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Chapter 03

financial statement analysis

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Chapter 03

financial statement analysis

Uploaded by

Shenovi
Copyright
© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
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POSTGRADUATE DIPLOMA IN BUSINESS FINANCE AND STRATEGY

Semester 1: Financial Statements Analysis [FSA]

H V C Waduge
ACA, BSc Mgt (Acc) sp, ICAEW Finalist (England & Wales)
Analysis of financial statements should always begin with trend analysis in which the data
provided in financial statements is compared with similar data. More in depth analysis may
then be performed through common size and ratio analysis. However because of the time
limitation we will start with Ratios and then move to others

- Ratio analysis

- Vertical trend analysis

- Horizontal trend analysis

- Common size analysis


Ratio analysis
Involves manipulating amounts in the financial statements to produce a ratio, which is then
compared with the same ratio for previous years, another company or industry averages.
Ratios are discussed in more detail in the next section.

Vertical trend analysis


Involves comparing the financial statements of one company from one year to the next. It is
most useful where more than two years’ financial statements are available in order that true
trends can be identified and conclusions are not skewed by unusual transactions.

Horizontal trend analysis


involves comparing the financial statements of one company with those of an equivalent
company in the same period or industry averages in the same period. No two companies
are identical in size or type of operations and therefore this type of analysis is not
conclusive.
Common size analysis
Requires the adoption of a common base figure in the financial statements (often
revenue). All other items are then expressed as a percentage of this base figure. The
percentages should be compared to the same percentages of previous years or
other similar companies.
The calculation of ratios can help with the analysis of financial statements; ratios can
be grouped as relevant to profitability, solvency, liquidity, efficiency and investors’
interests.

Profitability –

Solvency –

Liquidity –

Efficiency –

Investors Ratios -
Return On Capital Employed

Assesses how well capital employed is used to generate profit.


eg 25%ROCE means Rs. 25 profit for every Rs. 100 capital employed.

 Compare to other ROCEs or market borrowing rates.


Return On Equity
Assesses how well shareholders’ funds are used to generate profit for shareholders.

Gross profit margin


Assesses how much profit can earn from revenue before deducting other expenses.

Affected by: Selling prices, Costs per unit, Product mix


PBIT margin
Assesses how much of operating profit can earn from revenue

Affected by: gross profit margin, operating expenses


Net profit
Assesses how much of net profit can earn from revenue

Affected by: PBIT margin, interest costs and tax.


Net asset turnover
Turnover per Rs. 1 invested in the company

Eg: Net Assets turnover of 4 means 4 rupee revenue has been generated per Rs. 1
capital employed.
Debt Ratio

How much debt exists in the business in relation to assets.

 50% provides a benchmark however many businesses operate at a


 higher debt ratio.
Gearing Ratio (Leverage)

Shows debt funding as a proportion of total funding.

• Gearing varies by industry.


• A highly geared company (>50%) will have difficulty securing further funds in the
future.
Interest Cover

Shows whether profits cover interest payable. And if it covers, how many times?

• Interest cover of 3 or above is considered acceptable.


• Companies with low interest cover are sensitive to changes in costs.
What is the best indicator of liquidity?

Current Ratio

Shows whether current assets are sufficient to meet future commitments to pay off
current liabilities.

 Consider the type of company; service companies or those that deal in cash only
may have a current ratio of less than 1 but do not have liquidity problems.
 Too high a ratio indicates inefficient use of resources.
Quick ratio (Acid test ratio)

Removes the least liquid asset, inventory, from the current ratio.

 Again, consider the type of company being considered.


 Also remember that both liquidity ratios are based on SOFP data and this is not
necessarily representative of balances throughout the year.
Accounts receivable collection period

The average time to collect amounts due from credit customers.

 Reduced by high levels of cash sales. Use average trade receivables if known as
year-end trade receivables may be unusually high or low. Should correspond to
terms offered. Decreased where prompt payment incentives offered.
Accounts Payable payment period

Average time taken to pay credit suppliers.

 Cost of sales is used as an approximation for credit purchases. Should correspond


to terms given. An increase above these terms may indicate poor liquidity.
Inventory turnover period

Time on average that inventory is held before it is sold.

 Indicator of how vigorous trade is. Affected by bulk buy discounts, lead times,
seasonality

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