquid current assets Excludes less liquid inventory (readily saleable?) Illustration (HKDSE/BAFS/Sample Paper/1B/Question 6(b)) 2

3 TOPIC III RATIO ANALYSIS: MANAGEMENT EFFICIENCY Measure how efficiency a company utilises its operating assets and manages its resources 1A. Trade receivables turnover (times) 1B. Average trade receivables collection period 2A. Inventory turnover (times) 3A. Trade payables turnover (times) 3B. Average trade payables repayment period Credit sales Average trade receivables Measures how quickly receivable is converted into cash Expresses the number of times the company collects (average) receivables The higher the turnover rate, the more liquid the company s receivables Risk of having low turnover rate: incurrence of bad debt expenses 365 Expresses the average number of days an account receivable remains Trade receivables outstanding before it is collected turnover (times) Uses to assess the effectiveness of credit and collection policies (compare against the credit term granted) Cost of goods sold Average inventory Credit purchases Average trade payables Measures liquidity of inventory Expresses the number of times the company is able to sell a quantity of goods equal to its average inventory The higher the turnover rate, the more quickly the inventory can be sold Risk of having low turnover rate: higher chance of inventory obsolescence (application of LCM over inventory valuation) Measures how quickly payables are settled with the suppliers Expresses the number of times the company settles (average) its payables The lower the turnover rate, the slower the company is paying its suppliers Indication of having low turnover rate: slow payment may indicate worsening financial performance; may lead to dissatisfaction of suppliers which may demand quicker payments 365 Expresses average repayment time Trade payables turnover (times) 3

4 TOPIC IV RATIO ANALYSIS: SOLVENCY Measures the company s ability to survive over a long period of time Parties interested: long-term creditors and stockholders Focusses on: (1) ability to meet its interest requirements; and (2) ability to repay the principal of the debt when it falls due 1. Gearing ratio Non-current liabilities + Preference share capital x 100% Non-current liabilities + Shareholders fund (including Ordinary share capital (including share premium), Preference share capital and retained earnings) Indicates the degree of leverage Depicts the relationship between equity capital and fixed-interest loan capital (including preference share capital) The lower the ratio, the smaller the risk business may become unable to pay its debts (margin of protection to creditors contributed by shareholders is higher) Illustration (HKDSE/BAFS/Sample Paper/2A/Question 8(b)) 4

5 TOPIC IV RATIO ANALYSIS: PROFITABILITY & RETURN ON INVESTMENT Measure company s income (earning power) and operating success (including ability to obtain debt and equity financing) Parties interested: all parties including creditors and investors Focusses mainly on income statement items: (1) profit; and (2) sales 1. Gross profit margin 2. Net profit margin 3. Return on capital employed (ROCE) 4. Total asset turnover (time) 5. Earnings per share (EPS) 6. Dividend cover for ordinary shares (times) 7. Priceearnings ratio (P-E ratio) Gross profit Sales Net profit before tax Sales Profit before interest and tax Average capital employed Sales Total assets Net profit after tax Preference dividend Number of ordinary shares issued Net profit after tax preferred dividend Ordinary dividend paid Current price per ordinary share Earnings per share x 100% x 100% x 100% Measures percentage of sales contributing to gross profit Indicates management s ability to control cost of good sold and to retain a reasonable portion of its sales as gross profit Measures percentage of sales contributing to net profit before tax Indicates management s ability to control expenses and to retain a reasonable portion of its sales as profit Measures the ability to earn a return on funds supplied from all sources (i.e. longterm creditors and shareholders) Indicates the overall profitability and efficiency with which its capital is employed Measures how efficiently a company uses its assets to generate sales Indicates for each dollar of asset invested, how much of sales will be produced Measures the amount of net income applicable to each share of common stock Useful in making investment decision (compare the amount invested against: [i] EPS; and [ii] annual dividend per share to decide whether the investment price is reasonable) Measures the number of times annual ordinary dividend is covered by annual profit attributable to ordinary shareholders The higher the ratio, the more likely that the dividend can be maintained in the future (Note: High-growth companies reinvest most of the net income into the business) Measures relationship between market price of common stock and EPS Indicates outlook for future earnings (i.e. growth) 5

6 Illustration (HKDSE/BAFS/Sample Paper/1B/Question 6(a)) Illustration (HKALE/PA/2009/Paper 1/Question 4) Extension: Consider adding preference shares to the question to test students ability in classifying preference shares as debt-like in gearing ratio. Comprehensive Illustration (HKDSE/BAFS/2013/2A/Question 7) TOPIC V LIMITATIONS OF RATIO ANALYSIS The effectiveness of ratios depends on the quality of underlying financial information: Misleading results if the underpinning financial information is poor (e.g. poor estimation on depreciation and allowance for doubtful debts) Timeliness of financial information: Ratio is based on past financial information, however, past performance of a firm does not necessarily indicate its future performance Different judgment on the accounting policies to be used for certain transactions: With different accepted accounting policies used for the same transaction by different companies, it is difficult to compare and draw conclusion on their performance. Ratios can only identify the symptoms, but not the causes: Different interpretations can be drawn by different people. Adhere to the money measurement concept: Non-monetary but significant items, such as quality of goods, management, the diversity of product, could not be reviewed. 6

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