Financial Analysis

Welcome to Financial Analysis: Your Company's Health Check-up!

Hey everyone! Welcome to one of the most practical topics in BAFS: Financial Analysis.

Think of a company like a person. How do you know if a person is healthy? You might check their temperature, blood pressure, or heart rate. Financial analysis is the same idea, but for a business! We use special tools called accounting ratios to check a company's "health" in different areas.

In this chapter, you'll learn how to be a "business doctor". You'll calculate these ratios and use them to understand if a company is making good profit, can pay its bills, and is using its resources wisely. This is super important for managers, investors, and anyone who wants to understand how a business is really doing. Let's get started!

What are Accounting Ratios and Why Bother?

Financial statements like the Income Statement and Statement of Financial Position contain tons of numbers. On their own, they can be confusing. Accounting ratios are simple calculations that turn these big, confusing numbers into meaningful percentages or figures that are easy to understand and compare.

Functions of Accounting Ratios (Why they're useful!)

• Simplifying Data: They summarise complex information into one or two simple numbers. It's like getting a final grade for a subject instead of just looking at every single test score.
• Measuring Performance: They help us measure how well a company is doing in specific areas, like profitability or efficiency.
• Helping Decision-making: Managers can use ratios to spot problems and make better decisions. Investors can use them to decide if a company is a good investment.
• Allowing for Comparison: This is a big one! We can compare a company's ratios:
  • With its own past performance (e.g., comparing 2024 results to 2023). This is called intra-firm comparison or trend analysis.
  • With other companies in the same industry. This is called inter-firm comparison.

Key Takeaway

Accounting ratios are tools that help us analyse and understand a company's performance by simplifying financial data and allowing for meaningful comparisons.

The Main Categories of Ratios

We can group ratios into different categories, each telling us a different part of the company's story. Let's look at the main ones.

1. Profitability Ratios: Is the Company Making Money?

These ratios measure how good a company is at turning its sales into profits. A higher profitability ratio is usually better!

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: $$Mark-up = {Gross \ Profit \over Cost \ of \ Goods \ Sold} \times 100\%$$
• How to Interpret: A 40% mark-up means that for every $100 of cost, the company adds $40 to set its selling price. A higher mark-up generally means higher potential profit on each item.
• Everyday Analogy: If you buy a phone case for $50 (cost) and sell it for $70, your gross profit is $20. Your mark-up is ($20 / $50) x 100% = 40%.

Gross Profit Ratio (or Gross Profit Margin)

• What it tells us: What percentage of sales revenue is left after paying for the cost of the goods sold. It shows the basic profitability of the products themselves.
• The Formula: $$Gross \ Profit \ Ratio = {Gross \ Profit \over Sales} \times 100\%$$
• How to Interpret: A ratio of 30% means that for every $100 of sales, the company has $30 left to cover its other expenses (like rent and salaries) and make a net profit.
• Everyday Analogy: A cafe sells a coffee for $40 (sales). The coffee beans and milk cost $10 (COGS). The gross profit is $30. The Gross Profit Ratio is ($30 / $40) x 100% = 75%. That's a very profitable coffee!

Common Mistake Alert!

Don't mix up mark-up and gross profit ratio! They use the same Gross Profit figure, but the denominator is different. Mark-up is based on Cost, while Gross Profit Ratio (Margin) is based on Sales.

Net Profit Ratio (or Net Profit Margin)

• What it tells us: What percentage of sales is left as profit after ALL expenses (including rent, salaries, electricity etc.) have been paid. This is the 'bottom line' profitability.
• The Formula: $$Net \ Profit \ Ratio = {Net \ Profit \ before \ Tax \over Sales} \times 100\%$$
• How to Interpret: A ratio of 10% means that for every $100 of sales, the company makes $10 in final profit (before tax). This shows how well the company controls all its costs.

2. Liquidity Ratios: Can the Company Pay Its Short-Term Bills?

Liquidity means being able to turn your assets into cash quickly to pay off debts that are due soon (within one year). It's about short-term survival.

Working Capital / Current Ratio

• What it tells us: Compares what a company owns in the short-term (current assets) to what it owes in the short-term (current liabilities).
• The Formula: $$Current \ Ratio = {Current \ Assets \over Current \ Liabilities} : 1$$
• How to Interpret: A ratio of 2:1 means the company has $2 of current assets for every $1 of current liabilities. A generally accepted 'safe' ratio is often around 2:1, but this varies by industry. A ratio below 1:1 can be a warning sign!
• Everyday Analogy: You have $200 in your wallet (current asset) and you owe your friend $100, which you have to pay back this week (current liability). Your current ratio is 2:1. You're in a good position to pay them back.

Quick / Liquid / Acid Test Ratio

• What it tells us: This is a stricter test of liquidity. It's similar to the current ratio but it removes inventory (stock) from current assets, because inventory can sometimes be hard to sell quickly.
• The Formula: $$Acid \ Test \ Ratio = {Current \ Assets - Inventory \over Current \ Liabilities} : 1$$
• How to Interpret: A ratio of 1:1 is often considered healthy. It shows that the company can pay its short-term debts without needing to sell any of its inventory.
• Did you know? It's called the "acid test" because, in the old days, acid was used to test if a metal was real gold. This ratio is a tough "acid test" of a company's true liquidity.

3. Management Efficiency Ratios: How Well is the Company Using its Assets?

These ratios show how effectively a company is managing its assets and liabilities to generate sales. It's all about being efficient!

Inventory Turnover

• What it tells us: How many times a company sells and replaces its inventory over a period.
• The Formula: $$Inventory \ Turnover = {Cost \ of \ Goods \ Sold \over Average \ Inventory} \ (times)$$

  Note: Average Inventory = (Opening Inventory + Closing Inventory) / 2

• How to Interpret: A high turnover (e.g., 12 times) is generally good. It means goods are selling quickly and not sitting in the warehouse collecting dust. A very low turnover could mean poor sales or too much stock.
• Real-World Example: A fresh fruit shop wants a very high inventory turnover. A luxury car dealership will have a very low one. It depends on the industry!

Trade Receivables Turnover & Collection Period

• What it tells us: How quickly a company collects cash from its credit customers (trade receivables).
• The Formulas: $$Trade \ Receivables \ Turnover = {Credit \ Sales \over Average \ Trade \ Receivables} \ (times)$$ $$Average \ Trade \ Receivables \ Collection \ Period = {Average \ Trade \ Receivables \over Credit \ Sales} \times 365 \ (days)$$
• How to Interpret: A high turnover (times) and a short collection period (days) are good. It means the company is getting its money back from customers quickly. If the collection period is 60 days, it means it takes, on average, two months to get paid after making a sale.

Trade Payables Turnover & Repayment Period

• What it tells us: How quickly a company pays its own suppliers (trade payables).
• The Formulas: $$Trade \ Payables \ Turnover = {Credit \ Purchases \over Average \ Trade \ Payables} \ (times)$$ $$Average \ Trade \ Payables \ Repayment \ Period = {Average \ Trade \ Payables \over Credit \ Purchases} \times 365 \ (days)$$
• How to Interpret: This one is tricky. A very short repayment period might mean the company is not making full use of the free credit from suppliers. A very long repayment period might signal cash flow problems or risk damaging relationships with suppliers. A good period is usually one that matches the industry norm.

Total Assets Turnover

• What it tells us: How efficiently a company is using all of its assets (e.g., buildings, machines, inventory) to generate sales.
• The Formula: $$Total \ Assets \ Turnover = {Sales \over Total \ Assets} \ (times)$$
• How to Interpret: A higher ratio is better. It means the company is generating more sales for every dollar of assets it owns.

Quick Review: Efficiency

For efficiency, think "Faster is usually better".
- Sell inventory FASTER.
- Collect money from customers FASTER.
- Use assets to generate sales FASTER.

4. Solvency (Gearing) Ratio: Can the Company Survive in the Long Term?

This is different from liquidity. Solvency is about a company's ability to pay its long-term debts. A company with too much debt is considered 'highly geared' or 'highly leveraged', which is risky.

Gearing Ratio

• What it tells us: What proportion of the company's long-term capital is funded by debt.
• The Formula: $$Gearing \ Ratio = {Non-current \ Liabilities + Preference \ Share \ Capital \over Non-current \ Liabilities + Shareholders' \ Fund} \times 100\%$$
• How to Interpret: A high gearing ratio (e.g., over 50%) means the company relies heavily on borrowing. This is risky because interest must be paid no matter what. In bad times, a highly geared company can get into serious trouble. A low ratio is safer.
• Everyday Analogy: Gearing is like taking out a mortgage to buy a flat. A small mortgage (low gearing) is safe. A huge mortgage that takes up most of your income (high gearing) is very risky if you suddenly lose your job.

5. Return on Investment: Is the Company a Good Investment?

This category looks at how well the company is using the money invested in it to generate profits. It's a key measure of overall performance.

Return on Capital Employed (ROCE)

• What it tells us: This is a big one! It measures how much profit the business generates from the total long-term capital used. It's a key indicator of overall business efficiency.
• The Formula: $$ROCE = {Profit \ before \ Interest \ and \ Tax \over Average \ Capital \ Employed} \times 100\%$$

  Note: Capital Employed = Non-current Liabilities + Shareholders' Fund

• How to Interpret: A higher ROCE is better. If a company's ROCE is 15%, it means it's generating $15 of profit for every $100 of capital invested. This should ideally be higher than the interest rate you could get from a bank.

6. Investment (Investor) Ratios: What Do Shareholders Want to Know?

These ratios are particularly useful for current or potential shareholders to evaluate their investment in a limited company.

Earnings Per Share (EPS)

• What it tells us: How much net profit has been earned by the company for each ordinary share.
• The Formula: $$EPS = {Net \ Profit \ after \ Tax - Preference \ Dividend \over Number \ of \ Ordinary \ Shares \ Issued}$$
• How to Interpret: A higher EPS is generally seen as better, as it indicates higher profitability for shareholders. A growing EPS over time is a very positive sign.

Dividend Cover

• What it tells us: How many times the company can afford to pay its current dividend to shareholders out of its profits.
• The Formula: $$Dividend \ Cover = {Net \ Profit \ after \ Tax - Preference \ Dividend \over Ordinary \ Dividend \ Paid} \ (times)$$
• How to Interpret: A high dividend cover (e.g., 2 times or more) is safe. It means the dividend is well-protected by profits. A cover close to 1 is risky, as any small drop in profit could mean the company can't afford to pay the dividend.

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 every $1 of the company's earnings.
• The Formula: $$P/E \ Ratio = {Current \ Market \ Price \ per \ Ordinary \ Share \over Earnings \ Per \ Share}$$
• How to Interpret: A high P/E ratio often suggests that investors expect high future growth in earnings. A low P/E ratio might suggest the stock is undervalued, or that investors expect slow growth. It's best used to compare companies in the same industry.

Limitations of Ratio Analysis: It's Not Magic!

Don't worry, you've learned all the key ratios! But it's crucial to remember that ratios aren't perfect. They are tools, and like any tool, they have limitations. You must know these for your exam!

• Based on Historical Data: Ratios use past data from financial statements. The past is not always a good predictor of the future. A company that was profitable last year might not be this year.
• Ignores Qualitative Factors: Ratios are all about numbers. They can't measure important things like the quality of management, brand reputation, staff morale, or customer loyalty.
• Affected by Accounting Policies: Different companies can use different (but still legal) accounting methods, like for depreciation. This can make their ratios difficult to compare accurately.
• "Window Dressing": Companies might try to make their financial statements look better than they really are, especially at the end of an accounting period. This can make the ratios misleading.
• Not a Standalone Tool: A single ratio tells you very little. You need to look at trends over time and compare with industry averages to get a full picture.
• Inflation can Distort Figures: Inflation can make numbers from different years hard to compare. For example, an asset bought 10 years ago might be recorded at a very low cost, which distorts ratios like ROCE.

Final Key Takeaway

Financial analysis is a powerful skill. By calculating and interpreting ratios on profitability, liquidity, efficiency, solvency, and investment, you can gain deep insights into a company's performance. Always remember to compare ratios over time and with competitors, and be aware of their limitations to avoid making simple judgements. You're now ready to be a financial analyst!