8. Analysing financial statements Flashcards
(13 cards)
When analysing financial results, what should you watch out for?
Trends
Overtrading
Signs of financial failure
What is overtrading?
Overtrading is the practice of conducting more business than can be supported by a firm’s working capital.
OUTCOME:
The company will pay for the goods sold or produced, but not get the money for it = run out of cash = cannot pay its suppliers or fulfil short term liabilities or pay wages = Work in progress might be halted due to insufficient funds to transform it to finished goods = bankrupt and reputation damaged
KEY: To overcome overtrading a business must ensure that the finance available is consistent with the level of operations!!!!
Can a company still have problems associated with inefficiency and its effect on liquidity and NOT be overtrading?
Yes.
Investing heavily on growth opportunities
Managing cash flow tightly
Buisness model requires significant investment working capital.
OR
Company with ineffiecent managed can also have high liquidity ratio!
conservative financial management approach
not be investing in growth opportunities
What are the signs of overtrading?
Efficiency ratios:
Sales per capital employed ratio: High = producing money. Low = something is wrong, if the revenue is high, could be overtrading.
Average inventory turnover period: loner average = likely to overtrading = inventory is meant to bring in cash.
Average settlement period for trade receivables = long= cash tied up by the debtors - likely to overtrade
Average settlement period for payment payables = short = likely to overtrade. Cannot be used for other things.
Current ratio: - if bad = dont have money to put into productions.
KEY: ALWAYS INVESTIGATE
Why do we analyze trends with financial ratios?
It helps stakeholders make informed decisions about investment, lending, or strategic planning.
Doing trends will help us see the past and maybe predict the future.
You can combine ratios or the z models to see if you are heading towards failure?
Sales per capital employed ratio (average turnover ratio) - what is a sign of overtrading?
We want it high, however a a very high = indicate ‘overtrading’ on its assets. So, it is worth investigating
What is a single ratio? And why use it?
Single ratio focus on analyzing on specific aspect of a company performence or position.
KEY:
The specific aspect could be one of the ratios in the profitability (not good = failure), liquidity (not good= failure), efficiency, financial gearing or investment ratios (not good MAYBE failure).
Combination of ratios. Why do this?
Sometime you can not see it with one ratios so you have to combine the ratios.
ex with profitability ratio was good, but liquidity bad.
This enables the analyst to cover various dimensions of the financial health of the company and to gain a holistic understanding of the company.
What is the z score?
The z-score is a quantitative method for assessing the financial health and predicting the probability of bankruptcy of a company.
You get the score based on serveral ratios and other accounting.
Include:
Working capital / total assets ratio
Retained earnings / total assets ratio
Earnings Before Interest and Taxes/Total Assets Ratio
Market Value of Equity/Book Value of Total Liabilities Ratio
Sales/Total Assets Ratio
What do the result of the z-score say?
The result is the z-score. can be used to evaluate if the company is heading towards failure. Bad z-score you are heading towards financial failure.
Notes:
Help assessing credit risk and financial distress, helping investors, creditors, and analysts make more informed decisions about lending, investment, and business relationships
What is the limitation of ratio analysis?
If the financial statements are wrong = the ratios analysis wrong.
ALWAYS investigate that the ratios are correct.
Ratios gives not a full picture = you need more ratios to get a fuller view.
Benchmark to competition = always look at our closest competition - important who you compare yourself.
What is a vertical analysis?
A analysis that involves expressing each line item in a financial statement as a percentage of a base figure within the same statement.
Pick a base (often revenue) as reference point against the others.
Can use it in income statement, cash flow or balance sheet etc.
KEY: See how are we doing compared to the others? also compared to other years?
Explain the dupont method
The DuPont Return on Investment (ROI) is a variation of the traditional DuPont analysis that focuses specifically on return on investment
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