Lecture 9 - Financial Analysis pt2

Question 1

Why is ratio analysis important?

Answer 1

• Isolated values don’t have much value therefore they can be contextualized through ratio analysis to offer more value.

Question 2

Profitability ratio analysis: 4 key ratios

Answer 2

• Return on shareholders funds
• Return on capital employed
• GPM
• OPM

Question 3

Return on shareholders funds (return on equity: Equation and further detail

Answer 3

• Expressed as a percentage
• Is the amount of net income returned as a % of shareholders equity, the higher the better.
• Tells us how profitable a company is and how efficient they generate profits.

Equation:
Profit for the year/equity X100
Equity = ordinary share capital + reserves

Question 4

Return on Capital employed (ROCE):

Answer 4

• Expressed as a percentage
• Is a fundamental measure of business performance and is a key ratio for providers of capital.
• Tells us how efficiently a company can generate profit from their capital employed.
• Changes in capital employed may occur due to: changes in operating profit and changes to CE (new loans taken out, repayment of loans and issued shares).

Question 5

Equation of ROCE:

Answer 5

OP/CE X100

CE = Equity (shareholders funds) + long term debt (non-current liabilities)

Question 6

GPM (equation and further detail):

Answer 6

• Expressed as a percentage
• GP/Revenue X 100
• Helps evaluate production process efficiency.
• A measure of profitability before any other expenses are considered

Question 7

Why might GPM change?

Answer 7

• Changes in revenue (Sales prices and volumes)
• Changes in costs of sales (purchase prices and inventory levels)

Question 8

OPM (equation and further detail):

Answer 8

• Expressed as a %

OP/Revenue X 100

• Tells us how well a company is performing in relation to their operations.
• It provides an indication of the company’s ability to maintain its selling margin and control its costs.

Question 9

Liquidity ratio analysis:

Answer 9

• Liquidity refers to the company’s ability to meet it’s current liabilities (short term, within next 12 months)
• To understand liquidity it is important to look at the statement of cashflows and the statement of financial position.

Question 10

2 key liquidity ratios:

Answer 10

• Current ratio
• Quick ratio

Question 11

Current ratio:

Answer 11

• Express as a proportion e.g. 2:1
  Equation = CA/CL
• Can business survive in short term, is a concern for the firm if it is below 1
• Tells us how liquid a business is.
• Firms ability to pay liabilities (short term, 12 months).

Question 12

Quick Ratio: equation and further detail

Answer 12

CA - inventory/CL X 100

What does this tell us?
- Can business meet its liabilities in the short term.
- More of an “acid test” because it takes longer to turn inventory into cash.