Accounts

5.5.1 Analysing Financial Statements Using Ratio analysis

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Learning Outcomes

• To be able to interpret Financial Statements by calculating and analysing the following ratios:

– Gross Profit Margin– Profit Margin– Return on Capital Employed– Current Ratio– Acid Test Ratio

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Ratio analysis

• Used to analyse the financial security of a business

• Two types:1. Profitability2. Liquidity

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Accounts

1. Profitability ratios2. Liquidity ratios

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1. Profitability ratios

• These help to show how well a business is doing against its objectives

a.Gross Profit Marginb.Net Profit Marginc.Return on Capital Employed

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a. Gross profit margin (gross profit to sales ratio)

• GPM =

• Shows the percentage of sales revenue which is gross profit

• A high percentage indicates relatively low cost of sales compared to turnover

• Ignores indirect costs (overheads)

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Gross profitTurnover (sales)

x 100 = ?%

a. Gross profit marginexample

• Oddball Ltd’s trading account for 2006 is as follows:

• Complete the table• Calculate the Gross Profit Margin• Last year, the Gross Profit Margin was 50%.

Has it improved or worsened?7

£900

360Cost of sales (540)Turnover

Gross profit

b. Profit Margin (net profit to sales ratio)

• PM =

• Shows the percentage of sales revenue which is net profit

• A high percentage indicates that the business has a tight control over costs

• Includes all business costs (direct and indirect) and is thus more useful than GPM

• Needs to be compared with previous years or similar businesses

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Net profitTurnover (sales)

x 100 = ?%

b. Profit Margin example

• E.g. For Oddball Ltd above:

• Complete the table• Calculate the Profit Margin• Last year, the Profit Margin was 5%. Has

it improved or worsened?9

360Overheads (+ other income) (270)Gross profit

Net profit 90

£900540

TurnoverCost of sales

c. Return on Capital Employed (ROCE)

• ROCE =

• Where will you find Capital Employed?• Measures the rate of return being generated

by the money invested in the business• A high percentage indicates that the business

is well managed• Needs to be compared with previous years or

similar businesses

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Net profitCapital Employed

x 100 = ?%

c. Return on Capital Employed (ROCE)

• E.g. On Oddball Ltd’s balance sheet Capital Employed is £1,800 (net profit is £90)

• Calculate the ROCE

• Last year, the ROCE was 7%. What has happened?

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TaskBimbam Ltd

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GPM

NPM

2004 2005 2006

Sales

Gross Profit

Net profit

124,500

72,145

12,500

129,950

73,255

14,350

142,050

78,435

19,250

Describe the changes in profitability over the 3 yearsWhy do you think these changes have taken place?

Capital employed 256,500 266,350 278,550

ROCE

58% 56% 55%

10% 11% 14%

4.9% 5.4% 6.9%

Bimbam makes plastic recycling bins, selling them to local councils

Accounts

1. Profitability ratios2. Liquidity ratios

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2. Liquidity ratios

• These look at a firm’s ability to pay its debts• The faster an asset can be turned into cash, the

more ‘liquid’ it is

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a. Current ratio

• Current Ratio =

• A measure of short-term solvency• It indicates the extent to which money

owed in the short term is covered by liquid assets

• A prudent ratio is at least 1.5 : 1 (i.e. for every £1 of current liabilities there is £1.50 of current assets) however more than 3 : 1 suggests an inefficient use of assets

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Current AssetsCurrent Liabilities

= ? : 1

a. Current ratio Oddball Ltd example

• Complete the table• Calculate the current ratio• Last year, the Current ratio was 3 : 1.

What has happened?16

Current assets:Stock 20Debtors 10Cash  5

Current liabilities:Creditors 15

Net current assets

35

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b. Acid test ratio

• Acid test =

• A much better test of the immediate solvency of a business because of the length of time necessary to convert stocks into cash (via sales and debtors)

• Should typically be around 1 : 1

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Current Assets - stockCurrent Liabilities

= ? : 1

b. Acid test ratio Oddball Ltd example

• Calculate the acid test ratio• Last year, the Acid test ratio was 0.8 : 1.

What has happened?

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Current assets:Stock 20Debtors 10Cash  5

Current liabilities:Creditors 15

Net current assets

35

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TaskBimbam Ltd

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Current ratio

Acid test ratio

2004 2005 2006

Stock

Current assets

Current liabilities

12,840

39,425

28,095

19,520

43,420

28,565

26,450

44,375

26,980

Describe the changes in liquidity over the 3 yearsWhy do you think these changes have taken place?

1.4 : 1 1.5 : 1 1.6 : 1

0.9 : 1 0.8 : 1 0.7 : 1

Bimbam makes plastic recycling bins, selling them to local councils

Calculate the following:

Accounts

Uses of ratio analysis

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Uses of ratio analysis• Ratio analysis compares one piece of

financial information with another• Allows managers, shareholders and potential

investors to analyse and evaluate the financial position of a business

• Used to:– Compare the same ratio for two different

businesses– Compare the same ratio for one business over

time– Compare business with a yardstick or ideal value

for the ratio

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Limitations of ratio analysis

• Ratios are based upon past results and may not indicate how the business will perform in the future

• Accounting results are affected by inflation– Comparisons with previous years can be

misleading

• You would expect different ratios from different industries– e.g. you would expect a supermarket chain to

have more stock than a football club

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Ratio analysis

Task – Cornwall plc

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Cornwall plctask

• Cornwall plc takes out a long term loan for £200,000 on top of its share capital of £400,000. With it, it buys a derelict warehouse for £50,000 and a block of offices for £350,000. It also buys a fleet of vans for £100,000 and stock of £50,000, for which £20,000 is paid in cash and the rest is on credit

• List the different aspects of the information above under the following headings as appropriate:– Fixed assets– Current assets– Current liabilities– Long term liabilities– Share capital

• Produce a full balance sheet for Cornwall plc• Calculate and comment upon the following ratios:

– Current ratio– Acid test ratio

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Cornwall plcanswers

• List the different aspects of the information

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Share capital

Fixed assets

Current assets

Current liabilities

Long term liabilities

Cornwall plcanswers

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Fixed assetsWarehouse 50Offices 350Van

500Current assets

Stocks 50

Cash

Less: Current liabilitiesTrade creditors 30

Net Current Liabilities 100

Assets Employed

Financed by:Share capital 400Bank loans

Capital Employed

£’000 £’000

100

80

130

600

200

600

Cornwall plcanswers

• Current ratio

• Acid test

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Acid test = 80 ÷ 30 = 2.7 : 1Well above the benchmark so too high again.

Since it is significantly different from the current ratio it suggests that stock levels are

also too high

Current ratio = 130 ÷ 30 = 4.3 : 1Well above the benchmark of 2 : 1 so too high

– holding too much cash

Ratio analysis

Southampton FC task

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Southampton FCtask

• Investigate the profit and loss account and balance sheet of Southampton FC using appropriate financial ratios

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Southampton FCprofit and loss account – year ended 30 June 2006

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Administrative expenses (6,861)

Net profit(4,380)

Less: TaxationLoss after tax

Dividends paidRetained profit

(953)

Turnover 25,696Less: Cost of SalesGross loss

£’000 £’000

(31,363)5,667

Profit on sale of players 11,241Interest payable (2,008)

(2,372)

(2,342)

0(2,342)

Southampton FCbalance sheet – at 30 June 2006

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Fixed assetsLand and buildings 35,191Equipment and vehicles 675

Intangible assets

39,623Current assets

Stocks 404Debtors 6,466Cash

Less: Current liabilitiesCreditors 9,282Bank overdraft 11,294

Net Current Liabilities 276

Assets Employed

Financed by:Share capital 5,795Retained profit 2,959Bank loans

Capital Employed

£’000 £’000 £’000

3,757

4,700 11,570

2,012

39,899

31,145

39,899

Task

• Explain why someone thinking of buying shares in a company would find the published accounts of that company useful

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Ratio Analysis Bingo!task

• Test your understanding of accounts terminology and your knowledge of ratio analysis calculations

• An alternative Bingo game, focusing on ratio analysis calculations and interpretation of the numbers

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