3 4 ratio analysis (1)
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Transcript of 3 4 ratio analysis (1)
3.4 Interpreting Published Accounts
Objectives:By the end of this topic you should be able to:select, calculate and interpret ratios to measure financial performance, including:
Liquidity ProfitabilityFinancial efficiency GearingShareholder ratios
Key term bingo!Ratio analysis
Current Ratio
Profitability RatiosROCE
Payables period
Acid Test Ratio
Inventory turnover Asset Turnover
Receivables periodDividend per share
Financial efficiency ratio
Liquidity
Shareholder ratiosGearing
Dividend Yield
What is Ratio Analysis?
A method of assessing a firm’s financial situation by comparing two sets of linked data
Ratio’s turn financial accounts into easy-to-understand numbers
You can compare firm to firm, division to division or year to year
We usually look at the balance sheet and the income statement to extract the figures
Stakeholders can draw conclusions about a company’s performance
5 Types of ratio
Profitability
Liquidity
Gearing
Financial Efficiency
Shareholders ratios
TASK 1:In pairs, using a range of resources including textbooks, Business Review and tutor2u – fill in the ratio
grid sheet
Profitability RatiosProfitability ratios can help answer questions like…
Is the business making a profit? Is it growing?
How efficient is the business at turning revenues into profit?
Is the profit enough to finance reinvestment?
Is it sustainable (high quality)?
How does it compare to the rest of the industry
Main Profitability Ratios
Gross Profit Margin
Net Profit Margin
Return On Capital Employed (ROCE)
Gross Profit Margin
Formula Margin % = Gross profit Sales Revenue x 100
Income Statement 30.06.09 (£000s)Revenue £2,000Cost of sales (£1,200)Gross Profit 800
Example
800 2,000 x 100
= 40%
Net Profit Margin
Formula Margin % = Operating profit Sales Revenue x 100
The net profit margin should be compared with other competitors in the same market and over time
Company A Company B Company CSales revenue 150 250 500Net Profit 50 25 125Net Margin 20% 10% 25%
Example
Company A makes a higher net profit than company B,
even though revenue is lower
• Company C has the highest net profit margin
• Indicates that it is doing well turning sales to profit
• Is adding value to the production process
Return On Capital Employed (ROCE)
Formula ROCE % = Operating profit Capital Employed x 100
Capital employed = total equity + non-current liabilities
Evaluation
Higher % is betterWatch out for trends over timeConsidered the best measure of a firms size
Liquidity Ratios
Current Ratio
Acid Test Ratio
Current Ratio
Formula Current ratio = Current assets Current liabilities
Balance Sheet (£000’s)Non-current assets 1,250Stocks 150Receivables (debtors) 25Cash 25Total current assets 200Payables (creditors) (250)Current liabilities (250)
Example
200250
= 0.8
Below 1 indicates cash problems
Evaluation
Ratio of 1.5-2.00 suggests efficient management of working capital
Acid Test Ratio
Formula Current ratio = Current assets - stock Current liabilities
Balance Sheet (£000’s)Non-current assets 1,250Stocks 150Receivables (debtors) 25Cash 25Total current assets 200Payables (creditors) (250)Current liabilities (250)
Example
200 - 150250
= 0.2
Below 1 indicates liquidity problems
EvaluationA good warning sign of liquidity problems for businesses that hold stocksLess relevant for businesses with high stock turnover
Gearing RatiosFormula
Gearing % = Non current liabilities Capital Employed x 100
Capital employed = total equity + non-current liabilities
2008 2009Non-current liabilities (1356) (1532)Net assets 4417 4085
Share capital (2907) (2899)Reserves and retained earnings (1510) (1186)
Total equity 4417 4085
13564417 – 1356 x 100
= 44%
15324085 – 1532 x 100
= 60%
Example
Gearing RatiosEvaluation
Focuses on the long term financial stability of the businessGearing above 50% suggests potential problems in financingIt indicates it has borrowed a lot of money in relation to its capital
Low gearing is below 25%It indicates a firm has raised most of its capital from shareholders
Gearing may not be bad – often cheaper than equityIf interest rates are low businesses may wish to take advantage
Liquidity Ratios
Asset turnover
Stock turnover
Debtor days
Creditor days
Asset turnover
Formula Asset turnover = Revenue Net assets
Income Statement 30.06.09 (£000s)Revenue £2,000
Net assets 600
Example
2,000 600
= 3.3 timesEvaluation
Measures how well a company uses its assets to achieve revenueTakes no account of profitAverage figure for UK business in 2007 was 3.3High figure = business using assets well to achieve sales and vice versa
Formula Stock turnover = Cost of sales Average stock held
Stock turnover
Income Statement 30.06.09 (£000s)Revenue £2,000Cost of sales £1,200
Example
Balance SheetNon-current assetsStocks 150
1,200 150
= 8 times
EvaluationShows how quickly stock is converted to salesHigh figure = stock sold quicklyThe figure shows how many times in that year the firm sells its value of stockHere 8 times indicates this business sells its stock 8 times a year (8/365 = 45 days)Holding more stock may mean the business can improve customer serviceSeasonal fluctuations not accounted forNot relevant for all businesses i.e. retailers
Formula Debtor days = Trade debtors Revenue x 365
Debtor days
ExampleBalance SheetNon-current assetsStocks 150Receivables (debtors) 25
Income Statement 30.06.09 (£000s)Revenue £2,000
25 2,000 X 365
= 4.5 (5 days)
EvaluationShows the number of days it takes to convert debtors into cashEach industry will have a ‘norm’Firms generally want to have a low valueMarketing dept may wish to offer long credit termsComparisons with competitors is useful
Formula Creditor days = Trade payables Cost of sales x 365
Creditor days
Balance SheetNon-current assetsStocks 150Receivables (debtors) 25Cash 25Total current assetsPayables (creditors) (250)
Income Statement 30.06.09 (£000s)Revenue £2,000Cost of sales (£1,200)250
1200 x 365
= 76 daysEvaluation
Shows the number of days it takes to pay backGenerally the higher the betterA very high figure may suggest liquidity problemsCreditor days should exceed debtor days
Example
Shareholder Ratios
Dividend per share
Dividend yield
Dividend per share
Formula Dividend per share £ = Total dividends paid Number of shares issued
Number of shares issued 400Dividends paid 80
40080
= £0.05p
Example
EvaluationLimited usefulness as it lacks contextBasic calculationDoes not reveal how much the shares cost to buyonly the first stage of the calculation
Dividend yield
Formula Dividend yield % = Dividend per share (p)Share price (p) x 100
Example Share price £0.50
0.050.50
= 10% Evaluation
Good to compare with companies in the same sectorHelps shareholders decide on investmentGood to compare to other investment rates i.e. Banks, property, savings accounts etc
Who uses the ratios?
Managers Creditors
Shareholders
Competitors Suppliers
Government
Customers
Employees
TASK 3:Mind map these on your sheet
1. How effective is stock control in a business
2. Are shareholders likely to be happy with their share of the profit?
3. Is the business likely to be able to avoid a liquidity problem in the short term if it can convert all of its liquid assets into cash? 4. Is the business able to pay its short term debts if its inventories become unfashionable and difficult to sell? 5. Is the business likely to experience a liquidity problem in the long run? 6. How successful is the business at generating profit? 7. How successful is the business at generating sales revenue? 8. How quickly is the business receiving money from customers who buy goods on credit? 9. Would shareholders receive more money from putting their savings elsewhere? 10. Are suppliers providing the business with good credit terms?
Choosing the right ratio
Discuss in pairs and be ready to feedback
Limitations of ratio analysis
Discuss what value ratio analysis has in predicting future performance (12 marks)
Ratio analysis is of limited use because it shows the past and not the future. To what extent is this statement valid? (9 marks)
How useful are profitability ratios in assessing the financial position of a business (10 marks)
TASK 5: The three essay questions below are similar in nature. Pick one, use your books and notes and have a go at answering it