most common techniques of financial analysis, in which the financial performance and financial health of a company are analyzed based on its past performance.` Financial statement analysis is the process of examining relationships among financial statement elements and making comparisons with relevant information.
Prepared by: Muhammad akhtar
University of Libya BETC
Difference in Focus
Financial Statements are prepared by
financial accountants with a certain perspective, however the financial managers—the end users of these financial statements, have a different focus to draw meaningful conclusions out of these statements. These differences are listed below
Prepared by: Muhammad akhtar
University of Libya BETC
Financial Accounting (FA) Focus:
• Use Historical Value (assets are
booked at original purchase price) • Follow Accrual Principle (calculate Net Income based on accrued expense and accrued revenue) • How to most logically, clearly, and completely represent the financial data.
Prepared by: Muhammad akhtar
University of Libya BETC
Accrual Concept The income accruing to the owner of a business is not necessarily the amount of cash actually received in a period of account. Many difficult problems arise in deciding how much income has actually accrued in any period. Accrual of income is always measured over a period of time which is normally the accounting year. Expenses are costs incurred in earning revenues. Those expenditures which may be charged against revenues for a period will be considered as operating expenses. The Accrual concept is applied both in ascertaining the revenues for a period and in ascertaining the expenses to be charged against the revenues.
Prepared by: Muhammad akhtar
University of Libya BETC
Financial Management (FM) Focus:
Use Market Value (assets are valued at
current market price) • Follow Incremental Cash Flows because an Asset’s (and a Company’s) Value is determined by the cash flows that it generates. • How to pick the best assets and liabilities portfolios in order to maximize shareholder wealth.
Prepared by: Muhammad akhtar
University of Libya BETC
Sources of Information Used for Comparison
Company’s past years financial statements
and forecast of results. Information from credit agencies on other companies in the same industries. Information from trade association on the industries average figures. Notes to the financial statements also provide additional information that may greatly influence one’s judgment about the future potential of the company.
The liquidity ratios measure the firm’s abilities to pay its debts as they fall due. The following ratios provide an indication of the firm’s liquidity position. ¨ Current ratio ¨ Quick Asset ratio Current ratio = Current Assets/Current Liabilities Quick ratio (Asset test ratio) =Current Assets- inventory/Current liabilities
Prepared by: Muhammad akhtar
University of Libya BETC
Current Ratio: Current ratio: is a ratio between current assets and liabilities, which tells that for every dollar in current liabilities, how many current assets do the company possess. Since the current liabilities are usually paid out of current assets, it makes sense to compare the two figures to assess the liquidity of the firm. Liquidity implies the ease with which the current liabilities can be paid off. Generally, the higher the ratio, the better it is considered, but too high a ratio may imply less productive use of current assets. A ratio of two to one (2:1) is considered ideal. = Current Assets / Current Liabilities
Prepared by: Muhammad akhtar
University of Libya BETC
Quick Ratio / Acid Test ratio
Quick/Acid Test ratio: Quick ratio is relatively a stringent measure of liquidity. The ratio is obtained by subtracting inventory from current assets and dividing the result by current liabilities. Inventory is the least liquid of all current assets. By subtracting inventory from current assets, we are actually comparing more liquid assets with current liabilities. This ratio not only helps in gauging the solvency of the company, it may also show if the inventories are piling up. A desirable quick ratio can range from (0.8:1) to (1.5:1) depending on the nature of the business. = (Current Assets – Inventory) / Current Liabilities
Prepared by: Muhammad akhtar
University of Libya BETC
Question Using the following information, you are required to calculate the following: A .Working Capital. b. Working capital ratio. c. Acid test ratio. Year 8 Year 9 $ $ Stock 40,000 50,000 Debtors 10,000 12,000 Bank and Cash balances 5,000 3,000 Creditors 20,000 40,000
Prepared by: Muhammad akhtar
University of Libya BETC
Question Using the following information, you are required to calculate the following: A .Working Capital. b. Working capital ratio. c. Acid test ratio.
a. Working Capital Year 8 Year 9
Current Asset-Current Liabilities 55000-20000=35000 65000-40000=25000
b. Working Capital Ratio 55000 : 20000 65000 : 40000
Current Asset /Current 2.75 :1 1.62 : 1 Liability CA : CL
C. Acid test ratio: Quick 15000 : 20000 15000 : 40000
b.This ratio aims to test the liquidity of the business. That is ability to pay immediate debts out of current asset. A good rate is at least 2: 1 ( 2 Current Assets to pay 1 Current liability) In year 8, the liquidity is healthy but this could not be sustained in year 9, Where the ratio has weaken. C. Acid test ratio: There is insufficient liquid resources to pay current liabilites A good ratio is a least 1: 1 In both years the ratios are below the minimum rate.
Prepared by: Muhammad akhtar
University of Libya BETC
Profitability Ratios These ratios may be classified as follows: Ratios that measure the returns on the firm’s sales. ¨ Gross Profit margin ¨ Net Profit margin Ratios that measure the returns on the firm’s capital employed. ¨ Return on shareholder’s fund ¨ Return on equity fund
Prepared by: Muhammad akhtar
University of Libya BETC
Profitability Ratios Ratios that measure the returns on the firm’s sales.
Gross profit Margin= Gross profit/Net sales x100
Net Profit Margin = Net profit before Tax/net sales x100
Ratios that measure the returns on the firm’s capital employed.
Return on shareholder’s fund:
Return on equity fund: Net profit after tax less preference
dividend/ Ordinary Share Capital + Reserves
Prepared by: Muhammad akhtar
University of Libya BETC
Efficiency Ratios
These ratios measure the management’s
abilities to control the resources efficiently and effectively. ¨ Stock Turnover ¨ Debtors Turnover ¨ Creditors Turnover ¨ Fixed asset to sales ratios
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University of Libya BETC
Efficiency Ratios
Stock Turnover = Cost of Goods Sold/Average stock
Debtors Turnover = Debtors/Credit Sales x 365
Creditors Turnover=
Fixed Asset to sales Ratio= Sales /Fixed Assets
Prepared by: Muhammad akhtar
University of Libya BETC
Investment Ratios These Ratios are useful to users of financial statements in making investment decisions. 1. Earning per share. 2. Price Earning ratio. 3. gearing. 4. Dividend yield. 5. Dividend cover.
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University of Libya BETC
Earning Per Share
Earnings per share: Net profit available for equity shareholders/Number of Equity shares.
Example.
Monica Plc has equity share capital consisting of 250,000 ordinary shares $1 each, all ranking for dividend. Its after-tax profits available to equity holders total $125,000. What is the figure for EPS?
Solution:
EPS = Net earnings
No of ordinary shares ranking for dividend
= $125,000 = $0.50 250,000
Prepared by: Muhammad akhtar
University of Libya BETC
Price Earning Ratio
Exercise .
From Exercise Pervious , Monica’s shares stand at $4.50 each in
the market. What is the price earnings ratio?
Solution
P/E = Market price of one ordinary share
E.P.S = $4.50 $0.50 = 9
Prepared by: Muhammad akhtar
University of Libya BETC
Gearing Gearing is a measure of Financial Leverage, demonstrating the degree to which a firm’s activities are funded by owner’s funds verses creditor’s funds. The higher a company’s degree of leverage the more the company is considered risky
Financial Leverage:FL is the degree or extent to which a
company’s total capital is composed of debt. So a company with 80% debt is highly leveraged. Gearing:Debt/Equity Ratio = (Total Liabilities) / (Shareholders Equity). This is also known as Risk or Gearing, the extent to which a company is financed by borrowed funds; for example, if a company is highly geared, it borrows a lot.
Prepared by: Muhammad akhtar
University of Libya BETC
Dividend yield Dividend Yield Some stockholders invest primarily to receive regular cash income in the form of dividends. Others do so to secure capital gains through rising market price of common stock. Dividend yield = Dividend per share x 100) % Market price per share Dividend Yield is anticipated annual dividend divided by the market price of the stock. The dividend yield on a company stock is the company's annual dividend payments divided by its market cap, or the dividend per share divided by the price per share. It's often expressed as a percentage.
Prepared by: Muhammad akhtar
University of Libya BETC
Dividend Cover Dividend Coverage Ratio: = Net income . Amount of annual preferred dividend Normal Ratio: 5 to 10 Note: Ratios should be used with other elements of financial analysis. Most important is to use common sense and judgments. Also study the industrial sector in which the company operates and relate “Industry Sector” climate to current and projected economic developments.
