Ch 16 Financial Statements Analysis PDF

# Chapter 16 - Financial Statements Analysis ## Introduction This chapter focuses on analyzing financial statements and ratios to evaluate a business's: - Profitability - Liquidity - Efficiency of inventory management - Efficiency of trade receivables management ## Stakeholders Stakeholders inc...

# Chapter 16 - Financial Statements Analysis ## Introduction This chapter focuses on analyzing financial statements and ratios to evaluate a business's: - Profitability - Liquidity - Efficiency of inventory management - Efficiency of trade receivables management ## Stakeholders Stakeholders include: - Owners and shareholders - Managers - Employees - Competitors - Lenders - Government - Suppliers - Customers ## Financial Statement Analysis ### Purpose: - To make informed decisions - To evaluate profitability, liquidity, inventory management, and trade receivables management ### Tools: - **Absolute Figures:** Used to compare performance across time. - **Financial Ratios:** Express a relationship between at least two absolute figures and can be compared across time or against another business. ## Profitability ### Definition: The ability of a business to generate excess income to cover its expenses. ### Measuring Profitability: #### Absolute Figures: - Gross profit - Profit for the period - Sales revenue - Service fee revenue - Cost of sales #### Financial Ratios: - Gross profit margin percentage - Mark-up on cost percentage - Profit margin percentage - Return on equity percentage ### Ways to Improve Profitability: 1. **Sell goods at higher selling price:** Buy in bulk to obtain trade discounts. 2. **Buy goods at lower cost price:** Switch to a supplier that offers lower prices without compromising quality. 3. **Increase sources of other income:** Sublet excess space, pay early to take advantage of cash discounts. 4. **Reduce operating expenses:** Reduce the use of electrical appliances, hire freelancers or part-timers, negotiate for lower rental, relocate to a cheaper premise, capitalize on technology to reduce manpower costs. ### Absolute Figures A business should make a gross profit from buying and selling goods. If there's a gross loss, then the business is selling its goods at a price below its cost price. This can cause a business to be less competitive. The formula for gross profit is: - Gross profit (or loss) = Net sales revenue - Cost of sales ### Importance of Profit: A business should be able to make a profit so that it can be reinvested into the business. The formula for profit (or loss) for the period: - Profit (or loss) = Gross profit (or loss) + Other income - Other Expenses ## Liquidity ### Definition: The ability of a business to convert current assets into cash to pay current liabilities. ### Measuring Liquidity: #### Absolute Figures: - Working Capital #### Financial Ratios: - Current ratio - Quick ratio ### Ways To Improve LIquidity: 1. **Increase sources of cash:** Obtain cash contribution from owner or shareholders, obtain a long-term loan, sell excess non-current assets. 2. **Manage cash outflow:** Reduce operating expenses, negotiate for better credit terms from suppliers. ### Absolute Figures - Working Capital: The excess of current assets over current liabilities. Working capital formula: *Working capital = Current assets - Current liabilities* ### Liquidity Ratios - **Current Ratio:** Measures a business's ability to pay its short-term debts. *Current ratio = Total current assets / Total current liabilities.* The acceptable norm varies from industry to industry, but a general benchmark to use is 2. The higher the current ratio, the more liquid a business. - **Quick Ratio:** This ratio measures a business's ability to pay its short-term debts using quick assets which can be converted into cash quickly. *Quick Ratio = (Total current assets - Inventory - Prepayments) / Total current liabilities*. The acceptable norm also varies, but a general benchmark to use is 1. The higher the quick ratio, the more liquid a business.. ## Efficiency in Inventory Management ### Definition: Maintaining inventory at an optimal level to meet customer demand. ### Measuring Efficiency: #### Ratios: - **Rate of Inventory Turnover:** The number of times a business has sold and replaced its inventory during a period. The higher the rate, the more efficient the business is at inventory management. *Formula: Rate of inventory turnover = Cost of Sales / Average Inventory.* - **Days Sales in Inventory:** The number of days that a business takes to sell its inventory. The fewer the days, the more efficient the business is. *Formula: Days sales in inventory = (Average inventory x 365 days) / Cost of sales.* ### Ways to Improve Efficiency: 1. **Sell inventory faster:** Reduce selling price for slow-moving goods, provide trade discounts, attract more customers. 2. **Keep sufficient inventory on hand:** Use technological tools to track inventory, monitor inventory level closely. ## Efficiency in Trade Receivables Management ### Definition: Granting appropriate credit terms to promote sales and collecting cash from credit customers on a timely basis. ### Measuring Efficiency: #### Ratios: - **Rate of Trade Receivables Turnover:** How many times a business collects payment from its credit customers. The higher the turnover, the more efficient a business is at managing trade receivables. *Formula: Rate of trade receivables = Net credit sales revenue / Average net trade receivables OR Net credit service fee revenue / Average net trade receivables.* - **Trade Receivables Collection Period:** The number of days it takes a business to collect payments from its credit customers. The shorter the collection period, the more efficient a business is at managing trade receivables. *Formula: Trade receivables collection period = (Average net trade receivables x 365 days) / Net credit sales revenue OR (Average net trade receivables x 365 days) / Net credit service fee revenue.* ### Ways to Improve Efficiency: 1. **Improve Credit Granting Processes:** Monitor collection patterns, ensure credit is granted to customers who are financially stable. 2. **Provide Monetary Incentives:** Offer cash discounts to encourage early payments. 3. **Increase Debt Collection Efforts:** Send reminders, engage professional debt recovery agencies. ## Formats of Financial Statements The document includes formats of financial statements for three business types: - **Trading Business** - **Service Business** - **Sole Proprietorship** Each format includes: - **Assets:** Non-current assets and current assets - **Equity and Liabilities:** Owner's equity, Non-current liabilities, Current liabilities The document also includes a format for a **Private Limited Company** financial statement. This format is very similar to a sole proprietorship format but includes shareholder's equity categories such as share capital and retained earnings. ## Formulas & Calculations The document provides formulas for calculating: - The various financial ratios mentioned throughout this chapter - Working capital - Average inventory - Average net trade receivables. These formulas are very important for analyzing a company's financial performance and overall health. They are used to provide a more comprehensive understanding of a company's profitability, liquidity, efficiency in inventory and trade receivables management, and ultimately, its attractiveness as an investment.