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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