Lecture 10 - Financial analysis Part 3. Flashcards
(23 cards)
Key Efficiency Ratio Analysis:
- Inventory turnover.
- Inventory turnover days
- Trade Receivable days
- Trade Payable days
- Working capital cycle
What does Efficiency Ratio Analysis tell us?
How well a company utilises its short-term resources:
- Inventory, TR, TP
Measures how well a company is using its working capital.
What is Working Capital?
- Capital of a company which is used in day to day operations
What is inventory turnover?
Measures the speed at which inventory moves through the company.
How long inventory is kept on hand.
Higher the better- means firm is selling inventory quicker.
Inventory Turnover (Managing inventory)
Holding inventory incurs costs such as:
- Opportunity costs (interest in banks)
- storage costs
- Risk of damage
- Risk of obsolescence
To avoid holding excess inventory a company could:
a) Sell at a discount
b) Reduce Production
What does inventory turnover days tell us?
Measures the speed at which inventory is moving through a company.
The lower number of days the better.
What is Trade Receivable days?
Measures the average number of days it takes the company to collect cash from customers.
The lower the number of days the better.
THIS RATIO IS NOT RELEVANT WHERE MOST OF A BUSINESSES SALES ARE IN CASH.
Evaluating Trade Receivable Days:
- Useful to compare this ratio to the average credit terms given to customers.
If Trade Receivable Days are high it could be for reasons such as:
- Ineffective credit control
- Customers are not satisfied with the product
- Customers have liquidity problems.
Trade Receivable Days: Managing inventory.
- Cash tied up in TR can prevent paying suppliers/other expenses.
- Should be regular credit checks on current and prospective customers.
- Early payment discounts should be considered to encourage customers.
- Strong credit controls should be implemented (unpaid invoices from customers should be chased.
What are Trade Payable Days?
Measures the average number of days it takes for a company to pay its suppliers.
- The higher the number of days the better. TOO HIGH can be a problem and damage relationships with suppliers.
Therefore, should compare ratio with to the average credit terms given to the company buy its suppliers.
NOT RELEVANT to a business where most of their purchases are in cash.
What is the working capital cycle?
Inventories —- Trade receivables ——— Cash at the Bank ———- Trade payables.
What does the Working Capital Cycle show us?
The number of days it takes a firm to convert resource inputs into cashflows.
The Lower the number of days the better.
The Key difference between Liquidity and Solvency ratios?
- Liquidity ratios analyse the short term position.
- Solvency ratios analyse the long term position
2 Key solvency ratios:
- Gearing
- Interest cover
Gearing in further detail:
Refers to the company’s capital structure (how it’s financed).
Company’s are financed through a mixture of:
- Share capital
- Retained earnings
- Revaluation surplus
- Bank overdrafts
- Loans
- Leazes
A good range is 25% - 45%, but depends on age of business, nature of industry etc.
What does Gearing represent?
- Represents the relationship between the shareholders funds and debt financing (financial risk).
High gearing - vulnerable to changes in interest rates
low gearing - not taking advantage of cheaper financing
What is interest cover?
- Measures the amount of profit available to cover interest payable.
Higher is better.
TOO high is inefficient as debt financing is cheaper than equity.
Less than 1 is an indicator that current levels of debt are unaffordable.
Most companies aim for 8-12 times interest cover.
What are investors specifically interested in?
a) What are they earning from their interest?
b) Are the shares under or over-priced?
c) Are the assets of the company being used efficiently.
4 Key ratios: Investors return analysis.
Dividend cover
Dividend Yield
Earnings Per share
Price to Earnings ratio
What is Dividend Cover?
- Measures the amount of profit available to pay dividends.
Higher dividend cover indicates a company is retaining a substantial part of its profits (might not be popular with shareholders)
Low dividend cover may not encourage shareholders.
What is Dividend Yield?
- An indicator of the cash return received on the investment made by an ordinary shareholder.
Investors who view shares as source of income - will want a high dividend Yield.
Investor with a main concern of capital growth may not be deferred by a low dividend yield.
What is Earnings Per Share (EPS)?
Relates to the amount of profit generated during the period per ordinary share in issue during that period.
- Is a key measure of performance of shares.
IAS 33 Earnings per share, requires companies to present this figure in their statement of comprehensive income and states out the rules for its calculation.
Used to assess the investment potential of company’s shares.
What is Price to Earnings Ratio?
- Compares earnings per share with the market price of an ordinary share.
A high price to earnings ratio is more favourable because:
- EPS is a measure of PAST performance.
- Market price of a share reflects the stock market’s expectations of the company’s future performance.
- High means the market expects a company to perform well in the future.
