TOPIC 2+3: Analysing and Interpreting Financial Statements 1 Flashcards
Lecture 6+7, Chapter 7 (+ Chapter 8 on 'Investment Ratios') (50 cards)
Define ‘Financial ratios’.
A representation of numbers that shows the state of a company’s finances and company health.
A tool used for summarising, analysing and interpreting financial statements.
Why are financial ratios useful?
Financial ratios are used for tracking the company’s financial performance against internal benchmarks and for comparison with competitors or industry averages.
What can be compared to competitors?
Financial ratios can be used to compare:
- Past periods for the same business
- Similar businesses for the same or past periods
- Planned performance for the business
Which users are interested in financial ratios?
- Internal users: Management team, employees, and owners.
- External users: Financial analysts, retail investors, creditors, competitors, tax authorities, regulatory authorities, and industry observers.
Compliance: Getting insight into a financial ratio can help external users determine whether a company’s management uses sound business practices.
List the five primary groups of financial ratios.
1. Profitability ratios: Evaluating a company’s ability to generate profit relative to revenue, assets, equity etc.
2. Efficiency ratios: Indicating how effectively a company utilises its assets and manages liabilities to generate sales and maximise profits.
3. Liquidity ratio: Assessing a company’s ability to meet its short-term financial obligations using its current assets.
4. Financial gearing ratios (or leveraging financial ratios or leverage ratios): Assessing the extent to which a company is financed by debt compared to equity, reflecting financial risk.
5. Investment ratios: Analysing the return and value of investments in the company, useful for investors assessing potential profitability.
Are one group of financial ratios usually used alone?
In practice, most ratios are best used in combination with others rather than singly to accomplish a comprehensive picture of a company’s financial health.
Define ‘Profitability ratios’.
Financial metrics used to evaluate a company’s ability to generate profit (income) relative to revenue, operating costs, assets, equity, or capital employed.
When are profitability ratios most valuable?
Profitability ratios are most valuable when compared to similar companies or past periods.
Define and give formula: Capital invested
Definition: The total amount of money that investors, including both shareholders and creditors, have contributed to a business.
- It typically includes equity investments by shareholders and debt financing provided by creditors.
Formula: Invested capital (IC) = Net working capital (NWC) + Net property, plant, and equipment (PP&E)
- Net Working Capital (NWC) = Current operating assets – Current operating liabilities
If there are intangible assets then:
- Invested capital (IC) = Net working capital (NWC) + Net PP&E + Acquired intangibles + Goodwill
If the company operates in intangible-only industries then:
- Invested capital (IC) = Total debt + Common equity + Preferred stock + Equity equivalents
I.e. no need for net PP&E
Define and give formula: Capital employed
Definition: The total capital used by a company to generate profits, including equity and debt.
- It represents the total resources employed in the business operations, including fixed assets, working capital, and other long-term investments.
Formula: Capital employed = Total assets – Current liabilities
OR
Capital employed = Equity + Non-current liabilities
Define and give formula: Average long-term capital invested in a business
Definition: The total capital employed by the company over an extended period, including:
- equity (such as common stock and retained earnings)
- long-term debt (such as bonds or loans with maturities longer than one year)
Formula: Average long-term capital = (Total long-term debt - Total equity) ÷ 2
OR
Average long-term capital = (Beginning long-term capital + Ending long-term capital) ÷ 2
NB! Here, “capital” refers to capital employed. This could be equity or liabilities (debt capital).
Compare capital invested, capital employed and average long-term capital invested in a business.
- Capital invested: Total money contributed to the business by both owners (equity) and lenders (debt).
- Capital employed: Total resources used in the business.
- Average long-term capital invested: The average amount of capital employed over a period.
What are the two categories of profitability ratios?
1. Margin ratios represent the company’s ability to convert sales into profits at various degrees of measurement.
2. Return ratios represent the company’s ability to generate returns to its shareholders.
What are the two primary margin ratios?
- Gross profit margin ratio
- Operating profit margin ratio
Define and give formula: Gross profit margin ratio
Definition: Measures the percentage of sales revenue that remains after deducting the cost of goods sold (COGS).
- It shows how efficiently a company produces or buys its goods.
- Higher margin = better efficiency in managing production or purchasing costs.
Formula: Gross profit margin = (Gross profit ÷ Sales revenue) x 100%
- Gross profit = Revenue − Cost of Goods Sold (COGS)
- Sales revenue = net sales
Define and give formula: Operating profit margin ratio
Definition: Measures the percentage of sales revenue that remains after covering all operating expenses (excluding interest and taxes).
- It shows how efficiently a company runs its core operations.
- Higher margin = stronger operational efficiency.
Formula: Operating profit margin = (Operating profit ÷ Sales revenue) x 100%
- Operating profit = Gross profit – Operating expenses
What are the two primary return ratios?
- The ordinary shareholders’ funds ratio (ROSF)
- The return on capital employed ratio (ROCE)
Define and give formula: The ordinary shareholders’ funds ratio (ROSF)
Definition: Measures the return earned on the average equity invested by ordinary shareholders during a period.
- It shows how effectively the company uses shareholder capital to generate profit.
- Higher ratio = the company is generating more profit for each pound of ordinary shareholders’ investment, indicating better returns and stronger performance from the shareholders’ perspective.
Formula: ROSF = ((Profit for the year - Preference dividends) ÷ (Ordinary share capital + Reserves)) × 100
- Preference dividends: Fixed dividends paid to preference shareholders before ordinary shareholders receive any.
- Ordinary share capital: The total value of issued ordinary shares representing ownership in the company.
- Reserves: Profits or gains retained in the business instead of being paid out as dividends.
Ordinary shareholders’ equity = Ordinary share capital + Reserves
Define and give formula: The return on capital employed ratio (ROCE)
Definition: Measures how efficiently a company is using its long-term capital (equity and debt) to generate operating profit.
- It shows the relationship between the operating profit generated during a period and the average long-term capital invested in the business.
- Compare ROCE to cost of capital.
- Higher ratio = better use of capital to generate profit.
Formula: ROCE = (Operating profit ÷ Capital employed) × 100
OR
ROCE = (Operating profit ÷ ((Total share capital + Reserves + Total non-current liabilities) ÷ 2)) × 100
Define ‘Efficiency ratios’.
Financial metrics used for indicating how effectively a company utilises its assets and manages liabilities to generate sales and maximise profits.
What is the relationship between profitability and efficiency?
Profitability and efficiency are closely linked, as operational efficiency directly affects a company’s ability to generate profit.
- Efficiency ratios assess how well a company uses its resources (like inventory, receivables, and assets).
- Profitability ratios measure the ability to generate profit from those resources.
Efficiency ratios provide insights into how profits are achieved, not just how much.
Analysing both together gives a full view of a company’s financial performance and operational health. So, after calculating profitability ratios, you compare them with efficiency ratios to see if they “match.”
ROCE ratio highlights that the overall return on funds employed within the business will be determined both by the profitability of sales and by efficiency in the use of capital.
What are the five primary efficiency ratios?
- Average inventories turnover period
- Average settlement period for trade receivables
- Average settlement period for trade payable
- Sales revenue to capital employed
- Sales revenue per employee
Define and give formula: Average inventories turnover period
Definition: Measures the average number of days a business takes to sell its inventory.
- It shows inventory efficiency.
- Shorter period = inventory is sold quickly, which is usually better for cash flow and efficiency.
Formula: Average inventories turnover period = (Average inventories held / Cost of sales) × 365
- Average inventories held = (Opening inventory + Closing inventory) ÷ 2
- Cost of sales = COGS
Define and give formula: Average settlement period for trade receivables
Definition: Measures the average number of days it takes customers to pay what they owe after a credit sale.
- It shows customer payment efficiency.
- Shorter period = quicker collection of payments, which improves cash flow.
Formula: Average settlement period for trade receivables = (Average trade receivables ÷ Credit sales revenue) × 365
- The average trade receivables = (Trade receivables at opening period + Trade receivables at closing period) ÷ 2
- Credit sales are not just sales revenue, as this does not separate cash and credit. But this might be the only information given in the income statement, unless there are notes to accounts.