Purpose: To identify aspects of a business’s

performance to aid decision making Quantitative process – may need to be

supplemented by qualitative factors to get a complete picture

5 main areas:

� Liquidity – the ability of the firm to pay its wayf Investment/shareholders – information to enable

decisions to be made on the extent of the risk and the earning potential of a business investment

l Gearing – information on the relationship between the exposure of the business to loans as opposed to share capital

b Profitability – how effective the firm is at generating profits given sales and or its capital assets

l Financial – the rate at which the company sells its stock and the efficiency with which it uses its assets

Also referred to as the ‘Quick ratio’ (Current assets – stock) : liabilities 1:1 seen as ideal The omission of stock gives an indication of the cash the firm

has in relation to its liabilities (what it owes) A ratio of 3:1 therefore would suggest the firm has 3 times as

much cash as it owes – very healthy! A ratio of 0.5:1 would suggest the firm has twice as many

liabilities as it has cash to pay for those liabilities. This might put the firm under pressure but is not in itself the end of the world!

Looks at the ratio between Current Assets and Current Liabilities

Current Ratio = Current Assets : Current Liabilities Ideal level? – 1.5 : 1 A ratio of 5 : 1 would imply the firm has £5 of assets to cover

every £1 in liabilities A ratio of 0.75 : 1 would suggest the firm has only 75p in assets

available to cover every £1 it owes Too high – Might suggest that too much of its assets are tied up

in unproductive activities – too much stock, for example? Too low - risk of not being able to pay your way

Earnings per share – profit after tax / number of shares

Price earnings ratio – market price / earnings per share – the higher the better generally. Comparison with other firms helps to identify value placed on the market of the business.

Dividend yield – ordinary share dividend / market price x 100 – higher the better. Relates the return on the investment to the share price.

Gearing Ratio = Long term loans / Capital employed x 100

The higher the ratio the more the business is exposed to interest rate fluctuations and to having to pay back interest and loans before being able to re-invest earnings

Profitability measures look at how much profit the firm generates from sales or from its capital assets

Different measures of profit – gross and net Gross profit – effectively total revenue

(turnover) – variable costs (cost of sales) Net Profit – effectively total revenue

(turnover) – variable costs and fixed costs (overheads)

Gross Profit Margin = Gross profit / turnover x 100

The higher the betterEnables the firm to assess the impact of

its sales and how much it cost to generate (produce) those sales

A gross profit margin of 45% means that for every £1 of sales, the firm makes 45p in gross profit

Net Profit Margin = Net Profit / Turnover x 100 Net profit takes into account the fixed costs involved

in production – the overheads Keeping control over fixed costs is important – could

be easy to overlook for example the amount of waste - paper, stationery, lighting, heating, water, etc. e.g. – leaving a photocopier on overnight uses enough electricity to

make 5,300 A4 copies. (1,934,500 per year) 1 ream = 500 copies. 1 ream = £5.00 (on average) Total cost therefore = £19,345 per year – or 1 person’s salary

Return on Capital Employed (ROCE) = Profit / capital employed x 100

Be aware that there are different interpretations of what capital employed means – see http://www.bized.ac.uk/compfact/ratios/ror3.htm for more information!

The higher the better Shows how effective the firm is in using its

capital to generate profit A ROCE of 25% means that it uses every £1 of

capital to generate 25p in profit Partly a measure of efficiency in organisation

and use of capital

Asset Turnover = Sales turnover / assets employed Using assets to generate profit Asset turnover x net profit margin = ROCE

Stock turnover = Cost of goods sold / stock expressed as times per year

The rate at which a company’s stock is turned over A high stock turnover might mean increased efficiency?

But: dependent on the type of business – supermarkets might have high stock turnover ratios whereas a shop selling high value musical instruments might have low stock turnover ratio

Low stock turnover could mean poor customer satisfaction if people are not buying the goods (Marks and Spencer?)

Debtor Days = Debtors / sales turnover x 365 Shorter the better Gives a measure of how long it takes the business to

recover debts Can be skewed by the degree of credit facility a firm

offers

This test consists of 10 questions designed to test your understanding of Profit and Loss Accounts as well as analysis of P&L account analysis.

The links provide you with a choice of answer, along with explanations and solutions.

You will need a calculator to complete this test.

A Profit and Loss Account shows us a snapshot in time of the companies trading activities.

a. Falseb. True

The Profit and Loss Account is a historical record of trading activities, normally showing the previous 12 months

Your answer is correct.

A Balance Sheet gives us a snapshot in time of a companies assets and liabilities. The Profit and Loss Account is a historical record of trading activities, normally showing the previous 12 months

Sales less Cost of Sales gives us?A. Net ProfitB. ExpensesC. Gross Profit

Net Profit is found by taking expenses fromGross Profit. Try Again

Total expenses are found by adding together individual expenses, or by taking Net Profitfrom Gross Profit. Try again.

Correct. Sales less Cost of Sales =Gross Profit.

A firm has an opening stock of £37,000, a closing stock of £29,000, and has purchasing during the year stock costing £121,000. What is the firms cost of sales?

A. £115,000B. £129,000C. £140,000

Wrong. To calculate cost of sales add purchases toopening stock and take away closing stock. Try again.

Correct. To calculate cost of sales you added purchases to opening stock and took away closing stock.

Wrong. To calculate cost of sales add purchases toopening stock and take away closing stock. Try again.

A firm has a gross profit of £854,000 and a net profit of £421,000. What are the firms expenses?

A. £1,275,000B. £450,000C. £433,000

Wrong. To find expenses take net profitfrom gross profit. Try again.

Wrong. To find expenses take net profitfrom gross profit. Try again.

Correct. To find expenses you took net profitfrom gross profit.

Which of the following defines mark up?A. The % difference between net profit and gross

profitB. The difference between purchase price and gross

profit, as a % of purchase price.

Wrong. Mark up is the difference between purchase price and gross profit, as a % of purchase price.

Correct Mark up is the difference between purchase price and gross profit, as a % of purchase price.

A firm with gross profit of £67,000 has a sales figure of £521,000. What is the firms gross profit margin.?

A. 12.86%B. 7.77%C. 34%

Correct. You calculated Gross Profit as a Percentageof Sales.

Wrong. To find GPM you must calculate Gross Profit as a Percentageof Sales.

Wrong. To find GPM you must calculate Gross Profit as a Percentageof Sales.

Which of the following defines The Bottom Line?A. The lowest level sales can fall to if the firm is to

stay profitable.B. Profit remaining after all costs of the firmhave been paid

Wrong. The bottom line is Profit remaining after all costs of the firmhave been paid

Correct.

Which of the following firms is likely to have the highest GPM?A. A supermarketB. A restaurantC. A travel agent

Wrong. Supermarkets have low GPM’s

Correct. Restaurants have high GPM’s. With ahigh level of expenses, this is to be expected.

Wrong. Good Net profits will depend upona high level of sales, each with a low gross profitmargin.

Which of the following firms is likely to have low expenses in proportion to cost of sales

A. A jewelersB. A restaurantC. A petrol station

Wrong. This type of business has a high proportionof expenses to cost of sales.

Wrong. This type of business has a high proportionof expenses to cost of sales.

Correct. This type of business has a low proportionof expenses to cost of sales.

A computer firm has just launched its new intelligent mouse onto the market. The total costs of production are £3.00, the retail price is £8.00. What is the % mark up?

A. 62.5%B. 60%C. 166.67%

Wrong. To find % mark up, calculate the difference between production and retail prices,as a % of production price.

Wrong. To find % mark up, calculate the difference between production and retail prices,as a % of production price.

Correct.To find % mark up, you calculated the difference between production and retail prices,as a % of production price.

You have now completed the test. For further more detailed revision please use the case studies on

the ALoA web site. www.aloa.co.uk

© Mary Low

There are two key factors for business survival:Profitability Solvency

Profitability is important if the business is to generate revenue (income) in excess of the expenses incurred in operating that business.

The solvency of a business is important because it looks at the ability of the business in meeting its financial obligations.

© Mary Low

Financial Statement Analysis will help business owners and other interested people to analyse the data in financial statements to provide them with better information about such key factors for decision making and ultimate business survival.

© Mary Low

Purpose: To use financial statements to evaluate an

organisation’s Financial performance Financial position.

To have a means of comparative analysis across time in terms of:

Intracompany basis (within the company itself) Intercompany basis (between companies) Industry Averages (against that particular industry’s averages)

To apply analytical tools and techniques to financial statements to obtain useful information to aid decision making.

© Mary Low

Financial statement analysis involves analysing the information provided in the financial statements to:

Provide information about the organisation’s: Past performance Present condition Future performance

Assess the organisation’s: Earnings in terms of power, persistence, quality and growth Solvency

© Mary Low

To perform an effective financial statement analysis, you need to be aware of the organisation’s: business strategy objectives annual report and other documents like articles about

the organisation in newspapers and business reviews. These are called individual organisational factors.

© Mary Low

Requires that you: Understand the nature of the industry in which

the organisation works. This is an industry factor.

Understand that the overall state of the economy may also have an impact on the performance of the organisation.

→ Financial statement analysis is more than just “crunching numbers”; it involves obtaining a broader picture of the organisation in order to evaluate appropriately how that organisation is performing

© Mary Low

The commonly used tools for financial statement analysis are: Financial Ratio Analysis Comparative financial statements analysis:

Horizontal analysis/Trend analysis Vertical analysis/Common size analysis/ Component

Percentages

© Mary Low

Financial ratio analysis involves calculating and analysing ratios that use data from one, two or more financial statements.

Ratio analysis also expresses relationships between different financial statements.

Financial Ratios can be classified into 5 main categories: Profitability Ratios Liquidity or Short-Term Solvency ratios Asset Management or Activity Ratios Financial Structure or Capitalisation Ratios Market Test Ratios

3 elements of the profitability analysis: Analysing on sales and trading margin

focus on gross profit Analysing on the control of expenses

focus on net profit Assessing the return on assets and return on

equity

© Mary Low

Gross Profit % = Gross Profit * 100 Net Sales

Net Profit % = Net Profit after tax * 100Net Sales

Or in some cases, firms use the net profit before tax figure. Firms have no control over tax expense as they would have over other expenses.⇒ Net Profit % = Net Profit before tax *100

Net Sales

Return on Assets = Net Profit * 100 Average Total Assets

Return on Equity = Net Profit *100Average Total Equity

© Mary Low

Short-term funds management Working capital management is important as it signals the firm’s

ability to meet short term debt obligations.

For example: Current ratio

The ideal benchmark for the current ratio is $2:$1 where there are two dollars of current assets (CA) to cover $1 of current liabilities (CL). The acceptable benchmark is $1: $1 but a ratio below $1CA:$1CL represents liquidity riskiness as there is insufficient current assets to cover $1 of current liabilities.

© Mary Low

Working Capital = Current assets – Current Liabilities

Current Ratio = Current Assets Current Liabilities

Quick Ratio = Current Assets – Inventory – Prepayments Current Liabilities – Bank Overdraft

© Mary Low

Efficiency of asset usage How well assets are used to generate revenues

(income) will impact on the overall profitability of the business.

For example: Asset Turnover

This ratio represents the efficiency of asset usage to generate sales revenue

© Mary Low

Asset Turnover = Net SalesAverage Total Assets

Inventory Turnover = Cost of Goods SoldAverage Ending Inventory

Average Collection Period = Average accounts Receivable Average daily net credit

sales*

* Average daily net credit sales = net credit sales / 365

© Mary Low

Long term funds management Measures the riskiness of business in terms of debt

gearing.

For example: Debt/Equity This ratio measures the relationship between debt and

equity. A ratio of 1 indicates that debt and equity funding are equal (i.e. there is $1 of debt to $1 of equity) whereas a ratio of 1.5 indicates that there is higher debt gearing in the business (i.e. there is $1.5 of debt to $1 of equity). This higher debt gearing is usually interpreted as bringing in more financial risk for the business particularly if the business has profitability or cash flow problems.

© Mary Low

Debt/Equity ratio = Debt / Equity

Debt/Total Assets ratio = Debt *100Total Assets

Equity ratio = Equity *100Total Assets

Times Interest Earned = Earnings before Interest and TaxInterest

© Mary Low

Based on the share market's perception of the company.

For example: Price/Earnings ratio

The higher the ratio, the higher the perceived quality of the earnings by the share market.

© Mary Low

Earnings per share = Net Profit after taxNumber of issued ordinary shares

Dividends per share = Dividends Number of issued ordinary shares

Dividend payout ratio = Dividends per share *100 Earnings per share

Price Earnings ratio = Market price per share Earnings per share

© Mary Low

Trend percentage Line-by-line item analysis Items are expressed as a percentage of a base year This is a time series analysis For example, a line item could look at increase in

sales turnover over a period of 5 years to identify what the growth in sales is over this period.

All items are expressed as a percentage of a common base item within a financial statement

e.g. Financial Performance – sales is the base

e.g. Financial Position – total assets is the base

Important analysis for comparative purposes Over time and For different sized enterprises

© Mary Low

We must be careful with financial statement analysis. Strong financial statement analysis does not

necessarily mean that the organisation has a strong financial future.

Financial statement analysis might look good but there may be other factors that can cause an organisation to collapse.

© Mary Low

The following financial statements of Walker Ltd were prepared in accordance with New Zealand GAAPs. Walker

Ltd is a diversified enterprise with its main interests in the manufacture and retail of plastic products.

The financial statements of Walker Ltd need to be analysed. An investor is considering purchasing shares in

the company. Relevant ratios need to be selected and calculated and a report needs to be written for the investor. The report should evaluate the company’s

performance and position

2005 2006 Horizontal Analysis

$000 $000 $000 $000 Current Assets Bank 33.5 41.0 Accounts receivable 240.8 210.2 Inventory 300.0 370.8 574.3 622.0 108 Non-current assets Fixtures & fittings (net) 64.6 63.2 Land & buildings (net) 381.2 376.2 445.8 439.4 99 Total assets 1,020.1 1,061.4 104 Current Liabilities

Accounts payable 261.6 288.8 Income tax 60.2 76.0 321.8 364.8 113 Non-current liabilities Loan 200.0 60.0 30 Shareholders Funds

Paid-up ordinary capital 300.0 334.1 Retained profit 198.3 302.5 498.3 636.6 128 Total liabilities & equity 1,020.1 1,061.4 104

2005 2006 Horizontal Analysis

$000 $000 $000 $000 Sales 2,240.8 2,681.2 120 Less Cost of goods sold 1,745.4 2,072.0 119 Gross profit 495.4 609.2 123 Wages & salaries 185.8 275.6 Rates 12.2 12.4 Heat & light 8.4 13.6 Insurance 4.6 7.0 Interest expense 24.0 6.2 Postage & telephone 9.0 16.4 Depreciation - Buildings 5.0 5.0 Fixtures & fittings 27.0 276.0 32.8 369.0 134 Net profit before tax

219.4

240.2 109

Less Income tax 60.2 76.0 126 Net profit after tax 159.2 164.2 103

2005 2006 $000 $000 $000 $000 Cash flow from operations Receipts from customers 2,281 2,711.8 Payments to suppliers & employees (2,050) (2,460.4) Interest paid (24) (6.2) Tax paid (46.4) (60.2) Net cash flow from operating activities 160.6 185 Investing activities Purchase of non-current assets (121.2) (31.4) Net cash used in investing activities (121.2) (31.4) Financing activities Dividends paid (32.0) (40.2) Issue of ordinary shares 20.0 34.1 Repayment of loan capital -__ (140.0) Net cash outflow from financing activities (12) (146.1) Increase in cash & cash equivalents 27.4 7.5

Credit purchases for the year 2006 were $2,142,800. General prospects for the major industries in which

Walker is involved look good with a forecast glut of oil set to reduce the cost of production and world demand for plastic remaining strong.

Benchmarks: There are no exact benchmarks for Walker Ltd

because it is a diversified company. The following are average indicators that relate to the plastic retailing and manufacturing industries for the year 2006. Gross profit margin25% Net profit margin 7% Inventory turnover 6 times Debt/equity ratio 0.6 : 1 Return on Assets 12% Return on Equity 20%

© Mary Low

Profitability ratios:

Benchmarks 2005 2006

Gross Profit Margin

Industry

25%

22% 22.7%

Net Profit Margin

Industry

7%

7.1% 6.1%

Return on Assets

12% 15.6% 15.5%

Return on Equity

Industry

20%

32% 26%

Important note: The calculations of the ratios in this illustration did not use “averages” for total assets, equity and inventory. The 2005 and 2006 year end figures were used and this is a slight variation to the formulas provided.

© Mary Low

Asset Management

ratios:

Benchmarks 2005 2006

Inventory Turnover

Industry

6 %

5.8 times 5.58 times

Asset Turnover Not given 2.2 2.53

© Mary Low

Liquidity ratios:

Benchmarks 2005 2006

Current Ratio Ideal standard

2:1

Acceptable standard

1:1

1.78:1 1.70:1

Quick Ratio Ideal standard

2:1

Acceptable standard

1:1

0.85:1 0.69:1

Days Payable Standard

30 days

Credit purchases not

available

49.19 days

© Mary Low

Financial Structure

ratios:

Benchmarks 2005 2006

Debt/Equity Industry

0.6:1

Standard benchmark

1:1

1.05: 1 0.67:1

TIE Standard benchmark:

Between 3 and 5. Below 3 risky. Above 5 very

favourable

10.14 times 39.74 times

For the investor considering the purchase of shares in the company, the return they will earn is the key financial factor but an overall evaluation of the company’s performance and position is also important to get a better picture of how well the company is actually doing.

ROE in 2006 is 26%. Whether or not this is attractive depends on the perceived riskiness of this investment and other alternatives available but this return is certainly more attractive than current bank interest rates.

ROE has decreased by 4% but the company’s ROE at 26% is still better than the industry average of 20%

Riskiness of business is being reduced by the significant repayment of loan in 2006.

Profitability The NP% and ROA ratios show a small downward trend in %

over the 2 year period. ROE% ratio show a more significant decrease but is still better than the industry average.

Gross Profit Margin is slightly unfavorable at about 2.3% below the industry benchmark of 25%.

The horizontal analysis information show that Sales have increased by 20%. However operating costs have increased by 34%.

Asset Management

IT has gone down slightly from 5.8 to 5.58 times.

IT is still close to the industry benchmark of 6 times.

AT has increased showing more sales being generated from asset usage

Liquidity Current ratios of 1.78:1 (2005) and 1.70: 1

are at above acceptable levels but below ideal level.

Quick ratios appear more of a concern being below acceptable levels in both years and even more so in 2006 (0.69:1).

Raises some concerns over the liquidity of the business and inventory management (although IT ratio only shows a slight decline in 2006).

Days Payable is a concern as there may be poor debt payment management.

Financial Structure Although slightly higher than D/E industry

benchmark (0.67:1), business has become less risky due to the significant repayment of loan in 2006.

TIE is extremely good for the business at 39.74 times (well above 5 the standard benchmark).

Cash flow situation Strong cash flow from operating activities

(increased from 160,600 to 185,000). Spending under investing activities suggest more

growth. Repayment of debt under financing activities

imply restructuring of business to have more equity funding rather than debt funding.

Given:2) the strong forecast for the industry (ie general

prospects looking good and world demand for plastic products remaining strong),

3) the sales growth in this business, 4) acceptable ratios as they are quite close to the

industry averages, 5) good cash flows from operating activities and 6) favorable ROE, although it has decreased, it is still

better than the industry average ROE.

=> it is recommended that the investor purchase shares in the Walker Ltd company.