Financial Statement Analysis
L E C T U R E 3 – F I N A N C I A L A N A LY S I S - C O N T E N T S O F F I N A N C I A L S TAT E M E N T S &
F O U N D AT I O N O F R AT I O A N A LY S I S ( PA RT 1 )
Financial Analysis
Definition:
1. Financial analysis of a firm is the analysis and evaluation of the firm’s performance,
stability, solvency and liquidity.
2. Application of analytical tools and techniques to financial date to deduce estimates
and useful conclusions in business.
Objective:
1. Assess performance of an organization in the context of its strategy and goals
2. Decrease the uncertainty of business analysis.
3. Enables informed decision-making and enhances critical judgment.
4. Evaluate effectiveness of company’s management policies.
Management policies for
growth
A. OPERATING MANAGEMENT
B. INVESTMENT MANAGEMENT
C. FINANCING STRATEGY
D. DIVIDEND POLICIES
Financial Ratio Analysis
evaluation
1. TIME-SERIES comparison
- comparing year-on-year ratios for the same company
2. CROSS-SECTIONAL comparison
- comparing ratios between firms within the same industry
3. ABSOLUTE BENCHMARK comparison
- comparing to industry/market benchmarks
Financial Ratios - Categories
A. PROFITABILITY ratios
B. LIQUIDITY ratios
C. ACTIVITY ratios
D. SOLVENCY ratios
A.
PROFITABILITY
RATIOS
PROFITABILITY RATIOS
Assess the capability of a company to create profits from its earnings from:
Operations
Shareholders’ equity
Non-current assets
Focus is on Statement of profit or loss and Other Comprehensive income
(Income Statement).
Higher ratios – mean higher conversion of earnings to profits.
1. Mark-up ratio (%)
MARK-UP = (Gross Profit/Cost of Sales) X 100 = …%
Points to note:
1. Used in pricing policies and strategy.
2. Added to the cost of production/manufacturing of a good or service to cover the
costs and also lead to profit.
2. Gross profit margin (%)
GROSS PROFIT MARGIN = (Gross Profit/Revenue) X 100 = …%
Points to note:
1. Used to assess and evaluate a firm’s operational efficiency.
2. Can also be used in pricing policies and strategy
3. High gross profit margin is a positive sign with regards to the operational efficiency
of an organization.
4. Low gross profit margin is an indication of either:
1. Low selling price
2. High direct costs
3. Net profit margin (%)
NET PROFIT MARGIN = (Net profit/Revenue) X 100 = …%
Points to note:
1. Used to assess and evaluate a firm’s operational efficiency, as well as its ability to
manage administrative costs in addition to direct costs.
2. Can also be used in pricing policies and strategy
3. Low net profit margin is an indication of either:
1. Low selling price
2. High direct costs
3. High administrative or operational costs
4. Return on capital
employed (%)
ROCE = (Operating profit*/Total Capital employed**) X 100 = …%
* Operating profit = Net profit before interest & Taxes
** Total capital employed = Share Capital + Reserves + Non-current liabilities
Points to note:
1. Considered as first or primary ratio
2. Continuous decrease is an indication of operational inefficiencies
3. Used in mergers & acquisitions discussions
4. Declining ROCE is an indication of either:
1. Lower operational profits
2. Higher capital employed with no reflection on operational profits of this increase
5. Return on Shareholders
Funds (%)
ROSF = (PAT*/Owners’ Capital employed**) X 100 = …%
* PAT = Net profit after interest & Taxes
** Owners’ capital employed = Share Capital + Reserves
Points to note:
1. Considered as first or primary ratio as well
2. Continuous decrease is an indication of operational inefficiencies
3. This ratio provides clearer picture to shareholders after deducting the servicing of
loans and tax payments to tax authorities.
B. LIQUIDITY
RATIOS
1. Current ratio
CURRENT RATIO = (Current Assets/Current Liabilities) = ...:1 (ratio)
Points to note:
1. Used to assess to ability of a company to cover its short-term liabilities.
2. Generally, 2:1 is a good ratio, but it always depends on the industry and company.
3. Low current ratio is an indication of risk in the short-term
4. However, too high ratio may be an indication of inefficient current asset usage. For
example, large amounts of cash in the bank and not used for investments.
2. Quick ratio
ACITD TEST (QUICK) RATIO = [Current Assets-Inventory)/Current Liabilities] = ..:1 (ratio)
Points to note:
1. Like Current ratio, however ignoring Inventory – least liquid current asset.
2. Considers the possibility that the Inventory will not be sold or damaged.
3. Generally, 1:1 is a good ratio, but it always depends on the industry and company.
CASE STUDY –
ROLLS ROYCE
BENTLEY
ASTON MARTIN
