Business Strategy

By Gary Hill,2014-06-17 23:50
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Business Strategy ...

    Business Strategy

    Lecture 1

    Financial Analysis

    ? Liquidity

    ? Performance

    ? Capital Structure

Financial Analysis

Financial analysis is the evaluation of a firm’s past, present and anticipated future

    financial performance.

Its objectives are to identify then firm’s financial strengths and weaknesses and to

    assist in financial planning.

Financial Ratios

Financial ratios are the principal tools of financial analysis, because they can be used

    by a variety of people to help them diagnose the financial well-being of a firm.

People such as accountants, analysts, bankers, managers, investors and owners use

    ratios to evaluate a firm’s financial performance and financial condition and to

    compare these with other like firms or with itself over time. Profitability ratios, for

    example, measure financial performance whereas liquidity ratios measure financial


Users of Financial Ratios

The various people who might be expected to employ financial analysis can be

    grouped as follows:

User Group

    ? Analysts and advisers

    (accountants, investment analysts, credit rating agencies)

    ? Business Contacts

    (creditors, customers, employees, suppliers, trades unions)

    ? Investors

    (Banks, debenture holders, financial institutions, shareholders)

    ? Others

    (competitors, government agencies, public bodies, stakeholders)

Alternatively interested parties can be separated into internal and external users.

Internal External

    ? Directors ? Accountants/analysts

    ? Managers ? Bankers

    ? Employees ? Competitors

    ? Owners/shareholders ? Customers

     ? Government

     ? Investors/lenders

     ? suppliers

Each of these groups, however arranged, will be interested in different aspects of the

    firm’s finances eg. Loan providers will be particularly interested in:

    a) the firm’s ability to meet loan repayments plus interest (i.e. the firm’s

    liquidity and cash-flow position)

    b) the level of existing borrowings (i.e. the firms gearing position)

    c) the availability of assets for security

Employees and trade unions, in contrast will be primarily interested in issues of job

    security and wage negotiations.

A Framework for Analysis

A framework for financial analysis can be developed by seeking answers to the

    following key questions:

    1. Is this business making money, i.e. is it profitable?

    2. Can this business pay its bills on time, ie. Is it liquid?

    3. Is this business using its assets properly, ie. Is it operating efficiently?

    4. Is this business overly dependent on borrowed money, ie. Is it too highly


Selected Ratios can be used to examine a firm’s finances in order to provide answers

    to the questions mentioned above. Ratios to measure:

    1. Profitability

    2. Liquidity

    3. Operating Efficiency

    4. Capital Structure (gearing)

Ratios can be shown in the form of 2:1, 1:1 or as percentages or as so many times.

Risk and Return

Profitability ratios measure return: liquidity, efficiency and gearing ratios measure


Profitability Ratios

A study of the following ratios will help answer question 1.

    Return on in Investment (ROI)

    - the primary ratio

    There are many ways of calculating this ratio; a common one is:

     Net Profit (after interest and tax) x 100 = %


    - Gross Profit Ratio:

    Gross Profit x 100 = %


     Net Profit Ratio:

     Net Profit/sales x 100 = %

     Return on Equity (shareholders’ Funds) ratio:

     Net Profit (after tax and interest) / shareholders’ funds x 100 = %

Liquidity Ratios

A study of the following ratios will help answer question 2

     Level of Working capital

     Working capital = Current assets- current liabilities

     Working Capital should be sufficient to cover:

    a) Paying creditors

    b) Allowing trade credit to customers

    c) Carrying adequate stocks

    Current Ratio

    Current assets: current liabilities

    Eg: 2:1

    Acid Test Ratio

    Current Assets- stock : current liabilities

    Eg: 1:1

Operating Efficiency

A study of the following ratios will help answer question 3

     Stock turnover ratio;

     Cost of sales/average stock = times

     (average stock = (opening stock + closing stock) /2

     Cash turnover ratio:

     Sales for the period / average cash balance = times

     Debtors days (collection period) ratio:

     (Debtors / credit sales) x 365 = days

     Credit days (payment period) ratio:

     (creditors / purchases) x 365 = days

** the difference between credit days and debit days ratios is also an important ratio

    to be controlled

Capital Structure Ratios

A study of the following ratios will help answer question 4

Capital Structure Ratios measure the relationship between debt (external) finance and

    equity (owners) finance, ie. The level of gearing or leverage.

     Gearing Ratio

There are a number of methods of calculating this ratio, a few common methods are:

     (Fixed interest capital / fixed interest + equity) x 100 = %

     Long term loans + pref. Shares / shareholders’ funds x 100 = %

    shareholders’ funds + long tern loans

the gearing ratio gives an indication of a firm’s long term solvency; if the ratio is too

    high this usually suggests over-dependence on external financing and the firm could

    be at risk financially.

    Debt Ratio:

    This ratio shows the proportion of the firm’s total assets which are financed by outsiders and is closely linked to the gearing ratio.

     (Total debt finance / total assets) x 100 = %

     Interest cover

This ratio is also related to gearing as it too gives an indication of longer term

    solvency by assessing the firm’s ability to meet interest commitments.

     Profit before tax and interest & tax = times

     Total interest payable

     Eg. Profit (before tax and interest) = ?50,000

     Interest Payable = ?10,000

     Interest cover = 5 times

     Profit/Investment (ROI)

    Profit/Sales Investment/Sales

Production Selling Admin

    Costs* costs Costs Sales Sales Sales

* Labour costs

    * Material costs

    * Overhead costs

     Fixed Current

    Assets* Assets*

    Sales Sales

    ? Premises ? Stock

    ? Equipment ? Debtors

     ? Fixtures ? Cash

Here the profitability and efficiency ratios have been linked together.

Other Useful Ratio:

Sales Activity Ratios:

    1. Sales per employee

    2. sales per sq. metre of floor space

These ratios are particularly useful in retailing firms.

Limitations of Ratios

Many Ratios are available:

    It is important to be aware that many ratios are available for use in evaluating a firm’s financial performance, and financial analysts may even use different methods of calculating the same ratio!!

Interpret with care:

    Ratios need to be interpreted with care, and used selectively, and their results interpreted with care.

Accounting Policies:

    The use of differing accounting policies and procedures may distort comparisons: you need to compare like with like.


    Whatever the method of calculating a ratio is chosen it should be applied with consistency.

Information Availability:

    The quality and amount of financial information available will affect the quality of the ratios calculated and hence the quality of the analysis.


    Ratios are static, historic and retrospective: they may not be appropriate for making future projections.


Financial ratios are partial. They only reveal part of a firm’s overall performance,

    other non-financial measures eg, marketing, production, quality and manpower are also required.

    Financial ratio analysis on its own can give a misleading picture and must be used in conjunction with a more rigorous analysis of the business.

Financial Ratios Other considerations

Reasons for Analysis:

    It is important to consider why the analysis is being carried out and by whom as this will influence the choice of ratios.

Target Ratios:

Set target or standard ratios and compare actual performance with targets/standards



Use a cross-sectional analysis to compare the firm’s ratios with those of other firms in

    the same market sector at the same time eg. Industrial or retail sector averages.

Ensure comparability:

Compare like with like, size with size and same market sector.

Highlight Trends:

Use time series analysis to determine and highlight trends in a firm’s ratios over time


Use graphs and charts to facilitate presentation and understanding

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