BAFS Study Notes: Financial Analysis
Hello! Welcome to your study notes for Financial Analysis. Don't worry if this topic seems like it's full of complicated numbers. We're going to break it down together, step-by-step!
Think of yourself as a 'business doctor'. Your job is to check the health of a company. How do you do that? By looking at its financial statements and calculating some key numbers called ratios. These ratios tell us a story about how well the company is doing. In this chapter, you'll learn how to calculate these ratios and, more importantly, understand what they're telling you.
So, Why Bother with Ratios? (Functions of Accounting Ratios)
Financial statements like the Income Statement and Statement of Financial Position have a LOT of numbers. Ratios help us make sense of it all. Their main jobs are to:
- Simplify complex information: A single ratio can summarise a lot of data into one easy-to-understand figure.
- Assess performance: They help us check a company's health in specific areas, just like a doctor checks your blood pressure, heart rate, and temperature.
- Enable comparison: We can compare a company's ratios over time to see if it's improving (this is called intra-firm comparison), or compare it to other companies in the same industry to see how it stacks up (inter-firm comparison).
The Five Key Areas of a Company's Health Check
We group ratios into five main categories to get a full picture of a company's performance. Think of these as the main subjects on a school report card.
- Profitability: Is the company good at making a profit from its sales?
- Liquidity: Can the company pay its short-term bills on time?
- Solvency: Can the company survive in the long term and pay off its long-term debts?
- Management Efficiency: Is the company using its assets and resources wisely to generate sales?
- Investment: What is the return for the shareholders who invested in the company?
Let's Calculate! The Ratios You Need to Know
Ready to get started? We'll go through each ratio one by one. Remember to pay attention to the formula and what the result means!
A. Profitability Ratios (Are we making money?)
These ratios measure a company's ability to generate profit from its operations.
1. Mark-up
What it tells us: How much profit is made as a percentage of the cost of goods sold. It's the 'mark-up' added to the cost to get the selling price.
The Formula:
$$ Mark-up = {Gross \ Profit \over Cost \ of \ Goods \ Sold} \times 100\% $$Interpretation: A higher mark-up is generally better, as it means the company is adding more value on top of its costs.
2. Gross Profit Ratio (or Gross Profit Margin)
What it tells us: For every $100 of sales, how much is left after paying for the goods themselves. It shows the basic profitability of the products sold.
The Formula:
$$ Gross \ Profit \ Ratio = {Gross \ Profit \over Sales} \times 100\% $$Interpretation: A higher percentage is better. It means the company keeps a larger portion of its sales revenue as gross profit.
3. Net Profit Ratio (or Net Profit Margin)
What it tells us: For every $100 of sales, how much is left as net profit after ALL expenses (like rent, salaries, electricity) have been paid.
The Formula:
$$ Net \ Profit \ Ratio = {Net \ Profit \ Before \ Tax \over Sales} \times 100\% $$Interpretation: A higher percentage is better. This is a key indicator of overall profitability.
B. Return on Investment Ratios (Are we using our money well?)
1. Return on Capital Employed (ROCE)
What it tells us: This is a big one! It measures how efficiently a company is using all the long-term money invested in it (from both owners and lenders) to generate profits.
The Formula:
$$ ROCE = {Profit \ Before \ Interest \ and \ Tax \over Average \ Capital \ Employed} \times 100\% $$Wait, what is Capital Employed? It's the total long-term funds used by the business. According to the syllabus:
Capital Employed = Non-current Liabilities + Shareholders' Fund (for limited companies)
Interpretation: A higher ROCE is better. It shows that management is doing a good job of using its invested funds to make a profit.
C. Liquidity Ratios (Can we pay our short-term bills?)
Liquidity is all about having enough cash or assets that can be quickly turned into cash to pay off debts due within one year.
1. Working Capital / Current Ratio
What it tells us: Compares short-term assets (current assets) to short-term liabilities (current liabilities). It's the most common measure of liquidity.
The Formula:
$$ Current \ Ratio = {Current \ Assets \over Current \ Liabilities} : 1 $$Interpretation: A ratio of 2 : 1 is often considered healthy. It means the company has $2 of current assets for every $1 of current liabilities. Too low (e.g., 0.8 : 1) might mean trouble paying bills. Too high (e.g., 5 : 1) might mean the company isn't using its assets efficiently.
2. Quick / Liquid / Acid Test Ratio
What it tells us: This is a stricter test of liquidity. It's similar to the current ratio but removes inventory (stock) because inventory can sometimes be hard to sell quickly.
The Formula:
$$ Quick \ Ratio = {Current \ Assets - Inventories \over Current \ Liabilities} : 1 $$Interpretation: A ratio of 1 : 1 is often seen as a safe level. It shows that the company can pay its current liabilities without having to rely on selling its inventory.
D. Management Efficiency Ratios (Are we being productive?)
These ratios, often called 'turnover' ratios, show how well a company is using its assets and managing its liabilities.
1. Inventory Turnover
What it tells us: How many times a company sells and replaces its inventory over a period.
The Formula:
$$ Inventory \ Turnover = {Cost \ of \ Goods \ Sold \over Average \ Inventory} \ (times) $$Interpretation: A higher turnover is usually better, as it means goods are selling quickly. A low turnover might suggest poor sales or old, unwanted stock. (e.g., A fresh fruit shop wants a very high turnover; a luxury watch shop will have a lower one).
2. Average Trade Receivables Collection Period
What it tells us: On average, how many days it takes for a company to collect money from its credit customers (trade receivables).
The Formula:
$$ Collection \ Period = {Average \ Trade \ Receivables \over Credit \ Sales} \times 365 \ (days) $$Interpretation: A shorter period is better! It means the company is getting its cash faster. A long collection period could lead to cash flow problems.
3. Average Trade Payables Repayment Period
What it tells us: On average, how many days the company takes to pay its own suppliers (trade payables).
The Formula:
$$ Repayment \ Period = {Average \ Trade \ Payables \over Credit \ Purchases} \times 365 \ (days) $$Interpretation: This is a tricky one! A longer period can be good (it's like a free short-term loan from suppliers), but if it's too long, it could damage the company's reputation and relationship with its suppliers.
4. Trade Receivables Turnover
What it tells us: How many times per year the company collects its average accounts receivable. It's another way of looking at collection efficiency.
The Formula:
$$ Trade \ Receivables \ Turnover = {Credit \ Sales \over Average \ Trade \ Receivables} \ (times) $$Interpretation: A higher number of times is better, indicating faster cash collection.
5. Trade Payables Turnover
What it tells us: How many times per year the company pays off its average accounts payable.
The Formula:
$$ Trade \ Payables \ Turnover = {Credit \ Purchases \over Average \ Trade \ Payables} \ (times) $$Interpretation: A lower number means the company is taking longer to pay, which can help short-term cash flow.
6. Total Assets Turnover
What it tells us: How efficiently the company is using all its assets (e.g., buildings, machines, inventory) to generate sales.
The Formula:
$$ Total \ Assets \ Turnover = {Sales \over Total \ Assets} \ (times) $$Interpretation: A higher ratio is better. It means the company is generating more sales revenue for every dollar of assets it owns.
E. Solvency Ratios (Can we survive in the long run?)
Solvency is about long-term survival and the ability to pay off long-term debt. It looks at how much the company relies on borrowing.
1. Gearing Ratio
What it tells us: The proportion of a company's capital that comes from long-term debt. It shows how reliant the company is on borrowing.
The Formula:
$$ Gearing \ Ratio = {Non-current \ Liabilities + Preference \ Share \ Capital \over Non-current \ Liabilities + Shareholders' \ Fund} \times 100\% $$Interpretation: A high gearing ratio (e.g., over 50%) means the company is highly geared. This is risky because the company has to make fixed interest payments even if it's not making a profit. A low ratio is safer but might mean the company is missing out on opportunities to grow using borrowed funds.
F. Investment / Shareholder Ratios (What's in it for the owners?)
These ratios are particularly interesting for shareholders (the owners of a limited company) because they relate the company's performance directly to the value of its shares.
1. Earnings Per Share (EPS)
What it tells us: How much net profit the company made for each ordinary share.
The Formula:
$$ EPS = {Net \ Profit \ After \ Tax - Preference \ Dividend \over Number \ of \ Ordinary \ Shares \ Issued} $$Interpretation: A higher EPS is better, as it indicates higher profitability per share. It's a very common measure of a company's success.
2. Dividend Cover
What it tells us: How many times the company could have paid out its current dividend from its available profits. It's a measure of the safety of the dividend.
The Formula:
$$ Dividend \ Cover = {Net \ Profit \ After \ Tax - Preference \ Dividend \over Ordinary \ Dividend \ Paid} \ (times) $$Interpretation: A cover of 2 times or more is generally considered safe. A cover of 1 time means the company paid out all its profits as dividends, leaving nothing for reinvestment. A cover below 1 means it paid out more than it earned, which is not sustainable.
3. Price-Earnings (P/E) Ratio
What it tells us: Compares the company's current share price to its earnings per share. It shows how much investors are willing to pay for $1 of the company's earnings.
The Formula:
$$ P/E \ Ratio = {Current \ Price \ Per \ Ordinary \ Share \over Earnings \ Per \ Share} $$Interpretation: A high P/E ratio often suggests that investors expect high future growth in earnings. A low P/E might suggest the opposite, or that the share is undervalued.
Did you know? The P/E ratio is one of the most widely used metrics in stock markets around the world to gauge if a stock is 'expensive' or 'cheap' relative to its earnings.
Hold on! Ratios Aren't Perfect (Limitations of Ratio Analysis)
While ratios are super useful, our 'business doctor' needs to be careful. They have limitations and don't tell the whole story.
- Based on past data: Ratios use historical figures. They can't predict the future with certainty.
- Different accounting policies: Companies can use different methods for things like depreciation, which can make direct comparisons misleading.
- "Window dressing": Companies might try to make their financial statements look better than they really are around the end of the accounting period.
- No non-financial information: Ratios ignore important factors like staff morale, customer satisfaction, brand reputation, and the quality of management.
- Comparisons can be difficult: It can be hard to find a truly comparable company, especially for large businesses that operate in many different industries.
- A single ratio is not enough: You must look at a range of ratios and trends over time to get a meaningful understanding.
Key Takeaway
Financial analysis using ratios is a powerful tool to assess a company's performance in profitability, liquidity, solvency, efficiency, and investment potential. Your job is to calculate the ratios accurately, and more importantly, to comment on what they mean. Always remember to consider the limitations and look at the bigger picture!
You've got this! Go through the formulas one more time and try to explain what each ratio means in your own words. Good luck!