Financial statement consists of

Balance Sheet

- Asset- Liability- Equity

Income Statement

- Income- Expenses

Cashflow Statement

- Cash generated from operating activities – cash from core business (both inflow and outflow)

- Cash generated from investing activities (from investment from other companies and other assets)

- Cash generated from financing activities (from where the funds are raised, such as issuance of additional shares or long term loan, redemption of debentures (outflow), etc.)

Statement of changes in equity – shows the changes in the equity by issuance of shares or converting from retained earnings to ordinary shares issued to shareholders.

- Ordinary Shareso Opening Balanceo Changes during the yearo Closing balance

- Retained earningso Opening Balanceo Changes during the yearo Closing balance

-

Definition of accounting

Classification and recording of monetary transactions

Presentation and interpretation of the results

Monetary projection of future activities

Accounting statements are used as a bridge between business and internal & external stakeholders

Qualitative characteristics of financial information

- Relevance – Only relevant information should be provided based on the context- Comparability – standards should be followed when preparing the a/c statements so

that it is comparable (FRS compliant)- Understandability – it should follow standard so that it can be understood by the users.

Also users need to have some knowledge on how the statements should be read.- Timelines – Accounting information should be prepared in timely basis so that the same

can be used. Otherwise it will become useless- Materiality – some of the information which is of material value (significant), then it

should be either disclosed in the a./c statement of in the Notes to the a/c.- Completeness & Accuracy – The accounting should be complete and should not omit

anything. Otherwise it will not become complete and will not balance and should be accurate

- Verifiability – The a/c prepared should be verifiable.- Balance between cost & benefit – Not to disclose everything. But at the same time, it is

decided which is relevant and important to the user and should be disclosed.

Look into the Balance Sheet to find out what is the current position of the company.

Assets = Liability + Equity

If investing in company which is having high gearing, the returns should be high enough to invest (because we are taking high risk as the probability to go bust very high)

For the short term, cash is important to run business. Whereas in the long term, it is more on profitability. When looking at the profitability, it should be based on the trend.

When looking into the income statement, financial performance can be found

When there is a change required in cash movement, then it needs to be checked in cash flow statement.

DEPS (Diluted Earnings Per Share) – If the people who owns options comes in what is the earnings per share and will affect the investment decisions.

Definition of Finance

Account is historical. Finance is forward looking.

Funds

- Internal Fundo Retained Earnings – since this is the amount pertains to shareholders, expected

return should also be met in using the funds.- External Fund

o Long Term Ordinary Shares – cost involved is to meet expected return otherwise

the shareholder will pull out the money and invest somewhere. Preferential Shares Term Loan Leasing Sales & Buy back for assets Bonds Debentures Etc.

o Short Term Supplier Credit Terms Factoring invoices

Finance should always look into how to reduce the cost

Theoretically Debts financing is of lower cost than the equity

When it comes to investment, the company uses below tools

- NPV- IRR- Payback

Objective of Accounting and Finance

Accounting – to provide useful information to those who make business and economic decisions

Finance – to raise funds and making investment decisions

Assets = Liability + Equity

To know the value of the company, the following will be used

Net worth of the company = Assets – Liabilities

Disadvantages of the company is that the Information should be disclosed

Cost will be more

Agency Theory

Where the owner and the person who manages the company are different

Shareholder is the principal of the company

Boards of directors are engaged by shareholders to make decisions on their behalf.

Agency problem will arise due to conflict of interest

The problem can be solved by means of auditors, shares issuance, performance related bonus, etc. which incurs cost to the company.

Employees are interested in the company accounts for income, stability, carrier advancements

Chapter 2

Value of money changes over time based on

Consumption preferences

Risk preferences

Investment preference

Future Value = P (1+r)n

Present Value = Future Value / (1+r) n

Annuity is used to know how much to be deposited each period so that the future value is achieved after a particular period.

22-Oct-2011

Annuity – Consistently deposit a particular amount over a period of time

Compounding – Deposit one time and wait for the end of the period

29-oct-2011

Budget is a formal written statement of management’s plans for a specified future period, express in financial term

Budgeting – forward looking, how to achieve the target,

If the variance is significant, it needs to be analysed and controlled

Brainstorming – budget is made by management whereas it may be that they don’t have hands on. Hence ideas need to be received from ops. Also brainstorming relates to ideas on cost cutting.

In Japanese company they have something called Kaisen to have inputs of ideas on how to improve the efficiency

Resources – resources required to achieve the target. Also resources such as human resources and data, system, sufficient time, money is required which is also a resource required to prepare the budget.

Company Performance – to know the current performance and what is the target for performance

Negotiation – negotiation with management on targets, negotiate with external party such as suppliers, bankers, negotiate with staffs to set the targets, negotiate with customers (expectation of the market), between departments – how to interact with each other to achieve the common goal of the company.

Importance of Budgeting

- To aid the planning of actual operations – what we are going to achieve in the coming, how to achieve and resources required to achieve the same

- To co-ordinate the activities of the organization – (negotiation)- To communicate plans to various responsibility centre managers – communicate the

information to all the relevant persons to achieve the common goal.- To motivate managers to strive to achieve the budget goals – to motivate for rewards,

appraisal, etc. target should be challenging but achievable. If the target is not achievable it will de motivate the staff rather than motivating.

- To control activities – to see whether the staff is working towards the target by comparing the actuals with the target

- To evaluate the performance of managers

Budget System

Long term planning process

Short terms (annual budgeting process)

1. Identify objectives2. Identify potential courses of action (i.e. strategies)3. Evaluate alternative strategic options4. Select alternative courses of action5. Refer textbook……

Methods of Preparing Budget

- Bottom up budget – participation budgeto Advantages

Achievable Commitment Accountable Improve communication between staff Motivation the staff (as prepared by staff and gives motivation to achieve it)

o Disadvantages

Build in budget slack (which will be waste of resources as each will commit to less than what is achievable)

Too many opinions and will create confusion and will not be able to achieve the goal

Time consuming and requires more effort- Rolling Budget

o When one period expires (month, qtr, etc) one more period added so that it is always for next 1 year

o Advantages Up to date forecasting Immediate response to incorporate controls in the budget Always have clear direction Will have updated and relevant information in future

o Disadvantages Time consuming Moving targets (changing targets) which may create confusion on

organisational goal Could be contradicting with the long term target

- Top down budgeto Advantages

Aligns with the strategic goals of the company Time saving (as it involves resources to participate in budget preparation)

o Disadvantages Domino effect (gives the impression that the company is dominated by

managers) The target may be set targets which may be unachievable which in turn

demotivates the staff No commitment from staff Loss of human capital because of demotivation Survival of company falls in the small group of people

- Zero based budget (priority budget)o Prioritize resources according to the target and not based on the past achievemento Advantages

More focussed on achieving the target Will help innovations (new ideas on achieve the goals more efficiently and

effectively) Gives more freedom to budget to achieve the goals

o Disadvantages Will lead to trial and error Time consuming to support the budget facts The accuracy of the budget is in question as the previous data is not referred Gives way to manipulate the personal goals since past data is not used

- Incremental budgeto Refer to previous year and increase the target by referring to last year

o Advantages Accurate (based on past year) Realistic (based on past year) Time saving Easy to achieve as the budget is already implemented last year and it is well

known what should be done to achieve the targeto Disadvantages

May not increase the performance Not taken into the consideration of current market situations If budget slack was implemented earlier, this system will increase the

wastage Long term goals is not taken care in the budget and will not meet them over

the years.- Consultative budgeting

o Combination of both top down and bottom up budgeting system. Staffs are given opportunity to provide the ideas and this may or may not be taken into consideration when designing the budget by top management.

o Advantages Has certain level of participation Time saving

o Disadvantages Demotivation – if none of the ideas implemented and staffs will be reluctant

to achieve the target No responsibility and accountability – since is more towards top-down as

the budget is prepared by top management.-

Now a days company uses combination of multiple budgeting system

Order of budget preparation

- Sales Budget- Cost of sales budget

o Material budgeto Manpower / labor budgeto Overhead budget

- Selling and Administration budget (selling refers to marketing, human resources, etc.)- Income statement budget- Cash budget

o Capital expenditure- Budgeted Balance Sheet

Example: Sales Budget

ABC S/B sales volume is expected to be 3,000 units I n Qtr. 1 with 500 units increment in each succeeding quarter. Based on the selling price of Rm. 50 per unit, prepare the sales budget for year 2012

ABC S/BSales Budget for Year 2012

Quarter Qtr1 Qtr2 Qtr3 Qtr4Sales Quantity 3000 3500 4000 4500Selling Price per unit (RM) 50 50 50 50

Sales (in Rs.) (RM) 150,000.00

175,000.00

200,000.00

225,000.00

Example: Material purchases Budget

ABC S/B believes that it can meet future sales requirement by maintaining an inventory equal to 20% of next quarter’s budgeted sales volume in units. Prepare the material purchases budget for year 2012. (Assume that each unit of material cost RM 20 to purchase).

Material Purchases budget = Budgeted Sales Volume – Desired Closing inventory – Opening inventory

ABC S/BMaterial Purchase Budget for Year 2012

Quarter Qtr1 Qtr2 Qtr3 Qtr4Budgeted Sales Volume 3000 3500 4000 4500Add: Desired Closing Inventory 700 800 900 1000Less: Opening Inventory 600 700 800 900Materials Required to Purchase 3100 3600 4100 4600

Purchase Price per unit (RM) 20.00

20.00

20.00

20.00

Total Material Purchase (RM) 62,000.00

72,000.00

82,000.00

92,000.00

Example: Direct Labour Budget

It is estimated that each worker able to complete 100 units of product each quarter and each worker will be paid RM 20 per unit of output completed. Prepare the direct labour budget for year 2012.

ABC S/BDirect Labour Budget for Year 2012

Quarter Qtr1 Qtr2 Qtr3 Qtr4

Budgeted Sales Unit 3000 3500 4000 4500

Rate per unit (RM) 20.00

20.00

20.00

20.00

Budgeted Direct Labor Cost (RM)

60,000.00

70,000.00

80,000.00

90,000.00

ABC S/BCost of Sales Budget for Year 2012

Quarter Qtr1 Qtr2 Qtr3 Qtr4Budgeted Material Purchased (RM)

62,000.00

72,000.00

82,000.00

92,000.00

Budgeted Direct Labor Cost (RM) 60,000.00

70,000.00

80,000.00

90,000.00

Budgeted Cost of Sales (RM) 122,000.00

142,000.00

162,000.00

182,000.00

Critically Evaluate – Yes & No and support for both

1.1 Budget process (how this helps to convert the objective to data). The process involved in converting the objective to data.

Yes – It can be measured, gives directions to the employee (overall direction) put the growth in numbers to be able to achieve and focus. Will help to communicate the direction. Think and plan and convert the same to data. Improve communication, teamwork, planning, resources allocation, motivational factors, leadership of the management,

No – External factors – Economical & Political factors, Non participation of staff in preparation of budget, management and control doesn’t give clear direction to the employee then even though very good process in place, people doesn’t know what to do. Not having sufficient time will not convert the objectives and goals efficiently. attitude plays an important role

1.2 –

Yes - to move towards the direction,

No – External factors that makes the budget irrelevant such as inflation, rules and regulations

1.3 –

Yes – identify the area of issue and to respond to the issue, to avoid same mistake to be made in future,

No – cannot be prevented, the factors could be that the budget could be outdated, effective control depends on who implements the control and has human factor. It needs timely and effective response.

2.1

Imposed – Uses human resources that is management

Participatory – extensive human resources required

2.2

Yes – needs to be committed for employees to achieve the common goal of the company, if the employee have the perception that the budget is used to control, then it will have negative impact.

No – in case of top down, it is not necessary to have the correct perception and only required to implement it.

2.3

Yes – It requires communication in both imposed and participatory

No – too much communication can create confusion

Introduction – Objective about preparing the assignment. Should not be more than 350 words

Conclusion – summarize the main topic. Don’t put new points

Communication Flow – Provide table to show differences between imposed and participatory budget.

References – Atleast 20 references

05-11-2011

Fixed & Flexibile Budget

Example: Below are the product cost for 10,000 units of product

Cee RM (Per Unit)Direct Materials 60Direct Labour 30Variable Overhead 25Fixed Overhead (RM 150,000) 15Selling Expenses 15Administrative Expenses (RM 50,000) 5Distribution Expense 10

Total 160

Required:

Prepare a fixed budget and flexible budget (6000,7000 & 8000 units) based on the above information.

Fixed Budget @ 10,000 units UnitsCost / Unit Units Total Cost

Direct Materials 60 10000 600,000.00

Direct Labour 30 10000 300,000.00

Variable Overhead 25 10000 250,000.00

Fixed Overhead 150,000 1 150,000.00

Selling Expenses 15 10000 150,000.00

Administrative Expenses 50,000 1 50,000.00

Distribution Expenses 10 10000 100,000.00

Total 1,600,000.00

Flexibile Budget Units 6000 7000 8000Cee Cost / Unit Total Cost Total Cost Total Cost

Direct Materials 60 360,000.00

420,000.00

480,000.00

Direct Labour 30 180,000.00

210,000.00

240,000.00

Variable Overhead 25

150,000.00 175,000.00 200,000.00

Fixed Overhead 150,000.00

150,000.00

150,000.00

Selling Expenses 15 90,000.00

105,000.00

120,000.00

Administrative Expenses 50,000.00

50,000.00

50,000.00

Distribution Expenses 10 60,000.00

70,000.00

80,000.00

Total 1,040,000.00

1,180,000.00

1,320,000.00

Cash Budget

Three important sections

Cash Receipts

Cash Payments

Ending Cash Balances

Net Inflow / Outflow = Opening Balance +Cash Receipts – Cash Payments

Depreciation and provision for doubtful debts should not be included in the cash budget since these are not cash items and should only be shown as expenses in the income statement.

Example: Cash Budget

For the month of December 2011, below is the cash transactions.

Cash Receipts AmountCash Sales XxxCollection from customers XxxSales / disposal of fixed assets XXX

Total XXXXXXXXX

Cash PaymentsCash Purchases XxxPayments to supplier XxxPayments of salaries, utility bills, etc. XxxTax payments XxxDividend payment XxxPurchases of fixed assets Xxx

Total Xxxxxx

Net cash inflow A-BAdd: Opening Balance b/f XxxClosing Balance C-D

Additional Question 1:

Cash Budget for 3 Months Ending June 30thApril May June

Cash ReceiptsCollection from Sales from Cust 512,000.00 336,000.00 280,000.00Sales 84,000.00 70,000.00 78,000.00Sales of Fixed Asset 22,000.00 0.00 0.00

Total Receipts 618,000.00 406,000.00 358,000.00

Cash PaymentsPayment to Suppliers 396,000.00 252,000.00 171,000.00Purchases 27,300.00 18,525.00 21,450.00Salary & Wages 140,000.00 119,000.00 124,000.00Overhead Expenses 62,000.00 60,000.00 69,000.00Dividend Payment 0.00 55,000.00 0.00Taxation - 5,500.00 -

Total Payments 625,300.00 510,025.00 385,450.00

Opening Balance 110,000.00 102,700.00 -1,325.00Net Cash Inflow / Outflow -7,300.00 -104,025.00 -27,450.00Closing Balance 102,700.00 -1,325.00 -28,775.00

Question 2

Question 3

Flexibile Budget Units 9000 10000 11000 12000

Expense Type

Cost / 10000 Units

Variable %

Fixed Cost

Variable Cost (per Unit)

Total Cost

Total Cost

Total Cost

Total Cost

Group 1 45000 100% -

4.50

40,500.00

45,000.00

49,500.00

54,000.00

Group 2 30000 75% 7,500.00

2.25

27,750.00

30,000.00

32,250.00

34,500.00

Group 3 27000 50%

13,500.00 1.35

25,650.00

27,000.00

28,350.00

29,700.00

Group 4 18000 25%

13,500.00

0.45

17,550.00

18,000.00

18,450.00

18,900.00

Group 5 180000 0%

180,000.00

-

180,000.00

180,000.00

180,000.00

180,000.00

Total

291,450.00

300,000.00

308,550.00

317,100.00

Drawbacks of traditional budget

Traditional budget only emphasise on quantitative factors

Focuses on individual functional area

Emphasizes on a fixed time horizon

Based on incremental approach as previous year’s budget is used as a baseline

Process for effective budgeting

Clearly defined areas of authority and responsibility Realistic goals Participation by managers in setting budgets Acceptance by all levels of management Comparison of actual to budget Immediate action to be taken where comparisions indicate significant deviations from

budget Broken down into periods corresponding to those in the financial statements.

Budgetary slack

Capital Investment Decisions

Since capital investment is a long term, it is important to know how to take decisions. It is important because the expectation that expenditure today will generate future cash

gains It should be in real terms And that greatly exceed the funds spent today Five Main Investment Appraisal Criteria Methods

o Account rate of returno Pay back (doesn’t take into consideration of time value of money)

o Discounted pay back (time value of money)o Net present valueo Internal rate of return

Accounting Rate of Return (ARR)

Advantageso This will be in line with the share holders expectations

Disadvantageso Doesn’t take time value of moneyo Profit can be manipulated which is involved in calculation and hence may not be

accurate

Payback

The number of years it takes the cash inflows from a capital investment project to equal the cash outflows

Advantages

Improve cashflow of the company Will reduce the risk because of able to identify the paypback period Cannot be manipulated Easy to calculate

Disadvantages

Doesn’t take into consideration of returns after payback period Don’t take into consideration of time value of money

Key prnciples underlying investment selection criteria

- Real funds flows can be seen in cash but not in accounting profit- Interest charges become payable as soon as money is made available, for example from

a lender to a borrower not when an agreement is made or contract is signed.

ARR = average accounting profit over the project / initial investment x 100%

Activity 4.4

ARR = 25%

Example:

Company has 2 investment opportunities which the information is as follows

A BInitial Outlay 100,000 150,000Profit for year 1 15,000 20,000Profit for year 2 10,000 20,000Profit for year 3 10,000 25,000Profit for year 4 15,000 25,000

Profit is after charging depreciation. Company accounting policy is to charge depreciation on 4 years based on the straight line basis on all the initial outlay.

Required:

(i) Calculate the ARR for investment A & B(ii) Compute the payback from investment A & B

ARR =

tselvem@hotmail.com

How to find the discount rate for the company – it is based on the cost of capital

Cost of capital -> internal & external

Internal -> Retained Earnings

External Equity & Borrowing

Equity -> Ordinary Shares, Preference Shares

Borrowing -> Short Term & Long Term

The cost for Short Term & Long Term is the interest that needs to be paid

The cost for shares is the expected return from the share holder

The cost for retained earnings is also the expected return from shareholders because the amount pertains to the shareholders.

Discounted cashflow uses time value of many. It is using Net Present Value (NPV) or (IRR) and also it uses projected net cash flow using appropriate discount rate or cost of capital.

Net Present Value – today’s value of the difference between cash inflows and outflows projected at future dates, attributable to capital investments or long-term projects.

the IRR calculates the exact rate of return that a project is expected to achieve, which is the discount rate used that results in a zero net present value of the difference between cash inflows and outflows.

Calculation of IRR

IRR = a% + [(A / (A-B)) x (b%-a%)]

Where

a% = discounting rate that give Positive NPV

b% = discounting rate that give Negative NPV

A = NPV discounted at a%

B = NPV discounted at b%

Discounting Factor = 1/(1+r)^n where r is the discounting rate

Investment Appraisal Methods (Examples – Adhoc)

Question 1

a)Future Value @ end of No. of years 10000Discounting Rate 18%No. of Years 5Discount Factor 0.437109216Net Present Value 4371.092162

b)Future Value @ end of No. of years 5000Discounting Rate 15%No. of Years 8Discount Factor 0.326901774Net Present Value 1634.508869

c)Future Value @ end of No. of years 6000Discounting Rate 10%No. of Years 4Discount Factor 0.683013455Net Present Value 4098.080732

d)Future Value @ end of No. of years 3500Discounting Rate 13%No. of Years 18Discount Factor 0.110812312Net Present Value 387.843093

e)Future Value @ end of No. of years 8500Discounting Rate 8%No. of Years 13Discount Factor 0.367697925Net Present Value 3125.43236

Question 2

Discount Rate 10%Year Cashflow Discounting Factor Present Value

1 2000 0.9091 1,818.182 5000 0.8264 4,132.233 7000 0.7513 5,259.204 10000 0.6830 6,830.135 8000 0.6209 4,967.376 6000 0.5645 3,386.84

Present Value 26,393.97

Question 3

Initial Overlay 19000Discount Rate 12%Year Cashflow Discounting Factor Present Value

1 2000 0.8929 1,785.712 5000 0.7972 3,985.973 7000 0.7118 4,982.464 10000 0.6355 6,355.185 8000 0.5674 4,539.416 6000 0.5066 3,039.79

Present Value 5,688.53

Question 4

Project 1Initial Overlay 15000

Payback Period (years) 3 years

Discount Rate 10%

YearCashflow

Discounting Factor

Present Value

Cumulative Cashflow

1 4000 0.9091

3,636.36 11000

2 5000 0.8264

4,132.23 6000

3 6000 0.7513

4,507.89 0

4 7000 0.6830

4,781.09

0 15000 1.0000

- 15,000.00

Present Value -

12,942.42Project 2Initial Overlay 16000 Payback Period 3 yearsDiscount Rate 10%

8.571429

months

YearCashflow

Discounting Factor

Present Value

Cumulative Cashflow

1 2000 0.9091

1,818.18 14000

2 2000 0.8264

1,652.89 12000

3 7000 0.7513

5,259.20 5000

4 7000 0.6830

4,781.09 -2000

0 16000 1.0000

- 16,000.00

Present Value- 18,488.63

Project 3Initial Overlay 17000 Payback Period 3 yearsDiscount Rate 10%

7.058824

months

YearCashflow

Discounting Factor

Present Value

Cumulative Cashflow

1 3000 0.9091

2,727.27 14000

2 3500 0.8264

2,892.56 10500

3 5000 0.7513

3,756.57 5500

4 8500 0.6830

5,805.61 -3000

0 17000 1.0000

- 17,000.00

Present Value- 18,817.98

Question 5Project X

Initial Overlay 50000Payback Period (years) 3 years

Discount 9% 6 months

Rate

Year Cashflow Discounting Factor

Present Value

Cumulative Cashflow

1 10000 0.9174

9,174.31 40000

2 25000 0.8417

21,042.00 15000

3 25000 0.7722

19,304.59 -10000

4 20000 0.7084

14,168.50

0 50000 1.0000

- 50,000.00

Present Value 13,689.40

Project YInitial Overlay 50000 Payback Period 2 yearsDiscount Rate 9% 0 months

Year Cashflow Discounting Factor

Present Value

Cumulative Cashflow

1 25000 0.9174

22,935.78 25000

2 25000 0.8417

21,042.00 0

3 15000 0.7722

11,582.75 -15000

4 500 0.7084

354.21 -15500

0 50000 1.0000

- 50,000.00

Present Value 5,914.74

Project ZInitial Overlay 50000 Payback Period 2 yearsDiscount Rate 9% 9 months

Year Cashflow Discounting Factor

Present Value

Cumulative Cashflow

1 15000 0.9174

13,761.47 35000

2 20000 0.8417

16,833.60 15000

3 20000 0.7722

15,443.67 -5000

4 20000 0.7084

14,168.50 -25000

5 5000 0.6499

3,249.66 -30000

0 50000 1.0000

- 50,000.00

Present Value 13,456.90

Question 6Project XInitial Overlay 1600000

Payback Period (years) 4 years

Discount Rate 13% 11.2 months

Year Profit DepreciationCashflow

Discounting Factor

Present Value

Cumulative Cashflow

1 -60000 200000 140000 0.8850

123,893.81 1460000

2 80000 200000 280000 0.7831

219,281.07 1180000

3 160000 200000 360000 0.6931

249,498.06 820000

4 200000 200000 400000 0.6133

245,327.49 420000

5 250000 200000 450000 0.5428

244,241.97 -30000

6 250000 200000 450000 0.4803

216,143.34 -480000

7 250000 200000 450000 0.4251

191,277.29 -930000

8 250000 200000 450000 0.3762

169,271.94 -1380000

0Initial Overlay

1600000

1.0000

- 1,600,000.00

Net Present Value

58,934.96

ARR 10.78

IRRa% 13%b% 15%

A58934.9621

5B -

66579.08557

IRR 14%

Discounted Payback

Compute using Present Value instead of Cash Flow

Financial Statement Analysis

1. Balance Sheet (Statement of Finance position)2. Income Statement3. Cashflow statement4. Statement of changes in equity

a. Face / Par value goes as equityb. The premium goes as capitalisation of share premium as reserve (premium is the

difference between the listed price less the par value)

Different ratio classification

Profitability

Efficiency

Liquidity

Financial gearing what are the debts level. How much is the proption of debts over equity. What is the capital structure of the company.

Investment Mostly calculated by investor to check whether the company is worth investing.

Ratio Benchmarks – Ratios may be compared with past periods, similar businesses during the same period, Planned performance

Ratio can only be commented if it is compared with something else, either previous years, or some other benchmarking

Comparision should happen within same industry, same size, etc.

Ratios may be compared with Past periods (trend), similar business during the same period (competitiveness), planned performance (target achievement)

Profitability ratios

Return on ordinary shareholder’s funds (ordinary shares + reserves) = Net Assets

(Net profit after taxation and preference dividend (if any) / (Ordinary share capital + Reserves)) * 100

Return on capital employed (capital employed = funds raised and used by the company) -> used to identify company’s efficiency to use the funds raised and get the returns as performance

(Net profit before interest and taxation / (share capital + reserves + long-term loans)) * 100

Net profit margin

(Net profit before interest and taxation / Sales Revenue) x 100

Gross profit margin

(Gross profit / Sales revenue) x 100

Return on Asset -> how efficiently assets were used to generate income

(Net income / Average total assets) x 100

Efficiency ratios

Average inventories turnover period -> how fast the company can sell stock to customers

(Average inventories held / cost of sales) x 365

Where average inventories held = (opening inventory + closing inventory) / 2

Average settlement period for receivables -> how fast the company is able to collect from the customers

(Trade receivables / credit sales) x 365

Average settlement period for payables-> how fast the company is able to pay to its suppliers

(Trade payables / credit purchases) x 365

Sales revenue to capital employed

(Sales revenue / (share capital + reserves + Non-current liabilities))

Sales revenue per employee

(Sales revenue / Number of employees)

Operating cycle = Average inventories turnover period + Average settlement period for receivables

Cash conversion cycle = Operating cycle – Average settlement period for payables

Main elements comprising the ROCE ratio

(Net profit interest and taxation / sales) x (sales revenue / long-term capital employed) = ROCE

Liquidity Ratios

Whether the company has sufficient liquidity to satisfy short term liabilities

Current Ratio = Current Assets / Current Liabilities

Acid test ratio (Quick Ratio) = (Current assets (excluding inventories)) / Current Liabilities

Gearing Ratios

can be used to find the capital structure

Gearing Ratio = (Long-term (non-current) liabilities) / (Share capital + Reserves + Long-term (non-current) liabilities)

Interest cover ratio = Profit before interest and taxation / interest payable

Investment Ratios

Dividend payout ratio = (Dividends announced for the year / earnings for the year available for dividends) x 100

Dividend Yield ratio = ((Dividend per share / (1-tax%))/Market value per share) x 100

Earnings per share (EPS) = Earnings available to ordinary shares / No. of ordinary shares in issue

Price/Earnings ration (P/E) = Market value per share / Earnings per share

Limitations of ratio analysis

the quality of underlying financial statements (it is based on historical data and may not be relevant)

Restricted vision of ratios The basis for comparison Balance sheet ratios

measure both quanititave and qualitative such as customer satisfaction, growth, etc.