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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

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Users of financial statements

Business

Competitors

Lenders

Managers

Owners Customers

Suppliers Investment analysis

Community representatives

Government

Employees and their representatives

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Usefulness of financial information

• Reliability• Relevance

• Comparability • Timeliness

• Cost/benefit

• Useful accounting information

• Understandability

• can produce

• the lack of

• which will be limited by

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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

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The key stages of financial analysis

• Select and

calculate

appropriate

ratios

• Identify users and their

information

needs

• Interpret and

evaluate the

results

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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

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Financial statement analysis

•Cross sectional analysis•Trend analysis

Note:• it’s the interpretation that is

important•be consistent!

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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.

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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.

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Ratio analysis

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

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Profitability ratios

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

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

sales

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Profitability ratios (Continued)

• Net asset turnover (times): sales

capital employed• Gross profit margin (%):

gross profit × 100 sales

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Activity ratios

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

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

cost of sales

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Activity ratios (Continued)

• Inventory days: inventory × 365

cost of sales• Cash conversion cycle (days):

Inventory days + receivables days – payables days.

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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

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Liquidity ratios

• Current ratio (times):current assets

current liabilities• Quick ratio (times):

current assets less inventorycurrent liabilities

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Gearing ratios

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

capital employed• Debt/equity ratio (%):

long-term debt capital × 100share capital and reserves

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Gearing ratios (Continued)

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

interest charges

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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

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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

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

• Payout ratio (%): ordinary dividends × 100

distributable earnings

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

share price• Earnings yield (%):

earnings per share × 100share price

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Limitations with ratio analysis

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

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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.

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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.

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Inventory management

Concerned with:

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

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Inventory managementDecision criteria:

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

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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.

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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

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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

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• 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)

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• 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)

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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

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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%.

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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

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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.

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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

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Reading•Textbook : chapter 2, 3

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