Financial Reporting – (More) Financial Statement Analysis

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

Financial Gearing

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

Gearing Ratio

non current liabilities ÷ (share capital + reserves + non current liabilities)

Interest Cover Ratio

Operating Profit ÷ Interest Payable

Investment Ratios

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!


About Shaun
I'm super cool and I do computer science (unrelated to the coolness)

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