analysing financial statements
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Analyzing Financial Statements
Dr. Jatin PancholiWebsite: http://www.jatinpancholi.com
Dr. Jatin Pancholi has compiled and prepared this teaching 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 on website http://www.jatinpancholi.com. Those
wishing to co-author next edition of this handout may also contact.
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Financial Statement Analysis (1)
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Stakeholders get information from a company’s Published Accounts:Level of salesAmount of cash availableValue of debtors and creditorsLevel of Debt and EquityRevenues generatedCosts and Expensesetc
This information is available for the last and for previous years
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Financial Statement Analysis (2)
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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 judgeEven an increase or decrease rate may be
misleading
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Financial Statement Analysis (3)
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In order to achieve meaningful conclusions on a company’s performance, there is a need to make comparisons:vs. previous yearsvs. projectedvs. competitorsvs. industry averagesvs. known good performers (benchmark)
Ratio Analysis
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Ratio Analysis (1)
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Functions:Aids understanding of accountsIndicates relationshipsAllows for comparisons Shows trends over timeProvides additional information to the
Financial Statements
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Is a three step process:
Calculate appropriate
ratios
Identify users and their
information needs
Interpret and evaluate results
Ratio Analysis (2)
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Categories of Ratios
Profitability
Efficiency (activity)
Liquidity
Gearing
Investment
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Profitability Ratios
Return on ordinary shareholders’ funds
Return on capital employed
Net profit margin
Gross profit margin
Formula
Net profit after taxation and preference dividend (if any) x 100 Ordinary share capital + Reserves
Net profit before interest and taxation x 100 Share capital + Reserves + Long-term loans
Net profit before interest and taxation x 100 Sales
Gross profit x 100 Sales
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ROCE – Main Elements
Sales Long-term capital
employed
Return on capital employed
multiplied by
equals
Net profit before interest and taxation
sales
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Efficiency Ratios
Average stock turnover period
Average settlement period for debtors
Average settlement period for creditors
Fixed Asset Turnover
Formula
Average stock held x 365 Cost of sales
Sales per employee
Trade debtors x 365 Credit sales
Trade creditors x 365 Credit purchases
_______Sales_______ Number of employees
_______ Sales__________
Fixed Assets
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Liquidity Ratios
Current ratio
Acid test ratio
Operating cash flows to maturing obligations
Formula
Current assets_______________ Current liabilities (creditors due within one
year)
Operating cash flows Current liabilities
Current assets (excluding stock) Current liabilities
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Gearing ratio
Interest cover ratio
Formula
Profit before interest and taxation_ Interest payable
Long-term liabilities _______ Share capital + Reserves + Long-term
liabilities
Gearing Ratios
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Effect of Financial Gearing
Profit beforeinterest and tax
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Investment Ratios
Dividend per share
Dividend payout ratio
Dividend yield ratio
Earnings per share
Formula
Dividends announced during the period Number of shares in issue
Dividends announced for the year x 100 Earnings for the year available for dividends
Dividend per share/(1-t) x 100 Market value per share
Price/earnings ratio (P/E)
Earnings available to ordinary shareholders Number of ordinary shares in issue
Market value per share Earnings per share
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3.67
4.35 4.42
5.15
2.85
4.52
3.98
4.29
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4.83
Source: Constructed from data appearing in the Financial Times, 18 January 2003
Average Dividend Yield Ratios
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Average Price/Earnings Ratios
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22.86
8.45
16.77
12.87
18.62
12.54
18.83
12.93 14.06
22.6323.18
12.67
Source: Constructed from data appearing in the Financial Times, 18 January 2003
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Ratio Comparisons
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In isolation ratios’ benefits are very limited, as with absolute numbers
Conclusions can be drawn by comparisons against:The company’s budget / forecastExternal observers prior expectationsPrevious years ratiosOther companies ratios (current and prior
year)Industry averages
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Limitations of Ratios (1)
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Ratios don’t give you answers, they give you cluesThese clues need to be investigated to find the
reasonsFor example: stock days have doubled. Is that a
problem?Yes, if they went from 50 to 100No, if they went from 2 to 4Yes, if obsolete stock is the cause of the increaseNo, if the company is about to open a number of new
shopsTrying to take conclusions from the ratios alone,
may lead to the wrong decisions being made
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Limitations of Ratios (2)
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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 benchmarksRatios (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
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Thank you…
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Dr. Jatin PancholiWebsite: http://www.jatinpancholi.com
Dr. Jatin Pancholi has compiled and prepared this teaching 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 on website http://www.jatinpancholi.com. Those wishing to co-author next edition of this handout may also contact.