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Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010

56863 Managing Finance

Week 3 13/Oct/2010Dr. Chloe Yu-Hsuan Wu

Understanding and Analysing Financial Statements

Users of financial statements

Business

Competitors

Lenders

Managers

Owners Customers

Suppliers Investment analysis

Community representatives

Government

Employees and their representatives

Usefulness of financial information

• Reliability• Relevance

• Comparability • Timeliness

• Cost/benefit

• Useful accounting information

• Understandability

• can produce

• the lack of

• which will be limited by

Published annual report

•Financial statements▫Income Statement▫Balance sheet▫Cash flow statement

•Additional financial data and notes•Auditor’s report•Director’s report•Chairman’s report

The key stages of financial analysis

• Select and

calculate

appropriate

ratios

• Identify users and their

information

• Interpret and

evaluate the

results

Financial statement analysis

Undertaken by•Insiders Management•Outsiders Financial analysts

Potential/existing investors

Providers of debt finance

Ratios analysis is only one way of analysing

performance using financial statements

Financial statement analysis

•Cross sectional analysis•Trend analysis

Note:• it’s the interpretation that is

important•be consistent!

Scope of ratio analysis

Ratio analysis can be applied to financial statements and similar data in order to:

• Assess performance of a company.• Determine whether company is solvent and

financially healthy.• Assess risk attached to its financial structure.• Analyse returns generated for shareholders and

other interested parties.

Importance of benchmarks

Ratios must be compared with benchmarks• Pre-determined targets for ratios set by the

company, i.e. ROCE > 16%• Ratios of companies of similar size who are

engaged in similar business activities• Average ratios for business sector in which a

company operates, i.e. with industrial norms• Ratios for the company from previous years,

with data adjusted for inflation, if necessary.

Ratio analysis

Five broad ratio categories:• Profitability ratios• Activity ratios• Liquidity ratios• Gearing ratios• Investor ratios.

Profitability ratios

• Return on capital employed (ROCE) (%):profit before interest and tax × 100 capital employed

• Net profit margin (%):profit before interest and tax × 100

Profitability ratios (Continued)

• Net asset turnover (times): sales

capital employed• Gross profit margin (%):

gross profit × 100 sales

Activity ratios

• Receivables’ ratio or receivables days:trade receivables × 365 credit sales

• Payables’ ratio or payables days: trade payables × 365

cost of sales

Activity ratios (Continued)

• Inventory days: inventory × 365

cost of sales• Cash conversion cycle (days):

Inventory days + receivables days – payables days.

Activity ratios (Continued)

• Non-current asset turnover (times):sales or revenue

non-current assets• Sales/net working capital (times):

sales or revenue net current assets

Liquidity ratios

• Current ratio (times):current assets

current liabilities• Quick ratio (times):

current assets less inventorycurrent liabilities

Gearing ratios

• Capital gearing ratio (%): long-term debt capital × 100

capital employed• Debt/equity ratio (%):

long-term debt capital × 100share capital and reserves

Gearing ratios (Continued)

• Interest coverage ratio (times):profit before interest and tax

interest charges

Investor ratios

• Return on equity (ROE) (%):earnings after tax and preference dividends

shareholders’ funds• Dividend per share (pence):

total dividend paid to ordinary shareholdersnumber of issued ordinary shares

Investor ratios (Continued)

• Earnings per share (EPS) (pence):earnings after tax and preference dividends

number of issued ordinary shares• Dividend cover (times):

earnings per sharedividend per share

• Price/earnings ratio (P/E ratio) (times):market price of shareearnings per share

• Payout ratio (%): ordinary dividends × 100

distributable earnings

• Dividend yield (%): dividend per share × 100

share price• Earnings yield (%):

earnings per share × 100share price

Limitations with ratio analysis

•historic summarised data•symptoms not causes•changes •accounting regulations•biased information•users ability•different definitions

Working capital management

• Working capital concerned with short-term resources and short-term funding

• Net working capital =Current Assets - Current Liabilities

(inventory + receivables + cash - trade payables)

• The need for liquidity must be balanced against the need for profitability.

Working capital policies• Policies cover level of investment in working

capital and its components, and financing of working capital.▫ inventory management▫receivables management▫payables management, and ▫cash management

• Policies should take account of nature of business, credit policy, seasonal factors and manufacturing period.

Inventory management

Concerned with:

•financial constraints •buying opportunities•efficiency of production• legal requirements•market and customer demands, and•obsolescence of inventory

Inventory managementDecision criteria:

•stock ordering model•availability of discounts•uncertainty of demand

Inventory management (Continued)

• Seeks to minimise cost of holding inventory for production or resale.

• EOQ model calculates optimum order size if annual demand, holding cost and ordering cost are known.

• EOQ is a deterministic model, based on certainty of demand and costs.

Inventory management (Continued)

Economic Order Quantity: e = √ 2cd/h

Where:

•e = economic order quantity•c = order cost per order•d = annual rate of demand•h = annual holding cost per unit

Cash management

• Holding cash for short-term needs will incur opportunity cost of lost profit.

Concerned with

•holding sufficient cash to meet demand

• investing cash balances to maximise return

• Cash flow shortages can be eased by postponing expenditure, accelerating income and finding new cash resources.

• Optimum cash levels reflect liquidity needs▫ future cash needs and borrowing capability▫ efficiency of cash management▫ tolerance of risk.

Cash management (Continued)

• Invest short-term cash surpluses in appropriate short-term instruments.

• Must be no risk of capital loss.• Choice of investment depends on:

▫ size of the cash surplus▫ maturity of the short-term asset▫ yield required▫ any penalties for early encashment.

Cash management (Continued)

Receivables management

Concerned with the trade off betweenincreasing sales and profits by offering

credit

Key issues:

•the cost of carrying receivables•the risk of individual accounts•the possible cost of bad debts, and•debt collection management costs

Receivables management (Continued)

• Example: MB plc has £15m per year credit sales and gives 90 days credit.

• Proposal: give 3% discount if paid in 15 days, lower credit period to 60 days.

• 60% of customers will take discount.• Sales will not be affected.• Short-term borrowing is at 20%.

Receivables now: £15m × (90/365)= £3.7mProposed receivables:£15m × 60% × (15/365) = £0.4m£15m × 40% × (60/365) = £1.0m £1.4mDecrease in receivables: £2.3m

Finance saving = £2.3m × 0.2 = £0.5mDiscount cost = £15m × 3% × 60% = (£0.3m)Net benefit of new policy = £0.2m• Proposal is worth implementing.

Payables management

Concerned with:

•obtaining satisfactory credit from suppliers

•extending credit during periods of cash shortage, and

•maintaining good relations with regular and important suppliers

Reading•Textbook : chapter 2, 3

Lecture+2+Understanding+and+Analysing+Financial+Statements+11 12

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