Financial Analysis, Audit and

Performance

Chapter 6

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

 Learning Objectives
• understand what is meant by financial analysis
• identify the sources of funds available to companies
and the relative advantages and disadvantages of
each
• understand the cost and non-cost issues involved in
raising and using various forms of capital
• understand the importance of the cost of capital
• understand the limitations of a company report and
accounts as a source of data for financial analysis
• describe the major tools that can be used to analyse
a company’s financial position
• explain the importance of audit and understand the
concept of social audit

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

 Sources of Finance
Share capital has,
historically, comprised
the majority of capital
for a limited company’s
start-up and subsequent
development.
A placing involves the
selling of shares directly to
a small number of investors,
usually large financial
institutions.
David Campbell, David Edgar & George Stonehouse
Business Strategy: an introduction
A rights issue is when a
company issues new shares
to the stock market.
Retained profit, that
element of operating profit
not paid to shareholders
in the form of a dividend,
is the most common
method of funding strategic
developments.
 Gearing
Gearing is an indication of how the company has
arranged its capital structure

borrowed capital, that is, debt

total capital employed, that is,
borrowings plus shareholders’ capital

or as:

borrowed capital, that is, debt

shareholders’ capital, that is, equity.

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

 Cost of Capital
The cost of capital can be viewed as the annual
amount payable (as a percentage) against the
principal amount of money.

Cost of share capital (equity) as a percentage =

(current net dividend per share divided by current
market price of share) × 100 + average percentage
annual growth rate.

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

 Models of capital costing
The CAPM model
The Capital Asset Pricing Model (CAPM) is a more
complex but widely-used model used for this calculating
the cost of share capital.
Cost of share capital = Ri +(Rm-Ri)

The WACC model

Weighted Average Cost of Capital (WACC) can be
used to determine the overall cost of funding to a
company.
WACC = (proportion of loan finance x cost of loan
finance) + (proportion of shareholders' funds x cost of
shareholders' funds)

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

 Financial Analysis and
Performance Evaluation
There are three areas of financial analysis and
these are:

1.longitudinal analysis (sometimes called trend

analysis);

2.cross-sectional analysis (or comparison

analysis);

3.ratio analysis.

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

 Longitudinal Analysis

The simplest means of assessing

any aspect of a company's finances
is to compare the data for two or
more years and see what has
increased and what has decreased
over that time period, and by how
much.

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

 Cross Sectional Analysis

It is for the purposes of

comparisons of this nature that
cross-sectional analyses are
important. As well as comparing
accounting numbers like
turnover, it is often helpful to
compare two or more
companies’ ratios.

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

 Ratio Analysis

For most purposes, we can divide

ratios into five broad categories:

1. Performance ratios
2. Efficiency ratios
3. Liquidity ratios
4. Investors' ratios
5. Financial structure ratios

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

 Ratios: Performance

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

 Ratios: Efficiency

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

 Ratios: Liquidity

• Quick Ratio / Acid Test Ratio

• Cash Ratio
• Current Ratio

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

 Ratios: Investment

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

Ratios: Financial Structure

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

 Balanced Scorecard
The balanced scorecard
is a management tool for
managers to ‘balance’
the various indicators of
success (or ‘perspectives’)
for a given business.
■ Financial indicators: financial results
■ Behaviour and loyalty of customers:
customers are an indication of how
sustainable, in financial terms, a given
financial performance is
■ Internal business processes: these are
vital because they indicate the ‘health’ of
the business and its long-term viability
■ Learning and growth: the ability of the
business to learn and grow helps to
measure the longer term prospects in
terms of innovation, creativity and
entrepreneurship.

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

 Other Tools

• Financial benchmarking

• Common size accounts

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

 Audit and Social Audit

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

 Reading
Allen, D. (1997) An Introduction to Strategic Financial Management.
London: CIMA/Kogan Page.
Department of Trade & Industry 1992. Best Practice Benchmarking.
London: DTI.
Camp, R.C. (1994). Business Process Benchmarking. ASQC
Quality Press.
Ellis, J. and Williams, D. (1993) Corporate Strategy & Financial
Analysis. London: Pitman Publishing.
Franks, J.R. and Broyles, J.E. (1979). Modern Managerial Finance.
Chichester: John Wiley
Higson, C. (1995) Business Finance. Oxford: Butterworth-
Heinemann
Mott, G. (1991). Management Accounting for Decision Makers.
London: Pitman Publishing.

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction

 Review Questions
1. Explain what we mean by a financial analysis

2. Explain what the limitations are of a company report when

used for financial analysis.

3. Evaluate the alternative options for funding a company’s

developments based on current position, future prospects
and past performance.

4. Describe the main tools used to analyse a company’s

financial position.

ANSWER THE QUESTIONS ABOVE IN

NOT LESS THAN 200 WORDS EACH QUESTION

David Campbell, David Edgar & George Stonehouse

Business Strategy: an introduction