finance and accounts ratio analysis. the function of accounting is to provide information to...
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Finance and Accounts
Ratio Analysis
Ratio Analysis
The function of accounting is to provide information to stakeholders on how a business has performed over a period of time
Ratio Analysis
This is an examination of accounting data by relating one factor to another. Usually the information is taken from the final accounts and will hopefully identify a trend.
The information will then be used as a basis for a decision i.e. should we do business or invest in this business.
Ratio Analysis
Accounting ratios are very easy to calculate and they enable a business to highlight which areas of its finances are weak and therefore require immediate attention.
Ratio Analysis
Profitability ratios, these analyse the profit made over the last year.
Activity/efficiency ratios, these analyse the efficiency of the business in terms of the use of its resources
Shareholders’ ratios, these measure the strength of the company, its share price and its dividends
Liquidity ratios, these measure the businesses ability to meet short-term debts.
Gearing ratio, this compares the proportion of the money the business has borrowed to it’s share Capital
Who uses Ratio Analysis
ManagersThey wish to know how well they have done and what needs to be improved
EmployeesInterested in their long term prospects and useful when negotiating pay increases
ShareholdersProspective and present shareholders use it to assess if they should hold or sell shares
Who uses Ratio Analysis
CreditorsThey wish to know if the business will be able to pay them
BankersIf the business requires additional finance is it in a position to repay any borrowings?
CompetitorsHow are we doing in comparison it our opponents
Government
The Ratio Analysis process
1 Reason- What are needing to find out?
2 Identify- Find the figures you will need
3 Process- What calculations will you need?
4 Calculation
5 Comparison- Compare with other information
6 Interpretation- What does the info tell you?
7 Action- What do we need to do?
Profitability ratios
These analyse the profit made over the last year or previous years.
It may compare profit with those of a competitor, B&Q v Homebase
There are 3 ratios you need to know: Gross Profit RatioGross Profit Ratio Net Profit RatioNet Profit Ratio Return on Capital EmployedReturn on Capital Employed
Gross Profit Ratio
Gross profit is the difference between sales turnover and the cost of goods sold.
So comparing the Gross Profit to sales is a simple measure of a businesses performance.
Gross Profit Ratio= Gross Profit/Salesx100%Gross Profit Ratio= Gross Profit/Salesx100%
GP= £15m. Sales= £45m. 15/45x100= 33.33%
Gross Profit Ratio
For any ratio to mean anything it has to be compared to other businesses or years
Company BGross Profit= £16m. Sales £64
Company CGross Profit= £18m. Sales £45
Who has done best A,B or C?
The effectiveness of G.P.R.
As you are probably aware Gross profit is only the first measure of profit so to rely too heavily on it would be wrong.
It is better to use a firm’s final profit figure to make a comparison.
If a business wants to improve it’s GPR it must seek to reduce the cost of it’s goods sold as a percentage of the sales price
Net Profit Ratio
Taking the final profit figure gives a much better measure of a businesses performance.
The Net Profit Ratio is calculated:
Net Profit/ Sales x 100% Net Profit/ Sales x 100% Sales= £100,000 Net Profit = £25,000
NPR= 25,000/100,000 x 100%= 25%
Example
Company A Sales 600,000 Cost of Sales 150,000 Gross Profit 450,000 Operating Expenses
250,000 Net Profit 200,000 GPR= 75% Net Profit Ratio=200/600
= 33.3%
Company BCompany B Sales 800,000Sales 800,000 Cost of Sales 200,000Cost of Sales 200,000 Gross Profit 600,000Gross Profit 600,000 Operating ExpensesOperating Expenses
300,000300,000 Net Profit 300,000Net Profit 300,000 GPR= 75%GPR= 75% Net Profit Ratio=300/800Net Profit Ratio=300/800
= 37.5%= 37.5%
Net profit Ratio
If a business is trying to improve it’s Net profit ratio it must seek to reduce it’s operating expenses.
So it must seek to reduce it’s wage costs or use of electricity. Making workers more efficient through training or better equipment might help
Return on Capital Employed
This is often referred to as the ‘primary accounting ratio’ and it expresses the annual percentage return that an investor would receive on their capital.
For example, if a business had a net profit of £2.2m and a capital employed of £7.6m, then the Return on Capital Employed figure would be :
= 28.9%
Man Utd have a Net profit of £39.4m is this good or bad?Man Utd have a Net profit of £39.4m is this good or bad?
Return on Capital Employed (ROCE)
Company A Sales 600,000 Capital invested £1.2m Operating Expenses
250,000 Net Profit 200,000 Net Profit Ratio=33.3%ROCE= Net profit/Capitalx100% 200,000/1.2m x 100=
=16.67%
Company BCompany B Sales 800,000Sales 800,000 Capital invested £1.9mCapital invested £1.9m Operating ExpensesOperating Expenses
300,000300,000 Net Profit 300,000Net Profit 300,000 Net Profit Ratio=37.5%Net Profit Ratio=37.5%ROCE= Net profit/Capitalx100%ROCE= Net profit/Capitalx100% 300,000/1.9m x 100=300,000/1.9m x 100=
=15.79%=15.79%
Return on Capital Employed (ROCE)
FirmCapital
EmployedNet Profit ROCE
Spare Co. 250,000 55,000
3 A’s 400,000 85,000
Bamit &Co.
800,000 110,000
Dunlop 10.5m 1.95m
Return on Capital Employed (ROCE)
FirmCapital
EmployedNet Profit ROCE
Spare Co. 250,000 55,000 22%
3 A’s 400,000 85,000 21.25%
Bamit &Co.
800,000 110,000 13.75%
Dunlop 10.5m 1.95m 18.57%
Return on Capital Employed (ROCE)
To mean anything ROCE needs to be compared to previous financial information or to other businesses
Firm A Profit Capital Employed Yr1 0.30m Yr1 1.5m Yr2 0.65m Yr2 1.6m Yr3 0.60m Yr3 1.7m Yr4 0.50m Yr4 1.7m
Return on Capital Employed (ROCE)
To mean anything ROCE needs to be compared to previous financial information or to other businesses
Firm A Profit Capital Employed Yr1 0.30m Yr1 1.5m 20% Yr2 0.65m Yr2 1.6m 41% Yr3 0.60m Yr3 1.7m 35% Yr4 0.50m Yr4 1.7m 29%
Improving Return on Capital Employed
To do this a business has to be ruthless, To do this a business has to be ruthless, they mustthey must
Ensure assets are being used well Think seriously about any money invested Don’t hesitate to get rid of assets/
investments giving a high enough return-
Scottish and Newcastle Breweries have recently sold off all their pubs
Activity Ratios
Once you have analysed the profit situation Once you have analysed the profit situation you may then find you wish to delve deeper you may then find you wish to delve deeper into a businesses records. What are it’s into a businesses records. What are it’s strengths or weaknessesstrengths or weaknesses.
As a manager what do you have to make the the business do better.
These ratios look at different aspects of the businesses operations
Stock Turnover Ratio
We have already said in other parts of the course We have already said in other parts of the course that holding too much stock is bad for a businessthat holding too much stock is bad for a business
This ratio simply calculates how many times the business sells it’s stock in a year
Stock turnover = Cost of SalesCost of Sales
StockStock
The figures come from the trading Account and Balance sheet
Stock Turnover Ratio
= = Cost of SalesCost of Sales
StockStock
The result will be a figure like 4 or 5 or 6, it simply means they have sold their stock and bought in new stock 6 times.
Some use the formula
-Cost of Sales
Average Stock ( Op. Stock+ Cl. Stock)/2
Stock Turnover Ratio
Firm Stock Cost ofgoods sold
StockT/over
A 500,000 3.5m
B 15,000 100,000
C 1.05bn 12.5bn
D 4,000 300,000
Stock Turnover Ratio
Firm Stock Cost ofgoods sold
StockT/over
A 500,000 3.5m 7 times
B 15,000 100,000 6.67 times
C 1.05bn 12.5bn 11.9 times
D 4,000 300,000 75 times
Stock Turnover Ratio
Obviously the more times you can turnover your Obviously the more times you can turnover your stock the better, Companies like McDonald’s stock the better, Companies like McDonald’s would aim to do so very often. Their low profit would aim to do so very often. Their low profit margins mean they have to.margins mean they have to.
A firm selling luxury cars or jewellery would not A firm selling luxury cars or jewellery would not have to have as high a stock turnover as they have to have as high a stock turnover as they can make a big profit from relatively few sales.can make a big profit from relatively few sales.
Stock turnover is something a Manager may Stock turnover is something a Manager may choose to target.choose to target.
Assets Turnover
This simply compares the businesses Net Assets to the Sales the business has achieved.
Sainsbury’s may have a Asset Turnover of 4.5 whereas Tesco’s of 5.1.
This means that Tesco’s are generating more sales from their assets than Sainsbury’s
Or to put it another way Tesco’s generate £5.10 from Or to put it another way Tesco’s generate £5.10 from every £1 of Net Assets whereas Sainsbury’s every £1 of Net Assets whereas Sainsbury’s generate £4.50generate £4.50
Assets Turnover Ratio
Net Assets can be found in the Balance sheet and it is:Net Assets can be found in the Balance sheet and it is:
Fixed Assets + Current Assets- Current Liabilities
Assets Turnover = Assets Turnover = Sales Sales
Net AssetsNet Assets
£5,000,000£5,000,000
800,000+(75,000- 25,000)800,000+(75,000- 25,000)
= 5,000,000/850,000= 5.88 times= 5,000,000/850,000= 5.88 times
Assets Turnover Ratio
Year NetAssets
Sales AssetT/over
1 500,000 3.5m
2 550,000 4.1m
3 540,000 4.2m
4 600,000 4.8m
Assets Turnover Ratio
Year NetAssets
Sales AssetT/over
1 500,000 3.5m 7 times
2 550,000 4.1m 7.45 times
3 540,000 4.2m 7.78 times
4 600,000 4.8m 8 times
How to improve your Asset Turnover
This simply means making your assets work harder
A football club might hold concerts or international A football club might hold concerts or international matchesmatches
A restaurant may open for Breakfast and LunchA restaurant may open for Breakfast and Lunch Supermarkets trade for longer hours or sell different Supermarkets trade for longer hours or sell different
products- Tesco’s Bank, Insuranceproducts- Tesco’s Bank, Insurance Easyjet or Ryanair ensure their planes spend the Easyjet or Ryanair ensure their planes spend the
maximum time in the airmaximum time in the air
Debtors Collection Period
2 out of 3 businesses fail from a lack of cash to pay their bills.
The Government recently had it’s credit rating downgraded for slowness paying it’s debts.
The faster any business gets paid the faster it can then use the money to generate more sales. This ratio measures how quickly a business gets it’s money =
Debtors/ Sales x 365 days 120/600=0.2 x 365=Debtors/ Sales x 365 days 120/600=0.2 x 365=
73 days73 days
Assets Turnover Ratio
Year Debtors Sales Asset T/over
1 150,000 3.5m X 365=
2 175,000 4.1m X 365=
3 200,000 4.2m X 365=
4 180,000 4.8m X 365=
Assets Turnover Ratio
Year Debtors Sales Asset T/over
1 150,000 3.5m X 365= 15.64days
2 175,000 4.1m X 365= 15.57 days
3 200,000 4.2m X 365= 17.38 days
4 180,000 4.8m X 365= 13.68 days
Debtors Collection Period
How to improve the collection period?
If faced with problems the business might resort to:
Factoring Being more selective about customers Offering terms for quick payment Employing staff to chase debts
Shareholders ratios
A range of ratios calculated from share and dividend information to calculate how well the business has done:
Dividend per shareDividend yield
Shareholders ratios
Dividend per share
This is calculated by dividing the dividend paid by the number of shares issued.
Dividend Paid £500,000=25p
Shares Issued 2million
Shareholders ratios
The problem with Dividend per share is it ignores the actual price of the share
If you paid £3.00 for a £1 share then 25p is not a good return
Shareholders ratios
Dividend Yield gets round this, it takes into account the market price of the share:
Dividend yield = Dividend x 100%
Market Price
25/3.00x100= 8.33%
Shareholders ratios
Liquidity Ratios
As we have already said the importance of cash flow to any firm cannot be overstated.
For that reason there are 2 ratios that focus on a firms liquidity
The Current Ratio The Acid Test Ratio
The Current Ratio
This ratio measures the businesses ability to pay it’s debts. To do this you need to take 2 pieces of information from the Balance Sheet the Current Assets and Current Liabilities
Current Ratio = Current Assets Current Assets 100 100 = 1.25:1= 1.25:1
Current Liabilities 80Current Liabilities 80 This business has £1.25 of C.Assets for £1 of Debt,
which is good
The Current Ratio
Year CurrentAssets
CurrentLiabilities
CurrentRatio
1 150,000 160,000
2 175,000 170,000
3 200,000 180,000
4 180,000 175,000
The Current Ratio
Year CurrentAssets
CurrentLiabilities
CurrentRatio
1 150,000 160,000 .9375
2 175,000 170,000 1.03
3 200,000 180,000 1.11
4 180,000 175,000 1.03
The Current Ratio
Most businesses want to keep their current ratio at about 1:1, although some industries may differ. Falling below this ratio could be seen as being bad.
Our business started about .93:1 and improves to as high as 1.1:1
Acid Test Ratio
As we have already highlighted holding too much stock is bad for a business.
If your creditors were to demand payment on the same day they would be disappointed as they might not want 6 cases of Fairy liquid or boxes of Tayto crisps.
The Acid Test ratio removes Stock from the previous formula
Acid Test Ratio
Current Ratio = Current Assets - Stock Current Assets - Stock
Current LiabilitiesCurrent Liabilities 100-25100-25= .9375:1= .9375:1
8080
Here the business has £0.93.75 cash for each Here the business has £0.93.75 cash for each pound of debt.pound of debt.
Acid Test Ratio
Yr CurrentAssets
CurrentLiabilities
Stock CurrentRatio
1 150,000 160,000 20,000
2 175,000 170,000 30,000
3 200,000 180,000 25,000
4 180,000 175,000 20,000
Acid Test Ratio
Yr CurrentAssets
CurrentLiabilities
Stock CurrentRatio
1 150,000 160,000 20,000 0.8125
2 175,000 170,000 30,000 0.853
3 200,000 180,000 25,000 0.972
4 180,000 175,000 20,000 0.914
Acid Test Ratio
It is generally accepted that a business with a ratio of 0.8 : 1 is safe
The previous businesses ratio rises from about 0.81 to .91
If a business wishes to improve it’s Acid Test Ratio it needs to
Manage it’s Stockholding better Manage it’s credit control
Gearing Ratios
Put simply this is the ratio of borrowed funds to owners own funds.
Think of it as a mortgage, if you have a 100% mortgage you are heavily in debt. Whereas someone with a 50% mortgage owns half the building.
If a business is highly geared it has to pay a lot in interest and this can be dangerous
Gearing Ratios
Gearing is calculated:
Long-term liabilities+ Preference shares X 100
Total Capital Employed (from balance sheet)
Preference shares= Shares that have a guaranteed payback if the business goes bust. (Ordinary shares do not have this assurance)
Gearing Ratio
Firm Long-termliabilities
Capitalemployed
Gearing
A 500,000 2.5m
B 15,000 140,000
C 1.05m 2.5m
D 48,000 300,000
Gearing Ratio
Firm Long-termliabilities
Capitalemployed
Gearing
A 500,000 2.5m 20%
B 15,000 140,000 10.71%
C 1.05m 2.5m 42%
D 48,000 300,000 16%
Gearing Ratios
Once a businesses gearing gets above 50% this can be be seen as being dangerous
in the 1990’s when interest rates went up to 15% many highly geared firms struggled
Bankers, investors and Directors take a keen interest in Gearing Ratios.
Investors and bankers are reluctant to put extra money into a highly geared firm.
Summary
Ratio Analysis is like a medical check up for a business. It can tell an expert where the problems are. Hopefully they should then be able to take action to improve things.