Analyzing Financial Statements-1

Analyzing Financial Statements-1 Dr. Jatin Pancholi Website: http://www.jatinpancholi.com 1 Dr. Jatin Pancholi has compiled and prepared this note from various sources, as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The handling of a management situation requires personal guidance by a professional. To obtain copies, request permission to reproduce and to send feedback, please contact via website http://www.jatinpancholi.com. Those wishing to co-author next edition of this handout are requested to contact via the website. Financial Statement Analysis (1)  Stakeholders get information from a company’s Published Accounts:        Level of sales Amount of cash available Value of debtors and creditors Level of Debt and Equity Revenues generated Costs and Expenses etc  This information is available for the last and for previous years 2 Financial Statement Analysis (2)  But:  Sales of £1,000,000 is good or bad?  Debtors of £500,000 is good or bad?  Revenue increase of 15% is good or bad?  Absolute values are difficult to judge  Even an increase or decrease rate may be misleading 3 Financial Statement Analysis (3)  In order to achieve meaningful conclusions on a company’s performance, there is a need to make comparisons:  vs. previous years  vs. projected  vs. competitors  vs. industry averages  vs. known good performers (benchmark)  Ratio Analysis 4 Ratio Analysis (1)  Functions:  Aids understanding of accounts  Indicates relationships  Allows for comparisons  Shows trends over time  Provides additional information to the Financial Statements 5 Ratio Analysis (2)  Is a three step process: Identify users and their information needs Calculate appropriate ratios Interpret and evaluate results 6 Categories of Ratios Profitability Efficiency (activity) Liquidity Gearing Investment 7 Profitability Ratios Formula Return on ordinary shareholders’ funds Net profit after taxation and preference dividend (if any) x 100 Ordinary share capital + Reserves Return on capital employed Net profit before interest and taxation x 100 Share capital + Reserves + Long-term loans Net profit margin Net profit before interest and taxation Sales x 100 Gross profit margin 8 Gross profit Sales x 100 ROCE – Main Elements Net profit before interest and taxation sales multiplied by Sales Long-term capital employed equals Return on capital employed 9 Efficiency Ratios Formula Average stock turnover period Average stock held Cost of sales x 365 Average settlement period for debtors Trade debtors Credit sales x 365 Average settlement period for creditors Trade creditors x 365 Credit purchases Fixed Asset Turnover _______ Sales__________ Fixed Assets Sales per employee 10 _______Sales_______ Number of employees Liquidity Ratios Formula Current ratio Current assets_______________ Current liabilities (creditors due within one year) Acid test ratio Current assets (excluding stock) Current liabilities Operating cash flows to maturing obligations Operating cash flows Current liabilities 11 Gearing Ratios Formula Gearing ratio Long-term liabilities _______ Share capital + Reserves + Long-term liabilities Interest cover ratio Profit before interest and taxation_ Interest payable 12 Effect of Financial Gearing Profit before interest and tax 13 Investment Ratios Formula Dividend per share Dividends announced during the period Number of shares in issue Dividend payout ratio Dividend yield ratio Dividends announced for the year x 100 Earnings for the year available for dividends Dividend per share/(1-t) Market value per share x 100 Earnings per share Earnings available to ordinary shareholders Number of ordinary shares in issue Price/earnings ratio (P/E) Market value per share Earnings per share 14 15 1 2 0 3 6 4 5 3.67 Oil and gas Construction and building materials 4.35 4.42 Chemicals Engineering and machinery Pharmaceuticals and biotechnology Tobacco 5.15 2.85 4.52 3.98 Source: Constructed from data appearing in the Financial Times, 18 January 2003 Transport Leisure and hotels Food and drug retailers 4.29 3.35 6.32 Electricity 3.16 Real estate Average Dividend Yield Ratios 4.83 Banks 16 10 5 15 20 25 30 0 22.86 Oil and gas Construct. and building materials 8.45 16.77 Chemicals 12.87 Engineering and machinery Pharmaceuticals and biotechnology 18.62 12.54 Tobacco 18.83 Source: Constructed from data appearing in the Financial Times, 18 January 2003 Transport Leisure and hotels Food and drug retailers 12.93 14.06 22.63 Electricity 23.18 Real estate Average Price/Earnings Ratios 12.67 Banks Ratio Comparisons  In isolation ratios’ benefits are very limited, as with absolute numbers  Conclusions can be drawn by comparisons against:  The company’s budget / forecast  External observers prior expectations  Previous years ratios  Other companies ratios (current and prior year)  Industry averages 17 Limitations of Ratios (1)  Ratios don’t give you answers, they give you clues  These clues need to be investigated to find the reasons  For example: stock days have doubled. Is that a problem?  Yes, if they went from 50 to 100  No, if they went from 2 to 4  Yes, if obsolete stock is the cause of the increase  No, if the company is about to open a number of new shops  Trying to take conclusions from the ratios alone, may lead to the wrong decisions being made 18 Limitations of Ratios (2)  Ratios may also have intrinsic problems:  They are calculated from accounting data, and if there are mistakes in this…  The comparisons may be made against the wrong benchmarks  Ratios (as the Balance Sheet) are calculated at a point in time and significant changes may occur within a short period  Relying only on ratios when analysing a company’s performance is dangerous 19 Thank you… Dr. Jatin Pancholi Website: http://www.jatinpancholi.com 20 Dr. Jatin Pancholi has compiled and prepared this note from various sources, as the basis for class discussion rather than to illustrate either effective or ineffective handling of a management situation. The handling of a management situation requires personal guidance by a professional. To obtain copies, request permission to reproduce and to send feedback, please contact via website http://www.jatinpancholi.com. Those wishing to co-author next edition of this handout are requested to contact via the website.