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 c