Lecture Wk 6: FS Analysis & Interpretation with Ratios


Things to think about more:

  • Why EBIT is used;

  • Importance of each ratio;

  • Relationship charts

  • AI limitations in ratio calculations

FS Analysis Applications:

Informs judgements & decision making concerning:

  • Determining good investments;

  • Significance of debt burden;

  • Improving efficiency;

  • Determining sustainability long term;

  • Cash flow management;

  • Good strategy execution;

  • Etc. etc.



Also need:

  • Cash flow statements  

  • Information regarding specific assets and liabilities


Relationships between statements:


Gaining Meaning from Financial Reporting:


Accounting as Data Storytelling:

  • Examine relationships between diff accounting numbers

→ E.g. ratio between profit/loss, assets/liabilities etc. etc.;

→ In isolation, single figures mean nothing (e.g. company has $50000000 yearly income but does not disclose $60000000 losses each year);

  • Benchmark comparisons:

→ Can provide clearer picture about relative performance;

→ Benchmarks may include: similar businesses (size, goal, etc.), same business but diff time frame, firm specific benchmarks (management and analyst forecasts, etc.), heuristics



NOTE: EBIT (Earnings Before Interest & Taxes)

→ EBIT entails business operational costs (irrespective of financing and taxation)


Ratios Types & Key Questions:


  1. Profitability

  • Measures effectiveness of profit generated by firm vs operational costs;

  • How efficienctly assets are used to generate profit; &

  • Ability to turn revenue into profit


  1. Efficiency:

  • Managing assets to generate sales;

  • Quickness in collecting customer payments; &

  • Efficiency of inventory &/or resource use


  1. Liquidity:

  • Ability to meet short-term obligations (liabilities);

  • Ability to convert assets → cash (quickness and availability); &

  • Company resilience to short term economic volatility (unexpected events)


  1. Leverage/Gearing/Capital Structure:

  • How financed is company by debt vs equity;

  • Ability to meet long-term obligations;

  • Risk from capital structure

  • Sustainability of debt 


  1. Market Performance:

  • Relative valuation of shares compared to peers;

  • E.g. undervalued or overvalued compared to competitors



Caveats of Interpretation and Benchmarks:


Ratios:

  • Based on accounting numbers;

  • Accounting definitions must be considered for assets, rev, etc.;

  • Accounting measurement bases vary (harder to get faithful or consistent valuations);

  • Standards may change affecting comparability w/ other companies or measurements;

  • Recognition and measurement often based on judgement not objective standards


Benchmarks:

  • Comparisons need to be apples to apples; w/

  • Focus on trends and change to tell story;

  • Still requires context


Key Ratio Interpretation Table:



Ratio Calcs:

NOTE: probably will not need to remember any formulas or even compute difficult ratios;


  • What calculations are used may vary depending on source;

  • Consistency in calculation crucial for making comparisons and analysing trends;


Focus here should be on what a ratio represents rather than computation;


E.g. qualitative analysis of performance:

Profit of A is higher than B → How much higher: not a lot, a bit, a lot, etc.


Working Capital & Cash Flow Management:


  • How much financial capital needed for operational costs?

→ Working Capital = Current Assets - Current Liabilities

  • How much Working Capital & Cash is needed for operational purposes?

→ Operating cycle = Inventory Days + Accounts Receivable Days 

→ Cash cycle = Inventory Days + Account Receivable Days - Account Payable Days 




  • Reducing operating cycle frees up funds for better use;

  • Can be achieved by:

→ Reducing inventory days: holding less inventory at a time (caution);

→ Reducing receivable days: Tighten credit terms, better manage receivables 

  • Reducing cash cycle can be achieved by:

→ Reduce inventory and/or payable days (same as before);

→ Increase payable days;

  • Negotiate better business terms (caution);

  • Better manage payables (stretch payments as long as possible) (caution)


READ UP ON JUSTIFICATION FOR WHY SHORTENING CYCLES LESSENS REQUIRED CASH + CAPITAL


AI difficulties w/ ratios:

  • Decent for computations; but

  • Descriptively poor; in that

  • Essentially regurgitates stats but doesn;t provide any context; e.g.

  • Why (justification) for an interpretation (see slides)