Analysis of Business Performance

7/31/2019 Analysis of Business Performance

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Business Studies Online: Slide 1

Using Accounts to Interpret PerformanceUsing Accounts to Interpret Performance

Accounting information is used by stakeholders to

judge the performance and efficiency of a business

Different stakeholders will look for different things:

Suppliers

Creditors

Government

Society

Customers

Employees

Managers

Shareholders

POSSIBLE OBJECTIVESTAKEHOLDER

High dividends & Increased Share Price

Career Development & Opportunities

Job Security & Higher Wages

Good Value for Money

A Responsible Business

High Tax Revenues & More Jobs

Healthy Cash Flow to Secure Repayment

Increased Sales & Payment of Bills


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Using Ratio AnalysisUsing Ratio Analysis

There are 5 broad categories of ratios used:

EFFICIENCY RATIOSThese indicate how

efficiently a business is

using its resources and

collecting its debts

PROFITABILITY RATIOS

These compare the profits of the business

with sales, assets and the capital employed

in the business

SHAREHOLDER RATIOS

These can be used to assess the rate of

return on shares and the prospects of

shareholders investment

SOLVENCY RATIOSThese measure the degree to

which a business is relying on

long-term loans. They reflect of

a businesss financial strategy

LIQUIDITY RATIOS

These measure how

easily a business could

meet its short-term

debts or liabilities.


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Profitability Ratios:Profitability Ratios:1) The Return on Capital Employed1) The Return on Capital Employed

Calculated using the following formula:

This compares net profit to the amount of

money in the business

The higher this figure is the better

E.g. a ROCE of 12% means that for every 1 invested

in the business, a firm makes 12 pence net profit

This can be used to compare figures from previous

years, or the performance of the business with the

interest from a bank account

100xEmployedCapital

TaxBeforeProfitNet(ROCE)EmployedCapitalonReturn =

FromBalanceSheet

From TPLAccount

f b l


4/18 Business Studies Online: Slide 4

Profitability Ratios:Profitability Ratios:2) The Gross Profit Margin2) The Gross Profit Margin


It compares gross profit with the value of sales revenue


E.g. a GPM of 40% means that for every 1 received in

sales revenue, a firm makes 40 pence gross profit

An improved GPM may be achieved as a result of:

Increased turnover relative to costs

A relative decrease in costs

Generally in industries with high turnover, GPM is lower

100xTurnover

ProfitGross(%)MarginProfitGross =

From TPLAccount

From TPLAccount

f b lP fi bili R i



Profitability Ratios:Profitability Ratios:3) The Net Profit Margin3) The Net Profit Margin


It compares net profit with the value of sales revenue


E.g. a NPM of 23% means that for every 1 received in

sales revenue, a firm makes 23 pence net profit

It is used for comparisons over time

It indicates how well a firm is managing overheads

Generally in industries with high turnover, GPM is lower

100xTurnover

ProfitNet(%)MarginProfitNet =

From TPLAccount

From TPLAccount

Effi i R tiEffi i R ti



Efficiency Ratios:Efficiency Ratios:1) Stock Turnover1) Stock Turnover


Measured indays

This measures how quickly a business sells its stock

The lower this figure is the better

E.g. a stock turnover of 35 days means that onaverage stock is held in the business for 35 days

This ratio is not relevant to service industries since

they will not hold stocks

365xSalesOfCost

StocksTurnoverStock =

FromTPL

Account

FromBalanceSheet




Efficiency Ratios:Efficiency Ratios:2) Debtors Collection Period2) Debtors Collection Period


Measured indays

This measures how quickly a business is able to get

money it is owed from debtors

Generally the lower this figure is the better though

there is no right answer

E.g. a debt collection period of 58 days means that on

average debtors take 58 days to settle their bills

It can be improved through better credit control

365xTurnover

DebtorsPeriodCollectionDebt =

FromTPL

Account

FromBalanceSheet




Efficiency Ratios:Efficiency Ratios:3) Creditor Payment Period3) Creditor Payment Period


Measured indays

This measures how quickly a business pays the

money it owes to creditors

E.g. a creditor payment period of 47 days means that

on average invoices are paid 58 days after receipt

If the figure is too high it:

May indicate cash flow problems within the business

May lead to poor relationships with suppliers

365xTurnover

CreditorsTradePeriodPaymentCreditor =

FromTPL

Account

FromBalanceSheet




Efficiency Ratios:Efficiency Ratios:4) Asset Utilisation4) Asset Utilisation


This measures how much turnover is generated by the

assets owned by the business

Generally the higher this figure is the better though it

may vary considerably between industries

E.g. an asset utilisation figure of 3.75 means that every

1 invested in assets generates 3.75 of turnover

It can be improved by increasing turnover without further

investment in assets

AssetsNet

TurnoverisationAsset Util = From

BalanceSheet

From TPL

Account

Li idit R ti :Li idit R ti :



Liquidity Ratios:Liquidity Ratios:1) The Current Ratio1) The Current Ratio


The answer is shown as a ratio

It measures the ability of a business to pay its debts

over the next year

E.g. a current ratio of 1.78 would mean that for every1 a business owes it has 1.78 of assets that can be

used to pay it

The ideal will vary from business to business, but

between 1.5 and 2 is usually acceptable

sLiabilitieCurrent

AssetsCurrentRatioCurrent =

From Balance

Sheet

From BalanceSheet

Liquidity Ratios:Liquidity Ratios:



Liquidity Ratios:Liquidity Ratios:1) The Acid Test Ratio1) The Acid Test Ratio


The answer is shown as a ratio

E.g. an acid test ratio of 1.24 would mean that for

every 1 a business owes it has 1.24 of assets that

can be sold very quickly to pay itStock is not included because it may not be a finished

good ready for sale

The ideal will vary from business to business, but

generally a figure near to 1 is acceptable

sLiabilitieCurrent

Stock-setsCurrent AsRatioTestAcid =

Both From

Balance Sheet

From BalanceSheet

Solvency Ratios:Solvency Ratios:



Solvency Ratios:Solvency Ratios:1) The Gearing Ratio1) The Gearing Ratio


This measures how reliant a firm is on borrowed capital

E.g. a gearing ratio of 34% would mean that for every 1

invested in the business 34 pence of it is borrowed

A highly geared firm will have higher costs due to interestpayments

This may affect:

The ability to pay dividends to shareholders

Their ability to borrow further funds

100xEmployedCapital

CapitalLoan(%)RatioGearingThe =

From Balance

Sheet

From Balance

Sheet

Solvency Ratios:Solvency Ratios:


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Solvency Ratios:Solvency Ratios:2) Interest Cover2) Interest Cover


This measures how many times a firm is able to pay its

interest costs from net profit

E.g. an interest cover of 4 means that the business could

pay its interest costs 4 times from net profitThis gives an indication of how affordable a firm is finding

its borrowing

PaidInterest

Interest&TaxBeforeProfitNetCoverInterest =

From TPL

Account

From TPL

Account

Shareholder Ratios:Shareholder Ratios:


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Shareholder Ratios:Shareholder Ratios:1) Return On Equity Ratio1) Return On Equity Ratio


This measures the return made from money invested in

the business by shareholders

E.g. a return on equity ratio of 5% means that the

business made 5 pence profit for every 1 invested byshareholders

Shareholders do not usually receive this return

Note that (Share Capital + Reserves) may be referred to

as shareholders funds

x100ReservesCapitalShare

DividendsSharePreference&InterestTax,AfterProfitNetCoverInterest

+

=

From TPL

Account

From Balance

Sheet



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Shareholder Ratios:Shareholder Ratios:2) Earnings Per Share Ratio2) Earnings Per Share Ratio


This measures how much profit was made per share

issued

E.g. an earnings per share ratio of 0.1 means that 10

pence profit was earnt for each share issuedAlthough this profit is available for distribution to

shareholders they do not usually receive this amount

SharesofNumber

ProfitNetSharePerEarnings =

From TPL

Account

From Balance

Sheet



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Shareholder Ratios:Shareholder Ratios:3) Dividend Per Share Ratio3) Dividend Per Share Ratio


This indicates how much shareholders will receive for

each share that they hold

E.g. a dividend per share ratio of 0.25 means that

shareholders will receive a dividend of 25 pence for eachshare that they hold

The total dividend will be declared by the directors

SharesofNumber

DividendsTotalSharePerDividends =

From TPL

Account

From Balance

Sheet



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Shareholder Ratios:Shareholder Ratios:4) Dividend Yield Ratio4) Dividend Yield Ratio


This indicates the return a shareholder receives at the

current share price

E.g. a dividend yield ratio of 6% means that the dividend

paid to shareholders represents 6% of the current cost ofbuying the share

This can be compared directly to other investments

The result needs to be compared to previous years and

similar businesses

PriceShareMarket

SharePerDividend(%)YieldDividend =

From Previous

Calculation

From Stock

Market


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The Limitations Of Ratio AnalysisThe Limitations Of Ratio Analysis

One ratio alone is not very usefulRatios need to be compared with:

Previous figures

Similar businesses

Such comparisons need to consider:External factors change over time

Different businesses have different financial years

Ratios can be calculated using slightly different formulae

This makes direct comparisons very difficult

Different accounting principles may be employed

E.g. depreciation could be calculated differently

this would affect the value of ratios

Documents

Analysis of Business Performance