W13 - FINANCIAL STMT ANALYSIS - FINANCIAL STATEMENT...

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1 FINANCIAL STATEMENT ANALYSIS
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2 AN ILLUSTRATION OF THE NEED FOR AND USES OF ACCOUNTING RATIOS TO EVALUATE PERFORMANCE /PROFITABILITY/RETURN 1. Comparisons between entities – which of the following companies is the most profitable? Co. A Co. B £’000 £’000 Profit 200 1,000 Net assets 500 10,000 Return 40% 10%
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3 2. Comparisons over time – has there been an increase or decrease in profitability from one year to the next? Previous Current year year £’000 £’000 Profit 900 1,000 Net assets 8,00010,000 Return 11.25% 10% In both cases a comparison of the absolute profits would give a misleading evaluation which needs to be made in terms of the return.
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4 THE FUNCTIONS OF RATIO ANALYSIS The main function of ratio analysis is to enable users of published accounts to evaluate the financial performance and financial position of the reporting entity for the purpose of making share trading, lending and/or voting decisions. This usually takes the form of: 1. Comparisons with other entities (interfirm); and/or 2. Comparisons over time (time series analysis).
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5 THE CLASSIFICATION OF RATIOS 1. Measures of an entity’s financial performance 2. Measures of solvency and liquidity 3. Measures of the control of working capital 4. Measures of return on investment and risk
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6 MEASURES OF A COMPANY’S PERFORMANCE Return on capital employed (ROCE) Profit margin Asset turnover ratio
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7 RETURN ON CAPITAL EMPLOYED (ROCE) Profit before tax and interest x 100 Net capital employed Where net capital employed = shareholders interests + long term liabilities = total assets – current liabilities. Net capital employed at the start or end of the year, or an average for the year?
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8 ROCE is a measure of profitability that indicates how efficiently and effectively a company has utilized its assets/capital during a given accounting period. However, the use of historical cost data in times of rising prices overstates the ‘real’ return, and encourages the retention of old assets .
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9 PROFIT MARGIN Profit before tax and interest x 100 Turnover/sales This shows what percentage of sales revenue is profit. Different products/ industries and different sized businesses have different profit margins. Inter firm comparisons should therefore be limited to companies in the same industry of a comparable size. Variations in the profit margin over time may be due to changes in sales mix, selling prices and/or unit costs.
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10 ASSET TURNOVER RATIO Turnover/sales Net capital employed This shows the amount of sales revenue generated per £ of capital employed. It is a measure of the level of activity and productivity.
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Labour intensive industries usually have a high asset turnover ratio, whereas capital intensive industries normally have a low asset turnover ratio. Interfirm comparisons should therefore be limited to companies in the same industry. Changes in the asset turnover ratio over time may be due
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W13 - FINANCIAL STMT ANALYSIS - FINANCIAL STATEMENT...

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