Understanding & Managing Finance
Seminar 7
Seminar Seven - Activities
Preparation: readChapter 7 (M & A 2nd Edition)
Exercises: Ratio Activity Spreadsheet M & A Exercise 7.3 (pages 239-240) M & A Exercise 7.5 (pages 241-242)
Starting Points
Describe what is meant by Financial Ratio Analysis, and outline the key steps in performing such an analysis.
State some of the categories we need to consider when we are examining accounts, and describe some of the factors which might affect our analysis.
Describe some of the Key Ratios within each category, and what they mean.
Select and calculate
appropriate ratios
Identify the question and the
informationrequired
Interpret and
evaluate the results
The key steps of financial ratio analysis
Some Financial Issues to Consider
Categories
Profitability
Efficiency
Liquidity
Profitability
Return on ordinary shareholders’ funds
Return on capital employed
Net profit margin
Gross profit margin
Formula
Net profit after taxation and preference dividend (if any) x 100 Ordinary share capital + Reserves
Net profit before interest and taxation x 100 Share capital + Reserves + Long-term loans
Net profit before interest and taxation x 100 Sales
Gross profit x 100 Sales Sales
Efficiency
Average stock turnover period
Average settlement period for debtors
Average settlement period for creditors
Sales to capital employed
Formula
Average stock held x 365 Cost of sales
Sales per employee
Trade debtors x 365 Credit sales
Trade creditors x 365 Credit purchases
_______Sales_______ Number of employees
_______ Sales__________ Long-term capital employed
Liquidity
Current ratio
Acid test ratio
Formula
Current assets_______________ Current liabilities (creditors due within one year)
Current assets (excluding stock) Current liabilities
The main elements comprising the ROCE ratio
Sales______ Long-term
capital employed
Return on capital employed
multiplied by
equals
Net profit before interest and taxation
sales
P & Q Hypermarkets: CASE STUDYP & Q Hypermarkets are a small retail chain concentrating on evening and weekend trade. The company has been relatively profitable for the past few years, and has grown steadily. At the beginning of 2002, P & Q took out a Bank Loan of £100,000 to finance an expansion of business (fitting a new store). The new store was opened in January 2003. At that time there was an issue of shares which provided the capital to enable the Bank loan to be repaid.
P & Q Hypermarkets
Balance Sheet Summary 2001 2002 2003
Fixed Assets £536,000 £702,290 £739,190
Current AssetsTrade Debtors £8,150 £10,800 £12,100Bank Account £9,600 £33,500 £31,000
Stock £81,000 £73,000 £109,060
Current LiabilitiesTrade Creditors £81,500 £79,400 £98,800
Dividends owing £5,300 £20,100 £10,000Corporation tax owing £2,500 £12,760 £10,580
Long-Term LiabilitiesLT Loans £50,000 £150,000 £50,000
£495,450 £557,330 £721,970
Capital & ReservesShare Capital £400,000 £400,000 £500,000
Profit & Reserves £95,450 £157,330 £221,970
£495,450 £557,330 £721,970
P & Q Hypermarket
s
Profit & Loss Summary 2002 2003
Sales (Turnover) £1,040,000 £981,200Cost of Sales £845,400 £832,000Gross Profit £194,600 £149,200
Overheads £52,000 £38,400Net Profit £142,600 £110,800
Interest £15,000 £5,000Profit before Tax £127,600 £105,800
Tax £25,520 £21,160Profit after Tax £102,080 £84,640
Dividends £40,200 £20,000Profit After Tax & Dividends £61,880 £64,640
Earned Surplus £61,880 £64,640
P & Q Hypermarket
s
Profitability Analysis 2002 2003
Relevant Data From the P & L Accounts
Sales £1,040,000 £981,200Cost of Sales £845,400 £832,000Gross Profit £194,600 £149,200
Overheads £52,000 £38,400Net Profit £142,600 £110,800
Interest £15,000 £5,000Profit before Tax £127,600 £105,800
Tax £25,520 £21,160Profit after Tax £102,080 £84,640
Dividends £40,200 £20,000Profit after tax and dividends £61,880 £64,640
Relevant Data From the Balance Sheets
Share Capital £400,000 £500,000Reserves £157,330 £221,970LT Loans £150,000 £50,000
Profitability Ratios 2002 2003
Gross Margin% 18.7% 15.2%Net Margin% 13.7% 11.3%
ROCE 20.2% 14.4%
P & Q Hypermarket
s
Commentary on the Profitability Ratios
It is quite clear that the new store has reduced profitability. With every new venture, this is to be expected, however, in this case there are some concerns. Firstly, it would have been expected that with a new store, there would have been an increase in Turnover. This does not seem to have happened. Both the Gross Margin and the Net margin are lower in 2003 than 2002, and the ROCE seems to have dropped considerably. It is possible that given the expansion, the senior management has 'taken their eye off the ball' in other stores and this has led to the reduction in profitability.
P & Q Hypermarket
s
Liquidity Analysis
2,002 2,003Relevant Data From the Balance Sheets
Trade Debtors £10,800 £12,100Bank Account £33,500 £31,000
Opening Stock Value £81,000 £73,000Closing Stock Value £73,000 £109,060
Trade Creditors £79,400 £98,800Dividends owing £20,100 £10,000
Corporation tax owing £12,760 £10,580
Liquidity Ratios 2002 2003
Current Assets £117,300 £152,160Current Liabilities £112,260 £119,380
Current Ratio 1.0 1.3Acid Test 0.4 0.4
Commentary on the Liquidity Ratios
Current Ratio has increased, but Acid test Ratio has stayed the same. (This is very low, but P & Q is a retail store therefore has low levels of trade debtors). The Current Ratio signals an increase in stock levels. This is to be expected with a new store. There does not seem to be a threat to cash flow.
P & Q Hypermarket
s
Relevant Data From the P & L Accounts
Sales £1,040,000 £981,200Cost of Sales £845,400 £832,000Gross Profit £194,600 £149,200
Overheads £52,000 £38,400Net Profit £142,600 £110,800
Relevant Data From the Balance Sheets
Trade Debtors £10,800 £12,100Bank Account £33,500 £31,000
Opening Stock Value £81,000 £73,000Closing Stock Value £73,000 £109,060
Trade Creditors £79,400 £98,800Dividends owing £20,100 £10,000
Corporation tax owing £12,760 £10,580
Additional Data
Credit purchases £804,400 £942,800
Efficiency Ratios 2002 2003
Stock Turnover (Days) 33.2 39.9Creditors (Days) 36.0 38.2
Debtors (Days) 3.8 4.5Sales/Capital Employed 1.5 1.3
P & Q Hypermarket
s
Commentary on the Efficiency Ratios
Turnover Time has increased; this means that it is is not just that stock levels have increased, but that the stock is not moving as quickly as it did previously. It may be that in the new store, sales have not followed the normal pattern, and that a new strategy is required. Debtor payment time has increased somewhat but this is not really significant; similarly, Creditors have increased by 2 days, but this is only marginally higher than in
P & Q Hypermarket
s
Calculating and Using the Ratios (1)
To what extent should a business extend credit to its customers?
McLaney & Atrill Exercise 7.3
Conday & Co.
Solutions available after the seminar.
Calculating and Using the Ratios (2)
What should a supplier look for when deciding whether to supply a business customer?
McLaney & Atrill Exercise 7.5
Threads Ltd.
Solutions available after the seminar.
Additional Material:Using the Ratios
1. What sort of Liquidity Ratio is acceptable?
2. What early-warning signs can be detected that a company may be heading towards insolvency and failure?
Average current ratio and average acid test ratio for 1996 for UK listed companies in various industrial sectors
Mineralextraction
0.0Generalindustrie
s
Consumergoods
Services
0.2
0.4
0.6
0.8
1.0
1.6
1.2
1.4
Utilities
Current ratio
Acid test ratio
Current ratio
Time
19X1 19X419X319X2 19X5
XYZ Ltd
Industry average
Graph plotting current ratio against time
Mean ratios of failed and non-failed businesses
+0.35
+0.45
+0.25
+0.15
+0.05
-0.15
-0.05
+0.1
-0.1
-0.2
0.78
0.79
0.65
0.58
0.51
0.37
0.44
0.0
1 2 3 4 5 2 3 4 51 1 2 3 4 5
Cash flow Total debt
Net income Total assets
Total debt Total assets
Non-failed firms Failed firms
Mean ratios of failed and non-failed businesses
0.36
0.42
0.30
0.24
0.18
0.06
0.12
3.5
2.5
2.0
+0.15
+0.05
-0.05
-0.15
3.0
1 2 3 4 5 2 3 4 51 1 2 3 4 5
Working capital Total assets
Current ratio
No credit interval
Non-failed firms Failed firms
Scatter diagram showing the distribution of failed and non-failed businesses
Current ratio
ROCE ratio
Failed businessesNon-failed businesses