Financial Analysis

The Management Pocketbooks Pocket Correspondence Course

This is part of an extended management course. You can dip into it, or follow the course from the start. If you do that, you may want a course notebook, for the exercises and any notes you want to make.


No manager worth their salt can get away with a trite ‘I don’t do numbers’ – numbers are an integral part of every aspect of business. And while every business has finance experts on hand to manipulate and interpret the money, every manager needs to be able to understand financial analysis, so they can contribute to decision-making.

The three basic financial tools are:

  1. The Balance Sheet
  2. The Income & Expenditure (or Profit & Loss) statement
  3. Cash flow Statement

As a manager, you may never need to prepare one of these, but you should certainly be able to read and interpret each of them. What may be less familiar to you are the various measures used in performance and investment analysis.

Performance Ratios

Return on Equity
How much we make from shareholders’ investment. Higher returns suggest a more valuable business. Calculate by dividing net income by total assets.

EBIT
Earnings Before Interest and Tax is a quick measure of the underlying profitability of the business.Some prefer…

EBITDA
Earnings Before Interest, Tax, Depreciation, and Amortisation

Gross Profit Margin
Tells us how much sales contribute to fixed costs. Calculate by dividing gross profit by sales revenue.

Net  Profit Margin
Calculates the total margin on sales revenue, after all costs. Calculate by dividing net income by sales revenue.

Operating profit margin
Excludes interest and taxation from the net profit margin calculation. Calculate by dividing EBIT by sales revenue – or use EBITDA.

Inventory turnover
Tells us how fast we sell and then replace inventory or, conversely, how badly we get stuck with inventory. Calculate by dividing the cost of all goods sold by the average value of your inventory over the same period. This fails to identify particular items of stagnant stock.

Investment Analysis

To understand the real value of an investment over a long-term, you need to create a discounted cash flow, where each receipt and payment is applied to the time slot in which it will occur, and then reduced by a discount factor (or Present Value factor) that represents the time value of money. So, a pound next year is worth less than a pound today, due to the impact of inflation.

The total of the present values of all of the payments and receipts is called the Net Present Value (NPV) and represents the value of the investment you would have to make in today’s money, to receive the total cash flows.

NPV calculations all depend on getting one crucial assumption right: the discount rate.  Higher inflation rates give higher discount factors. At the time of writing, the UK Treasury advises a discount rate of 3.5 per cent. The discount rate that a business would use is typically the rate they would pay to borrow money to fund the investment.

Discounted Cash Flow - Net Present Value

 

Click on the image to enlarge it

An alternative measure is the Internal Rate of Return (IRR). This is the discount rate that we would need to use to make the investment worthwhile. Higher IRRs are good and any IRR that is less than or just a little bigger than the the discount rate you would use (your cost of capital) will suggest that the investment will either be negative and lose money or, if just a little bigger, will be marginal and therefore very risky.

Discounted Cash Flow - Internal Rate of Return

Click on the image to enlarge it

Further Reading

From the Management Pocketbooks series:

  1. The Balance Sheet Pocketbook
  2. The Managing Cashflow Pocketbook
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