Accounting: Understanding Financial Statements and Financial Analysis | John Colley | Skillshare

Accounting: Understanding Financial Statements and Financial Analysis

John Colley, Digital Entrepreneurship

Accounting: Understanding Financial Statements and Financial Analysis

John Colley, Digital Entrepreneurship

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21 Lessons (2h 5m)
    • 1. Financial Analysis Course Introduction

    • 2. Overview of Financial Statements

    • 3. GAAP Accruals vs Cash Accounting

    • 4. Income Statement or Profit and Loss Account

    • 5. Introduction to the Balance Sheet

    • 6. Introduction to the Cash Flow Statement

    • 7. Cash Flow Metrics Explained

    • 8. Case Study Apple Financial Statements

    • 9. What is Financial Analysis

    • 10. Measures of Profitability Financial Analysis

    • 11. Balance Sheet Ratios

    • 12. Cash Flow Statement Analysis

    • 13. Valuation Ratios

    • 14. Now Its Time To Do The Course Project

    • 15. Apple Inc. Financial Analysis Assignment

    • 16. Apple Inc. Financial Analysis Solution

    • 17. Measures of Growth Discussion

    • 18. Measures of Profitability

    • 19. Measures Of Trading Performance

    • 20. Working Capital Liquidity & Efficiency

    • 21. A Few Closing Thoughts

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About This Class


Understanding Financial Statements and Financial Analysis

Join 30 year senior Investment Banker, John Colley to discover how to understand the three principal financial statements every budding analyst should know.  But this course goes further and shows you how to analyse these statements to help you to interpret the numbers.

Whether you are in a Wall Street job or want to have one, this course will share with you the key step by step information you need to know about the Income Statement, the Balance Sheet and the Cash Flow Statement.

There is a detailed (challenging and fun) project for you to engage with which is also then discussed in detail in the course. 

At the end of this you will be able to:

1. Understand the three financial statements

2. Know which Ratios to use in their analysis

3. Do the actual Ratio Analysis yourself!


These are the detailed course notes to help you to benefit from the Course.

Overview of Financial Statements

A Strategic Plan needs a solid financial foundation. You need to be able to forecast your future performance on the basis of your strategic planning. In this section and the financial sections that follow we are going to work together to develop that essential grounding.

GAAP: Accruals and Cash Accounting

It is important when working with Financial Statements that you understand the difference between Accrual Accounting and Cash Accounting.  Leading on from that Accrual Accounting is prepared to a set of common standards and principles, in the US set out in the "Generally Accepted Accounting Principles" or GAAP.  This lecture explains what this all means and why it is important to understand when working with the Income Statement, the Balance Sheet and the Cash Flow Statement.

Income Statement or Profit and Loss Account

The Income Statement or Profit and Loss Account is one of the three major financial statements and shows the profit or loss made by the firm during the accounting period.  This can be months, quarters or years.  This lecture will help you to understand the key lines in the statement so that we can move forward with our strategy and business planning later on.

Introduction to the Balance Sheet

The Balance Sheet is the second of the primary financial statements of the business.  It is a measure of the total assets and liabilities of a business at a snapshot in time.  It must always balance! The Assets must always equal the Shareholders's Equity and the Total Liabilities.

Introduction to the Cash Flow Statement

Cash is critical and cash is King! So we need to know how much cash is generated or used by a business during the accounting period.  Welcome to the Cash Flow Statement.

Cash Flow Metrics Explained

What do we mean by Cash Flow?  Well it depends…on which numbers you use

I thought it would be helpful to discuss the range of possible cash flow metrics and understand what they mean.

We discuss and explain the differences between:

  • Cash Flow from Operating Activities
  • Free Cash Flow
  • Free Cash Flow to Equity
  • Free Cash Flow to Firm

Case Study: Apple Financial Statements

This is a small case study to show you a real set of financial statements - from Apple Inc.  You will be able to recognise all the key areas of the three main financial statements we have been working through.

Financial Analysis

What is Financial Analysis?

Financial Analysis is the analysis of a company and its performance using financial and numerical data. This involves working with historic data and creating an integrated financial model to forecast future performance. 

There are 12 Types of Financial Analysis:

1. Vertical

2. Horizontal

3. Leverage

4. Growth

5. Profitability

6. Liquidity

7. Efficiency

8. Cash Flow

9. Rates of Return

10. Valuation

11. Scenario and Sensitivity

12. Variance

Measures of Profitability Financial Analysis

The first group of Financial Ratios are the Measures of Profitability and we are going to look at these in a little detail in this lecture.  They are focused on the Income Statement/Profit and Loss Account although we do draw on the Balance Sheet for two of the ratios.

Balance Sheet Ratio Analysis

Balance Sheet ratios measure the operational efficiency of a business

These are divided into:

  • Liquidity ratios
  • Leverage ratios
  • Operating Efficiency Ratios

We look at each of these groups to see what we can learn about the business and how you can use these ratios to improve business operating efficiency.

Cash Flow Statement Analysis

The Cash Flow Statement is less useful for direct ratio analysis but it provides a considerable amount of useful information about the business if we know how to read and interpret it.  We can also use if for horizontal time based analysis too of course.

Valuation Ratios

Valuation Ratios are very helpful for management and investors to measure the value of the company and its common stock.  These are widely used and you need to understand them.

Financial Analysis - Case Study and Assignment

Case Study Assignments Apple Inc Financial Analysis

Prepare a professional Financial Analysis from Apple's audited financial statements using the spreadsheet provided for you and then answer the 21 questions relating to the financial ratios you will have calculated in the spreadsheet

Apple Inc Financial Analysis - Solution

Here is the solution to the Assignment in the form of a completed spreadsheet which you can download and use.  I do hope you spent time on the assignment as there is no substitute for experience but I wanted to make sure that you had a completed spreadsheet.  The Statements are also included in the Slide Deck and you can download the Slide Deck PDF from the resources section too.  

Discussion of Measurements of Growth Analysis

This lecture covers a detailed discussion of the Measures of Growth Financial Analysis from the Assignment to make sure that you understand what we are calculating and why we are calculating it.

Discussion of Measures of Profitability Analysis

This discussion focuses on the second of our two groups of ratios and we are looking at Returns on Capital and Gearing.  These help us to understand both the performance of the firm and the level of financial risk.

Discussion of Trading Performance Analysis

This discussion focuses on the three measures of Trading Performance that we produced in the Assignment.  This discussion is designed to ensure that you properly understand what these are and what they are telling you about a business.

Discussion of Working Capital (Liquidity and Efficiency) Analysis

This discussion focuses on the three measures of Trading Performance that we produced in the Assignment.  This discussion is designed to ensure that you properly understand what these are and what they are telling you about a business.

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John Colley

Digital Entrepreneurship


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1. Financial Analysis Course Introduction: welcome to this course where you're going to learn how to interpret and analyze the three main financial statements. Income statement. Balance sheet on the cash flow stayed in a really easy to follow step by Step away. I'm John Colley on the 30 year senior investment banker on. When I had my first company report back in 1988 I could not make head or tail of it. Fortunately, I was working for one of the leading city investment analyst, she spectacle. Considerable amount of valuable time. Helping me to get started as well is doing all her final Thank you, Paula. Don't forget to follow me to make sure that you don't miss any of my future courses, particularly those on finance and stashed. In this course, you'll discover three things. How to read the financial statements, key ratios you need toe. Analyze them on critically how to analyze them yourself, using a bespoke project that I put together, complete with all the answers on after that, a detailed discussion. Everything you need is here. I've sent it out to make it as easy as possible. If you're Bunning analysts working in finance the finance function of all you want to work on Wall Street or in the City, then this is a great stuff. You won't regret investing the time in yourself by taking this course the way this course is for everyone, whatever your standard, even if your experience with financial statements, because I know you're going to get an awful lot of fun from the challenge off during the project in this course discover amazing stories. The financial statements could tell you about this. Impress your boss with your knowledge and insights. Learn how to interpret rather than just read the numbers. It's all here. At the end of this class, you will be able to read and understand ALS three financial statements on how they relate to one another. And did I mention the assignment you're going to love completing the assignment, using a real spreadsheet that I have used time and time again in my investment banking career at such organizations as Security, Pacific West, Georgia Landers, Bank, Charter West, L. B and sausage, Asian. And so what are we waiting for? We have a lot to cover, so let's get started now and I look forward to seeing you in 2. Overview of Financial Statements: Now we've come to the section which deals with the financial information. We're going to look at both for our strategic plan on for our business plan. So I want to give you a little summary quickly and over. Overview, if you like, of what's coming up so that you can start to think on understand how these two elements fit together. A strategic plan clearly needs toe. Have a solid financial foundation. You need to be able to forecast your future performance on the basis of your strategic planning on the assumptions that go in it. However, this is not a modeling course. I'm not going to teach you how to build an integrated financial model. I'm already trying to cover a huge amount of ground on. This isn't the right place to go and do that, but I am going to give you a very solid grounding in the financial information. This section on the financial sections that follow it are designed to give your strategic plan these essential financial foundations you need to understand and be able to work with the three main financial statements, the profit and loss account or income statement. The balance sheet on the cash flow statement. You'll need a grounding in financial analysis, which I'm going to provide to you. I'm going to give you the high level picture and I'm gonna give you lots of detail because you're going to need to be able to calculate on Dwork with the key elements of ratio. Analysis on this includes their interpretation and we are going to cover that too. So this section is going to start with an introduction to the three main financial statements Onda Small Case study sharing you a set of real statements. I'm actually going to give you a set off statements from Apple's reporting accounts their 10-K and show you what they really look like for real. But after I've talked, take new through the three statements themselves. So when you look at them, you should be able to read through them and understand how they laid out in the critical sections off them. I'm also going to show you the financial information and explanations you will need to include in your business plan on. I want you to start thinking about that as well. So, while you're learning about financial information, financial analysis at the same time. You understand how the business plan is going to dovetail with the information that you're working working with. So that's the number of you to this section and to the financial sections that follow. I think this is going to be a really interesting section. I've got a lot to share with you on. I can't wait to get started. 3. GAAP Accruals vs Cash Accounting: If you're new to financial statements than understanding the General Lee, accepted accounting principles gap on the different stream. Accruals and cash Accounting is absolutely critical, and that's what we're gonna cover in this lecture. There are basically two methods for accounting. There's accrual accounting on this cash accounting now in accrual accounting, you measure the performance of position of a company regardless off the timing off the cash transactions on when they occur. It basically matches up with a transaction, the revenue and expenses when the transaction occurs, rather than when the cash is received. Now. This is relevant because when you are trying to look at the performance of a company over a period of tight fixed time period, it gives you a more accurate picture off. The company's overall financial position and accrual accounting forms the basis off the accounting principles used in the preparation of the profit and loss account and or income statement on the balance sheet. So it's important that you understand that it's not cash accounting on what you're seeing on the profit and loss account Stroke income statement on the balance sheet is a set of financial numbers where A with the the income and expenses are matched to one another at the time of the transaction, occurring as opposed to, you know, if you buy stuff on credit, then you don't pay for 70 days and you said it and you don't get paid for another 30 days away. The timings are everywhere, and crude accounting brings it all together and matches everything up so you can see exactly what's happening. So accrual accounting is more complicated than crash accounting, and therefore it's actually more expensive to implement and prepare. But it deals with the timing differences, which occur the normal course of business, particularly when you're buying and selling on credit. That's the critical idea. It's takes away all the timing differences, and it matches the economic effect of a transaction to the time that that transaction occurs so you can see a profit and loss account for a year. Cash accounting, on the other hand, only recognizes all transactions when there's an exchange of cash, so you get a lot of timing differences. Now, of course, it is important when you're dealing with a business to know about the cash flow to know when the cash is going out on when the cash is coming in. So that's why cash accounting is important. You do need to understand in your management accounts exactly what's happening with your cash flows. That's clear. But when you present your accounts for external examination, you need to do so on a standard form on the basis that everybody understands on one that matches the events with the transactions and eliminates the timing difference. And that's why accrued accounting so important. Now most large companies and public companies or public companies use the accrual method based on accounting standards, which is then set down by the regulating authorities in their jurisdiction. Now the details of these accounting standards do very in their detail. But the overall principles off them are broadly speaking. The same in the US, firms are expected to conform to the generally accepted accounting principles gap on there were, you hear about Gap accounting. It really means accrual accounting done to the gap standards. So these principles mean that accounts provide consistent information to the reader, which means that investors, creditors, regulators, government and authorities tax authorities can read them on not only understand what they say because they know what to expect in terms of the format, but also they can compare one company to another because the accounts are being prepared on a consistent basis just to take it a little step further. There are five classes of financial data in accounting revenues, expenses, assets, liabilities and equity. Now the financial results off a firm are determined in the net income off the firm, which is at the bottom of the income statement, net income income statement or the profit loss account, as we call it in the UK the assets liabilities and equity. So you revenues on profits and then your assets liabilities, inequities or revenues, expenses in the income statement, assets, liabilities and equity recorded in the balance sheet. And then the cash flow statement recognized reconciles the movement of cash in the firm between these two financial statements, which we've already established are prepared on not on a cash basis, but on an accruals basis. So you have the profit and loss on the balance sheet prepared to gap standards on an accruals basis, and then the cash flow statement enables you to recognize, reconcile and understand that what that means in terms of the movement of cash across the business through those two statements. So that is why gap accounting is important. That is why accruals and cash accounting are different. And if you understand those when you look at the profit loss account stroke income statement that balance sheet on the cash flow, you'll understand now why you need those three statements and how they relate to one another. 4. Income Statement or Profit and Loss Account: take a look now at the Incan statement or profit and loss account. This is one off three financial statements which 1/4 all your financial analysis and indeed all the financial accounting off pretty well, every company on the planet, at the other two being balanced, even cash flow will come onto those shortly. What it shows you is the profit and loss over time that the company firm organization makes now. This is not a cash profit and loss. This is a an accounting, standards based profit and loss. So all the costs and expenses have bean married up, using the accounting principles and the accounting standards to give a true and fair picture over the performance of the company over this time period. So it's critical you understand that it's not a cash statement. It's a profit and loss statement, which is organized according to accounting principles. So let's take a look at the key headings in the profit and loss account. I'm giving you various examples as we go through this lecture. They are the revenues or the sales line, which comes right at the top, and there can be different different lines of these, depending on what you earning? So here you can see income from services and you've got different lines there. And on the other one, you've got sales and other. So then you have the costs directly associate it with those sales. Okay, so it's effectively costs of goods sold or costs of services the cost of sale. Then you have one from the other. You get the gross profit. After that, you get all the indirect expenses off the organization which are in American pardons and owners. The SGN A the selling general and administrative expenses in E the UK you find they can be broken out is fixed or variable expenses or other expenses. Whatever it is, you can see lots of examples down here. And really, each of these is tailored pretty well to a company. As long as they fit within the accounting standards to make sure you get a detailed and accurate reflection off the expenses the company has incurred at the bottom of that, then you get through the ordinary net income. Obviously, then, after that, you have to pay tax on. Then you get the net income so you can see the the basic structure off the profit and loss account from these schedules. The time element of this can be divided into pretty well anything you like. But classically, it's either months, quarters or years, depending on the requirements off the statement in an annual statement. It's obviously annual in a financial model. Very often, it's quarterly. Business accounts provided for management are often monthly and quarterly, so you shouldn't see the time period does vary, so let's look at the revenue and sales line. This is what's known as the top line on. Basically, it's the income from sales at products and services, so you can see there the an example. Of course, if you've got lots of different lines of income than your, you may have multiple revenue lives. It's entirely down to the organization of the business. Next, you have costs of goods sold. So these are the direct costs associated with making and selling the products and services okay, and in a business service business, it's referred to as the costs of sales. Now it also includes labor, parts, materials and other directly allocated expenses to those sales off those products and services. That brings us down then to the gross profit line to get to the gross profit. You simply subtract the cost of goods sold from the revenues, so you can see we have that here. Then we talk about the general and Mrs expenses. They've selling general and administrative expenses. SGN A. Its marketing advertising, promotion expenses. All of these different charges. And again, you can see lots of examples on the screen. But these are all the indirect expenses not covered off before the gross profit line. This brings us down to the E bit d a. Now the e Bit D A. Stands for earnings before interest, taxation, depreciation and amortization. You don't see it in every profit loss count in every income statement. But it is a key line used by investors used by venture capitalists and used by private equity. Because it is the closest you get to a a cache line independent of finances financing because interest is obviously part of the financing because it's the debt interest. Taxation is effective by financing because you can shelter interest before tax depreciation is a non cash item. It's the capital depreciation on fixed assets, which is basically in a cruel you made the investment. That fixed asset will last 10 years, so every year you depreciate 10% of it on amortization. Is the reduction in capital value off a nascent or alone or something? So you see that you've got different factors which could be taken into account here and the bit D A. Lines are really critical and you'll hear a lot about it, particularly when we look at ratios and we look at anything to do with valuation. So then you get the e bit a line, which is the operating income after appreciation. But before amortization, you can then get the operating income, which is interest before earnings before interest in tax, which is operating income before any financial income or cost. Then you get the E bit, a line which is operating after appreciation interest, but before amortisation of goodwill. And then you get the earnings before tax E b t. So you can see depending on how you want to look at the earnings and profit line, and different people have different uses, you can have different measures of profit, and these air this off the main ones. I've shown you eating a bit d A on the previous light. These are the main ones that you are likely to see don't way too much about them. The ones to wear really about a bit D A and a bit profit a bit D and then a profit before tax. Those are the two main lines you need to lie about. The others are slightly more unusual and slightly more used for specific purposes. Now there may be an other expenses line before the tax, which covers non operating costs. Andi. It's a sort of thing where you get technology are in the investment stock based compensation, impairment charges, gains and losses on the sales and investments. Those sorts of things because they're they're not really directly related to the operation of business. But no unless the company has to expense them and they can tax shelter them. But, um, they are set out separately to make sure to make clear that they're not to do with the normal operation of business. You then get to the income tax or corporation tax line. Now this is again a complicated line because it's affected by the not only the of the principles and the accruals, but it's affected by the timing differences. What this is showing is the tax a probe appropriate to the profit that's bean earned, which can include present and future taxes. Because the timing of tax payments that does not always match up with the dates of the income statement. So just be aware again, it's a non cash item on any tax payments. Jew are then accrued on the balance sheet. So you then get to the net profit and loss or net income on this amount. That goes into the retained earnings in the balance sheet after the deduction off any dividends. So that's a walk through the income statement or profit and loss account. Don't get too worried about it. You're get used to where the main lines are in the statement and you'll get used. Once you start doing ratio analysis and that sort of thing, you'll get used to understanding what they represent and how you can best use them. But it's important that you do get this grounding in the financial statements if you're going to do any strategic planning, which has got a financial aspect to it, 5. Introduction to the Balance Sheet: I would like to now introduce you to the balance sheet. The balance sheet shows the assets off the company and how their finance with equity and debt at a fixed point in time. And it's normally the last moment off the accounting period. So if you have a year, 12 month year than it would be at the 31st of December off that year. Assuming it's a calendar year for the accounting year, which is not always the case on, basically, then the assets of the company are financed by the liabilities, plus the equity off the business. The balance sheets, organized in the most simple terms into two sides now bear in mind that different accounting standards and different counting organizations have slightly different styles of presenting the balance sheet. But essentially the principles remain the same. So this is a very basic balance sheet, but it will absolutely due to illustrate how they're set out and laid out. And if you come to any other balance sheet anywhere else, you'll recognize the key framework. So on the left we have assets, and on the right we have liabilities and stockholders equity on when they talk about the balance sheet. Balancing the assets should balance with the total of the liabilities on the stockholders equity. Many items are classified by liquidity. Now. Liquidity means the ease of which you can turn them into cash. So more liquid things. The things liken Venturi obviously cash on payables, which is money that people owe you. Less liquid are things like plant property and equipment, where if you gotta sell a building, it's obviously going to take time, as sex and liabilities are also organized into short term current assets on long term non current. Now the standard split between the two is assets or liabilities, which are, if you like, due within one year. So current assets. It's all the current stuff, but the with current liabilities. It's all the liabilities you have to pay within 12 months. On the long term, ones are greater than 12 months, so we look a debt in a minute. But long term debt gets split into a current portion and a long term portion. There are five main groups on the balance sheet, and I'm going to talk you through each one reasonably quickly, but you need to be aware off the structure. So on the asset side we have current assets and long term assets. And on the liability side, we have current liabilities, long term liabilities and stockholders equity. You can see the sections which are in the on the balance sheet, which are basically embolden. So let's take a look at the current assets at the top. We have cash and investments. These are the most liquid on easily turned into cash. Temporary investments might be something like, You know, you've got some surplus cash, so you're basically putting it into government bonds or something just to gets months of some sort of the return. Or you may put it into the money market for a week or two weeks just to get a bit of interest back from it. Accounts receivable. These are the balance of sales still on credit and awaiting payment. So this is money that you are due to receive from customers to pay you for goods and services provided Thean, Venturi and supplies. These of raw materials work in progress, which is like half finished product toe work, raw materials and, of course, finished products. So your stock goes on there and then other any other current assets, like prepaid insurance. So that's an illustration of the other assets. Non current assets are your long term assets, your property, your plant and equipment. These are also known as tangible fixed assets. Intangible assets. These things you can't actually touch. Goodwill. This is where you've paid over book value for an asset, and you have to recognize the excess as good. Well, this is the extra value that the assets worth to you obviously brand value. If you've capitalized it, then that appears here. And also since I pet patents and licences, which might have value. So if you've invested in getting a pattern to capitalize the value of that investment here . Turning to the liability side, we have accounts payable. This is money you owe people. This is money you have to pay out so it's owed to suppliers on as it's paid. The amount decreases, but you also decrease the equivalent amount from your cash on your balance sheet that keeps your balance sheet balanced. Other liabilities, which were due within 12 months, so taxes, warranty liabilities, anything like that. You can also include, as I think I've already mentioned the current portion of long term debt, which is due within the current accounting period. Long term liabilities are liabilities, which you have to pay, which are more than 12 months away. So notes and bonds if you've issued bonds to raise money or low notes of any kind on they're not due within 12 months, they go in here, and it's also the long term portion of any long term debt on the short term portion. That long term debt sits in the short term liabilities because it's due within 12 months, The Stockholders equity, The first line of this is normally the share capital the common stock issued on then the retained earnings. Actually, I should should mention on on the common stock issue, you'll have the nominal on the premium. This is not reflected in this balance sheet, but let's say you've got a one penny stock, but you issue in her pound so you'd have the nominal value of that. Recognized on your balance sheet is one penny, and then the premium to the payment off the nominal value, which is 99 p, would then be on the next bit, which would be the share premium account. Neither of which are distributable as dividends. The retained earnings is the total amount of the net income kept by the company and not paid out as dividends. But that is the line that if you want to pay dividends, you have to see if you've got any money in your retained earnings. Then there are other accumulated liabilities on Treasury stock. Now. Treasury stock is something you can do in America, but you can't do in the UK If you buy in some of your own stock from the stock market, you can hold it for a period of time on your balance sheet. And obviously you've paid out for it. So it's an asset. So it's a it's a it's a liability. You're owed it in a sense, to the treasury off your own company, but you can cancel it, which would also be acceptable. But you may want to issue it again, and you have to get through the whole performance so you can hold Treasury stock under Polish in the UK If you buy back shares, you have to cancel them immediately. So let me just talk about four key points about the balance sheet. Now it's a really useful tool the balance sheet on. We're going to come and look at it quite a lot more when we look at the financial analysis . But I just want to touch on four areas now, which will help lead into that final financial analysis section. The first is liquidity, and the liquidity is really establishing how liquid your company is on. Essentially, can you meet all your current liabilities from your current assets? So the easiest way to check that is to divide your liabilities by your current assets, and you want the number to be less than one or you do it the other way when you want the number to be more than one. So the question is here. Can the company cover its current liabilities from its current assets? In the ratio analysis, you look at the current ratio in the quick ratio. I won't go into detail on those now, but we will come back to them. Leverage is how is all about how the company is financed, how much debt it's got in it now. If you think about it, the more debt that's in the business at the more risk you take on because you have a very slim line of equity. And then suddenly, if you have to pay back all the debt, you might have liquidity problems. So leverage is not only a measure of the debt ratio, it's also measure off or it's a It's a measure you can use to evaluate the risk in the business. And here we look to the debt to equity ratio and the debt to total capital ratios to see how leveraged or how risky the business looks. Efficiency is a question of how well does the firm use its capital? And it's achieved by comparing a number of the numbers on the income statement on the balance sheet. And this is where they to start to come into play and they become very useful. So how efficiently doesn't use its capital and the course? You're looking at things like the revenues divided by the fixed assets, so the asset turnover, So how much revenue do you get per pound of assets? And if it's very efficient, you get lots of revenues and it's not so efficient, you get less revenues and the other one is the working capital cycle, which is how quickly. There's a pound turnover in the business, so you have a pound in the business and you buy raw materials with it. You then turn Israel materials into a product. You then sell the product, and you may sell it on 30 days. Notice remorse or 90 days notice, but if you sell it on 30 days, you'll get paid in 30 days, so the money comes back faster. If you sell it on 90 days, the money comes back more slowly. And if you don't collect your your debtors, we don't collect your receivables. Then the money doesn't come back at all. So it's a measure of how quickly £1 is turning over or $1 is turning over in the business , and capital efficiency is very important. Finally, we look at rates of return, which is basically how well a company generates returns for every dollar invested. And here we're looking at the return on equity. So if you put in equity into the business regarding you, finance the rest with debt. How much is that equity earning? And if you take the total assets which includes the debt, then on a low the the liabilities of you. Like all the assets financed by the equity on the liabilities, you divide that divine net income. By that you get the return on assets. So again you're taking numbers from the income statement and your divided them by numbers in the balance sheet, and you're getting useful information out of it. But we'll come on to a lot more in the financial analysis section. I want you to think about these for major issues, which are really important when you're doing your analysis on when you're doing your strategic and forward planning. So that's our introduction to the balance sheet. I hope you've now got a clear idea of its structure. How it works, why it's important. It's a snapshot in time. It is still not a cash related thing. You have a lot of accrued information in there, still based on a lot of the accounting principles, but it's a really important you understand exactly what a balance sheet is and how it works and why it must always balance 6. Introduction to the Cash Flow Statement: Now, let me introduce you to the third off the three major financial statements. The cash flow statement. Cash is critical and cash is king. You can't afford to run out of cash. What is your brush? Cash flow break even. All these things are all cash driven, but the balance sheet on the income statement are Krul's calculated. So they're not cash statements. So you need 1/3 statement which reconciles all the movements in the income statement and the balance sheet in order to show you a picture off What is happening with the cash in the business? So we need to know how much cash is generated or used by a business in the accounting periods. Absolute critical. Which is why we have the cash flow statement. There are three key sections in the cash flow statement cash from operations, cash from investing and cash from financing. So I've shown you an illustrative cash flow statement here on the right. But these are the three key areas, and we're going to talk through those on the net. Cash of the cash balance at the bottom. You, on the right hand side is basically the cash flow is added to the opening balance, which is the brought forward balance at the bottom on. Then the changes then carry forward to the next accounting period, and that becomes the net cash flow for the period. And we understand we've opened with one number is changed over the period, and we end up with a close number at the end of that. So the key is to compare in the the key objective off the cash flow statement is the comparison off cash movement to net income, which is the accounting a Krul's number on it helps you to see what is actually happening. So if you have accounting standards in the Krul's, you're actually getting an accurate picture of the performance of the business. But you don't get a cash position because all the numbers are adjusted not for the cash flow timing, but for the record to recognize the accounting timing off when an event takes place. So if you take a more materials, you turn into product and it takes a month, then the costs associated with that month's worth of conversion is put in for your costs of sales. But that may not reflect the fact that you actually bought the materials on credit and you don't pay them for 90 days. So there's a completely different cash behavior going on there to what is actually happening in the profit and loss account. So net incomes prepared under a cruel assumptions and accounting principles on what you want to know is what is the cash from operations? Because that is cash. That's the whole purpose off the cash flow statement. So what we're going to do now is discuss the key lines of the cash flow statement just to understand these three major areas off it. The first of these is the investing cash flow. This is the the 1st 1 to look at is the cash from operations on What we're looking at here is we take the net income on DWI, add back the depreciation and amortization, which are non cash charges on any changes in working capital Now on the screen, you can see it starts at the e bit line. So you then basically add back the depreciation amortization to get T B D A. And then you can see the working capital changes in debtor's stock and creditors and any tax and you end up with a net cash outflow from operations on. This is basically telling you how much cash is generated from the company's business activities. The investing cash flow is the next line, or the next group of lines on it basically takes into account than any capital expenditure . Any investment implant on machinery, any fixtures and fittings, investment motor vehicles. You can see those lines on here and any capital expenditure, which or whatever it may be. But it could be investment in debt and equity instruments from other companies. Or, indeed, it could reflect investments in acquisitions. So you get this number, which is basically then the cash from investing activities, which is then the balance number, which opens up the next section, which is the financing cash flow and you hear it says cash flow available for debt retirement. This is taken from, as you can see, a VC model, but essentially, you're talking about the what you have available to issue or repurchase of stock, shares or debt, so you might want to raise money or you want to pay it down on any changes in long term liabilities and shareholders equity accounts. So that then gets us to the net cash flow for the period. But what we want to know is what the cash balances. So we have to go back to the previous period and take our closing number there. We add or subtract the net cash flow for the period to that, and we end up with our closing balance. So we see what are closing cash position is, and that's how the cash flow statement works. So it's a really critical a statement because it actually tells you a lot more about the cash in your business, which, after all, is critical because you might have the most wonderful panel account. But if you run out of cash, you won't be in business for very long. 7. Cash Flow Metrics Explained: we all use the term cash flow, but actually cash foca mean quite a lot of different things, and it's important, actually, that were precise about our use of the term cash flow. So in this lecture, I'm going to explain some of the different metrics that can be represented his cash flow and try to show you why they're different on what they're useful for. So the key question is, Well, what do we mean by cash flow? And of course, the answer to that is, Well, it depends on which numbers you use, because different numbers have different implications for the actually what you're getting . So I thought it would help to discuss this range of possible cash flow metrics with you to help you to understand what they mean. The first of these is the much maligned e bit D A, which, incidentally, Warren Buffett doesn't like at all. But the were also going to look at cash flow from operating activities, free cash flow, free cash flow to equity, and then free cash flow to the firm on. We'll start with the big D a a bit D A stands for earnings before interest, tax depreciation and amortization. Now it's often used as a cash flow metric, but it can be very different from cash flow. Of course, it's very easy to calculate it from income statement. And it's something that private equity firms and VC firms love because it's easy the cash flow from operations. And now we're going from the income statement across to the cash flow statement. These are the is a cash flow from operations, but the levered cash flows and that means you're taking into account the interest that's being paid on them. So the operational cash flow is the pure operations from the business. To get to the number, you have to add back, depreciation and amortization. Because these air non cash items, you also have to add back any other non cash items such a stock based compensation, unrealized gains or losses or write offs in order to come up with the actual Castro number from operations. Unlike anybody, A. The cash flow from operations include changes in networking capital accounts receivable accounts payable in adventuring. But it doesn't include capital expenditures, so you can see there's quite a lot of adjustments to take the cash flow from the basically the net income statement on then adul these items back, including the working capital movements, to come up with the cash flow from operations. And this means that the Castro from operations doesn't automatically match the e bit. D a. Because although you've added back the depreciation and amortization, Andi have taken out the interest payments. You haven't made any adjustments to the non cash items such a stock based compensation and you haven't taken into account changes in working capital so automatically those things will make the two numbers different. You can see how he bit d A is now drifting away from cash flow. The free cash flow FCF is the operating cash flow before capital expenditure as a the free cash flow. FCF is the operating cash flow less any capital expenditure, so it's the cash flow. After financing activities, it's the next level down in the cash flow statement. Effectively, this is saying independent or financing. This is the free cash flow that can be spent on allocated to expenses by the management investors so they could be completely debt free, interest free on pay themselves or the dividends. A little of the free money as dividends or they could decide to have debts on the balance sheet. Take that money out, lever the business up, and then use some of that to pay the interest on the principal repayments. So this is after financing activities, having taken off the capital expenditure on gets the free cash flow FCF. So the next level down after that is the free cash flow to equity. So basically, what we're saying is we're taking the free cash for the operating cash flow. We've taken off the capital expenditures and now we're adding or subtracting net debt. Now, this includes any interest expenses on the debt and any net debt issued or we paid. And it represents the free cash flow, the net cash flow after this to equity holders after holders of debt had been paid their interest and principal payments. Now, finally, you have the free cash flow to the firm, the FCF F, which is also called the unleavened cash flow. Unfortunately, this is the most difficult to arrive at, and in part it will always be hypothetical. You need a step by step process to calculate it, and I'm about to explain that to you But this is the line that is normally produced and calculated in order to create a an enterprise value using a discounted cash flow. But this is how you arrive. At the number. You start with the E bit. The earnings before interest and tax you then have. This is the difficult, but you have to calculate the tax bill without the advantage of the tax shield from the interest payments. See, the interest payments will reduce the tax bill. That's the tax shield, so you have to assume that there's no interest payments, but they're going to pay more tax. You then deduct that adjusted tax from a bit to arrive at a net income an unlevel net income statement, because there's no interest now because there's no interest payments. So you you immediately go to any bit tea, and then you take that the adjusted tax off toe Arriva to net income. There you go across to the catch for state. When you add back the depreciation amortization, you deduct any increases in non cash working capital and take off any expenditures. But because there's no debt, you then don't go into the financing activities and you stop there on that result is the free cash flow to the firm, the F C F f. And that's the line that's used in DCF's. So if you want to calculate an unleavened valuation of a firm using a discounted cash flow calculation, you need to compute this number. And that's why it's so useful. But it is difficult to get to. So which free cash flow number is best? Because I've just showed you there all actually quite different. The D A number is easy to understand. It's an easy proxy. Four cash flow. It's commonly used by venture capitalists and private equity houses, but it can be very different to cash flow, particularly as it doesn't take into account some of these non cash adjustments on it doesn't take into account next changes in working capital, so it can be very different, and you have to be aware of that limitation. Operating cash flow is easy to read from the cash flow statement, and it's a true picture off cash flow for the period, but it does contain the distortions from movements in working capital. The free cash flow to equity F C F E is easy to calculate after the capital expenditure. But unfortunately, most models are built on unleavened enterprise basis. So you need to find further refine this number to arrive if you're going to create ah, calculation that is the Enterprise Valley or to reconcile equity valuation on enterprise valuation because you can only use this to create a an equity valuation of the firm. The final warm entry just explained in some detail the free cash flow to the firm has the highest correlation to the firm's economic value because it takes out the effect of leverage. It is independent of the financing structure off the business, but it does require considerable analysis and assumptions about the unleavened tax bill. It is commonly used in most forms of discounted cash flow, where the valuations independent of the firing structure in order to arrive at the enterprise value. So this is the probably the most commonly used one, but the easiest one to uses. Ebert d A. But as you can see, they are very different numbers. So I hope you find that helpful cash flow can mean different things to different people, and it really depends which line you want to use. But If you use them intelligently and you know what you're talking about, then you can still use them appropriately for different tasks. But don't use a bit d A as a number to generate a discounted capture, a calculation because what you will end up with will be completely meaningless. So cash flow Metrics explained. I hope you now understand why I thought it was worth explaining it, because it is quite a complicated topic. 8. Case Study Apple Financial Statements: I thought a little case study at this point would be helpful. So when I produced for you is just a little lecture showing you the three major statements from Apple taken from their 10-K So I've got in the next slides. I'll show you pictures and you can download them from the resources section. Example. Off Rheal financial statements to just say what they look like in real life, having taken through you through the key principles of what the profit and loss or income statement is, what the balance sheet is and what the cash flow statement is now any in the U. S. If you go to any public company, you confined these statements and ah, whole load off notes and exploratory discussion in the company's 10-K statement. And in the UK, you have to look in the reporting accounts of the company for the year so that very easy to find and they're publicly accessible. So in the income statement here, you can see we've got the sales, the cost of sales, the operating expense expenses on the operating income. Justus we went through and you can see that how all the numbers work through, but we've also got on. I would get you to appreciate this. You can see three years worth of numbers here. The most recent are to the left, and then the historic ones are to the right on. This gives you the ability to compare year on year. They've also provided a calculation off earnings per share on the number of shares used in the calculation, both in terms of basic, which is the shares in issue and diluted, which reflects all the option schemes shares, which are being promised but not yet issued on. Those are obviously two very important on different numbers on you'll see it says the bottom. See a company notes to consult with a financial statements. You get a huge amount of detailed explanation, but we're just trying to focus on the main statements in the balance sheet. You'll note that it's at a specific date 28th of September 2000 and 19 and you can see you've got the current assets, the non current assets, that current liabilities and the non current liabilities and at the bottom, the shareholders equity exactly as we would expect in the cash flow statement, you can see that we start with net income and we're looking at the cash from operations or operating activities. You can see all the adjustments and changes to the share based compensation to accounts receivable or the working capital changes until you get down to the line, he says. Cash generated by operating activities So that's the first segment and you can see is ruled off. Then you can see the cash from investing activities and it takes you through all the various adjustments and that the bottom, he says, cash generated by its negative, used in investment activities on all the different things they've been doing for those I won't go through them. You can read them for yourself and then finally the financing activities and you can see what they've been doing with their financing activities, and you can see the net number, then, is the cash used in financing activities. So the three statements are the three segments off the statement are very clearly laid out on then at the bottom, we can see the changes that the increased decrease in cash or cash equivalents in the period on the ending balance is so you can see that It's exactly as we would expect the three segments to the cash flow. You can see the balance sheets all laid out as we expected. You can see the profit and loss account is so that's a little case study. I'll make sure you can see these three statements in the resources section. You can download them for yourself and study them if you wish, But I just wouldn't be worth while giving you a look at a really set off statements s so you can get a bit more familiar with them because you tend, don't do, then have a lot more detail in them. Don't be put off by the detail because the structure and the segments are or exactly what you would expect to see. 9. What is Financial Analysis: is going to be quite an important lecture because the question I'm asked asking and answering is what is financial analysis? And this is the bedrock off understanding how to make good use or financial information. So financial in from analysis is Thean Alice ISS off a company and its performance using financial and numerical data. You've got all this valuable four car stater. You've got all this audited accounts. You need to be out to do something constructive with it to get meaningful information out off the numbers. Now it involves working with the historic accounts and also creating an integrated financial model to forecast the future. And typically you look at three years historic and five years forecast. I'm not going to teach you for integrated financial model creation in this course, but I am going to discuss it quite a lot, so you understand what you can get out of it. So there are essentially 12 types of financial analysis and they're shown on the screen, and we're going to go through each of these individually. So we have vertical horizontal leverage, growth, profitability and liquidity, and then we have efficiency, cash flow, rates of return valuation scenario, insensitivity and variants. Let's start with vertical analysis. Vertical analysis is when you compare the figures with in a statement, typically the income statement on Did you look at various lines and you divide it by revenues. Knicks? You express it as a percentage. It enables you to look at the information in the income statement, turned it into percentage terms so you can compare a benchmark with other companies, even if they're of a different size and scale. Horizontal analysis is basically analysis over time you're looking at several years and comparing them against each other. This helps you particularly to be able to evaluate the growth rate, but it also enables you to understand important trends over time. As I've just said, you normally model three years historic and five years forecast. That gives you eight years to work with, and you can get quite a lot of insight by looking over that sort of period. Leverage analysis helps you understand the company performance based on its financial structure. On particularly, we're looking at the debt equity ratio, the debt, the debt has come up debit. So the debt to a bit D a ratio on the e bit to interest. Which is that the interest coverage? Again, I'm not gonna go on. Explain all these ratios now. We're going to cover the ratios later on. I want you to understand the overall framework for financial analysis, and that's what we're challenge we're covering here. So then we have growth rates, and this is looking at the growth off various lines, particularly revenues and profits. Over time, you can do year on year announces just comparing one year to the previous year or year to the future year. But you can also look a bottom up growth so you can start it with but with drivers of revenue and build a model up. Or you could go top down, start with market size and market share and build it from there. But you can look at growth rates over the period, so you might start with a 10% growth in revenues every year. See what that does to the rest of the business, or you may say, well, the market size is a 1,000,000,000. It's going to grow by 5%. We've got a market share of 3%. We're going to grow that by 0.1% a year. And then you see what those assumptions due to the growth off the whole business over time , profitability analysis looks at the key economics off the business. Now, these are gross margin ee be de a margin, the EBIT margin and the net profit margins. So you're looking at the prophet lines down the income statement and evaluating the profit of the business on the basis of different lines. So if you started the gross margin, you're just seeing how efficient the businesses in terms of its costs of sales. You look at the ive but D a margin. You're looking at the profitability of all the business costs, but effectively before any financings taken into account on, obviously, a bit margin takes into account, depreciation and amortization, and then the net profit margin is after interest and tax, so you can see it at different levels. It's useful to compare it. Over time, the tax rate may change. You may get some savings in your SGN a and see how that can improve your profit margins at different levels off the PML account. Liquidity analysis focuses on the balance sheet and really what we're talking about here is the ability to meet short term obligations. If everything went disastrously wrong, can you pay out your short term liabilities? So the ratios you look at here are the current ratio, the asset test, the cash ratio in the networking capital ratio. Essentially, what you're looking at is elements off the net asset, the current net assets that the current assets against the current liabilities and hoping that the elements of the current happen assets can meet all the current liabilities. That's the core on the essence of the court if he announces, efficiency announces is how well the company uses its assets to generate revenues and cash . So we look at the asset turnover ratio, the fixed asset turnover ratio, the cash conversion ratio and the in Venturi Turnover Asia. So it's a very helpful guide. And if you got these four and you're looking at the most different periods of time, you can begin to build up a picture off the efficiency in which the company is generating money. Cash flow is critical. Of course. We've talked about this several times. Cash is absolutely critical to a business without it, businesses die, so you need to understand your cash Now in the cash flow statements, we looked at the three core segments off the cash flow statement, the operating activities, thean vesting activities and the financing activities. Now the ratios were looking at or the lines were looking at Are the operating cash flow, the free cash flow, the free cash flow to the firm and the free cash flow to equity? And again, I'm not going to explain all these in detail now. I just want to give you the framework you need to work with. Rates of Return Help Investors and the owners of the business understand what risk adjusted rate of return there making from the business. So we're looking at things like the return on equity, the Return on assets, the return on invested capital, that dividend yield the capital gain the accounting rate of return on the internal rate of return evaluation, announces asked the simple question. But it's a difficult answer. What is a firm worth and to get to any sort of range of values, you always need to use a variety off techniques so you can use the cost approach. What is the cost? What would cost to actually buy all these assets to get them working. The cost of building replace That's the current value of those assets. The relative value to you looking at a market approach to that, the comparable company analysis comparing your company to the valuations and the known valuations of other companies. President transactions So we can see where companies have been bought and sold in the parson. You can compare them to those intrinsic value, the basic intrinsic value of the business and then the discounted cash flow analysis, which looks at the future value off all cash flows from the business. Discounted back to the present to give you a number including a terminal Valium scenario and sensitivity analysis, basically allows you to evaluate future options and make assumptions and to test out what happens in a best case. Worst case scenario. It's very useful to understand what the risks the company is running if things don't turn out as you want them to and where the breaking points are likely to come. So where you likely to run out of cash or where you likely not be able to pay back your your liabilities? Whatever it is testing the scenario and sensitivity analysis is a really important part or any financial analysis program variance is where you compare a budget or forecast to the actual result. Now that result may be favorable or unfavorable. But what you're looking for here is to try to identify the causes off why the forecast or the budget didn't turn out as you expected, and then to understand the underlying causes. The underlying drivers behind that. And that's important because you need to work out where your view, your assumptions, have not being correct on where things may have changed, too in the market or with customers or prices or whatever that you didn't anticipate. So variance analysis really important. Now some best practice for financial analysis just to give you a few hints when you're doing your financial advances. This is these are some guidelines to make sure that you make the best of it. You don't make rookie mistakes. First of all, make sure you're very organized with your data, and you you only use the same sets of data for the analysis. You know where your data is come from. You make sure it's being rigorously prepared. Keep order formulas and calculations as simple as possible because when your game back in order, ting spreadsheets if you have multiple less ness it if statements it gets very complicated , make notes and comments in cells to help guide people. Her reading the the spreadsheet so you they can understand what that particular seller formula does as Ugo audit and stress test your spreadsheet models to make sure that there aren't any mistakes in them. So if we make some big changes, does your balance sheets still balance? For instance, always we again when working in the bank, we used to have what we call the four eyes principle. Nothing went out the office unless two people had reviewed it and passed it. Approved it on. That is particularly important for spreadsheets, which can get very complicated and actually more than two people is probably a good idea. So having several analysts and several people reviewing it and checking it is a very good idea. Redundancy checks are important. Use data, tape tables and chance to present your data. Make sound data based assumptions in your modeling. Pay extreme attention to detail, but don't lose the big picture. Remember, you're trying Teoh create a scenario. We're trying to make a forecast off a business going forward. It's got to be based in reality, but it is dependent on the detail and my last hint to you. Whatever you do, do not get in the circularity in your model. The minute you get a circularity warning up, you need to stop what you're doing and go and find out what's caused it and eliminate it because a circular model is basically garbage. And that's basically where one set of data feeds off itself and it becomes a continual loop and you end up with a completely meaningless, meaningless result. So this is all about helping you to understand what financial analysis is all about. We're going to look into a lot more detail into ratios and financial analysis, but I wanted to give you the big picture. I wanted to give you the framework. I wanted you to understand the different types off financial announces that you can carry out 10. Measures of Profitability Financial Analysis: I want to discuss with you now The measures of profitability. Financial analysis The income statement analysis is focused on the profitability off the company on. We can do this in one of two ways. We can do it vertically up and down the income statement, looking at the different lines and looking at the different margins as we go down the income statement or profit and loss account. Alternatively, we can do it horizontally, which is like this, which is year on year. So you look at 2018. You look at 2019 and you see the changes in margin year on year so you can see not the absolute numbers. But you can see in percentage terms whether the performance of the company has improved. So vertical analysis. We look at each of the major lines as a percentage off revenue that you could technically look at every line to see for how much revenue, how much products or how much services in terms of cost of sales. So you can look at absolutely every line, but the main lines are two. To understand the net levels of profitability on, it enables us to understand really how the company is performing. I have here the data from the Apple Income Statement 20th September 2019. You're gonna get quite familiar with this because I've used it in a number of different lectures so that you can get some consistency of style if we do horizontal analysis. We're looking on the year in the year change, and here we have data from 2000 and 18 and 2000 and 19. And if we take the value from the current year, divided by the value in the previous year and subtract one to get a percentage change, sorry there's a e missing. Then you can see that exactly how the company has done compared to, you know, one year to the next. The key profitability ratios are first of all gross margin, and this is the gross profit divided by the net sales than the operating margin, which is the operating income divided by the Net sales. And these are both highlighted on the screen. The E B T margin. The earnings before tax margin divided by net sales, is shown there, and then finally, the net profit margin, the net income divide about that sells now. You could also do Eve it ti earnings before interest in tax margin. You could do the e bit d a margin. It just depends on what you want to compare Onda reason that you're using those numbers. So, for instance, if you were doing trying to do some sort of venture capital P or investor based, um, analysis, then very often it's the e bit d a margin which they're interested in, and so you be focusing on that one. Now, if we take the total assets from the balance sheet, we can arrive at the return on assets ratio shown at the bottom on. Basically, you take the net incoming, you divided by the total assets, and this gives you a clear idea of how efficiently the company is using its assets to generate income. The return on equity is the how efficiently the companies using equity its equity to generate profit, and you arrive at that with the formula net income divided by shareholder equity, and we show it at the bottom here. So those are the key pressure measures off profitability that you'll need to understand for your financial analysis. We're going to go into these in some detail because it's important that you get your mind around them and you understand how they're calculated on by breaking them into these 44 areas. It becomes much more intuitive and much easier to understand. Then, if we were doing on the basis of the P and L account, if you're doing on the basis of the balance sheet and income statements, so the next ones you'll see are not based purely on one particular income statement or one particular financial statement there based on groups off related ratios. 11. Balance Sheet Ratios: I want to take a look now at balance sheet ratios, these ratios measure the operational efficiency of a business in the income statement of the Property Loss Scout. We're measuring profitability and performance. Now we're measuring liquidity, leverage and operating efficiency. Which of the three categories that these ratios is divided into on we're going to deal with them one at a time. The first of group are the liquidity ratios, which basically measure the ability of the firm to repay back short and long term obligations. I eat liabilities. The liquidity ratios include the networking capital ratio or current ratio. The quick ratio, or acid test the cash ratio on the operating cash flow ratio. So the net working capital aeration, which also known as the current ratio if you do it as a ratio, basically looks at the relationship between current assets and current liabilities. And ask the question. Do you have more current assets than current liabilities? Because the implication is, if you do, then you can afford to pay off your current liabilities with your current assets. So the networking capital ratio is the current assets minus the current liabilities or kind us. It's divided by the current liabilities. If you either way, you want to have a relationship which is greater than one. The quick ratio acid test so takes us a step further, and it looks at the firm's ability to pay off short term liabilities using only it's most liquid assets. I e. Does not include stocks. Adam entries The The idea behind this is that if you had to pay off your liabilities quickly and you still have to sell your stocks or convert your stocks into a product and then sell your inventions your products, that could take time. If you have to do it quickly, you'll have to discount and therefore the value of those stocks. Adventures on the books wouldn't be the same. So if you were in a push, could you do it just from your most liquid, um, assets on DPI off all your liabilities. So the acid test ratio is current assets minus in Venturi's, divided by current liabilities. The cash ratio takes this another step further. Could you pay off your short term in overseas only with cash and cash equivalents so that the cash ratios, cash and cash equivalents divided by current liabilities so you don't You're basically saying, Have I got enough cash in my business to cover all my current liabilities Now is not necessarily efficient to be like this, but it's a good test to see how close to one that you are. The operating cash flow ratio looks at the ability of a firm to pay off its liabilities, its short term liabilities only using the cash generated during that counting period. So you go to the cash flow statement, you look at the operating cash flow and he basically take the operating cash flow and divided by current liabilities. And you see, if you have a ratio of greater than one now we come on to the leverage ratios on these are designed to understand the level of debt in the company. Now leverage has its implications for financial risk as well as working. Capital. Efficiency is probably not efficient to operate a company without any debt whatsoever, but equally, if you have too much debt, too much leverage, you may not be out of Fort of to fund it to finance it, to pay the interest to pay off the the principal on. Therefore, your business might be at risk. So it's a question of getting the happy medium, and these ratios help you to make that judgment. Now the leverage ratios are Aziz. You can see here I've got the debt ratio for you. The debt to equity the debt to capital, the debt T B D A. The interest coverage. The debt service ratio on the fixed charge cover ratio. So let's dive into these. The debt ratio measures the proportion off the firm's assets provided from debt. Very straightforward. How leverages business. So you take the total liabilities and you divide them by the total assets. And if you have a number greater than one, then you've got more debt than you want more liabilities than assets. So it's simply a balance off. The to the debt to equity ratio takes us down a step further, and so we're looking at the total assets. You're looking just at the shareholder's equity, and it measures the amount of total debt to the stakeholders or shareholders equity, and you calculate it by dividing total liabilities by just shareholders equity. The debt to capital is it is another basic meant measure of leverage. You divide the total debt by the total capital, which is the total debt plus shareholders equity. So you get debt to capital, which is debt divided. My debt on and share holds equity, so that's a plus. Shelves equity, not unequal. Sign the debt T B D A. Measures the cash being generated by a firm that is available to pay that payback or service debt. It's nothing to do with how much income is being owned by the firm, so you take the debt and divide it by the e bit. D A. It's sometimes used as a covenant by banks when lending, they want a certain level off ability of the firm to pay back debts. So if you have debt of 180 but D A of 10 it be a 10 to 1 ratio. Maybe not very good. But if you're A B D A was 50 you have a 2 to 1 ratio, which might be a more sustainable ratio. As far as the banks are concerned, the interest cover is a measure of how easily a company can pay its interest expenses just its interest, not the capital. So you take the operating income and divide it by just the interest expense. And this is really saying that in a normal course of events, with no capital repayments to wear about, can you cover the interest expenses from the debt and the lab Ellis is you have on the balance sheet. The debt service ratio is how it easily accompany compares debt obligations on. We look here at the operating income on look at the total amount of debt. So instead of just looking at the interest, we're now looking at the whole amount of debt against the operating income, which is as close to E but d A as you like. It's just after E, but it's after the depreciation and amortization. But it gives you an idea of how much income is available to service both the interest on the capital repayments. The fixed charge cover ratio is well, is how well affirm concolor. It's fixed charges now by fixed charges. We mean debt payments, interest expenses and things like equipment, lease expenses. So these are all charges which a fixed and committed to and they have to be paid. You get to it by first of all, you add back to a bit all the charges. So the fixed charges before tax, you had them back to the But so you get a combined number and then you divide them by the fixed charges before tax, plus the interest payments on that gives you the amount of cash flow available to service debt and interest payments. Now we'll turn to the operational efficiency ratios on. We're going to look at how well a firm uses assets and resources to generate sales and profits. We have five to look at here. They're the in Venturi. Turn over the accounts receivable days, the accounts payable days, the total asset turnover on the net asset turnover. The adventuring turnover is how many times in a year affirms Inventor has turned over or sold was during any accounting period. It's normally a year. So you're basically saying in my sales, if I have sales of 100 I have in Venturi of 10 I'm selling that invent tree 10 times in the air, which actually pretty efficient, and you arrive at it by looking at the cost of goods sold on divided by the average in Venturi. Now you should use the average in Venturi through the, but that may not be available. Remember, the balance sheet is a snapshot in time. If you can get the average in Venturi by taking the average of the 12 months, then that's great. Otherwise, you have to rely on the figure in the year and balance sheet, which is OK as a proxy. But technically, you should try and use the average in Venturi through the accounts receivable. Days is telling you how long it takes for the Kurt firms customers to pay you for products and services. Think about it. I sell a product to you, Onda. I send you an invoice and you pay that invoice immediately. Great. I get my money straightaway, but you may not pay that invoice for a month or even two or three months. 30 60 90 days. If you don't do that and you hold onto the money, you don't give it to me, then that money isn't available to me to finance my business. So you're holding that cash in your business, and I don't have that cash in my business, So I have to find that's my business of somewhere else. I have a cash gap on the accounts receivable days measures how long that is and you take the accounts receivable divided by sales on multiplied by the number of days in the accounting period, normally 365. And obviously, the quicker you can get your customers to pay you the better because the money comes back into your business. This is all about working capital management. The other side of this coin is the accounts payable days. This is how long you take to pay your suppliers. Now they send you some raw materials on credit. You don't pay them for 30 days. Okay? You don't pay them for 90 days. You've got that money in your business for an extra 60 days. So you're using that money to finance your business at their expense, which is a good thing. View may not be necessarily a good thing for them. You revive at the accounts payable days by dividing your accounts, payable by sales by the total sales number and then multiplying it by the number of days in the period. Normally 365. The total asset turnover is a measure off the firm's ability to generate sales from from its total assets, and you simply divide sales by the total assets. That's that's it. But it tells you how many. If you have assets off 10 and you have sales of 100 it's saying that you know, I got a 10 to 1 ratio there. I'm generating a lot of sales from a relatively small amount of assets. If your assets of 50 then you're jenny got a 2 to 1 ratio, you're generating good sales, but you're using a lot more assets to generate those sales. The net asset turnover tells you the amount off the firm's ability to generate sales from its Net assets. So instead of total assets, were talking about net assets here. And that's the difference. So you've got your sales divided by the Net assets, which includes all the liabilities rather than just the total assets on that will give you another different, a different ratio. But it's taking into account the debt funding off the business, so those are the ratios from the balance sheet. As you can see, there's quite a Siri's off them. They're grouped into the three different groups. They tell you an awful lot about the liquidity of your business. They tell you a lot about the capital efficiency of your business, and they tell you about the leverage in your business. So you put all those three things together and you get a very interesting picture about how well your business is being run, and you can use that. Track it over time, and you can use that to improve the performance of your business. 12. Cash Flow Statement Analysis: I want to talk you through now. The cash flow statement analysis. Because the cash flow statement Francis is slightly different because what the cash flow is telling you is about the movement of cash in the business, as opposed to giving you the snapshot of the business that the income statement and the balance sheet does, which you can run most of the ratios from. But you can still get a lot of understanding about the business and what's happening in it if you look at the cash flow with a an objective viewpoint, and that's what I'm gonna try and do with you here. So the purpose off the cash flow, remember, is to understand how cash is generated or used in different parts of the business. It tells us how well the company is likely to be able to meet its current obligations as well as finances future growth. The three sections of the Castro statement, as we have seen, are the operating activities, the investing activities and the financing activities on. We need to understand the cash movements for the key components of each of these sections On this is where the understanding and interpretation comes from. So with the operating activities, we start with the basic cash flow from the operating of the business operating activities off the business. Andi, you basically take this starting point from the bottom of the income statement. Now, remember that if the cash flow is negative, that may not be surprising or necessarily a bad thing, because often early stage companies don't make profits and our cash flow negative so it can be perfectly acceptable to see a negative cash flow. Starting off the statement, of course, you have to make up with it with financing activities later. You then add back the depreciation and amortization, and you consider any one time adjustments on the special villain Raila Gains and losses of a sale of a particular asset is a one off. You have to also take in the changes from working capital on. The result, then, is the cash flow from operations and that is the first segment. And you can look at these different parts off the statement and ask yourself, you know, what can we do differently? Can this be done more efficiently? Should we be looking at our working capital so cash flow If you then divide it by. Sales enables you to interpret how much cash is produced for each dollar of cells, and this could be quite a useful little ratio because you're not talking about profit. Now you're talking about the cash generation from the business. Clearly, the higher the better. But if you track this over time, you also get a feel for maybe seasonality in cash flow related to sales. Or, indeed, you get a better historic picture if you track it over several years when we moved to the next segment, we're looking at the investing activities and we really looking at the long term investments in the future off the business. So this means we have to take into account the any changes in capital expenditure, plus or minus. We have to look at any net investments made in perhaps an acquisition, and that gives us the cash flow from investing activities, which again is a line where we are independent of finance and we can say, well, this is the cash flow available on. We can now consider different financing options or maybe returning cash to shelters, which brings us now to the financing activities and basically This is where the shareholders and investors come decide how to allocate the resources to get to the cash flow from financing activities. We have to make the following adjustments. First of all, Obviously, if we pay out any dividends, then we have to make an adjustment for that. If we sell or purchase any shares or common stock to share, buy back or issues more shares, that's a plus or minus. We have to take that into consideration and then any adjustment to net borrowings, interest payments and principal and then that gives us the cash from financing activities and then when needy that, but not quite because to bring all these together, we have to look at the cash flow from operating activities. We have to look at the cash from investing activities and the cash flow from financing activities on that then gives us the net changing cash over that period just for that period. Then we go back to the previous period and take the closing cash figure from that period added to the net changing cash on. We end up with the cash balance at the end of this period and that cash balance should reconcile on balance with the balance sheet. So that's how you look objectively at the cash flow statement analysis. And again, you need to continually be aware of how these three statements work together. The fact that the profit and loss or income statement on the balance sheet are Krul's, based on the fact that cash flow statement is telling you what it says on the tin. It tells you about the cash flow in the business. So I hope you found this further explanation helpful. I'm going through it in a lot of detail because I know it can be complicated. And if I give it to you in enough different ways and hopefully you'll get a grip of Haridwar works. 13. Valuation Ratios: take a look now at valuation ratios, which could be very helpful both for your strategic planning. Andi for your business plan Valuation ratios Air used to evaluate the value of a company shares or its common stock, and this can be calculated either on the basis of the shares outstanding at the moment or if you've got option plans and things in place, then on a fully diluted basis, where you assume that all the options have converted and so you take the maximum number of shares that there can possibly be. And this is quite a useful exercise, particularly with private companies, where there are a lot of options in place because you do need to understand what's gonna happen, because in the event of any transaction event, those options normally vest automatically. So the valuation ratios we're going to look at include the book value per share. The dividend yield, the earnings per share on the price earnings ratio. So what do we mean by the book value per share? Well, essentially, what we're saying is that it's the shareholders equity in the balance sheet. What is the value of that? And you divided by the total shares outstanding. Now, of course, this is not necessarily connected to either on M and a deal where the valuation could be completely different. You. If you had a lot of property and assets, then it's very subject to when they were last revalued. But at least you get a book money. You get some sort of basis for starting your value Asian, and you can take it straight off the balance sheet on you. Just take the equity value on the shelves equity and divided by two for shares, and you get the book value per share. It's useful, but only to a certain extent. The dividend yield, however, is useful is very useful for investors, particularly if they're looking to invest in a company, particularly when they want to get a yield from it. And it's the relationship between the the three amount of dividends paid on the share price . So you take the dividend per share on divided by the share price, and that will give you a percentage differences. If the share price is 100 the dividend is being paid at five pence per share, or five in a five cents a share, then the dividend yield will be 5% on That gives investors an idea about if they put their money into this, they'll get a yield of that and they put their money into government bonds and they might get 2%. So it helps them to evaluate where they might choose to make an investment earnings per share again, very important to investors. It's one of the key metrics, which is used for comparison on year on year performance and also in terms of comparison between companies because it detaches you both from the size of the company on from it allows you to make relative comparisons across time. This is the net earnings in the year divided by the number of outstanding shares, so how much the company has earned in the year for each share that it has an issue. So the earnings per share ratio, or the E. P s ratio, as it's often referred to, is net earnings divided by total shares outstanding. The price earnings ratio, which is a measure off the value off the how expensive the shares are, compares the company's share price to its earnings per share. So it's saying how much do you have to spend to get this particular amount of earnings when you buy the shares? So how many times does the earnings per share go into the share price? How expensive is as a multiple of the share price, and it's the E. P s ratio share price divided by earnings per share. And that gives you an idea about how expensive the company is relative to other companies, or, indeed, how expensive it is now compared to how it was a few months ago. So these valuation ratios very useful to investors, very useful toe external people from the company, the sorts of ratios that are watched and managed very carefully by management. They provide real benchmarks in the public markets, and you should certainly be aware off what they are and how they work. 14. Now Its Time To Do The Course Project: At this point in the course, I'm going to ask you to pause watching the videos because I would really like you to consider taking the assignment during the project that I have set for this course. The reason for that is that the rest of the course will follow on from that assignment, and if you're going to get the most out off the learning lessons in this course, then that's what I recommend you do. So what you would need to do is tow watch the next video, where explained the set up for the assignment on, then go across to the project and follow the detailed questions in the project. So what I'm expecting you to do is to download a spreadsheet, which I've done all the hard work for you. I filled in all the basic data, and I've created ALS, the the the formulas. But what I want you to do is to go and input into the green squares. The key data from the profit and loss account the balance sheet in the spreadsheet that will then create the ratio analysis for you, which you can then use to answer the questions that I've set you now, Don't worry. All the solutions are also provided in the project area. So you've got all the questions and you've got all the solutions. And then in the rest of the course, I'm going to discuss the findings off the the assignment, the formulas that we're using and we're looking at so that you can see exactly how it all fits together and what comes out of it. Now, don't worry. If you haven't got time to do the assignment, do the project. Just keep watching the course. You'll get to see the answers. You'll get to see the discussion on. You won't miss out on anything. But if you want that extra layer off fun an extra layer off involvement with the course, then this is the time to to think about during the project rather than going to the end of the course, as is normal before looking at whether you're going to do the project or not, So I hope you find this helpful. I've set this up to be as informative and is helpful as possible. I hope you enjoy doing the assignment during the project. Onda. Let's carry on with the course 15. Apple Inc. Financial Analysis Assignment: come to the financial analysis assignment and actually had a lot of fun putting this together for you, and I hope you're going to enjoy it. I have taken it form an actual piece off financial analysis that I did for a client about 10 years ago. So I'm using something which is being professionally used in the field, as it were on. What we're going to do is to actually create using the Apple financial information a set off financial ratios so that it's like you're doing the analysis on Apple's financial statements. So what I've done is I've created a spreadsheet for you, Andi. I've done all the hard work. I put in all the numbers. I'll share what you have to do in a minute. And then I've created 21 questions relating to the financial race years, which you simply once you've done the little exercise, all you'll have to do is read them off on take them off. So if you open the Excel file attached below okay, I'll also provide a numbers file if you want to do it in Mac, and it's called the Apple in Case Study, financial analysis assignment dot XLs you open that up? This has four sheets. It has the income statement balance sheet, the cash flow on the ratio analysis I have done. I'm going to show you the spreadsheets in a minute. But I have input from the 10-K All the information you need in these 43 statements the income statement, balance sheet, the cash flow. I then set up the ratio analysis for you so that all you have to do is to focus on the ratio announces. Everything that you need is already in the three main financial statements. Okay, everything's being put in, and you just need to for focus on this four sheet, the ratio analysis. What you need to do here is in the cells in green. You need to go and input from the other three sheets by using this of equals, then go along and find it and then clicking on it. So it appears in that in that cell, the correct cell inputs for the financial statements. Now I have given you some help on the right hand side to show you where these might come from. On the left hand side in the column, it says p you'll be, which is profit and loss of balance sheet, which will again help you know which statement it comes from. And then when you've completed this correctly, the spreadsheet would duel the Kochs for you and all the cells in blue. In the numbers of Simon, I'm not sure if the colors have carried through into excel, but the the all the numbers in blue will show the correct financial ratios for you. Now I'm going to show you an example of this, and I'll also make sure that in the following discussion, which I'm going to provide to cover all these ratios so we're going to go through them after the assignment. You'll also get a A print out off a p A picture off the actual spreadsheets, and I'm also going to provide you a pdf in cases. Any ambiguity off the finished, um, spread, You know, the finish complete, especially so you've got everything you need in terms of the after effect, even if you don't decide to do the assignment. So let's have a look. So let's go now and have a look at the spreadsheets and I'll show you how to do one of them . Just if you make sure you understand what I need you to do. Okay? We are in the spreadsheet, and in fact, we're starting on the ratio analysis sheet and you can see that all the areas and blue are the ratios calculated for you. Or they will calculate once you put the numbers in. And what you need to do is to put the numbers in these empty cells in green, which are down here. There's not that many to do. But let me show you what you need to do, because here you have the income statement. Here you have the balance sheet. Here you have the cash flow statement and we're back to Beijing. Announces So in the first cell, just to show you what you need to do in the first cell here, we need to look at set. We're looking at sales growth, so we need to know there's also some notes here, which will help you understand what's going on on where to get the information for. But let's go to this one. What we need to do is put in this the sales for 2000 and 19 so you click on the cell press equals on an exhale. It will do the same thing, and now you need to go in. This case is to the profit and loss account. The income statement on. We're looking for the total sales for 2019. So it's that one, and then you click on there. You can see it's populated, the cell press equals for best return. And now that cell is in there and you can see that the sales per employee has now can calculated. And you can see that you've got other data beginning to come through where you got these red triangles and other issues in In Excel. They will fill in when you get the right data in. So that's all you have to do for these plane. These empty green cells in these two columns E N f. And when you've done that, you will end up with a complete set of data and you'll have all the ratios that you need, and then you'll be answering the questions. So that's how it it's a pretty simple exercise. I've done all the hard work for you, but you need to apply a little bit of thinking to make sure that you populate the cells with the right data. Otherwise, you won't get the answer. You will then have a spreadsheet, which you can use to answer the questions in the assignment because all the ratios will calculate for you. So I hope that explains what's required. I hope that makes it easy to understand, and I hope you enjoy the assignment. It's taken me a little while put it together, but I had to get a lot of fun from it. 16. Apple Inc. Financial Analysis Solution: I want to present to you now The financial analysis on Apple Inc sold the solution to the assignment so that whatever happens, one you can check your and spreadsheet. But secondly, if you haven't got time to do the assignment now, you can still move on with the course. So what I've done is I've provided a completed Excel spreadsheet with this lecture so you can actually download and see exactly what numbers should be and where you can follow through the formulas, that sort of thing. Andi, just make sure you understand exactly how it's all put together, and if you got this mechanic, you can use it as a template, obviously going forward. I've also completed the ratio analysis spreadsheet in the following sections of this document so you can see them one at a time in hard copy. And you can also download this as a PdF from this lecture. So I'm trying to make it as easy as possible for you to see the answers on. Then later, lectures were going to go through each one of these step by step, so you really understand exactly what they're covering. So this is the measurements of growth ratios. I don't need to talk through the whole screen. You can see the numbers on the screen, and you can reflect on it at your leisure. These are the measures of profitability ratios, and you can see again. Everything's filled in where the numbers have come from, and you should be able Teoh. Replicate this without too much trouble. The measures of trading performance are here on again, very straightforward profit margin operating margin, a net profit after tax margins and then finally, the longer one, the working capital liquidity and efficiency ratios. And again, it looks quite complicated. But actually it's pretty straightforward because each of these ratios only has two or three lines in it. It's just a question of making sure you're picking out the right lines to get the right ratios. So there we go. That's the solution to the financial analysis in the assignment, making sure you got it every which way. You can possibly have it making it as easy as possible for you. But I do hope you you have actually taken the assignment and spent the time because if you have you'll learn it. It'll go in much better on next time you're asked to do something similar, you'll have that in the back of your mind. And it'll work, work much better for you. There's no substitute for actually doing it on. I found it relatively straightforward to do because they can remember. I have done hundreds of these in the past, so I'm delighted to share one with you now. 17. Measures of Growth Discussion: want to further discuss the various groups of ratios that we've covered in the assignment just to bring home the lessons on the rationale behind them, to make sure you completely understand them. The first criteria the first ratio we looked at was sales growth, and this is the increase in sales year on year in percentage terms. Now, sales growth is a measure of the increase in market power of a company how well it is doing in its market. So you obviously want to see sales growth year on year, and it gives you a very accurate feel for how fast and organization is growing. And of course, trends are really important. The formula is very simple. You simply take the current year's sales divided by the previous year's sales. On then, if you take that number and then go minus one, you'll end up with the percentage change. The second ratio is the profit growth and this is the increase in net profit after tax year on year. In percentage terms. Now you can look at any of the prophet lines you like this. That one, the one we actually happened to look out was net profit but you can look at e bit the air. You could look at e bit. You can look at profit before tax whatever you want. We happen to be looking at net profit after tax year on year in percentage terms. So the profit growth shows how much more money or businesses generating for shareholders, which in turn can be powered back to finance. Further great, because after the profit after taxes have retained earnings line, it's the the amount you've paid off everything, including your tax bill. And that's what's left headcount. Growth is the percentage increase in the number of full time or full time equivalent employees year on year. Now the issue with this is course. During the year, the number of employees bounces around all the time on INF act. Under the SEC rules, you have to disclose the median number of employees in the year, and that's the number you need to work on the average number of employees in the year. You can't really do it. You can't really to take into account seasonality. It also needs to be accompanied by three further ratios to show whether or not you're getting good value for the extra people and not just a bigger overhead bill. Okay, so we first of all, look at how many more people we've got. And now we're going to see how well they bean doing for this. And the three ratios are sales per employee, profit per employee and value added per employee. And I'm going to show you how they're calculated. So the sales per employee you take the net sell the total sales on you, divide it by the number of employees, pretty straightforward, so you can see how many people you had to generate that level of sales. And, of course, if you look at the sales per employee one year on the sales per employee in the year before , you can see how that has changed year on year. So we're doing vertical analysis, and we're doing horizontal announces the ratio. Number five profit per employee. Now, in most cases, in a business or one of the principal assets anyway, are people Andi Then it's not just the capital assets such as machines and plant machinery . You need to do to watch. You need to see what value you're getting out of your people. So to get to the profit per employee. You take the net profit after interest, but before tax and then you divide it by the number of employees. Now you take the pre tax number because salaries and wages are a tax deductible expense for the business. So you want to actually do that before you wanted. T Look at the really announces before you pay the tax, and that's why you use the pretax profit. And of course, when you as ever you've got the vertical announces they're put two years together, and you could look at the year on year change in that particular margin in the profit per employee, the value added per employee. You take the sales less materials and bought in services, which are in the cost of sales. And you divide that by the number off employees on. That shows you what value added, you're getting its sales less material is basically sort of gross margin on. You can see the number off development of employees, and you can see how how bandy, how much value add you get per employee. And of course, as ever, with two numbers together, year on year, you can look at the change that those are the numbers and ratios have discussed. This is the spreadsheet that you calculated and you put together in the assignment, and you can see the various ratios we've just discussed shown on this spreadsheet so you can print this out, have a look at it, compare it, think about it. But I'm hopefully really getting you so familiar with these that you'll be able to do them for yourself very straightforwardly. So those are the measurement of growth ratios that we covered in the assignment on. I hope these further discussion off them will help you to really understand how they work, what they are, and it means that you're going to find them much easier to do when you're called upon to do so. 18. Measures of Profitability: Now let's take a closer look are at the measurements off profitability that again we went through in the assignment. The next ratio is then the return on capital employed, otherwise known as the R O C E. The financial resources employed in the business are called Capital Capital can come into business from a number of different sources, but essentially it's equity and debt. These sources have one thing in common. However. They want a return. They want a percentage interest on the money they invest. So equity investors are looking for an equity return on debt. Investors are looking for an interest payment from their debt. Eso There are a number of different ways in which return on capital can be measured. But for a small business, there are two particularly important ones. The first of these is the return on capital employed the R O CE ratio, and this is calculated by expressing the prophet foot before interest and tax as a proportion off the total capital employed. So you were looking at the total capital net assets, which is which is equity and debt. The great strength of this ratio lies in the overall view. It takes the financial health of the whole business. Or though this ratio gives you no indication as to any changes that maker over the years, it's simply a snapshot in time. And it's the starting point for an analysis of business performance on an overall yardstick against to compare absolute performance. Now if I used to be an investor banker Onda, a banker, might look at this ratio to see if the business could support MAWR long term borrowing, although, of course it wouldn't be the only ratio they'd look at. And you arrive at the R. O. C. Dividing the operating profit by the capital employed. The next ratio is the return on shareholder's capital. Slightly more complicated are OSC on. This is the second way of small business would calculate a return on capital, and you look at the prophet available to shareholders now. This isn't actually the money paid out as dividends, but it's a measure of the increase in worth of the funds invested by shareholder, says the return. You look at the net profit after tax and you divide it by shareholders funds, and this gives you an idea of how much profit you're getting for the funds invested. So if somebody was considering investing in shares in the business, this would be a ratio that they would look at. Let's take a look now at gearing. I've already mentioned businesses have got fundamentally two types off money, equity and debt. Now equity or owners, Capital is included in retain earnings, and it's money that is not at risk to the business. So if no profit to made than the owner and the other shareholders don't get their dividends . But they can't really get the money out. They might not be happy about it, but they can't sue to get their money back. They could sell their shares. If there's a market for their shares, a public limited company, they could sell the shares. But if it's a private company, they're probably locked him. Debt capital is money borrowed by the business from outside sources. Normally a bank, it puts the business at financial risk. And it's also risky for the lenders because if the company loses the money, then the banks don't get their money back on. The company's lost the money, said they banks then have a right to demand the money back and if they can't pay, then they can. The company can go bust in return for taking the risk. The lenders expect an interest payment every year, irrespective off the performance of the business, so dividends don't have to be paid every year. But normally interest unless there's, there's something in the terms off the debt agreement that says interest can be delayed or rolled over, or whatever interest is expected to be paid regularly. So the first ratio we look at is the debt to equity. So you look at the creditors Jew over 12 months as the long term creditors, plus any bank overdraft. I mean, in Apple's case, there is no bank overdraft. They've got lots of cash, but you had the creditors on the bank overdraft. That's the debt, and you divide it by shareholders. Funds. With the debt to capital ratio slightly more complicated, you take the long term creditors on the bank overdraft, but you divide it by the creditors that the long term credits his bank overdraft on the shareholders funds, you get a different measure off the of the gearing. Now, bear in mind that gearing levels are critical to a business a business with too much gearing can be at risk of business with too little. Gearing potentially hasn't got a very efficient balance sheet. But the you have to look at gearing levels and they can have strategic implications that affected company's competitive position affect the way that external investors look at the company affect the way customers and suppliers look at the company. So you must be aware off how Gearing works and what it is. Interest cover is calculated by dividing the operating profit by the loan interest. Essentially, it's showing you how many times the loan interest can be paid by the existing profit. It also gives the lender some idea off safety margin. So working rule of thumb for a small company is that if it's much less than three times covered, the interest earned is unlikely to give the lenders much confidence. Now Apple is considerably below that, But then Apple has got a huge amount of cash on the balance sheet on. It's a very, very well established company. I don't think the lender is going to be too concerned. The interest cover is the operating profit divided by the bank loan and interest Now, this is the spreadsheet that we created in the assignment. You've already got a working copy of this, but I just wanted you to see a lot. These ratios on the screen, you can see how the numbers you can see where they've come from. And hopefully this will not give you a very sound grounding in how you calculate these particular ratios. So those are the measurements of profitability. I hope you find the discussion helpful having done the assignment because I really want you to get underneath this financial analysis topic. It's a really important part of strategic thinking on. You need to also be able to prepare and present detailed figures like this when you're putting up business plan. 19. Measures Of Trading Performance: we're now going to take a look at and discuss measures off trading performance. The first of these is the gross profit margin. So we're focusing in these ratios on the profit and loss account on the income statement on essentially looking at the different types of profit margin on the gross profit margin is arrived at by deducting the cost of sales from the sales. So you get to the gross margin on, then you divide that by the sales. See you expressed as a percentage off sales. Andi. Basically, this ratio gives you an indication off the relative manufacturing or production efficiency off the company. Bear in mind if it's a service is going to be cost of sales. It's still showing you how profitable it is to create that service. So you get to the gross profit margin by dividing the gross profit by sales. The next ratio is the operating profit percentage or trading profit percentage, and you arrive at this by deducting the expenses the SGN eyal, the business expenses from the gross profit to arrive at the operating profit, which is the prophet effectively before interest and taxes effectively e bit you could be looking at this at the e bit d a level the operating profit before interest, tax depreciation on amortization entirely up to you. But however you do it, whichever operating profit line you take, you then divided by sales to express it as a percentage. So it's operating or trading profit percentages. The operating profit divided by sales. The last one is the net profit after tax percentage. So this is basically the net profit margin. And in this case, finance charges are detected from the operating profits Survivor net profit after tax. So that's the net income statement the net income line in the in the income statement and you express that as a percentage of sales, you can, of course, also do this before before tax. The net profit after tax percentage is the net profit after tax P 80 divided by sales. So remember that high profit margins are not automatically the passport to riches if you don't understand the strategic implications off how you get to that profitability. So those are the three or three examples off the profitability margins that you can calculate from the income statement to understand the trading performance. Of course, if you take two side by side, you can do horizontal allowances and do it year on year as well. But the idea is to understand how profitable the business is at each line. Here is the completed spreadsheet from the assignment. You can see the three profit ratios, and on the right hand side, you can see the year on year analysis as well. So I hope again, this is reinforcing what we've covered to make sure you really get this off pat. Lots of numbers can be confusing, but hopefully by covering it again like this, you'll get a clear understanding of what we're trying to achieve. So those are the measures off trading performance that we calculated in the assignment on I hope you found this discussion helpful to their understanding. 20. Working Capital Liquidity & Efficiency: like to discuss with you the working capital ratios, the working capital financial analysis that we have done on. We're looking really at issues to do with the quantity and efficiency. The next ratio, then, is the current ratio. Now this is looking at the ability of a company to meet its immediate liabilities on. You can estimate this by relating current assets to current liabilities. Now, for if any reason currently, a liabilities can't be met. The business is at risk because it's exposed to the chance that supplies may stop supplying on. They may even a petition for bankruptcy if they're kept waiting too long for payment. So basically, you're looking at the current assets, and you're saying, if I have, I got more current assets than current liabilities. So the ratio wants to be well covered so that you are sure that in your current assets the the most liquid assets you can actually pay your current liabilities. So when you do that ratio, you divide the current assets by current liabilities, you get ratio and you wanted to be covered by a certain number of times. Let's say 3.4 times, so the ratio would then be explained or expressed at three as 3.4 to 1. So that's showing you how maney what? How maney current assets you have for every one of your current liabilities. Now, if that ratio comes down to, say, 2.2, it may suggest that things are worse than the previous year. Andi, Certainly current liabilities would have grown faster than current assets. But up to a point, you have to remember that this can be desirable because it means the money is having to find less capital to finance its working capital. Because all the money tied up in stocks and things in your assets cost you money. And if you basically getting some of your suppliers to fund that, we'll look at some of these other ratios in a minute. Then obviously, you don't have to find as much capital from somewhere else. The current ratio is basically, uh, looking at the issue of a wedge of Where's your capital? Efficiency on the rule for the current ratio, whether it's high or low should basically have that ratio is closed toe oneto one, as the safe conduct of the business will allow. Of course, it's not the same for every type of business. A shop that bias finished goods on credit and cells of a cash could safely run at 1.321 But a manufacturer with raw material to store and customers to finance may need to be over 2 to 1. This is because the period between paying cash out for raw materials and receiving cash in from the customers is longer in a manufacturing business than in a retail business. So that's the working capital cycle, and that's what you're having to look at. So it's a bit like the oil on a car that, you know when you put the dipstick into car to measure the oil on, there's a band with it within which the oil level can be on levels above or below. That cause different problems. So for most come come, businesses having less than 1.2 for one probably means you're cutting it a bit fine. Over 1.821 means that too much cash is being tied up in such items of stock and debtors. So we're really looking at how efficient you can make your working capital so that you can get the most from that capital, and you don't It's bit like being overweight. You've got too much capital in the business, and you're not using it efficiently. The quick ratio, or acid test, is really a sort of belt embraces number. It's really saying if we look at only the assets that can be realized quickly, such as debtors and cash in hand, and then divide that by the current liabilities. So it's a really use of saying If everything got really dramatically urgent and I had toe pay off my liabilities, I could probably only without having a fire sale of stock, I could only really get out of my debtors in my cash. So what does that ratio look like? And so again, as a general rule, I think anything less than 0.8 toe one is something to worry about on above, nor 10.8 toe one is probably acceptable for most types of businesses. The defensive ratio is simply a company's ability to pay daily running costs from debtors on cash. Okay, and we show that in the analysis, it's not a ratio that's used. That that often debtor days, however, is and It's a very important ratio because we're really looking at the thing. This is one of the few, like the components off the current ratio on was saying, How many days credit are we giving our customers? So how long are we allowing them to take to pay on the way you get to this? Figures. You divide the debtors by sales and multiply than the resulting number by the days in the period, which is normally 365. So the average in the UK is about 60. Many firms take 70 to 80 or 90 days to get paid on. The more quickly that you get paid by the people you've sold to, the more quickly you can put that money back in your business because you're if you're having to take and give your customers that long three months credit, you've got to find that money and finance the business from somewhere else, and one of the ways you can do it is to take it from the creditors. This is the other side of the coin, because in a small business you'll also be relying on your suppliers to give you credit for the raw materials and things that you get from them. But it's important to keep an eye on that and make sure that you're not taking tomb advance to much advantage off them because they may not be happy with that. And they may decide not to supply you on. The way you arrive at creditor days is very simpler is similar that of debt. Today's you divide the creditors by the cost of sales and multiply it by 365 or the number of days in the period. In essence, the longer credit period you can get from your supplies the better, because then they are funding your business. Your customers, you know, are costing you money. But if you can get credit from your suppliers, then if you like, they're providing you with capital that you can on your business. You have to think about this in terms of the working capital cycle. But of course, if you take too long to pay, they may put you at the bottom of the list. When supplies get scarce or get give up on with you automatically or altogether when they find a better customer, stock turn is really about how efficiently your your stock is being turned over. So any manufacturing subcontracting assembling business will have to buy and or materials and work on them to produce finished goods. OK, they then have to keep track of three sorts of stock raw materials work in progress and finished goods and of retailing business of probably only concerned with finished goods. Obviously, because they're buying in finished goods to sell on and a service, businessmen have no stocks at all. So you could do this calculation for if you've got the breakdown of the data, your raw material costs, you're working progress number, annual finished goods. But if you take the whole of cost of sales, your encapsulating, all three of those and if you take the if you take the finished goods stock and divided by cost of sales, then you are seeing what your stock turns gonna be when you multiply it by the days in period 365 and you use cost of sales because this accurately reflects the amount of stock. The sales figure also includes obviously, things such as the profit margin, but you use the cost of sales, then you're using the right number. If you're looking an external company, it's possible the only figure available would be for cells, in which case you can use it as an approximation. But cost of sales is better than using the total sales number. It's impossible to make any real general rule about stock levels. Companies vary so much between one another. Obviously, a business has to carry enough stock to meet its customers. Demands and retail business must have enoughto have on display or in the stock room. The same equation can of course, be replied to both raw material and work in progress. But you need to have that those details. But to reach more material stock, you should substitute raw materials consumed for cost of sales. Once again, the strength of this ratio is that the business can quickly calculate how much is costing to carry a given level of stock in just the same way as customer credit costs were calculated earlier. The next one is the circulation of working capital on working capital is it was critical concept in the business because it's the you like it is. It's the money you need to be turning around in your business, and you want to keep your whole business finance The primary ratio calling controlling working capital is usually considered to be the current ratio. This, however, is MAWR. Interest outside bodies such as bankers and suppliers who want to see how safe their money is the manager of a business more interested in a how well the money tied up working capital is used. So to get to the circulation of working capital number, you divide sales by the working capital, and that gives you the circulation of, and you can see how many times in a year your working capital turns round for the annual sales. Use of fixed assets is important because you want to look and see how well your assets are being used is the same as the working capital ratio. When we were looking at working capital, we also looked at stock debtors and creditors. Well, with fixed assets, you can look at both the whole of fixed assets and in its various component parts. So whichever line you take, you divide sales by that line. So, through use of fixed assets or plant property and equipment, you divide sales by that number, and that gives you that ratio. Payroll costs are obviously a critical line, and you need to understand the cost per employee when managing your costs. If the headcount is growing, it's important to keep a close eye to see that your costs are growing in proportion to the headcount. And actually, since 2015 this has beena disclose herbal number under the SEC rules, and the median cost per employee is arrived at by taking the whole payroll cost on, divided by the average number off employees. And in fact, when I did the Apple test, I actually had to Google on find the average number of employees for the year because I think it was put out as a separate disclosure. It wasn't in the 10-K or at least I couldn't find it in the 10-K So this is the spreadsheet with all these different ratios on it and how they've been arrived at, you should be familiar with this from the assignment. But if you're not, then here it is and you can see the different elements of it, and hopefully this will help you to understand them in more detail. So that is the working capital discussion, looking at liquidity and capital efficiency on I hope you're really beginning to get grounded now and have a better understanding about how all these ratios work. 21. A Few Closing Thoughts: John here again. Well, congratulations on completing the course. I really hope you found it. Interesting. You should now have a very clear idea about the role of the profit and loss account, the balance sheet on the cash flow statement and how they tie in to one another and how they're independent with it while another. I hope you enjoyed the project. I had a lot of from putting it together. The whole idea is to get you working with the numbers and looking at the numbers so that they almost become so automatic and instinctive. You understand immediately how things fit together. And if you've done the project, you'll understand the power off interpretation with ratio analysis both horizontally and vertically. So I strongly encourage you to do the project. Definitely submit them up to the course. I would be fascinated to see what you've done. What you think, Andi, obviously get any feedback from your peers as well. I really hope you've enjoyed this course. I'm gonna be producing a lot Mawr finance and business courses on skill share. Andi, I do hope that you follow and look out for these because I'm sure you'll find them equally stimulating and interesting. If you got any comments or anything, you want to learn from me, then definitely message me here. I just tell me what topics and subjects you'd like particularly to learn from me on benefit from my 30 years of investment banking experience. That only leaves me to say thank you very much for taking the course. Hope you really enjoyed it. Tell your friends about it on. I'll see you again very soon in the next one.