3.4 Interpreting Published Accounts

Objectives:By the end of this topic you should be able to:select, calculate and interpret ratios to measure financial performance, including:

Liquidity ProfitabilityFinancial efficiency GearingShareholder ratios

Key term bingo!Ratio analysis

Current Ratio

Profitability RatiosROCE

Payables period

Acid Test Ratio

Inventory turnover Asset Turnover

Receivables periodDividend per share

Financial efficiency ratio

Liquidity

Shareholder ratiosGearing

Dividend Yield

What is Ratio Analysis?

A method of assessing a firm’s financial situation by comparing two sets of linked data

Ratio’s turn financial accounts into easy-to-understand numbers

You can compare firm to firm, division to division or year to year

We usually look at the balance sheet and the income statement to extract the figures

Stakeholders can draw conclusions about a company’s performance

5 Types of ratio

Profitability

Liquidity

Gearing

Financial Efficiency

Shareholders ratios

TASK 1:In pairs, using a range of resources including textbooks, Business Review and tutor2u – fill in the ratio

grid sheet

Profitability RatiosProfitability ratios can help answer questions like…

Is the business making a profit? Is it growing?

How efficient is the business at turning revenues into profit?

Is the profit enough to finance reinvestment?

Is it sustainable (high quality)?

How does it compare to the rest of the industry

Main Profitability Ratios

Gross Profit Margin

Net Profit Margin

Return On Capital Employed (ROCE)

Gross Profit Margin

Formula Margin % = Gross profit Sales Revenue x 100

Income Statement 30.06.09 (£000s)Revenue £2,000Cost of sales (£1,200)Gross Profit 800

Example

800 2,000 x 100

= 40%

Net Profit Margin

Formula Margin % = Operating profit Sales Revenue x 100

The net profit margin should be compared with other competitors in the same market and over time

Company A Company B Company CSales revenue 150 250 500Net Profit 50 25 125Net Margin 20% 10% 25%

Example

Company A makes a higher net profit than company B,

even though revenue is lower

• Company C has the highest net profit margin

• Indicates that it is doing well turning sales to profit

• Is adding value to the production process

Return On Capital Employed (ROCE)

Formula ROCE % = Operating profit Capital Employed x 100

Capital employed = total equity + non-current liabilities

Evaluation

Higher % is betterWatch out for trends over timeConsidered the best measure of a firms size

Liquidity Ratios

Current Ratio

Acid Test Ratio

Current Ratio

Formula Current ratio = Current assets Current liabilities

Balance Sheet (£000’s)Non-current assets 1,250Stocks 150Receivables (debtors) 25Cash 25Total current assets 200Payables (creditors) (250)Current liabilities (250)

Example

200250

= 0.8

Below 1 indicates cash problems

Evaluation

Ratio of 1.5-2.00 suggests efficient management of working capital

Acid Test Ratio

Formula Current ratio = Current assets - stock Current liabilities

Balance Sheet (£000’s)Non-current assets 1,250Stocks 150Receivables (debtors) 25Cash 25Total current assets 200Payables (creditors) (250)Current liabilities (250)

Example

200 - 150250

= 0.2

Below 1 indicates liquidity problems

EvaluationA good warning sign of liquidity problems for businesses that hold stocksLess relevant for businesses with high stock turnover

Gearing RatiosFormula

Gearing % = Non current liabilities Capital Employed x 100

Capital employed = total equity + non-current liabilities

2008 2009Non-current liabilities (1356) (1532)Net assets 4417 4085

Share capital (2907) (2899)Reserves and retained earnings (1510) (1186)

Total equity 4417 4085

13564417 – 1356 x 100

= 44%

15324085 – 1532 x 100

= 60%

Example

Gearing RatiosEvaluation

Focuses on the long term financial stability of the businessGearing above 50% suggests potential problems in financingIt indicates it has borrowed a lot of money in relation to its capital

Low gearing is below 25%It indicates a firm has raised most of its capital from shareholders

Gearing may not be bad – often cheaper than equityIf interest rates are low businesses may wish to take advantage

Liquidity Ratios

Asset turnover

Stock turnover

Debtor days

Creditor days

Asset turnover

Formula Asset turnover = Revenue Net assets

Income Statement 30.06.09 (£000s)Revenue £2,000

Net assets 600

Example

2,000 600

= 3.3 timesEvaluation

Measures how well a company uses its assets to achieve revenueTakes no account of profitAverage figure for UK business in 2007 was 3.3High figure = business using assets well to achieve sales and vice versa

Formula Stock turnover = Cost of sales Average stock held

Stock turnover

Income Statement 30.06.09 (£000s)Revenue £2,000Cost of sales £1,200

Example

Balance SheetNon-current assetsStocks 150

1,200 150

= 8 times

EvaluationShows how quickly stock is converted to salesHigh figure = stock sold quicklyThe figure shows how many times in that year the firm sells its value of stockHere 8 times indicates this business sells its stock 8 times a year (8/365 = 45 days)Holding more stock may mean the business can improve customer serviceSeasonal fluctuations not accounted forNot relevant for all businesses i.e. retailers

Formula Debtor days = Trade debtors Revenue x 365

Debtor days

ExampleBalance SheetNon-current assetsStocks 150Receivables (debtors) 25

Income Statement 30.06.09 (£000s)Revenue £2,000

25 2,000 X 365

= 4.5 (5 days)

EvaluationShows the number of days it takes to convert debtors into cashEach industry will have a ‘norm’Firms generally want to have a low valueMarketing dept may wish to offer long credit termsComparisons with competitors is useful

Formula Creditor days = Trade payables Cost of sales x 365

Creditor days

Balance SheetNon-current assetsStocks 150Receivables (debtors) 25Cash 25Total current assetsPayables (creditors) (250)

Income Statement 30.06.09 (£000s)Revenue £2,000Cost of sales (£1,200)250

1200 x 365

= 76 daysEvaluation

Shows the number of days it takes to pay backGenerally the higher the betterA very high figure may suggest liquidity problemsCreditor days should exceed debtor days

Example

Shareholder Ratios

Dividend per share

Dividend yield

Dividend per share

Formula Dividend per share £ = Total dividends paid Number of shares issued

Number of shares issued 400Dividends paid 80

40080

= £0.05p

Example

EvaluationLimited usefulness as it lacks contextBasic calculationDoes not reveal how much the shares cost to buyonly the first stage of the calculation

Dividend yield

Formula Dividend yield % = Dividend per share (p)Share price (p) x 100

Example Share price £0.50

0.050.50

= 10% Evaluation

Good to compare with companies in the same sectorHelps shareholders decide on investmentGood to compare to other investment rates i.e. Banks, property, savings accounts etc

Who uses the ratios?

Managers Creditors

Shareholders

Competitors Suppliers

Government

Customers

Employees

TASK 3:Mind map these on your sheet

1. How effective is stock control in a business

2. Are shareholders likely to be happy with their share of the profit?

3. Is the business likely to be able to avoid a liquidity problem in the short term if it can convert all of its liquid assets into cash? 4. Is the business able to pay its short term debts if its inventories become unfashionable and difficult to sell? 5. Is the business likely to experience a liquidity problem in the long run? 6. How successful is the business at generating profit? 7. How successful is the business at generating sales revenue? 8. How quickly is the business receiving money from customers who buy goods on credit? 9. Would shareholders receive more money from putting their savings elsewhere? 10. Are suppliers providing the business with good credit terms?

Choosing the right ratio

Discuss in pairs and be ready to feedback

Limitations of ratio analysis

Discuss what value ratio analysis has in predicting future performance (12 marks)

Ratio analysis is of limited use because it shows the past and not the future. To what extent is this statement valid? (9 marks)

How useful are profitability ratios in assessing the financial position of a business (10 marks)

TASK 5: The three essay questions below are similar in nature. Pick one, use your books and notes and have a go at answering it