Financial analysis: the key points
A company’s financial position and performance can be of significant interest to various stakeholders. For example, banks and other financial institutions, employees, tax authorities and potential investors. Some stakeholders are looking at specifics, whereas other stakeholders may just want an overview of the financial position (using the balance sheet) or financial performance (using the profit and loss account).
Understanding Financial Analysis
Financial analysis can essentially be split into three aspects: profitability, liquidity and risk. Each stakeholder will want to look at each one in isolation, or maybe have an interest in all three aspects. Regardless of which area they are interested in, stakeholders are guaranteed to be interested in the company’s ability to generate sufficient profits to sustain its going concern.
Measuring Profitability
Stakeholders can use a variety of ratios to measure a company’s profitability. The main ones used are:
| Gross profit ratio: Gross profit / turnover x 100This is a measure of gross profit as a percentage of turnover.
Net profit ratio: Net profit / turnover x 100 This is a measure of net profit (turnover less all expenses) as a percentage of turnover. Return on capital employed: Net profit / capital employed x 100 There are other, equally valid, methods to calculate this ratio and this ratio is a key measure of profitability and shows the net profit that is generated from each £1/$1/€1 of assets employed. |
Measuring Liquidity
A company can be profitable but at the same time encounter cash flow problems. Liquidity and working capital ratios give some indication of the company’s liquidity and a few of the more common methods of measuring liquidity are given as follows:
| Current ratio: Current assets / current liabilitiesThis ratio measures the company’s ability to meet its short-term liabilities as they fall due.
Quick ratio (acid test): Current assets less stock / current liabilities This is a similar test to the current ratio but stock (inventory) is removed from current assets due to its poor liquidity in the short-term. Stock (inventory) holding period: Stock / cost of sales x 365 This indicates the average number of days that stock (inventory) items are held for. Gearing: Debt / equity x 100 OR Debt / debt plus equity x 100 A high level of gearing indicates the company relies heavily on debt to finance its long-term needs. |
Managing the Flow of Cash
‘Cash is King’ is a familiar mantra. A sound cash flow is critical to the ongoing stability of a business. Increasing debtor days and decreasing creditor days is unfortunately a common theme nowadays, but to keep an eye on just how long your customers are taking to pay and how long you are taking to pay your suppliers, use the following calculation:
| Customers: Trade receivables (debtors) / sales x 365Suppliers: Trade payables (creditors) / trade purchases x 365 |
Paying the Interest
Borrowing comes with a price tag. This price tag is in the form of interest and one of the most important aspects lenders will look at is the ability of the company to meet the interest payments. A key calculation is a company’s ‘interest cover’. This is calculated as:
| Operating profit / interest charges |
A decrease in the interest cover indicates the company is facing an increased risk of not being able to meet its interest payments as they fall due.
Paying Dividends
Maximising shareholder wealth is the objective of most shareholders. They want larger profits to enable them to get a higher rate of return from their investment. A calculation used by shareholders to calculate their ‘dividend cover’ is:
| Net profit / dividend |
A decrease in the dividend cover indicates the company is facing an increased risk of not being able to make its dividend payments to shareholders.
Non-Financial Performance Measurement
It is not just all about the numbers. Some stakeholders are interested in non-financial performance measurement. For example BAA (the former state-owned British Airports Authority) uses regular customer surveys for measuring customer perceptions of a wide variety of service qualities such as:
- the cleanliness of its facilities
- the helpfulness of its staff
- the ease of finding one’s way around the airport
Transfer Pricing
Transfer pricing is the price at which goods or services are transferred from one division to another within the same organisation. The general objectives of transfer pricing are:
- goal congruence
- performance measurement
- autonomy
Two methods used are the ‘market based’ approach and the ‘cost based’ approach. The market based approach suggests that if an external market exists for the transferred goods, the transfer price could be set at the external market price. The cost based approach states that the transferring division would supply the goods at cost plus a percentage of profit.
Financial Ratios and Changes to the Accounting Environment
Investors and other stakeholders need to bear in mind that financial ratios are no more objective than the accounting policies and methods employed by a company. If a company changes their accounting policies or methods (for whatever reason), this can have a dramatic effect on the ratio values to an extent that comparing two companies in the same industry may yield significantly different results.
Creative Accounting
Creative accounting (also referred to as ‘earnings management’) is the somewhat unorthodox method adopted by companies who wish to report manipulated results (not every company is guilty of this practice – it is fairly uncommon but not unheard of). Accelerated revenues or increased expenses can have a significant influence over the figures reported in financial accounts and can also have a bearing on the decisions reached by the users of those financial accounts. Bear in mind that the information conveyed in financial analysis is only as good as the information on which it is based.
This article appears in Greater Manchester Business Week Magazine and was featured as a Tip Sheet in Pro.Manchester SME weekly newswire.
Category: Accounting and standards
