Why do we need Financial Analysis ? We need to Know: • How profitable the firm is • The trading position of the firm • The firm’s solvency • The way in which the firm is funded • What are the important trends
The Company’s Cash-Cycle Raw Materials Work in Progress Finished Goods Working Capital Cycle Labour Costs Overheads Sales Creditors CASH POOL Debtors Yearly Cash Flows Capital Dividends Loans/Overdrafts Investment Taxation Rights Issues Interest Govt Grants Equity
Financial Ratios Ratios Profit & Loss Balance Sheet Account Income and Assets and Expenditure Liabilities (Revenues & Costs) (Company Worth)
Different Types of Ratios • Liquidity Ratios • Solvency or Gearing Ratios • Activity Ratios • Profitability Ratios • Investor Ratios
Strategic Aspects of Financial Analysis The Dupont Strategic Profit Model
Dupont Model The Dupont Model looks at the relationships between COSTS and REVENUESand the way assets are deployed and used by the firm. The Model shows how company returns are affected.
Dupont Model The Dupont Model implies that Profitability can be improved by three sets of means: • Margin Management • Asset Management • Leverage 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 optimization 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 Foods • The 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 Spencer • The 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 Management Firms 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 refelects 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 Equity ROE 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
Iso-ROE Curves for two firms A & B Firm A Net Profits/ Total Assets = ROI Firm B Firm A & Firm B have the same ROI but not ROE due to the leverage effect Total Assets/Total Equity = Leverage proxy
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 eg. scrip issue, special shares etc..