Financial Analysis

Financial analysis of the firm helps in finding its own strengths and weaknesses
Financial analysis helps in monitoring the key indicators of the firm
Financial analysis helps in comparison between different firms (competitive analysis)
Financial Analysis helps in understanding a firm’s past, present and future financial conditions

What are Financial Statements?

Financial statements are written records that convey the business activities and the financial performance of a company.
Balance sheet (annual financial record) (provides performance of company) , income statement (sources of income) (sales, interests, etc), cash flow statement (provides for liquidity position), statement on retained earnings

Ratio Analysis

Ratio analysis helps firms to evaluate performance, do structural analysis, provide useful insights and relationship between various business activities and performance
Objectives of ratio analysis are to study efficiency of operations, study risk of operations, compare performance with the past performance, compare performance with other firms, evaluate current performance and etc

Limitations of Ratio Analysis

Accounting practices may differ from one firm to another
Seasonality affects ratio analysis, eg: one quarter saw huge increase in performance (via. ratios) because of more festivals in that quarter which is not the right indicative. In such cases along with that quarter you could compare it with Annual performance to make sense of it.

5 Major Ratios

Liquitdity: the ability of a firm to pay its way
Investment/Shareholders : Information to enable decisions to be made on the extent of the risk and earning potential of a business investment.
Gearing : Information on the relationship between the exposure of the business to loans as opposed to share capital.
Profitability : How effective the firm is at generating profits given sales and or its capital assets.
Financial : The rate at which the company sells its stock and the efficiency with which it uses its assets.

Quick ratio = (current assets - stock inventory) / liabilities
1:1 is an ideal ratio to have
3:1 is a healthy ratio, and would mean that there exists lot current assets compared to liabilities
0.5:1 is an unhealthy ratio, this would put lot of pressure on the firm

Current ratio = current assets / current liabilities
Too high or too low current ratio could be problematic
Too high would mean that there are too many current assets and mostly tied up with unproductive assets
Too low would mean the risk of not able to pay your way
Ideal ratio is 1.5:1
5:1 ratio would mean Rs 5/- in assets is available to cover every Rs1/- of liabilities
0.75:1 ratio would mean 75p in assets is available to cover every Rs1/- of liabilities

Earnings Per Share : Profit after tax / number of shares
Price Earnings Ratio : Market Price / Earning per share - The higher the better generally for company. Comparison with other firms helps to identify value placed on the market of business.
EV / EBITDA Ratio : The higher the better for the company. It measures operational performance of the firm.
Dividend Yield : Ordinary share dividend / market price * 100 - the higher the better. Related the return on the investment to share price.

Gearing ratio =( long term loans/capital employed) * 100
This ratio provides for an idea on how much capital is employed from the long term loans taken

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

Gross Profit : Effectively total revenue (turnover) - cost of goods sold
Gross Profit Margin

Gross Profit Margin = Gross Profit / Turnover * 100
- The higher the better
- Enables the firm to assess the impact of its sales and how much it cost to generate those sales.
- A gross profit margin of 45% means that for every 1$ the firm makes 0.45$ in gross profit.
Net Profit : Effectively total revenue (turnover) - Variable costs and fixed costs (overheads)
Net Profit Margin

Net Profit Margin = Net Profit / Turnover * 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.
ROCE : Return on Captial Employment = Profit / Capital Employed * 100
- The higher the better
- Shows how effective the firm is in using its captial to generate profit
- Partly a measure of efficiency and use of capital in an organisation.
- A ROCE of 25% means that it uses 1$ of capital to generate 25p in profit.

Stock piling up is a big problem in stock intensive industries such as textile, cement etc
Stock turnover ratio = cost of goods sold / stocks expressed as times per year
Low stock turnover ratio would mean poor customer satisfaction of the goods and people may not be interested in the goods
This ratio indicates the rate at which company stocks are turned over

What is debtor days?

Summary of Financial Ratios

Ratios help to:
- Evaluate Performance
- Structure Analysis
- Show the connection between activities and performance.
Ratios adjust for differenct sizes.