Welcome to the World of Financial Analysis!

Ever wondered how investors decide whether a business is a "gold mine" or a "sinking ship"? They don't just look at the bank balance; they dive deep into the numbers using Financial Analysis. In this chapter, we are going to learn how to peel back the layers of a company's financial statements to see how well it's really doing. Don't worry if it seems like a lot of formulas at first—we'll break them down into simple stories that make sense!

Section Context: This chapter is part of your "Analysis, Interpretation and Ethics" studies. It’s the "detective work" of accounting where we interpret the clues left in the accounts.


1. Profitability: Is the Business Making Enough Money?

Profitability ratios measure how effectively a business generates profit compared to its sales or the money invested in it. Think of it like a grade on a test: it's not just about the score, but how much you studied to get it!

Key Profitability Ratios
  • Gross Profit Margin (%): \(\frac{\text{Gross Profit}}{\text{Revenue}} \times 100\). This shows how much of every £1 of sales is left after paying for the goods sold.
  • Markup (%): \(\frac{\text{Gross Profit}}{\text{Cost of Sales}} \times 100\). This tells you how much extra you added to the cost price of your items to set the selling price.
  • Profit in Relation to Revenue % (Operating Profit Margin): \(\frac{\text{Operating Profit}}{\text{Revenue}} \times 100\). This checks how well the business manages its overheads (expenses like rent and electricity).
  • Return on Capital Employed (ROCE %): \(\frac{\text{Operating Profit}}{\text{Capital Employed}} \times 100\). Capital Employed is the total of Total Equity + Non-Current Liabilities.

Analogy: Imagine ROCE as the interest rate on a savings account. If a business has an ROCE of 15%, it’s like getting 15p back for every £1 invested. If a bank only offers 2% interest, the business is a much better use of your money!

Quick Review Box:
- Margin is always based on Sales.
- Markup is always based on Cost.
- If your Profit in Relation to Revenue is falling while Gross Profit Margin is steady, your expenses are getting too high!

Key Takeaway: Profitability isn't just about the total amount of money made; it's about how efficiently the business uses its resources to create that profit.


2. Liquidity: Can the Business Pay Its Bills?

Liquidity is all about cash flow. A business can be profitable but still go bust if it runs out of cash to pay its suppliers or employees. This is often called "Overtrading."

Key Liquidity Ratios
  • Current Ratio: \(\frac{\text{Current Assets}}{\text{Current Liabilities}}\). Ideally, this should be between 1.5:1 and 2:1.
  • Liquid Capital Ratio (Acid Test): \(\frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}\). This is a "tougher" test because it assumes you can't sell your inventory (stock) quickly in an emergency. Ideally, this should be 1:1.

Did you know? A ratio that is too high (e.g., a Current Ratio of 5:1) might actually be bad! it suggests the business is "lazy" with its cash—it has too much money sitting idle in the bank instead of being reinvested to make more profit.

Key Takeaway: The Liquid Capital Ratio is the "gold standard" for safety. If it's below 1:1, the business might struggle to pay its immediate debts.


3. Efficiency: How Well Are Assets Being Managed?

Efficiency ratios (also called "Activity Ratios") show how quickly a business turns its resources into cash. Think of this as the "speed" of the business cycle.

Key Efficiency Ratios
  • Rate of Inventory Turnover: \(\frac{\text{Cost of Sales}}{\text{Average Inventory}}\). (Measured in "times" per year).
  • Inventory Turnover (Days): \(\frac{\text{Average Inventory}}{\text{Cost of Sales}} \times 365\). How many days does an item sit on the shelf before being sold?
  • Trade Receivable Days: \(\frac{\text{Trade Receivables}}{\text{Revenue (Credit Sales)}} \times 365\). How long do customers take to pay us?
  • Trade Payable Days: \(\frac{\text{Trade Payables}}{\text{Cost of Sales (Credit Purchases)}} \times 365\). How long do we take to pay our suppliers?

Memory Aid: You want Receivable Days to be low (get cash in fast!) and Payable Days to be higher (keep your cash longer), but be careful not to upset your suppliers!

Common Mistake to Avoid: When calculating average inventory, don't forget it is: \(\frac{\text{Opening Inventory} + \text{Closing Inventory}}{2}\). If you only have one figure, just use that!

Key Takeaway: A business is most efficient when it sells stock quickly, collects cash from customers fast, and pays suppliers at a manageable pace.


4. Capital Structure and Gearing

This looks at how the business is funded. Is it funded by the owners (Equity) or by borrowing (Debt)?

The Gearing Ratio

\(\text{Capital Gearing} = \frac{\text{Non-Current Liabilities}}{\text{Capital Employed}} \times 100\)

Note: Capital Employed = Equity + Non-Current Liabilities.

  • High Gearing (over 50%): The business is mostly funded by debt. This is risky because interest must be paid even if the business makes a loss.
  • Low Gearing (under 25%): The business is mostly funded by the owners. This is safer but might mean the business isn't expanding as fast as it could by using loans.

Step-by-Step Check:
1. Find the Long-term Loans (Debentures).
2. Divide by the total of (Shares + Retained Earnings + Loans).
3. Multiply by 100. If it's high, keep an eye on interest rates!

Key Takeaway: Gearing measures financial risk. High gearing can lead to "financial distress" if profits fall.


5. Investor Ratios: The Shareholder's View

If you own shares in a PLC, you care about different things than the manager. You want to know about dividends and share prices.

Key Investor Ratios
  • Earnings Per Share (EPS): \(\frac{\text{Profit for the year}}{\text{Number of Ordinary Shares}}\). This is how many pence of profit "belongs" to each share.
  • Price Earnings (P/E) Ratio: \(\frac{\text{Market Price per Share}}{\text{Earnings Per Share}}\). This shows how much investors are willing to pay for £1 of profit. A high P/E means investors expect high growth in the future.
  • Dividend Yield (%): \(\frac{\text{Dividend per Share}}{\text{Market Price per Share}} \times 100\). This is the "return" on your investment based on the current share price.
  • Dividend Cover: \(\frac{\text{Profit for the year}}{\text{Total Dividends Paid}}\). Can the company afford its dividends? A ratio of 2 means they could have paid the dividend twice over from their profits.
  • Interest Cover: \(\frac{\text{Operating Profit}}{\text{Interest Expense}}\). How many times over can the profit pay the interest bill? (Lower than 3 is usually a warning sign!).

Key Takeaway: Investors use these ratios to decide if the share price is "fair" and if their dividend income is safe.


6. Profit vs. Cash: The Great Divide

It is vital to understand that Profit is NOT Cash. You can have a million pounds in profit but zero pounds in the bank.

Why the difference?
  • Credit Sales: You record the profit when you sell the item, but the cash doesn't arrive until 30 days later.
  • Depreciation: This is an expense that reduces profit but involves no cash leaving the business.
  • Buying Assets: Spending £10,000 on a van takes cash out immediately, but only a small amount (depreciation) hits the profit account this year.
  • Inventory: Buying stock uses cash, but it doesn't count as an expense (Cost of Sales) until it is actually sold.

Key Takeaway: "Profit is a matter of opinion (accounting rules), but cash is a matter of fact." Always check both!


7. Limitations: The "Buts" and "Howevers"

Ratios are powerful, but they aren't perfect. When writing your exam answers, use these points to show evaluation.

Financial Limitations
  • Historic Cost: Accounts show what things cost years ago, not what they are worth today (inflation).
  • Window Dressing: Businesses might try to make their accounts look better just before the year-end (e.g., delaying a purchase to keep cash high).
  • Different Policies: Two companies might use different depreciation methods, making it hard to compare them fairly.
Non-Financial Factors (Qualitative)
  • Staff Morale: Ratios won't tell you if the workers are about to go on strike.
  • Reputation: A company might have great profits but a terrible environmental record that will hurt it later.
  • The Economy: A business might be doing well, but if a recession is coming, the ratios don't show that threat.

Encouraging Phrase: Don't worry if you find evaluation tricky. Just remember to ask yourself: "What is this number NOT telling me?" That is the secret to top marks!

Key Takeaway: Ratios are just the starting point. To truly evaluate a business, you must look at the "big picture," including non-financial factors.


Final Quick Review: The "Ratio Cheat Sheet"

Profitability: How much did we keep? (GPM, ROCE)
Liquidity: Can we pay the electric bill today? (Current, Acid Test)
Efficiency: How fast is the "hamster wheel" spinning? (Inventory, Receivables days)
Gearing: How much do we owe the bank? (Debt vs Equity)
Investors: Is the share price worth it? (P/E, Dividend Yield)