Financial Reporting – (More) Financial Statement Analysis
January 8, 2010 Leave a comment
More Financial Statement Analysis
Let’s start with some recapping from the last section.
- Let’s say that a company’s average debtor payback time in 2008 was 62 days, and in 2009 was 31 days. A possible reason for this is that the company has improved their credit control procedures, meaning they now collect their debts more quickly.
- The quick ratio (aka acid test ratio) is a measure of liquidity, as it compares the current assets of the business that are ‘liquid’ with their current liabilities.
- The gross profit margin doesn’t need to be at any set value to mean a company is doing well. What a ‘good’ profit margin is depends on the industry you’re talking about. Here’s an example:
- When the iPhone came out it cost Apple $250 to build it, but they sold it for $599, so they were making a 40% profit on each one, so it was very high margin
- McDonalds has around 7% profit margins on their items, so it is low margin, although actually quite high for that industry
- Creditor days tell you how long it takes a business to pay it’s suppliers
When a business is financed by borrowing, financial gearing is happening. This is an important indicator of risk.
There are a few reasons why a business might want to be ‘geared’ (funded by borrowing):
- They might need more money than they have (the obvious one)
- Debt is cheaper as a form of finance, and is less risky to the lender
- Interest expenses are tax deductible
Ratios concerning financial gearing
There are 2 that you need to know:
- The gearing ratio: Measures how much of the business’s capital is coming from long term lenders
- Interest cover ratio: How much operating profit is available to cover interest that is payable
non current liabilities ÷ (share capital + reserves + non current liabilities)
Interest Cover Ratio
Operating Profit ÷ Interest Payable
These assess the returns and the performance of the business
There are 3 this time:
Earnings per share
Earning available to ordinary shareholders ÷ Number of ordinary shares issued
Dividend cover ratio
Earning for the year available for dividend ÷ Dividend announced for the year
Price to earning ratio
Market value per share ÷ Earnings per share
- A measure of market confidence in the future of the business
- Supermarkets have a high ratio for this
- Gas companies have a low one
Limitations of using ratios
- You need benchmarks to compare them to
- Context is important, you need to know what is a ‘good’ ratio
One more to go!