lecture 9 AKA lecture 8B AKA financial analysis part 3 (FC37-40)

Flashcards 37-40 are literally everything you need to know

Horizontal analysis, Vertical analysis, Ratio analysis (reminder)

Horizontal analysis — you're looking across time. You take one year as your base (100%) and compare every other year to it. It spots trends and abnormalities — e.g. if finance costs suddenly jump to 400% of the base year, something changed (new loan, higher interest rate). You covered this in Lecture 7.

Vertical analysis — you're looking within a single year. Everything on the SPL is expressed as a % of revenue. Everything on the SOFP is expressed as a % of total assets. It lets you compare how much of every £1 of revenue ends up as gross profit, operating profit etc. Also Lecture 7.

Ratio analysis — you're calculating specific ratios to assess performance in five areas: profitability, liquidity, efficiency, solvency, and investors' returns. This is the big one — Lectures 8 and 8B. Things like gross profit margin, current ratio, gearing, EPS etc.

For the exam, the most likely thing they test is ratio analysis since it has the most formulas. Horizontal and vertical are simpler — just remember horizontal = across time, vertical = within one year.

Efficiency ratios — what do they measure?

How well a company utilises its short-term resources: inventory, trade receivables, and trade payables. Efficiency and liquidity are linked — efficiency ratios measure how well a company is managing its working capital.

Working capital — definition and formula

The capital used in a company's day-to-day operations.
(Cheers Sherlock)

Formula: (a) Current assets − Current liabilities, or

(b) Inventories + Trade receivables + Cash − Short-term borrowings − Trade payables.

Five efficiency ratios

1. Inventory turnover (times). 2. Inventory turnover days. 3. Trade receivables days. 4. Trade payables days. 5. Working capital cycle (cash conversion cycle).

Inventory Turnover — formula and unit

Cost of sales ÷ Inventory. Expressed in times (per year)

Inventory Turnover — what does it tell us?

Measures how quick we can turn inventory into a sale. — how many times inventory is sold and replaced in the period. Higher is better: the higher it is, the quicker the company is selling its inventory and the more times it has turned inventory into sales.The lower= inventory is staying in the shop for a long time.

Inventory Turnover — why does managing inventory matter?

Holding inventory incurs costs: (1) funds are tied up that could be used elsewhere (e.g. interest-earning account); (2) storage costs; (3) risk of damage; (4) risk of obsolescence (out of fashion). Excess inventory can prevent paying suppliers or wages.

Inventory Turnover Days — formula and unit

(Inventory ÷ Cost of sales) × 365. Expressed in days.

MEMORY TRICK: flip the formula from inventory turnover and times by 365 (and changed to expressed in days NOT expressed as times). Also REMEMBER to flip the number- this is one of the formulas where the lower the number- the better-you want to hold it for as little days as possible.

Inventory Turnover Days-what does it show

shows us how many days on average it takes to turn inventory into a sale.- the lower the number the better.

Trade Receivables Days — formula and unit

(Trade receivables ÷ Revenue) × 365. Expressed in days.
NOTE: its always SOFP on the top and SPL on the bottom for DAYS ratios.

trade receivables what it tells us?

how quick can you turn a trade receivable into cash.
Measure the average number of days it takes to collect cash form its customers.

The LOWER the better=get cash quicker as it takes LESS days to get cash.

Trade Receivables Days — why might it be high? (3 reasons)

1. Ineffective credit control (not chasing customers for payment).2. Customers have liquidity problems of their own.

Trade Receivables Days — how to manage it

Regular credit checks on future and existing customers. Early payment discounts can encourage prompt payment. Strong credit controls should be in place and customers with unpaid invoices should be chased. Excessive cash tied up in receivables can prevent paying suppliers or wages.

Trade Payables Days — formula and unit

(Trade payables ÷ Cost of sales) × 365. Expressed in days.

The higher the better (as your holding onto the cash for longer so it can be used for other things)-BUT may harm relationships.

Trade Payables Days — what does it tell us?

TL;DR:How quickly a business pays its suppliers on average

The average number of days the company takes to pay its suppliers. Higher is generally better — the longer the company holds onto its cash before paying, the better for liquidity. However, paying too slowly can damage supplier relationships.

Working Capital Cycle — formula, alternative name, and unit and what it tells us

Inventory turnover days + Trade receivables days − Trade payables days.

Also called the cash conversion cycle.

Expressed in days.

Shows how quickly a business can convert the purchase or manufactured inventory into physical cash.

Working Capital Cycle diagram (flow)- dont need to know

Inventories → (sell goods on credit) → Trade receivables → (receive payment from customers) → Cash at bank → (pay suppliers) → Trade payables → (purchase goods on credit) → Inventories.

Working Capital Cycle — what does it tell us?

The number of days it takes to convert resource inputs into cash flows. Lower is better — the lower the cycle, the quicker the company converts its resources into cash. A longer cycle puts more pressure on liquidity.

Liquidity vs Solvency — whats the difference?

Liquidity ratios analyse the SHORT-TERM financial position (ability to meet liabilities within 12 months). Solvency ratios analyse the LONG-TERM financial position (how the company is financed overall and whether it can survive long-term)

Two solvency ratios

1. Gearing. 2. Interest cover.

Gearing — formula and unit

(Non-current liabilities ÷ (Equity + Non-current liabilities)) × 100%. Expressed as a percentage.

Gearing — what does it measure?

Gearing shows how much of a business is financed by debt compared to its own money and reflects financial risk.

How a company is financed (its capital structure). Companies are financed through a mix of: (1) share capital, (2) retained earnings, (3) revaluation surplus, (4) loans, (5) bank overdrafts, (6) leases.

what does a Highly geared vs low geared number represent?

Highly geared: high levels of debt financing; higher interest to pay before ordinary dividends; could indicate more risk including bankruptcy risk. Low geared: not taking full advantage of cheaper financing — debt is cheaper than equity because interest is tax-deductible.

Gearing — so what is a good range

25%–45% is generally considered a good range. However, this depends on the age of the business, the nature of the industry, and other factors — there are always exceptions.

Interest Cover — formula and unit

Operating profit ÷ Finance costs. Expressed in times. (Note: no × 100% — it is a times figure, not a percentage.)

Interest Cover — what does it tell us?

Measures the amount of (operating) profit available to cover interest payable. Higher is better — the higher it is, the more comfortably the company can meet its finance costs (e.g. interest from loan re-payments). Less than 1 means the company cannot cover its interest from operating profit — a serious warning sign. Most companies aim for 8–12 times. Too high could be inefficient since debt is cheaper than equity.

Four investors' returns ratios

1. Dividend cover. 2. Dividend yield. 3. Earnings per share (EPS). 4. Price to earnings ratio (P/E).

What are investors specifically interested in?

a) What are they earning from their investment? b) Are the company's assets being used efficiently — is their capital investment being used well?

Dividend Cover — formula and unit

Profit for the year ÷ Ordinary dividends. Expressed in times.

Dividend Cover — what does it tell us?

TL:DR-compares how many times over the business can use its profit to pay dividends-high=bad because they are not using the profit to pay dividends.Low is good for investors.
Measures the amount of profit available to pay dividends. High dividend cover means the company is retaining a large share of its profits (retained earnings grow but shareholders may be unhappy with lower dividends). Low dividend cover may mean there’s no buffer if profits fall one year, not a lot of profit is being re-invested, they may struggle to maintain this. A ratio below 1 means dividends exceed profit for the year- so they need to pay off dividends using alternatives methods (borrowing, profit from previous years etc)

Dividend Yield — formula and unit

(Dividend per ordinary share ÷ Market price per ordinary share) × 100%. Expressed as a percentage.

Dividend Yield — what does it tell us?

TL:DR compares the actual dividend payment to the market price of the share.

The cash return received on the investment made by an ordinary shareholder. Investors who want income (regular cash) prefer a high dividend yield. Investors focused on capital growth (share price rising) may not be deterred by a low dividend yield.

Earnings Per Share (EPS) — formula and unit

(Profit for the year ÷ Number of ordinary shares in issue) × 100. Expressed in pence.

Earnings Per Share — what does it tell us?

The amount of profit earned per ordinary share in issue. A key measure of share performance. Used to assess the investment potential of a company's shares.
Higher=more profit being returned per share- so an investor would like this
Lower=less profit earned per share-the firm is potentially wasteful with capital from shares

Price to Earnings Ratio (P/E) — formula and unit

Market price per ordinary share ÷ Earnings per share (in £, not pence). Expressed in years.

Price to Earnings Ratio — what does it tell us?(ICL just skip this I dont get it)

Compares the market price of a share to the earnings it generates. Calculates the number of years it would take to recover the share price paid if earnings remained constant. A high P/E is viewed more favourably because: EPS reflects past performance, but market price reflects the market's expectations of future performance — so a high P/E means the market expects strong future growth.

Key principles of ratio analysis (full summary)

1. Different ratios have different purposes — efficiency ratios assess how well assets are used and managed; solvency ratios analyse the long-term financial position and capital structure; investors' returns ratios help investors decide if a company is a worthwhile investment.

All efficiency ratios summary

Inventory turnover (times) = Cost of sales ÷ Inventory [higher better]. Inventory turnover days = (Inventory ÷ Cost of sales) × 365 [lower better]. Trade receivables days = (Trade receivables ÷ Revenue) × 365 [lower better]. Trade payables days = (Trade payables ÷ Cost of sales) × 365 [higher better]. Working capital cycle = Inventory days + Receivables days − Payables days [lower better].

All solvency ratios summary

Gearing = (Non-current liabilities ÷ (Equity + Non-current liabilities)) × 100% [good range 25–45%]. Interest cover = Operating profit ÷ Finance costs [higher better; aim 8–12 times; below 1 = danger].

All investors' returns ratios summary. (these are hard to understand so if u dont get it just skip)

Dividend cover = Profit for year ÷ Ordinary dividends [times; higher = more retained; below 1 = unsustainable]. Dividend yield = (DPS ÷ Market price per share) × 100% [high = income investors]. EPS = (Profit for year ÷ Shares in issue) × 100 [pence; higher better]. P/E = Market price per share ÷ EPS in £ [years; high = market expects growth].