Principles of Business Introduction to Finance –lecture 3

Overview

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• Developing financial fluency• Interpreting financial statements

- Profitabilty- Liquidity- Gearing- Investors

• Budgeting

Learning outcomes

By the end of this session you should be able to:

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• Analyse a company using financial statements• Apply key ratios• Understand the role and purpose of budgets• Prepare a cash budget

Recap from finance week 1

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The key financial statements:

Income statementBalance Sheet /

Statement of Financial Position

Statement of Cashflows

Financial Performance Financial Position Cash inflows and outflows

Revenue – costs = Profit Assets – Liabilities = Equity Inflow – outflow = net

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Financial fluency• Making the numbers talk…• What is the story of the company that the financial statements are

telling us? • Do the financial statements show that the company has been

successful? How? • What do your calculations mean?• What potential issues can we identify from the financial statements?

Developing financial fluency

How to analyse financial statements:

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Step 1: Scan through each financial statement, and identify:- Large numbers- Significant variances from prior year- Inconsistencies (e.g. between revenue growth and movements in

costs of sales).

Step 2: Identify areas of the financial statements to focus on (eg. risky areas, profitability, liquidity)

Step 3: Calculate appropriate ratios

Step 4: What do those ratios tell you?

- How do they compare to prior year or other organisations?- How do they relate to qualitative information that you have?- What are the implications for the company?

Key ratios

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1. Profitability ratios

Gross ProfitGROSS PROFITSALES REVENUE

Net ProfitNET PROFITSALES REVENUE

Sales Revenue per EmployeeSALES REVENUENUMBER OF EMPLOYEES

Key ratios

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Profitability ratios

Return on Capital EmployedOPERATING PROFITTOTAL CAPITAL EMPLOYED (long term debt plus equity)

Asset Turnover(Asset Utilisation)

SALESTOTAL CAPITAL EMPLOYED

Return on Shareholder’s fundsOPERATING PROFITSHAREHOLDER’S FUNDS (EQUITY)

Key ratios

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2. Liquidity ratios

Current Ratio

= Current Assets : Current Liabilities

Liquidity/Quick/Acid Test Ratio

= Liquid Current Assets (ie. Exclude inventory) : Current Liabilities

Ability to pay debts as they fall due:

= Cash Generated from Operations/Current Liabilities

Key ratios

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3. Gearing: debt/equity ratio

Total Capital Employed

Equity

for Ordinary

Shareholders

External Debt

including any

redeemable

preference

shares

Key ratios

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4. Investor ratios

Dividend yield:

Dividend per Share net of base income tax rateMarket Value per Share

Earnings Per Share

Ordinary Shareholder’s EarningsNumber of Shares in Issue

PE Ratio

Market Price Per ShareEarnings Per Share

Budgeting

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A Budget is a short-term business plan, designed to link planning and decision making to strategic objectives

NB. It is not a Forecast, which is an estimate of future financial outcomes

Budgeting

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Perform review and

control

Select strategic options

and formulate plans

Identify and assess the

strategic options

Undertake a position

analysis

Establish mission and

objectives

Evaluate options and make a selection

Respond to variances

Revise plans (and budgets) if necessary

Consider options

Identify business objectives

Prepare long-term (strategic) plan

Prepare budgets

Measure actual performance

Budgeting

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Budgeting approaches

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Top down budgeting: Top management impose the budget

that the organisation must work to.

Bottom up budgeting: Developed by lower-level managers

who submit to top management.

Incremental budgeting: Modification of current year actual

results.

Zero-based budgeting: budget prepared from scratch each

period.

Rolling budget: continuous budgeting

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Pre-seminar work

• Read Chapters 7 and 12 of core textbook and attempt the questions at the back of the chapter.

• You will need access to a FTSE 100 company’s financial statements for the seminar!