Financial Analysis

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

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

Financial RatiosRatios

Profit & Loss Balance Sheet Account

Income and Assets andExpenditure Liabilities(Revenues & Costs) (Company Worth)

Different Types of Ratios

Liquidity RatiosSolvency or Gearing Ratios

Activity RatiosProfitability RatiosInvestor Ratios

Strategic Aspects of Financial Analysis

The Dupont Strategic Profit Model

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.

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 …

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 …

Margin Management

The implication here is :That Managers can control costs.

However there is a paradox:

Cost control strategies compete with growth strategies

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.

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.

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

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

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)

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

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.

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

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

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

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

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

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..