Interpreting accountsThe objective of financial statements is to provide information that is useful to a wide range of users in making economic decisions (International Accounting Standards Committee)

• Trends– Comparing performance one year with a previous year, eg growth

in revenues, costs and profits• Ratios

– Allow comparisons with previous years and competitors, looking at:• Liquidity (has a company got enough money)• Profitability• Efficiency• Shareholders ratios

Liquidity ratios• Measure of a firm’s ability to meet day to day expenditure, ie to

pay bills• 2 ratios measure whether a company has enough short-term

assets to pay short-term debts if repayment is requested (eg a supplier demands payment):– Current ratio

• current assets divided by current liabilities or CA : CL• General view of about 1.5 is right (less may mean not enough liquidity, more

means too much money is tied up). Should be above 1– Acid test (sometimes called quick ratio)

• (current assets minus inventories) divided by current liabilities• Takes into account it may be hard to turn inventories into cash• Much below 1 is viewed as potentially dangerous, eg 0.6

Calculations

• What is the current ratio?– 550/430 = 1.28– Is this OK?– No, so look at acid test

• Acid test?– 250/430 = 0.58– Is this OK?– No, so firm may struggle

to pay bills– What should it do?

£000Non-current assets: Land and buildings 550 Equipment 600 Total non-current assets 1150 Current assets: Inventories 300 Trade receivables 200 Cash 50 Total current assets 550 Current liabilities: Trade payables 250 Short-term borrowings 180 Total current liabilities: 430 Net current assets 120 Non-current liabilities: Bank loans 600 Total non-current liabilities 600 Net assets 670 Equity Share capital 400 Reserves and retained profits 270 Total equity 670

Profitability• Specification

• ROCE is the main measure, but in reality we need to look at other measures, particularly profit margins– Gross profit margin– Operating profit margin – a good one

• ROCE is (operating profit/capital employed) x 100 (CE equals non-current liabilities plus total equity)

Profitability• ROCE

– Operating profit / capital employed

– Capital employed is non-current liabilities plus total equity

– 300/(600+670) x 100– So ROCE = 23.6%

• A good ROCE?– 0-5% very poor– 5-10% mediocre– 10-15% acceptable, normal– 15-20% good– Over 20% very good

Non-current liabilities: Bank loans 600 Total non-current liabilities 600 Net assets 670 Equity Share capital 400 Reserves and retained profits 270 Total equity 670

£000

Revenue 1050

Gross profit 550

Operating profit 300

Interest 10

Profit before tax 290

Net profit 230

Efficiency ratios• Can be used to compare with competitors, but main use is

internal• How efficiently is management controlling the financial

operations of the business?– And how efficiently is the business being run

• 5 principal ratios– Asset turnover– Inventory (stock) turnover– Payables (creditor) days– Receivables (debtor) days– Gearing (not really an efficiency ratio!)

Efficiency ratios – Asset turnover• Asset turnover

– How efficiently assets are being used to generate revenue

– Calculated as revenue / net assets• This formula is misleading. Should

be revenue / total assets or capital employed!

– So 1050 / 670 = 1.57– This means for every £1 invested

in net assets, the business generates £1.57 in revenues

– Higher number is better, but there is no right answer because it depends on the industry• So compare over time

Non-current liabilities: Bank loans 600 Total non-current liabilities 600 Net assets 670 Equity Share capital 400 Reserves and retained profits 270 Total equity 670

£000

Revenue 1050

Gross profit 550

Operating profit 300

Interest 10

Profit before tax 290

Net profit 230

Efficiency ratios – inventory turnover• Inventory turnover measures how many

times a business turns over its inventories in a year

• Measured as cost of sales / inventories• So 500 / 300 = 1.67

– This means inventory is turned over (sold) 1.67 times in the year

• An alternative is to calculate how long inventories are held– 365 / inventory turnover, or from scratch– Inventory days = (inventories / cost of sales)

x 365– In this case, 300 / 500 x 365 = 219 days– This means on average inventories are held

for 219 days, or the business has 219 days worth of inventory

• Appropriate inventories– Depends on the industry –

bakery/fishmonger will have high turnover, whilst a furniture shop will have low turnover

– Calculate for Ted Baker – what do you think

£000 Revenue 1050

Cost of sales 500Gross profit 550Expenses 250Operating profit 300

£000Non-current assets: Land and buildings 550 Equipment 600 Total non-current assets 1150 Current assets: Inventories 300 Trade receivables 200 Cash 50 Total current assets 550

Efficiency ratios – payables/receivables days

• These measure how quickly a company collects payments from customers, and how quickly it pays suppliers

• Receivables (debtor) days– (receivables/revenues) x 365– (200/1050) x 365 = 69.5 days– Takes 69.5 days for it to receive cash

from customers– Too long

• Payables (creditor) days– (payables/cost of sales) x 365– (250/500) x 365 = 182.5 days (6 months)– Takes 6 months to pay suppliers which is

terrible – may find it hard to continue to be supplied

£000 Revenue 1050

Cost of sales 500Gross profit 550Expenses 250Operating profit 300

£000Current assets: Inventories 300 Trade receivables 200 Cash 50 Total current assets 550 Current liabilities: Trade payables 250 Short-term borrowings 180 Total current liabilities: 430

Efficiency ratio - gearing

• Not really an efficiency ratio!• Look at previous notes• Considers what % of the capital

employed in the business is from debt (loans)

• Formula is in the sheet in the exam and is non-current liabilities / (non-current liabilities + total equity) then x 100 to put into %

• 600/(600+670) x 100 = 47.2%• High gearing can be risky – if interest

rates rise then a business will (eventually) have to pay more in interest which it might not afford– If you had a mortgage of 500,000 and

interest rates rose from 2% to 6% what happens to monthly interest payments?

£000 Revenue 1050

Cost of sales 500Gross profit 550Expenses 250Operating profit 300

Non-current liabilities: Bank loans 600 Total non-current liabilities 600 Net assets 670 Equity Share capital 400 Reserves and retained profits 270 Total equity 670

Shareholder ratios• Dividend per share (DPS)

– Dividends are paid out of profits– Dividend per share measures how much a

shareholder receives each year from each share held

– Dividends/number of shares issued. Be careful about the units

– (100/800) x 100 to be in pence =12.5p• Dividend yield

– How do you know if the dividend per share is good?

– Compare it with the value of the shares– (DPS/share price) x 100 (in %)– This tells you how much in dividends you

receive each year for every £100 you have invested in shares

– (DPS/share price) x 100– (12.5/200) x 100 = 6.25%

£000 Revenue 1050

equals Gross profit 550equals Operating profit 300equals Profit before tax 290equals Net profit 230minus Dividends 100equals Retained profit 130

Non-current liabilities: Bank loans 600 Total non-current liabilities 600 Net assets 670 Equity Share capital 400 Reserves and retained profits 270 Total equity 670

Number of shares (000) 800Share price (p) 200

Are shareholders happy• Dividends per share

– Compare with previous year• Dividend yield

– Compare with other shares or other investments

• Change in share price– Has the share price risen or fallen– Share price will generally rise when

the prospects for a company are improving

• So sum up with total shareholder returns (TSR)– Add DPS to change in share price for

the total return, then compare with price at start

Price nowPrice 1 year ago

Change in share price

Share price change 200 160 40Dividend 12.5

Total shareholder return 52.5TSR (%) 32.8%

Are shareholders happy

• TSR is the best measure, because if the business is improving (faster than expected) then the share price will rise– But you may not always be given this information

• If you are not given the share price, then you must consider how well the business is performing– Is the business growing? What has happened to

profitability?• Key measures ROCE and operating profit margin