Analysis & Interpretation of Financial Reports
Analysis & Interpretation of Financial Reports
Learning objectives
After this lecture, you would
Understand why different user groups require financial reports to be analysed and interpreted
Understand the nature and purpose of financial analysis
Appreciate the analytical methods of horizontal analysis, trend analysis, vertical analysis and ratio analysis
Be able to calculate and explain the significance of the main ratios that indicate the financial performance and position of a business and its market performance
Understand the interrelationships between ratios
Appreciate the limitations of ratio analysis
Tools of Financial Analysis
Horizontal Analysis/Trend Analysis
Common size statement/Vertical Analysis
Ratio Analysis
Examples are based on the 2006 accounts of McPhersons Ltd and preceding years
Horizontal/Trend analysis
This technique calculates the percentage change of an item (e.g. sales) in one year compared to the previous year.
Using Sales as an example
2004 2005 2006
Sales 333m 325m 315m
2005 Sales 325m
x 100 (%) =
= 98%
2004 Sales 333m
2006 Sales 315m
x 100 (%) = = 97%
Sales 325m
What we can say then is that Sales decreased by 2% in 2005 compared to 2004 and it decreased another 3% in 2006 compared to 2005
Using another example to show an increase, IF the Sales figures were
2006=$315 and 2007=$340 then
Sales x 100 340m
== 108%
2006 Sales (%) 315m
What we can say then is that Sales increased by 8% between 2006 and 2007.
Whilst we have used figures from the Profit & Loss
Statement, we can do the same for Balance Sheet items
Common Size Statement
This technique presents each item in a financial statement as a percentage of a base item from the same statement (such as revenue in the income statement, or total assets in the balance sheet). For example:
Not using McPherson but a fictitious co. Income statements for the years ending:
31/12/2005 31/12/2006
$000 % of Sales $000 % of Sales
900
600
1200
800
Sales 100% 100% less
Cost of goods sold 67% 67%
Gross profit 300 33% 400 33%
less Expenses:
45
90
70
20
60
200
100
20
Advertising 5% 5%
Wages 10% 17%
Rent 8% 8%
Sundry 2% 2%
225 25% 380 32%
Net Profit 75
75
8% 20
20
2%
The Common Size Statements helps us to understand why Net Profit decreased in spite of sales increasing, pointing to Wages.
Can also change the base item to eg Expenses when we are analysing Expense items
Common Size Statement on Balance Sheet
Not using McPhersons Accounts here using Total Assets as base
13%
8%
5%
57%
17%
100%
7%
Assets
Cash
Accounts receivable
Inventory
Total Current Assets
Property, plant equipment
Other assets
Total Non-current Assets
Total Assets
Liabilities
Accounts Payable
$30,000
18,000
12,000
-120122-56160
60,000
130,000
40,000
-120122-56159
170,000
$230,000
15,000 Total Current Liabilities 15,000
5389634-369699
Loan 50,000 22%
Total Non-Current Liabilities 50,000
Total Liabilities 65,000 28%
Equity
Capital 165,000 72%
5373617-58833
Total Liabilities & Equity $230,000 100%
Common Size Statement
using Current Assets as base
Assets
Cash $30,000 50%
Accounts receivable 18,000 30%
Inventory 12,000 20%
Total Current Assets -445992-62742
60,000 100%
It can be applied to any other any other group of numbers (e.g. Liabilities or Current Liabilities) to analyse the relative importance of each item in the group.
Ratio Analysis
Examines the relationship between one item and another item, either from the same financial report or another. (E.g. the ratio between profit and sales; sales and assets).
We can then compare ratios over time as part of a trend analysis, or with those of a competitor or an industry average.
It is one of the most useful analytical techniques, and will be the focus of the remainder of this lecture.
Individual Activity 1: Ex 8.19
8.19 The most recent annual income statement for Vertigo Enterprises is presented below. Prepare a vertical analysis of the statement.
Individual Activity 1: Ex 8.19 Solution
Individual Activity 2: MobileNet
Prepare a Vertical Analysis of its assets using
Total Assets as base
Structure of Financial Analysis
Different structures are used by organisations. Below is one example that is used by the prescribed text:
Profitability (indicates companys success in generating additional wealth)
Asset Efficiency (indicates companys success in managing assets such as inventory and debtors)
Liquidity (indicates how well the entity can meet short-term obligations as and when they fall due)
Capital Structure (indicates if the entity has a viable financial structure for the long term (in particular, whether it has an appropriate mix of debt and equity)
Market performance evaluates the entity from the point of view of existing and potential shareholders (including making use of share price information).
Profitability Ratios - Return on Equity
This ratio relates Profit to Shareholders Equity.
It indicates the return or profit the company generated from shareholders investments expressed as a percentage.
720700256873
Net profit after Tax x 100
Average Shareholders Equity
720700257149
13,553 x 100 = 11% (127,732 + 118,261) / 2**
This shows that for every $100 invested by shareholders, the company generated $11 of net profit.
** Many students forget to calculate the average. Make sure you dont!!
Profitability Ratios - Return on Assets
This ratio relates Profit to Total Assets. It indicates the return or profit the company generated from assets.
In this subject, we use Net Profit After Tax as the top figure but some books use Earnings Before Interest and Tax (EBIT) (refer next slide for the reason).
Net Profit After Tax or EBIT x 100
Average Total Assets
1584300230251
13 553 x 100 = 4.2% (317,702 + 327,554) / 2
This shows that for every $1 of assets, the company generated 9.6 cents of earnings (profit) before interest and tax.
Why use EBIT?
(when we want to compare profitability regardless of source of financing or tax)
Co A
Sales
Expenses
Interest 100
-80
-10 Co B
Sales
Expenses
Interest 100
-80 -0
68799450Tax-2Tax
Profit8Profit
Capital
Borrowings 30
20 Capital
Borrowings 50 0
EBIT = Profit +Tax + Interest. EBIT of A & B are the same even though Profit was different
Profitability Ratios - Gross Profit Margin
Gross profit = Sales revenue less cost of good sold expense
Cost of Goods Sold is the major expense for trading companies
It tells us how much is left over to cover other expenses after covering COGS
250800306959
Gross Profit x 100
Revenue (from Sale of Goods)
x 100 = x 100 = 40%
This shows that for every $1 of sales revenue, the company generated 40 cents of gross profit. Alternatively, the company has an average mark-up of 40%.
What is the risk of having a very small margin?
Profitability Ratios - Profit Margin
This ratio relates Net Profit (or we can also use EBIT) to Sales
It indicates how much Profit was made from every dollar sales
1082269307086
Net Profit After Tax x 100 Revenue (From ALL sources)
13 553 x 100 = 4.3%
315,445
This shows that for every $100 of sales revenue, the company generated $9.80 of Profit.
Asset Efficiency Ratios - Asset Turnover Ratio
. This ratio indicates if assets were used efficiently to generate revenues
Revenue (from all sources)
Average Total Assets
315,445 315,445
=
= 0.98 times
(315,702 + 327,554) / 2 321,628
This shows that for every $1 invested in assets, $0.98 of sales revenue was generated.
Asset Efficiency Ratios -Times Inventory Turnover And Days Inventory
This ratio indicates how long the business takes to turn over inventory during the accounting period. Formula used:
4716501307213
Cost of Good Sold = 188,880 =
Average Inventory(44,551 + 51,211) / 2
= = 3.95 times
.Inventory thats sold quickly provides cash to pay shortterm commitments.
Holding large amount of inventory (especially if it is slow moving) is poor management of cash flow.
It also increases the risk of damage or obsolescence Days Inventory is another way of stating this ratio, which may be calculated as:
914375307467
365 = 365 = 93 days Inventory turnover in times 3.95
This shows that, on average, 93 days passed between the buying the inventory and selling it. Alternatively, the company held sufficient inventory to, on average, last for 93 days.
Note that days inventory may also be calculated using the following formula:
Average Inventory x 365 days = 47,881 = 93 days
Cost of goods sold188,880
Times debtors turnover and days debtors
Very similar to those applying to inventory. The underlying principles are the same. Efficient management of debtors enables prompt collections and improved cash flow. A large dollar value of debtors who are slow paying can be costly.
Revenue (from sale of goods)
Average Trade Debtors (Use Gross balance & excl Other Debtors)
= ____315,445______ = 315,445 = 6.6 times
(47,513 + 48,017) / 2 47,765
Another way of stating this ratio is days debtors which may be calculated as:
649262230124
365__________
Debtors turnover in times
_365_ = 54 days
6.8
This tells us that, on average, customers paid 54 days after the sale was made.
Alternatively, at any time the company has an average of 54 days outstanding in debtors.
Note that days debtors may also be calculated using the following formula:
Average Trade Debtors x 365 days
Revenue (from sale of goods)
= (47,513 + 48,017) / 2 x 365 = 47,765 x 365 = 54 days
314,567314,567
Liquidity Ratios - Current Ratio
This ratio relates Current Assets (expected cash from Current Assets) to Current Liabilities (expected short term payments
Current Assets = 98,512 = 2.02 Times
Current Liabilities 48,673
This shows that the company has $2.02 of current assets for every $1 of current liabilities.
Liquidity Ratios - Quick Asset Ratio
Similar to current ratio but applies a stricter test.
Recognises that some current assets take longer to convert to cash.
Excludes those that take longest to convert to cash.
Usually excludes inventory as it is two steps away from being converted to cash i.e. first converted to accounts receivable, then to cash when customer pays.
Some analysts exclude prepayments which do not convert to cash.
The formula used is:
Current Assets less Inventory - Prepayments Current liabilities
98,512 44,551 - 0 = 53,961 = 1.11 times
48,67348,673
This shows that the company has $1.11 of quick assets for every $1 of current liabilities.
Cash Flow Ratio
Operating activities provide cash that is used to meet shortterm obligations. This ratio indicates the extent of this capacity.
Net Cash Flows From Operating Activities Current liabilities
= 0.50 times
This shows that for every $1 of current liabilities, the company generated $0.50 of cash from operating activities during the year.
Capital Structure Ratios - (1) Debt to Equity Ratio
Capital structure deals with the important issue: What is the mix between debt (liability) and equity which are the 2 sources of finance.
Total Liabilities x 100
Total equity
x 100 = 148% (or 1.48 times)
This shows that for every $1 of equity finance, company is using $1.48 of debt finance.
Capital Structure Ratios (2) Debt Ratio
Total Liabilities X 100 Total Assets
188,970 x 100
316,702
= 60% (or 0.60 times)
This shows that for every $1 of assets, the company is using $0.60 of debt finance.
Capital Structure Ratios (3) Equity Ratio
Total Equity X 100Total Assets
x 100 = 40.3%
This shows that for every $1 of assets, the company is using $0.40 of equity finance.
Repayment ratios (1) Debt coverage ratio
This ratio indicates the ability to repay long-term debts from operating cash flows.
1131926307213
Non-Current Liabilities =
Net Cash Flows From Operating Activities
= 5.7
This shows that the company will take 5.7 years to repay existing long term debt.
Repayment Ratios (2) Interest Coverage Ratio
For a business, debt is more risky than equity because There are fixed repayments it must make.
Most debt have fixed obligations for the payment of interest.
Earnings (Profit) Before Interest and Tax
Interest Expense
3837026019,099 + 11,203 = = 2.70 times 11,203
The interest coverage ratio indicates the ability of a business to cover its interest commitments from current profits. In this example, it covered Interest by 2.7 times.
Market Performance Ratios
These ratios
are of special interest to shareholders.
provide a per share perspective on the company.
Net Tangible Assets Per Share (NTA per share)
This ratio indicates the NTA backing up each share (i.e. the assets that could usually be sold for cash if necessary). Assets such as goodwill however, are excluded..Ordinary Shareholders Equity Intangible Assets
Number of ordinary shares on issue at year-end
= - $0.93
*Deferred tax assets
This indicates that the company did not have sufficient net tangible assets (at book value) backing up each ordinary share (7 cents short).
Earnings Per Share (EPS)
This ratio relates the profit (i.e. earnings) made to the number of shares issued.
73000307086
Net Profit Available to Ordinary Shareholders
Number of Ordinary Shares
EPS for McPherson Ltd: 22.4 cents (this information would normally be
disclosed in the financial statements)
This shows that the company made 22.4 cents of profit for each ordinary share.
Dividend Per Share
Shareholders (and investors) are very interested in the amount of dividend paid per share.
Usually this information is provided in a companys general However, if only the total dividend is disclosed the dividend per share can be calculated as:
Dividends Paid or Provided in Current Year Number of Ordinary Shares
Dividend per share for McPherson Ltd : 14 cents (as disclosed)
Price Earnings Ratio (PE ratio)
This ratio relates Earnings Per Share to the Market Price of the share.
Shows how much the market is currently prepared to pay for every $1 of profit made by company. The formula is:
298425306959
Current Market Price Earnings Per Share
Calculate the ratio for McPherson Ltd
(share price needs to be obtained):
$1.77 =7.9 times
$0.24
This shows that at this date the market was prepared to pay 7.9 times the current earnings (or profit) per share
Company list for Assessment 3 of T2 2024:
Emirates Airlines
Westpac Bank
Netflix
Apple
Reliance Industries Ltd
General Motors
Berkshire Hathaway
Microsoft
Amazon
Alibaba Group
Nike
Tesla and SpaceX
UBSS cover sheet
Cover page: showing your name, student number, the subject name, the subject code, the case topic, and the date of submission. UBSS assignment cover page also needs to be attached with the assignment.
Executive Summary
Table of Contents
Introduction
Discussion / Findings (explain the answers to the questions)
Describe the Core Business activity of the company. Provide full details of its different activities and/or operating segments.
Alibabas key resources include its online platforms, technology infrastructure, data analytics capabilities, and human capital. The company invests heavily in technology development, data analytics, and talent acquisition to maintain its competitive edge and drive innovation in the e-commerce industry.
Alibabas key activities revolve around platform management, customer acquisition, product sourcing, logistics, and marketing. The company continuously optimizes its platforms, acquires new customers, expands its product offerings, enhances its logistics network, and executes marketing campaigns to drive growth and profitability.
Discuss any major changes in financial performance from the chairmans message or managing directors review.
Calculate the key financial ratios for the selected company based on the consolidated financial statements, for 2019 & 2020 or 2020 & 2021 or 2021 & 2022 or 2022 & 2023.
Identify challenges faced by the Leader of your selected company, suggestions to tackle challenges as a responsible business ~ specially impact of Covid 19 and responsible practice
4.Challenges that directors facing in modern business
4.1.Technology changes
4.2.Post-covid pandemic
4.3.Shareholder activism
4.4.Corporate Social Responsibility
Provide an overall assessment of the company and its future prospects by SWOT analysis, PEST analysis, Future plan or development information from Directors report, recent news or online article related to the company etc.
Conclusion (Recommendation to conclude the Report)
List of references: Please read reference notes from Moodle.
Appendices:
Make an appointment with the Academic Learning Support Coordinator, Wilhelmina Woortman (Level 10, Working days: Tuesday, Wednesday, Thursday) to receive feedback of the assignment on learning purpose before final submission.
The evidence of appointment & feedback in the report after the references!
