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Understanding and Managing Finance 7 This Presentation is in Self-Study Form To start the presentation: Press F5 (Top Row of Keyboard) Then use the navigation
Understanding and Managing Finance 7 This Presentation is in
Self-Study Form To start the presentation: Press F5 (Top Row of
Keyboard) Then use the navigation buttons at the foot of each
page.
Slide 2
Managing Finance and Budgets Presentation 7 Financial
Ratios
Slide 3
Session 7 - Financial Ratios Learning outcomes: Understand how
financial data contained within the Balance Sheet and Profit &
Loss Account can be used to analyse the effectiveness of a
business. To be able to calculate and interpret ratios in the
following areas: Profitability Liquidity Efficiency
Slide 4
Financial Ratios Menu Content: A: Analysing AccountsAnalysing
Accounts B: A Focussed ApproachA Focussed Approach C: The Different
Types of RatioThe Different Types of Ratio 1.Profitability
RatiosProfitability Ratios 2.Liquidity RatiosLiquidity Ratios
3.Efficiency RatiosEfficiency Ratios D: Preparation for Seminar
7Preparation for Seminar 7
Slide 5
A: Analysing Accounts
Slide 6
Analysing Accounts Now that we have a reasonable grasp on the
standard financial statements used by businesses, we can use that
knowledge to obtain information as to whether or not the business
is functioning effectively. Today we will look at the Balance
Sheets and Profit & Loss accounts of one fictional
manufacturing Company to analyse its performance over the past two
years. What we learn here can be applied to real companies whose
financial reporting has been made public.
Slide 7
These figures show financial summaries of the Balance Sheets
for M & N Manufacturing over the past three years. In our
analysis, here, we will concentrate on the figures from 2002 &
2003
Slide 8
Analysing The Balance Sheet Normally, you will require two
Balance sheets in successive years, and you should look out for any
large proportional changes to items within: Fixed Assets Current
Assets Current Liabilities Long Term Liabilities Capital &
Reserves
Slide 9
Interpreting Large Upward Changes Fixed Assets: The business
may have bought new plant, machinery or transport. This might be
part of a deliberate strategy Current Assets: The business may
holding higher stock levels, carrying more debtors or simply have
more cash in the bank. Current Liabilities: The business may owe
more to its creditors Long Term Liabilities: The business may have
taken out an additional Long Term Loan Profit & Reserves: The
business may have made a large profit over the year.
Slide 10
Interpreting Large Downward Changes Fixed Assets: The business
may have sold plant, machinery or transport. Again, this might be
part of a deliberate strategy Current Assets: The business may
holding lower stock levels, carrying fewer debtors or simply have
less cash in the bank. Current Liabilities: The business may owe
less to its creditors Long Term Liabilities: The business may have
paid back a Long Term Loan Profit & Reserves: The business may
have made a loss over the year. SAQ 7.1
Slide 11
1.Examine the Balance Sheet, and note down any large
proportional changes from 2002 to 2003. 2. What do you think these
changes might mean? 1.Examine the Balance Sheet, and note down any
large proportional changes from 2002 to 2003. 2. What do you think
these changes might mean? Answer
Slide 12
Increase in Fixed Assets Small Increase in Trade Debtors
Increase in Stock Large Increase in Trade Creditors Large Decrease
in Long Term Loans Large Increase in Reserves
Slide 13
SAQ 7.1 Interpretation Fixed Assets: The business has probably
bought some new machinery or transport. This is not a large
increase, and is probably not significant, especially when viewed
in the light of the previous years larger increase. Current Assets:
The business is now holding higher stock levels, and levels of
trade debtors. This is not normally a good thing unless Turnover (
see P & L) has increased. Current Liabilities: The business
owes a lot more more to its creditors than last year. In general
this is a bad idea, as creditors may withdraw credit arrangements.
Long Term Liabilities: The business has probably paid back a loan.
Profit & Reserves: The business has made a profit over the year
(confirmed by P & L account- see later)..
Slide 14
Analysing The Profit & Loss Account Some information can be
obtained simply on the basis of one years Profit & Loss
Account, but it helps very much to see the comparison with the
previous year. The main headings to look at are: Turnover ; Compare
to Cost of Sales Gross profit; Compare to Overheads Net Profit
(called the Operating Profit) Earned Surplus
Slide 15
What to look out for on the Profit & Loss Account Has the
business increased its Turnover ? How big a proportion of the
Turnover is taken up by Cost of Sales? How big a proportion of the
Gross Profit is taken up by Overheads? Has the business made a Net
Profit (called the Operating Profit). Has this increased from last
year? Has the business made an overall profit (Earned Surplus)? Has
this increased from last year? Can you identify the main reason for
the overall profit or loss? SAQ 7.2
Slide 16
1.Examine the Profit & Loss Account note any large changes
from 2002 to 2003. 2. What do you think these changes might mean?
1.Examine the Profit & Loss Account note any large changes from
2002 to 2003. 2. What do you think these changes might mean?
Answer
Slide 17
SAQ 7.2 Solution Increase in turnover but also in Costs
Increase in gross profit, but very large increase in Overheads
Small increase in net profit Small Increase in earned surplus
Slide 18
SAQ 7.2 Interpretation The business has increased its Turnover
by over 600,000. This looks good. However there has been a
corresponding increase in Cost of Sales by about 500,000. This is
not so good! When we note that Overheads have risen by around
100,000, that all but wipes out the increase in Turnover, and our
Net Profit is almost the same as in the previous year. There has
been an increase in Earned Surplus of around 9,000, which looks OK,
but this is actually all due to the fact that we had less interest
on loans to pay this year. If that had not been the case there
would actually have been a decrease in Earned Surplus from last
years figures.
Slide 19
B: A Focussed Approach
Slide 20
A Focussed Approach As we have seen, we can look at accounts
and make some sense of them, but it is clear that we need a much
more focussed approach First of all, we need to concentrate on
areas where the financial statements can give strong insights into
how effectively the business is being managed: Three of these are:
Profitability Profitability Liquidity Liquidity Efficiency
Efficiency
Slide 21
Profitability This means examining not only whether a business
is profitable, but where does that profit come from, and is it
possible that with better management or financial controls that
profitability can be improved. Clearly, where a business is
loss-making, such an analysis is crucial
Slide 22
Liquidity Liquidity looks a the Current Assets compared to the
Current Liabilities. The difference between these two is called the
Working Capital, and we will look at this in more detail in the
next two lectures. This is important, because without a good
Working Capital, a business cannot pay its way, and will get into
very serious Cash Flow problems.
Slide 23
Efficiency Efficiency basically means the manner in which all
the elements of Working Capital are being utilised This means
looking at specifically: How long are we holding onto stock? How
long are our customers taking to pay us? How long are we taking to
pay our suppliers?.
Slide 24
Other Aspects If you read Chapter 7 in McLaney & Atrill,
you will see that there are two other areas: Financing (how the
business raises money) Investment (whether outsiders, such as
shareholders & banks would find the business a secure and
profitable place to invest their money) You can read these for
interest, but these areas do not form part of this course.
Slide 25
The Use of Ratios To help in the process of Analysis we can
define Ratios which give a single summary figure - a snapshot of a
particular type of activity or answers a particular question.
Normally, a ratio compares one figure with another, or gives a
percentage. Most ratios are straightforward, easy to understand
with names which convey what they actually do, for example, Average
Stockholding Period Is simply the average number of days we hold
onto stock before it is sold.
Slide 26
Why Use Ratios? They can be used as basis of comparison - e.g.
other companies, other periods, targets or forecasts They allow
comparisons between and within businesses They enable trends to be
identified They enable comparisons to be made where scale is
different
Slide 27
Sample Ratios Retail Sales per square metre Sales Cost per 1000
loaned Food cost per patient % Bed Occupancy % of sales spent on
advertising (or anything) Cost of water (electricity) per kilo
manufactured Average number of students per class Expenditure on
books per student Cost per outcome for different departments SAQ
7.3
Slide 28
Discuss the following: Imagine you are the proprietor of a
hotel and restaurant. Identify a series of key ratios which would
help you to monitor on a day to day basis how well the hotel is
performing. Answer
Slide 29
Activity 7.3 - Solutions Key ratios to monitor how well a hotel
is performing. These might include: % Room occupancy Average
customer payment Reservations as a % of total occupancy Cleaning
Costs per room Average direct cost per room occupancy Total
Overheads bill per days operation Total Salaries as a percentage of
turnover % food wastage per day and many more!
Slide 30
C: The Different Types of Ratio
Slide 31
The Different types of Ratio As discussed in the previous
section, we will use three we different types of Ratio: 1.
Profitability RatiosProfitability Ratios How successful is the
business? 2. Liquidity RatiosLiquidity Ratios Is the flow of cash
sufficient to meet obligations? 3. Efficiency RatiosEfficiency
Ratios How is the business using its resources? In each of these
cases, we will use the data taken from the M & N Manufacturing
Financial Statements. These are summarised on the handout and on
the spreadsheet.
Slide 32
Profitability Ratios
Slide 33
The first set of ratios we will look at, attempt to measure
profitability; that is, whether or not the business is financially
successful. Note that just looking at the the amount of of profit
made by a company in a particular year may give a distorted picture
of the companys position. A 1.5m profit generated on a turnover of
10m, can look very good. The same profit on a turnover of 100m
looks poor. However there may be reasons why the first company has
generated so much profit; there could be a one-off sale of assets,
for example, which have increased in value.
Slide 34
Three Profitability Ratios We look at three important ratios:
______________________________________________________________________________________________________________________________________________
Gross Margin% = Gross Profit x 100 Gross Margin Sales
______________________________________________________________________________________________________________________________________________
Net Margin% = Net Profit before tax & interest x 100 Net Margin
Sales
______________________________________________________________________________________________________________________________________________
Return on Capital Employed (ROCE) =Return on Capital Employed
(ROCE) Net Profit before tax and interest x100 (Share Capital +
Reserves+ LT Loans) Examine Data Used in Profitability Analysis SAQ
7.4
Slide 35
NOTE THAT: The data that we will use is mainly taken from the
Profit & Loss Account, but other Data is extracted from the
Balance Sheet NOTE THAT: The data that we will use is mainly taken
from the Profit & Loss Account, but other Data is extracted
from the Balance Sheet
Slide 36
Gross Margin Ratio Example of the Calculation Calculation for
2002 Gross Margin: 494,600 x 100 = 22.1% 2,240,000 DEFINITION:Gross
Margin% = Gross Profit x 100 Sales Selec t What does this
mean?
Slide 37
Gross Margin Ratio Explanation 2002 Gross Margin: = 22.1% The
business makes 22p on every 1.00 sales. Some of this needs to be
used to pay overheads etc. This figure is the percentage profit
made on sales, only counting the costs directly incurred in making
the sale. It depends on the type of business, but if the gross
margin is much below 20%, the business will be hard pressed to make
a surplus. This means that 22% is OK, but not spectacular
Slide 38
Net Margin Ratio Example of the Calculation Calculation for
2002 Net Margin: 242,600 x 100 = 10.8% 2,240,000 DEFINITION:Net
Margin% = Net Profit before Tax & Interest x 100 Sales Selec t
What does this mean?
Slide 39
Net Margin Ratio Explanation 2002 Net Margin: = 10.8% After
paying all costs, the business makes 11p on every 1.00 it brings
in. This figure is the percentage profit made on sales, taking into
consideration all costs, direct and indirect incurred in making the
sale. Again, It depends on the type of business, but if the net
margin is much below 10%, the business will be hard pressed to make
a surplus. This means that 10.8% is OK, but not spectacular
Slide 40
Return on Capital Employed (ROCE) Example of the Calculation
Calculation for 2002 ROCE: 242,600 x 100 = 29.2% 830,130
DEFINITION:ROCE% = Net Profit before tax and interest x 100 (Share
Capital + Reserves+ LT Loans) What does this mean? Selec t Add
Together
Slide 41
Return on Capital Employed Explanation 2002 ROCE = 29.2% The
company makes 30p for every 1.00 invested. This figure is the
operating profit expressed as a percentage of all the money
currently invested in the business, whether from original Capital,
Retained Profits or borrowed from external sources as Long Term
Loans It is useful to compare such an amount with the current rate
of interest that one might get in a Bank or Building Society
currently much less than 5% In that light, the ROCE looks pretty
good! However, investors will not actually get this money directly,
as most of it will-be re-invested in the business.
Slide 42
Activities 7.4 a,b,c & d Use the data on the Ratio Analysis
Handout for Profitability to calculate the three financial ratios
for 2003: aGross Margin for 2003 bNet Margin for 2003 cROCE for
2003 dComment on the differences between the 2002 ratios and the
2003 ratios. Solution to Parts a,b,c Solution to Part d
Slide 43
Solution to 7.4 a,b,c 7.4a Calculation for 2003 Gross Margin:
599,200 x 100 = 20.8% 2,881,2000 7.4b Calculation for 2003 Net
Margin: 247,800 x 100 = 8.6% 2,881,200 7.4c Calculation for 2003
ROCE: 247,800 x 100 = 29.7% 833,410
Slide 44
7.4d Explanation The Gross Margin has been reduced by 1.3%. It
is still acceptable, but the increase in Turnover seems to have
generated some very large costs. The Net Margin has been reduced by
2.2% This is more worrying, since the operating margin is now in
single figures. The element mainly responsible for this is the
overheads. The ROCE has increased by 0.5%. This is a good sign that
the business is using its capital more effectively. The main reason
for this is the pay back of about 140,000 worth of loan during the
year, and therefore have lower interest payments.
Slide 45
Liquidity Ratios
Slide 46
These Ratios seek to answer the question: Can the business pay
its way? All of these ratios look at the flow of cash in the
company, and try to determine whether or not, at a particular point
in time, the business has enough cash to pay what it owes.
Liquidity can be interpreted as the amount of cash, stock, and
debt, which can be easily converted into cash, offset by those
elements which are currently owed, such as trade creditors, tax
& interest etc. Liquidity Ratios summarise the current Working
Capital situation
Slide 47
Ratios - Liquidity We look at two ratios:
____________________________________________________________________________________________________________________
Current ratio = Current Assets Current Liabilities Current ratio
_______________________________________________________________________________________________________________
Acid test = Current Assets excluding stock Acid test Current
Liabilities Examine Data Used in Liquidity Analysis SAQ 7.5
Slide 48
Opening Stock is not directly relevant to the calculation, but
might be useful when we try to interpret it. The Data we use is
taken from the Balance Sheet Data Used to Calculate Liquidity
Ratios
Slide 49
Current Ratio Data Current ratio = Current Assets Current
Liabilities Add Together All these Add Together All These
Slide 50
Current Ratio Calculation Current Assets : Trade Debtors240,800
Bank Account 33,500 Closing Stock Value300,000 574,300 Current
Liabilities: Trade Creditors 191,400 Dividends Owing 20,100
Corporation Tax Owing 21,860 233,360 Current Ratio= 574300= 2.5
233,360 What does this mean?
Slide 51
Current Ratio Explanation The Current Ratio is 2.5 N.B. This is
not a percentage. The business currently owns 2.5 times as much in
readily- convertible assets (stock, cash, debtors) as it currently
owes to creditors, tax etc. The value of 2.5 is quite high, and it
means that there is a lot of spare working capital in the business.
The effect of this is that it will be relatively easy to acquire
new stock. Perhaps with this much we might think of paying off some
of our creditors, especially if they are threatening to charge
interest on the amount owed, or curtail credit.
Slide 52
Acid Test Ratio Data Acid Test ratio = Current Assets excluding
stock Current Liabilities Add Together These two Add Together All
These
Slide 53
Acid Test Ratio Calculation Current Assets excluding Stock :
Trade Debtors240,800 Bank Account 33,500 274,300 Current
Liabilities: Trade Creditors 191,400 Dividends Owing 20,100
Corporation Tax Owing 21,860 233,360 Acid Test Ratio= 274300 = 1.2
233,360 What does this mean?
Slide 54
Acid Test Ratio Explanation The Current Ratio is 1.2 N.B. This
is not a percentage either. The business currently owns 1.2 times
as much in cash terms (cash, debtors) as it currently owes to
creditors, tax etc. Stock is ignored here because it might be
difficult to turn stock into cash quickly without having to sell at
a loss. The value of 1.2 is quite respectable, and it means that
the business is solvent. If creditors demanded payment immediately,
ways could be found to pay.
Slide 55
Activities 7.5 a, b & c Use the data on the Ratio Analysis
Handout for Liquidity to calculate the three financial ratios for
2003: aCurrent Ratio for 2003 bAcid Test Ratio for 2003 cComment on
the differences between the 2002 ratios and the 2003 ratios.
Solution to Parts a & b Solution to Part c
Slide 56
Solution to 7.5 a & b 7.4a Calculation for Current Ratio
662,060= 2.0 233,360 7.4b Calculation for Acid Test Ratio: 247,800
= 0.9 307,960
Slide 57
7.5c Explanation The Current Ratio has reduced from 2.5 to 2.0.
As it was previously quite high, this might be seen as being
positive; however if one looks at how this has been achieved, it is
through increasing the amount owed to creditors and holding onto
more stock. Neither of these strategies is healthy in the long
term. The Acid Test Ratio has reduced from 1.2 to 0.9. Here we see
in stark terms the effect of the change. We can no longer pay our
way comfortably, and there is not enough readily available cash to
pay all that we owe. There is a small potential here for cash flow
problems.
Slide 58
Efficiency Ratios
Slide 59
These ratios are concerned with the way that assets are used in
an organisation. Some of these are very useful financial management
tools for example the average stock turnover and the average credit
period. These can be very useful in controlling the flow of cash in
an organisation. These ratios are important measures of how
effective particular changes in management practice have been.
Slide 60
Efficiency Ratios Stock turnover (days) Stock turnover (days) =
Average Stock Value x 365 Cost of Sales
_____________________________________________________________________________________________________________________________________________
Debtors (days) Debtors (days) = Total Debtors x 365 Total Credit
Sales
_____________________________________________________________________________________________________________________________________________
Creditors (days) Creditors (days) = Total Creditors x 365 Credit
Purchases
_____________________________________________________________________________________________________________________________________________
SAQ 7.6 Examine Data Used in Efficiency Analysis
Slide 61
The data we use is taken from the Balance Sheet, the Profit
& Loss Account and other places Data Used to Calculate
Efficiency Ratios
Slide 62
Stock Turnover Period Data Stock turnover (days) = Average
Stock Value x 365 Cost of Sales Average These Two Select
Slide 63
Stock Turnover Period Opening Stock Value261,000 Closing Stock
Value300,000 Cost of Sales 1,745,400 Stock Turnover (Days) =
(261000+300000)/2 x 365 1745400 = 58.7 days What does this
mean?
Slide 64
Stock Turnover Period Explanation The Stock Turnover Period is
58.7 days N.B. This is not a percentage either. On average, it
takes 58.7 days to turn over the stock. In simple terms that can be
interpreted to mean that it takes 58.7 days for all the stock which
is currently held to be sold To put it another way, it is as if we
got a whole batch of stock, held onto it for 58.7 days then sold
it, replacing it immediately with new stock. 58.7 days is nearly 2
months, and in the scheme of things is quite acceptable. Some
industries hold stock for much longer than this (Car Spares
retailers, for example expect to hold onto stock for several
months.) On the other hand, some business (e.g. restaurants) would
not be able to trade if their stock turnover was this long.
Slide 65
Average Settlement Period for Debtors Data Debtors (days) =
Total Debtors x 365 Total Credit Sales Select Here we are assuming
for simplicity that all sales are on credit. This may not be true
in all cases
Slide 66
Average Settlement period for Debtors Trade Debtors240,800
Total Sales 2,240,000 Average Settlement Period for Debtors =
240800 x 365 2240000 = 39.2 days What does this mean?
Slide 67
Average Settlement Period for Debtors Explanation The Average
Settlement period is 39.2 days N.B. This is not a percentage
either. On average, it takes 39.2 days for a customer to pay their
bill. To put it simply, we can think about it as if we made a whole
batch of sales on one day, made no more for 39.2 days, and then got
the money. We then make immediately make some more sales. 39.2 days
is over a month, but in the scheme of things is quite acceptable.
However, some suppliers prefer customers to pay within 28 days, and
invoke penalties (such as interest payments) if this is not done.
In some industries, however, there are traditions of not paying for
up to 3 months (100 days or more)
Slide 68
Average Settlement Period for Creditors Data Creditors (days) =
Total Creditors x 365 Credit Purchases Here we have additional
information about purchases on on credit. This may not be true in
all cases, and you may need to assume that Cost of Sales =
Purchases on Credit. Select
Slide 69
Average Settlement period for Creditors Trade Creditors191,400
Total Sales 1,804,400 Average Settlement Period = 191400 x 365
1804400 = 38.7 days What does this mean?
Slide 70
Average Settlement Period for Creditors Explanation The Average
Settlement period is 38.7 days N.B. This is not a percentage
either. On average, it takes 38.7 days for the business to pay its
suppliers for a particular order. Again, to put it simply, we can
think about it as if we took delivery of a whole batch of items on
one day, received no more for 38.7 days, and then paid the money.
We then immediately take delivery of more items. 38.7 compares very
favourably with 39.2 days, the time the customers take to pay their
debts, and in the scheme of things is quite acceptable. As remarked
earlier, some suppliers prefer customers to pay within 28 days, and
invoke penalties (such as interest payments) if this is not
done.
Slide 71
Activities 7.6 a, b, c & d Use the data on the Ratio
Analysis Handout to calculate the three financial ratios for 2003:
aStock Turnover (Days) for 2003 bDebtor (Days) for 2003 cCreditor
(Days) for 2003 dComment on the differences between the 2002 ratios
and the 2003 ratios. Solution to Parts a, b & c Solution to
Part d
Slide 72
Solution to 7.6 a,b,c 7.6a Calculation for 2003 Stock Turnover
(Days): (300000 + 340960)/2 x 365 = 51.3 days 2,282,000 7.6b
Calculation for 2003 Debtor (Days): 250,100 x 365 = 31.7 days
2,881,200 7.6c Calculation for 2003 Creditor (Days): 258,800 x 365
= 29.7 days 2,142,800
Slide 73
7.6d Explanation Both the Stock Turnover Period and the Debtor
Payment Period have reduced (Stock by 7.4 days, and Debtors by 7.5
days). This reduction is a good thing, since this releases cash,
and provides the business with a greater flexibility of Working
Capital. The Trade Creditor Period has increased by 5.4 days. This
means that the business is taking longer to pay; again, the effect
of this is to release more cash, and provide a greater flexibility
of Working Capital.
Slide 74
Seminar 7- Activities Preparation: read Chapter 7 (M & A 2
nd Edition) You should make sure that you have calculated all the
ratios within this presentation, and have completely understood all
the explanations. Complete the Ratios Activity Spreadsheet Further
Exercises: M & A (2 nd Ed.) Exercise 7.3 (pages 239-240) M
& A (2 nd Ed.) Exercise 7.5 (pages 241-242)