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Financial Analysis
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Why do we need Financial Analysis?
We need to Know:How profitable the firm isThe trading position of the firmThe firm’s solvencyThe way in which the firm is
fundedWhat are the important trends
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The Company’s Cash-Cycle
Work
ing C
apital
Cycle
Yearly C
ash
Flow
s
Creditors CASH POOL Debtors
Raw Materials Work in Progress Finished Goods
Labour Costs Overheads Sales
Capital Dividends Loans/OverdraftsInvestment Taxation Rights Issues Interest Govt. Grants Equity
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Financial RatiosRatios
Profit & Loss Balance Sheet Account
Income and Assets andExpenditure Liabilities(Revenues & Costs) (Company Worth)
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Different Types of Ratios
Liquidity RatiosSolvency or Gearing Ratios
Activity RatiosProfitability RatiosInvestor Ratios
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Strategic Aspects of Financial Analysis
The Dupont Strategic Profit Model
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Dupont Model
The Dupont Model looks at the relationships between COSTS and REVENUES and the way assets are deployed and used by the firm. The Model shows how company returns are affected.
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Dupont ModelThe Dupont Model implies that
Profitability can be improved by three sets of means:
Margin ManagementAsset ManagementLeverage Management
Let’s look at each in some detail …
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Margin Management As the term implies managers
have control of profit margins in their businesses
Firms can set specific gross margins %age goals and emphasize the optimisation of the differences between costs and revenues.
However …
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Margin Management
The implication here is :That Managers can control costs.
However there is a paradox:
Cost control strategies compete with growth strategies
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RHM FoodsThe labour content of RHM
Foods manufacturing is already low and at least half its costs are materials and packaging which are not easily controllable.
RHM could cut overheads - HQ staff and marketing costs etc.
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Marks and SpencerThe biggest difference to our
business is the way in which we sell our goods. We need to sell our products at full price and at targeted margins.
Others have tried to build sales at the expense of profits and look at where they are now.
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Asset Management Managers must control the Assets
that they use. Asset usage is linked with margins and ultimately with Returns on Investment and Return on Capital
In practice managers are likely to control their Current Assets more effectively than their Fixed Assets, as capital assets are ‘fixed’ over the short run
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Asset ManagementFirms have devised ways of managing
their current assets to improve their efficiency and their yields.
JIT Systems EDI Systems Debtor Control Systems
Asset management is directly linked to ROI
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ROI and its Derivation
ROI = Net Profits x 100 Total Assets
ROI = Net Profits x 100 x Sales Sales Total Assets
Net Margins Asset Turnover(Marketing Effectiveness) (Production Effectiveness)
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Leverage Management
Leverage or gearing is about managing the debt in the company. It reflects the ability of the firm to successfully employ debt in its capital structure.
Leverage or gearing can effect the ROE Firms with similar ROIs may have
different ROEs due to the gearing effect
Growth strategies and debt funding
are related
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Return on EquityROE is perhaps the most important
ratio from the strategic management point of view and understanding how it is linked to : The Capital Structure Return on Assets Dividend Payout
ROE issues are essential for formulating strategic plans.
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ROE and its Derivation
ROE = Net Profit x 100 Total Equity
ROE = Net Profit x 100 * Sales x Total Assets Sales Total Assets Total Equity
ROI Leverage Marketing Production Financial Effectiveness Effectiveness Effectiveness
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Total Assets/Total Equity =Leverage proxy
Net Profits/ Total Assets= ROI
Firm BFirm A
Iso-ROE Curves for two firms A & B
Firm A & Firm B have thesame ROI but not ROEdue to the leverage effect
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Growth Strategy and Finance
Financial Strategy 1: Boost growth by raising the debt
to equity ratio
Financial Strategy 2: Reduce the interest paid on debt
by seeking cheaper sources of funds - shareholders
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Growth Strategy and Finance
Marketing Strategy - increase rates of return by doing the following: Volume Strategy - selling more
through lower prices Revenue Strategy - raising prices
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Growth Strategy and Finance
Manufacturing Strategy: Increase rates of return on assets by: Improving production efficiency
through reducing unit costs Improving production by increasing
volume using fewer assets
Contracting out hollowing out
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Growth Strategy and Finance
Dividend Strategy - reducing the payout Reducing the dividends paid out Retaining earnings to fund
growth operating a more tax efficient
payout systems e.g. scrip issue, special shares etc..