Financial analysis A

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Who analyses financial statements

-Analysts
-Investors or shareholders
-Creditors
-Lenders
-Management
-Others

What information are they interested in?

-Financial performance (profitability)
-Return on investment
-Liquidity
-Financial risk
-Efficient utilization of assets

Why is cash from operations important?

1.Quality of earnings
2.Sustainable cash flow: Is cash from operations sufficient to cover:
-Non discretionary (unavoidable) cash flows
-Primary cash payments

Non discretionary (unavoidable) cash flows

-Interest
-Tax
-Replacement of assets

Primary cash payments

Dividends paid, loan repayments and expansion investment paid.

LIQUIDITY RATIOS

Current ratio, Acid-test ratio (quick ratio),

current ratio

current assets/current liabilities

current ratio indicates

Indicates / measures the ability of the firm to settle short-term debt (current liabilities) immediately using funds tied up in current assets

What may happen if the business is unable to pay its current liabilities as and when they become due?

May be liquidated

What financial risk does the current ratio highlight

Short-term liquidity risk.

Acid-test ratio (quick ratio)

Current assets - inventory/ current liabilities

Acid-test ratio (quick ratio) measures

the ability of the firm to settle short-term debt without having to rely on the sale of inventory (the least liquid current asset) and it is a more reliable indicator of the business's ability to settle short term debts

acid test comments

-look at increase/decrease from previous year
-guide: 2:1
- does ratio show that company is low/high risk in terms of short term liability
- state overall performace: weak/ strong liability position and whether a case for concern

recommended practices for managers of listed companies with large cash reserves available

Finance internal growth, Undertake a share-buyback, make a dividend payment
and undertake business acquisitions

ASSET MANAGEMENT (EFFICIENCY) Ratios

Measures how effectively management uses company assets to generate income.

-Current assets (working capital management)
-Non current or total assets turnover.

Working capital cycle

Is the time that the company's cash is tied up in relatively unproductive assets like inventory and debtors. The longer the cycle, the greater the financing needs of the business

Working capital cycle formula

Days inventory on hand + Debtors collection period - Creditors payment period

inventory turnover ratio (days of inventory on hand)

Inventory x 365 /Cost of sales

Indication of inventory turnover ratio

how many days the inventory sits in the warehouse before it is sold OR how fast the entity is turning over (selling) its inventory (as No. of times)

Inventory turnover ratio comment

-Compare the two years
-If decrease, there is a deteroriation in effeciency because tied up in inventory and more inventories may become obsolete and increase in storage/insurance costs

Inventory ratio turnover (As number of times)

Cost of sales / inventory

Inventory ratio turnover (As number of times) comment

A change in this ratio, means a change ineffeciency

Debtors collection period (in days)

Debtors x 365 /Credit sales (ASSUME ALL SALES ARE ON CREDIT)

Debtors collection period (in days) measures

how long it takes your debtors to pay and if it is longer than the stated policy need to consult with credit manager about effectiveness of credit policy and consider incentives to encourage debtors to pay sooner or penalties to force debtors to settle on time

Debtors collection period (in days) comment

- A change means a change in effeciency.
- If this period decreases, increase in effeciency, which reduces bank overdraft and decreases bad debts

Creditors payment period

Creditors x 365/Credit purchases

Creditors payment period detailed information

It measures how long your firm takes to pay creditors and if you can't calculate purchases: use cost of sales.

Creditors payment period comment

-A decrease in payment period is only good if taking advantage of the discounts or trying to remain within credit terms
-check whether it doesnt negatively effects the cashflows by looking whether collection period<payment period

Working capital cycle (WCC) or Operating Cycle

the number of days that money is tied up in inventory and accounts receivable without earning a return. The longer the WCC, the less efficient the management of inventory, accounts receivable and accounts payable

Comments on the WCC

-negative WCC means that: (a) the company is using creditors to finance its inventory and accounts receivable; and (b) that the company is also enjoying the use of cash received from debtors before paying creditors. Note that a WCC of zero means (a) is fulfilled but not (b)

WAYS OF REDUCING WORKING CAPITAL CYCLE AND ASSOCIATED DIFFICULTIES

1-Reducing the levels of inventory held. However, inventory re-order cost will rise, and sales and customers may be lost.
2-Reducing the debtors collection period. Difficulties: May result in lost sales and customers (if credit is tightened).
3-Delaying payments to trade creditors. Difficulties: May lead to loss of early settlement discounts and credit facility.

Total asset turnover formula

Revenue/Total assets (at carrying amount)

Total asset turnover information

-Measures how efficient the business has been in utilizing its assets to generate revenue.
-Measures the ability of the firm to use assets to generate income
-If there is a large change from one year to the next, consider calculating the non-current asset turnover ratio

Total asset turnover comment

If increase, the company used its assets more efficiently to generate revenue

Non current asset to turnover or Fixed asset turnover ratio

Sales/Non current assets (at carrying amount)

Non current asset to turnover or Fixed asset turnover ratio comment

-every rand in the company invested in non-current assets generated X in sales
-An increase means the company has become more effecient in using its non-current assets to generate sales

DEBT MANAGEMENT (FINANCIAL LEVERAGE) - all ratios

-It measures the level of debt in the capital structure of a business in relation to either total assets or total equity. Thus the greater the gearing or leverage, the greater the risk.
-It is a key ratio for banks because it provides the debt cushion

debt cushion

refers to amount of value that the assets can loose in a liquidation and still allows the bank/creditors to get their money back

Debt ratio formula

Total debt x 100 /Total assets (at carrying amount)

Debt ratio comment

A decrease indicates that the company is less risky

Debt equity ratio

Total debt x 100 /Total equity

Debt equity comment

A decrease indicates decrease in financial risk

Interest bearing debt to equity ratio formula

Interest bearing liabilities x 100 /Total equity

Interest bearing debt to equity ratio information

the level of interest-bearing debt in relation to equity. Interest-bearing debt is considered more risky than non-interest bearing debt

Interest cover ratio (Times interest earned)

Operating profit before interest and tax/ Interest expense

Interest cover information

It indicates how many times operating profit (I/S) covers interest expense. However, it is cash that pays interest and NOT profit. There is therefore a need to check whether cash from operations (CFS) was enough to cover interest paid

Interest cover comment

- a decrease means decrease in financial risk

Profitability Ratios

Combined effect of liquidity, asset and debt management on operating results, which are

Gross profit margin on sales

Gross profit x 100 /Sales

Gross margin on sales comment

For each R1 of sales, the company made a gross profit of X cents in Year 1 compared to Year 2, thus it has become slightly more/less profitable

Possible factors causing the decrease in gross profit margin

-Decrease in selling price (without a corresponding decrease in cost price).
-Increase in cost price (without a corresponding increase in selling price).
-Understating closing inventory (which increases COS).
-Changing the sales-mix (for example, including a new product with a lower gross profit margin).
-Increase in wastage / pilferage of inventory (this in turn increases cost of sales and decreases gross profit).

Net margin formula

Net profit after tax x 100 /REVENUE

Factors that may cause the net margin to increase or decrease

-An increase or decrease in gross profit margin
-An increase or decrease in operating costs
-An increase or decrease in interest expense
-An increase or decrease in tax expense.

profitability comments

If net profit>gross profit, indicates more effective control of operating costs

Return on assets

Profit after tax x 100 /Total assets

Return on equity (ROE) formula

Net profit after tax x 100 /Total equity

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