Interpreting Accounts

You owe HWK

Textbook page 32 progress questions

Do Q 1, 7, 11, 12 (24 marks)

Interpreting Published Accounts

Interpreting Published Accounts

Ratios you MUST know

• Profitability (ROCE).

• Gearing

• Liquidity (current and acid test ratios),

• Financial efficiency (asset turnover, stock turnover, creditor and debtor days),

• Shareholder ratios (dividend per share and dividend yield)

Which is better?

Company A has

£100,000 profit

Company B has£1m profit

Which is the more successful company?

Which is better?

Company A has£100,000 profit, where £200,000 was the capital

invested

Company B has£1m profit,

where £10m was the capital

invested

Which is the more successful company?

Which is better?

Company A has£100,000 profit, where £200,000 was the capital

invested

Company B has£1m profit,

where £10m was the capital

invested

How can you use % calculation to see the differences?

100,000/200,000 x100

= 50%1m / 10m x100

= 10%

Profitability ratios

Gross Profit Margin *Gross Profit Margin *

Operating Margin *Operating Margin *

ROCEROCE

* Covered in AS BUSS2

This is one type of ratio!

… Known as ROCE

Return on Capital Employed

Profitability Ratios

• The ‘primary ratio….’

• ROCE – return on capital employed

• This tells us how efficient the company is by looking at their profits & comparing it to the funds invested in the business.

• ROCE = Operating profit x 100Capital employed

Examples of ROCE (2007)

Company Annual operating profit

Capital employed

ROCE

Burberry £157m

B.P. $32,352m

Tesco £2,648m

Cadbury Schweppes

£796m

Which company looks the

more impressive just on raw

profit figure?

Which company do you think might be

the most efficient at generating profits?

Remember to consider the reasons

why?



Capital employed

ROCE

Burberry £157m £419.3m

B.P. $32,352m $158,845m

Tesco £2,648m £16,655m

Cadbury Schweppes

£796m £6,706m


more impressive

now?



Capital employed

ROCE

Burberry £157m £419.3m

B.P. $32,352m $158,845m

Tesco £2,648m £16,655m

Cadbury Schweppes

£796m £6,706m

Calculate the ROCE figure

Operating profit x100 Capital employed



Capital employed

ROCE

Burberry £157m £419.3m 37.44%

B.P. $32,352m $158,845m 20.37%

Tesco £2,648m £16,655m 15.90%

Cadbury Schweppes

£796m £6,706m 11.87%

For every £1 invested in the

company, Burberry make

37p back in profits

Evaluating ROCE

ROCE%

ROCE%

Higher % is betterHigher % is better

Watch for trend over timeWatch for trend over time

Watch out for low quality profit which boosts ROCE

Watch out for low quality profit which boosts ROCE

Leased equipment will not be included in capital employedLeased equipment will not be included in capital employed

Other profitability ratios…

• At AS you looked at…

– Gross profit margin – & – Net profit margin,

and in A2 you will be given credit for looking at this profitability ratio again!

Gross Profit MarginGross Profit Margin = Gross Profit x 100 = %

Turnover

The Gross Profit margin ratio tells us the profit a business makes on its cost of sales or cost of goods sold. It is a very simple idea and it tells us how much gross profit per £1 of turnover the business is earning.

For example,

A 40% GPM means for every £1 sold 40p equates to gross profit

A 14% GPM means for every £1 sold 14p equates to gross profit

Gross Profit is the profit we earn before we take off any administration costs, selling costs and so on. So we should have a much higher gross profit margin than net profit margin.

Remember: Turnover = sales Gross Profit = Turnover – Cost of Sales

Gross Profit Margin

Here are a few examples of the gross profit margins from different businesses.

The Gross Profit Margins may vary from business to business and industry to industry.

For example, the International Airline has a gross profit of 5.62% yet the Accounting Software business has 89.55%

If a company’s raw materials and factory wages go up a lot, the gross profit margin will go down unless the business increases its selling prices at the same time.

Leisure & Hotel

International Airline

Manufacturer Retailer Discount Airline

Refining Pizza Restaurants

Accounting Software

Gross Profit

9.64% 5.62% 35.14% 11.41% 27.46% 12.63% 47.52% 89.55%

What does the Gross Profit

Margin also tell us about the cost of

sales?

Net Profit MarginNet Profit Margin = Net Profit x 100 = %

Turnover

Remember Net Profit = Gross Profit – overheads + income earnt

The Net profit margin ratio tells us of net profit per £1 of turnover. That is, after taking into account the cost of sales, administration costs, the selling and distribution costs, the net profit is the profit that is left, out of which they will pay interest, tax, dividends and so on.

Leisure & Hotel




Accounting Software

Net Profit

7.36% 4.05% -10.48% 1.63% 10.87% 11.99% 7.55% 27.15%

Just like the gross profit margins, the net profit margins also vary from business to business and industry to industry. When we compare the gross and net margins we can gain a good impression of their non-production and non-direct costs such as administration, marketing and finance costs.

We saw that the International airline’s gross profit margin was the lowest of the 8 industries at 5.62% but its net profit margin is 4.05%, only a little bit lower. On the other hand, the discount airline gross profit margin is 27.46% but its net profit margin is 10.87% These comparisons give us a great insight into the cost structure of these businesses.

Compare Ryanair with BA management structures.

Comparing Gross to Net Profit Margins

Leisure & Hotel




Accounting Software

Gross Profit

9.64% 5.62% 35.14% 11.41% 27.46% 12.63% 47.52% 89.55%

Leisure & Hotel




Accounting Software

Net Profit

7.36% 4.05% -10.48% 1.63% 10.87% 11.99% 7.55% 27.15%

Look at the software business – a very high GPM of 89.55% but a NPM of 27.15% . This is still high, but we can see that the administrations costs are very high while the costs of sales are very low.

So what’s happened to

Manufacturing?

How to improve profits?

• Remember your hwk recently to read article on profitability?

• “Improving Profits” Business Review Nov 2008

• What can you remember?

Recap profitability ratios

• There are THREE profitability ratios..

Gross Profit Margin *Gross Profit Margin *

Operating Margin *Operating Margin *

ROCEROCE

To help you learn all of this

Ratio formula

Ratio name

Fill in the profitability ratio info for ROCE

Gearing – another ratio

A Liquidity ratio

Gearing

• This tells us how much of the company’s finance is through debt!

• A highly geared business is funded heavily through long term debts

• A low geared business is funded mainly through its owners/shareholders.

Gearing

• A company with 80% gearing….

• has 80% of funds through long term debts and 20% through owners/shareholders.

• A company with 35% gearing…

• has 35% of funds through long term debts and 75% through owners/shareholders.

Which is in the better position?

Calculating Gearing

Gearing = non current liabilities x 100total equity & non current liabilities*

• Aka capital employed

So if a company has £280 in non current liabilities and £1,000 in capital employed

Gearing = 280 x 100 = 22% 1000+ 280

Examples of Gearing (2007)

Company Date of balance sheet

Non current liabilities

Capital employed

Gearing

BA 31/3/08 £4,646m £7,679m 60.50%

Tesco 23/2/08 £7,999m £19,901m 40.20%

Morrisons 29/7/08 £1,356m £5,773m 23.49%


more impressive just on the

figures?

Why could the differences in dates

be important?

Which is in the better position?

Benefits of high gearing

• With low interest rates – highly geared companies benefit from cheap finance…. But when Interest rates go back up…

• Relatively few shareholders – easier to keep control of the company.

• Fewer shareholders could mean that the business has less dividend pressure, and could retain profit for future investments.

Benefits of low gearing

• Most of the capital is ‘permanent’ and does not have to be ‘repaid’ with interest!

• Less risky where creditors can not force the business into liquidation (think Woolies!)

• Easier to borrow more in the future if the company wants to expand.

To help you learn all of this

Ratio formula

Ratio name

Fill in the gearing ratio info

Liquidity ratios

Assess whether a business has sufficient cash or equivalent

current assets to be able to pay its debts as they fall due

Assess whether a business has sufficient cash or equivalent

current assets to be able to pay its debts as they fall due

Liquidity ratios.

• What is liquidity?

• Liquidity is an asset's ability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value.

• Money in the bank or cash on hand, is the most liquid asset.

Liquidity Ratio

• These tell us how healthy the business is in the SHORT TERM

• It tells us whether the working capital is sufficient to cover the immediate debts!

– Current Ratio– Acid Test Ratio

Quick recap…

• What is the money owed to a business from customers called on the balance sheet?

– Receivables (from debtors)

• What are the other ‘current assets’?– Cash– Inventories (stock)

Current Ratio

A liquidity ratio

Current Ratio

Current Ratio = current assets : current liabilitiesorCurrent Ratio = Current assets

Current liabilities

• So what do you think a current ratio of 2:1 means?

• The company has £2 of assets for every £1 of debt

Examples of Current ratios

Company Balance sheet date

Current assets

Current liabilities

Current ratio

BA 31/3/08 £3,148m £3,244m

Tesco 23/2/08 £6,300m £10,263m

Tate & Lyle

31/3/08 £1,695m £1,204m

Burberry 31/3/08 £588.4m £436.2m


more impressive just on the

figures?

Calculate their Current Assets ratio…= current assets / current liabilities

Written as ? : 1

Examples of Current ratios


Current assets

Current liabilities

Current ratio

BA 31/3/08 £3,148m £3,244m 0.97:1

Tesco 23/2/08 £6,300m £10,263m 0.61:1

Tate & Lyle

31/3/08 £1,695m £1,204m 1.41:1

Burberry 31/3/08 £588.4m £436.2m 1.35:1

Should Tesco & BA panic about a ‘liquidity’ of

<1?

http://news.bbc.co.uk/1/hi/business/8009848.stm

What can they do to improve Current ratio?

• Sell under used non current assets – but is this really wise?) BA is grounding 22 planes this winter!

• Raising more share capital (what the banks have done!)

• Increase long term borrowing! (OK when IR’s are soo low!)

• Postpone planned investments – eg Stelios disagreement over Easyjet!

Good video link

• http://news.bbc.co.uk/1/hi/uk/8178474.stm

• About BA & how ‘well it’s positioned’ to survive the current crisis – looks at reducing CA, increasing N-CL & gearing all in one clip!

http://news.bbc.co.uk/1/hi/uk/8178474.stm

Acid Test Ratio

A liquidity ratio

Acid Test Ratio

• This ratio looks at comparing assets with liabilities BUT with removing stock figures

• ACID TEST RATIO • =(current assets – inventories) : Current liabilities

Or

• ACID TEST RATIO = Current assets – inventoriesCurrent liabilities

Why remove the inventories?

• Stock is THE MOST illiquid asset of the business

• It can take a long time to convert inventories (stock) into cash

• It can ‘depreciate’ if sold as 2nd hand rather than ‘produced’ into final product.

Acid Test Ratio

• So another way of calculating the Acid Test Ratio

= Cash & receivable (debtors)Current liabilities

• So what would an Acid Test Ratio of 1.5:1 mean?

• The company has £1.50 worth of liquid assets to every £1 of debt!

• The ideal situation is an Acid Test ratio of 1:1

Quick Q

• If Tesco has a current ratio of 0.61:1, what do you think their Acid Test Ratio will be?

• Will it be higher or lower than this?

Examples of Acid Test ratios


Current assets

Current liabilities

Current ratio

BA 31/3/08 £3,148m £3,132m

Tesco 23/2/08 £3,870m £10,263m

Tate & Lyle

31/3/08 £1,133m £1,204m

Burberry 31/3/08 £318.4m £436.2m

Examples of Acid Test ratios


Current assets

Current liabilities

Current ratio

BA 31/3/08 £3,148m £3,132m 1.01 :1

Tesco 23/2/08 £3,870m £10,263m 0.38 :1

Tate & Lyle

31/3/08 £1,133m £1,204m 0.94 :1

Burberry 31/3/08 £318.4m £436.2m 0.73:1

Much lower due to having so much

stock!

Why is 1:1 ideal?

• Why is the acid test ideal 1:1?

• If a company has a ratio of 2:1 – what does this mean?

• Why is that not the most efficient use of its liquidity?

• If a company has a ratio of 0.1 : 1 – what does this mean?

• What does this suggest about the company’s financial strength?

So use your colour sheetRatio formula

Ratio name

Fill in the Liquidity ratios info

Financial efficiency ratios

Assess how effectively a business is managing its

assets

Assess how effectively a business is managing its

assets

Financial efficiency ratios

Asset turnoverAsset turnover

Stock turnoverStock turnover

Debtor daysDebtor days

Creditor daysCreditor days

Asset Turnover

• This tells us how well the company uses all it’s assets to generate its sales

Asset turnover = Revenue (sales turnover) Net assets*

* where net assets are Total Assets -Total liabilities* this is also the total equity figure at the bottom of the balance sheet.

Examples of Asset turnover

• It’s very difficult to compare different industries

• This is a ratio that definitely to be used benchmarking inter-firm comparison or over a period of time with the same firm.

• For example, • Tesco will have a high asset turnover – ‘pile them

high & sell them cheap’. Meanwhile, Harrods would have a low asset turnover of lower quantity sales but with a high profit margin!

Stock Turnover

Stock Turnover

• This tells us the number of times a business will sell & replace its stock.

• A fishmonger should have a HIGH stock turnover of 365 times – as it gets fresh fish delivered every day of the year!

• Where as a second hand car dealer may have a stock turnover of 12 times – which is selling & replacing its cars on the forecourt once a month!

Calculating Stock Turnover

Stock Turnover = Cost of goods soldAverage stock held

1. List three business that would have a high stock turnover and three that would have a low figure for stock turnover.

2. A bread shop has an opening stock of £5 000 at the start of the financial year and at the end of the year its stock is £6 000. The cost of sales for the shop is £55 000. Calculate its stock turnover.

Factors that influence rate of stock turnover

• Nature of the product – perishable, antiques

• Importance of holding stock – in large or smaller quantities – imagine going into M&S with empty shelves! High street stores need large quantities of stock.

• The length of the product life cycle• Stock management systems• Variety of products being held.

Debtor & Creditor days

Debtor Days

• Debtors are known as receivables

Debtor days = receivables x 365revenue

• This tells us how much credit the company gives to its customers.

• Sofa companies often give ‘buy now pay later options’ – whereas at the local petrol station I have to pay immediately!

Creditor Days

• Creditors are known as payables

Creditor days = payables x 365revenue

• This tells us how long the company takes to pay back the money it owes to its suppliers.

• Delaying payment for as long as possible can help the business!

• BUT – can cause problems with suppliers in future!• BUT – can incur interest charges (Late Payment Act 1998!)


Ratio name

Fill in the financial efficiency ratios info

Shareholder ratios

Dividend per share

Dividend yield

Dividend per share

DPS = Total dividendsNumber of shares issued

• Answer is expressed as number of pence per share

• In 2008 M&S anounced dividends of £343.6m for 1,586.48m shares 21.65p per share.

• Obviously the higher the dividend the better for shareholders! The lower the dividend per share might mean that the company is retaining profit for investments!

Dividend Yield

Dividend Yield = Dividend per share x 100Market price of share

• So using the M&S calculation previously, if the share price was 220p on one day… the Dividend yield would be 21.65/220 x 100 = 9.48%

• You would need to compare this figure with past figures & can vary greatly with fluctuations in the stock market!


Ratio name

Fill in the Shareholder ratios info

What do these ratios mean?

• NPM of 24%• ROCE of 15%

• Debtor days of 20 and Creditor days of 10.

• Stock turnover of 12 times?

• Dividend per share 80p• Dividend yield 5%

• Acid test ratio of 1.8 : 1 ?• Acid test ratio of 0.78 : 1 ?

• Gearing of 12% or Gearing of 66% - which is better for the business?

• Why is it a bad situation for a company to have a gearing of 90%?

Interpreting Ratios

• Textbook p169 B1 ….. Do Q3

• Which business would you buy based on the quantitative factors?

Not too sure about the wobble!

Your set of calulations

You will need your ratio colour sheet & a calulator

Your go – Calculate ratios…

• ROCE• Gearing• Current Ratio• Acid Test Ratio

Balance Sheet £mNon-current assets 19550Inventories 2375Receivables 1170Cash & cash equivalents 2300Total current assets 5845Current liabilities (8160)Net current liabilities (2315)Non-current liabilities (6000)Net assets 11235

Share capital 6000Reserves & retained earnings 5235Total equity 11235

Income Statement £mRevenue 35400Cost of sales (30100)Gross profit 5300Expenses (720)Operating profit 4580Finance income 300Finance cost (260)Profit before tax 4620Taxation (1109)Profit for the year 3511

• Asset Turnover• Inventory / Stock Turnover• Payable days (assume payables are

50% of current liabilities for your calculation)

• Receivable days

Answers

Profitability ratioBalance Sheet £mNon-current assets 19550Inventories 2375Receivables 1170Cash & cash equivalents 2300Total current assets 5845Current liabilities (8160)Net current liabilities (2315)Non-current liabilities (6000)Net assets 11235


ROCEOperating profit x 100total equity + non-current liabilities

4580 x 10011235 + 6000

4580 x 100 = 27%17235


For every £1 of capital employed in the businesshow much is being generated in profit?

Why would it be meaningful to compare this to the current rate of interest?

Why might a high street retailer compare

ROCE between individual stores?

Gearing ratioBalance Sheet £mNon-current assets 19550Inventories 2375Receivables 1170Cash & cash equivalents 2300Total current assets 5845Current liabilities (8160)Net current liabilities (2315)Non-current liabilities (6000)Net assets 11235

Share capital 6000Reserves & retained earnings 5235Total equity 11235Gearing

Non-Current Liabilities x 100total equity + non-current liabilities

6000 x 100(11235 + 6000)

=6000 x 10017235

=35%

For every £1000 invested in this business how much of it is from long term loans?

Why might a high gearing be more of a concern toa business with small profit margins?


Liquidity ratios



Current RatioCurrent Assets : Current Liabilities

5845 : 8160= 0.716 : 1

For every £1 of CL the firm owes it owns £0.716 in CA

Acid TestLiquid Assets : Current Liabilities

1170 + 2300 : 8160= 3470 : 8160

= 0.425 : 1For every £1 of CL the firm owes it owns

£0.425 in CA

Financial Efficiency ratioBalance Sheet £mNon-current assets 19550Inventories 2375Receivables 1170Cash & cash equivalents 2300Total current assets 5845Current liabilities (8160)Net current liabilities (2315)Non-current liabilities (6000)Net assets 11235


Asset Turnover

RevenueNet assets

3540011235

= 3.15 times


For every £1 of net assets in the businesshow much is being generated in revenue?

What is meant by the term sweating your assets?

Why might asset turnover help a business assess operational efficiency between factories?

Financial Efficiency ratioBalance Sheet £mNon-current assets 19550Inventories 2375Receivables 1170Cash & cash equivalents 2300Total current assets 5845Current liabilities (8160)Net current liabilities (2315)Non-current liabilities (6000)Net assets 11235

Share capital 6000Reserves & retained earnings 5235Total equity 11235Inventory/ Stock Turnover

Cost of sales Inventory

301002375

=12.67 times


On average for how long does this business hold stock?

What type of business might have this level of inventory turnover? Justify your answer

Why might it be more accurate to divide by average inventory held rather than just inventory?

Financial Efficiency ratio



Payables (Creditors) days

Payables x 365cost of goods sold

Assumed payables are 50% of current liabilities

4080 x 36530100

= 49 days


Receivables (Debtors) days

Receivables x 365Revenue

1170 x 36535400

= 12 days

Interpreting Ratios

• Dodgy scanning

Working Capital = CA – CL= 280 – 200 = 80

Capital Employed = Share capital + reserves

You can calculate Net Profit and another profitability ratio!

Non current assets

Interpreting Ratios

NPM = net profit /turnover10% of 1,460,000

180/1460 x 365 = 45 days

ROCE = op profit / capital employed

HOMEWORK 2

Yellow Work booklet – 5 pages…

Complete the tasks

Homework 1

Read textbook chapter on Ratios – we’ll be continuing with these

next lesson

Documents

Interpreting Accounts