Financial Analysis. Financial Analysis

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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? 1 2 1

2 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: Beware of the source: The fact that a figure has changed may be more important than the absolute size of the change. The trend is key. - External auditor. - Generally accepted accounting principles. - Inflation / Foreign Currency issues. - People pose for a picture like a corporation poses for a financial statement. 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

3 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: Ratios allow us to : The relationship (ratio) of current assets to current liabilities The ratio of accounts receivable to annual sales. Ratio Analysis 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"

4 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! 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 however

5 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

6 Profitability Ratios Gross Profit Margin: Gross Profit as a % of. Gross Profit X 100 Net Profit Before Tax Margin: Pre-tax Net Profit as a % of Net Profit before tax X 100 Profitability Ratios Net Profit After Tax Margin: Net Profit (after tax) as a % of Net Profit after tax X 100 Total Asset Turnover : Annual 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 decisions

7 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 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