Techniques of financial analysis

Welcome to Your Guide on Financial Analysis!

Hello there! Welcome to one of the most practical chapters in your Financial Management journey. Think of financial analysis as being a financial detective. Instead of just looking at a pile of numbers and saying "that's a lot of money," you are going to learn how to look behind those numbers to see if a company is truly healthy, efficient, and profitable. Whether you are a math whiz or someone who finds numbers a bit intimidating, don't worry! We will break everything down step-by-step.

In this chapter, we focus on the tools used to Produce Financial Analysis. These techniques help stakeholders (like investors or bank managers) make smart decisions. Let's dive in!

1. The Core Tool: Ratio Analysis

Ratio analysis is like a medical check-up for a company. Just as a doctor looks at your blood pressure and heart rate to see if you're healthy, we use ratios to see if a business is "fit."

We generally group these ratios into four main categories:

A. Profitability Ratios

These ratios tell us how good a company is at turning its activities into profit. If a company sells a lot but keeps very little, it might have a profitability problem.

1. Return on Capital Employed (ROCE)
This is the "Granddaddy" of profitability ratios. It shows how much profit the company generates for every dollar of capital invested (both equity and debt).
Formula: \( \text{ROCE} = \frac{\text{Operating Profit (PBIT)}}{\text{Capital Employed}} \times 100\% \)
*Note: Capital Employed = Total Equity + Non-current Liabilities.

2. Operating Profit Margin
This shows how much "operating room" a company has after paying for its cost of goods and operating expenses.
Formula: \( \frac{\text{Operating Profit}}{\text{Revenue}} \times 100\% \)

Quick Review: If ROCE is high, the company is using its money very efficiently to make profit. If it's falling, the company might be getting "lazy" with its assets.

B. Liquidity Ratios

Liquidity is all about cash flow. Can the company pay its bills tomorrow? A company can be profitable but still go bankrupt if it runs out of cash!

1. Current Ratio
Formula: \( \frac{\text{Current Assets}}{\text{Current Liabilities}} \)
Analogy: Imagine you have $10 in your pocket (Current Assets) but you owe your friend $5 (Current Liabilities). Your ratio is 2:1. You are safe!

2. Quick Ratio (Acid Test)
This is a "stricter" version of the current ratio. It ignores Inventory because inventory can be hard to sell quickly in an emergency.
Formula: \( \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} \)

Common Mistake to Avoid: Don't assume a very high current ratio is always good. If a company has a ratio of 5:1, it might be holding too much cash or inventory that isn't earning any interest. It's like keeping $10,000 under your mattress instead of investing it!

C. Efficiency (Activity) Ratios

These ratios measure how well the company manages its daily resources. How fast do they sell their stock? How long do customers take to pay?

1. Inventory Turnover Period
\nHow many days does stock sit in the warehouse?
\nFormula: \( \frac{\text{Average Inventory}}{\text{Cost of Sales}} \times 365 \text{ days} \)

2. Receivables Collection Period
\nHow long do we wait for customers to pay us?
\nFormula: \( \frac{\text{Trade Receivables}}{\text{Revenue (Credit)}} \times 365 \text{ days} \)

Memory Aid: For efficiency ratios, if the answer is in days, you usually want the number to be smaller (get the cash faster!), except for "Payables Period" (where you might want to hold onto your cash a little longer—without upsetting your suppliers!).

D. Solvency and Gearing Ratios

This looks at the long-term risk. Does the company have too much debt?

1. Gearing Ratio
\nFormula: \( \frac{\text{Long-term Debt}}{\text{Equity} + \text{Long-term Debt}} \times 100\% \)
\nHigh gearing means the company is risky because it has to pay interest even if profits are low.

Key Takeaway: Ratios mean nothing in isolation. You must compare them to last year’s figures or competitors' figures to see the full picture.

2. Horizontal and Vertical Analysis

While ratios are great, we also use two other simple techniques to spot trends.

Horizontal Analysis (Trend Analysis)

This looks at the same line item (like Revenue) over several years. We look at the percentage change from one year to the next.
\nFormula: \( \frac{\text{New Amount} - \text{Old Amount}}{\text{Old Amount}} \times 100\% \)
\nExample: If Revenue was $100 last year and $120 this year, that is a 20% growth.

Vertical Analysis (Common Size Analysis)

This looks at one year and compares everything to a "base" figure.
- In the Income Statement, the base is usually Revenue.
- In the Statement of Financial Position, the base is Total Assets.

Why do this? It helps us see if expenses are growing faster than sales. If Rent was 5% of sales last year but is 10% this year, we have a problem!

Did you know? Vertical analysis is the best way to compare a giant company like Samsung with a small local electronics shop. Because everything is a percentage, the size of the company doesn't matter!

3. The Limitations of Financial Analysis

Don't worry if you find a company that looks perfect on paper but feels "off." Financial analysis has its limits. As a student, you must be able to criticize the data.

1. Historical Data: Financial statements look at the past. They don't guarantee what will happen in the future.
2. Inflation: Prices go up over time, which can make "growth" look better than it actually is.
3. Window Dressing: Some companies try to make their accounts look better just before the year-end (e.g., delaying a purchase to keep cash high).
4. Different Accounting Policies: One company might depreciate assets over 5 years, another over 10. This makes comparing them tricky!

Step-by-Step for Exam Questions:
1. Calculate: Do the math carefully.
2. Identify: Is the ratio going up or down? Is it better or worse than the industry average?
3. Explain: Why did it change? (e.g., "The current ratio fell because the company used cash to buy a new machine").
4. Conclude: What should the company do next?

Summary and Key Takeaways

Final Checklist:

- Profitability: Is the company making money relative to its size? (ROCE, Margins)
- Liquidity: Can they pay their bills tomorrow? (Current/Quick ratios)
- Efficiency: Are they managing assets well? (Inventory/Receivables days)
- Solvency: Is the debt level safe? (Gearing)
- Context: Always compare results to something else—ratios alone don't tell the whole story!

Pro-tip: In your HKICPA exam, always show your workings for ratios. Even if your final answer is slightly off, you can still get marks for using the right formula! You've got this!