Financial Statements and Ratios Look up your stock portfolio at Howthemarketworks.com

Two main types of financial statements (or final accounts) Profit and Loss Account Also known as the income statement Shows records of income and expenditure flows for a business over a given period of time Establishes whether a business has made a profit or loss and how it was distributed at the end of that period Balance Sheet Also known as the statement of financial position Lists the assets, liabilities, and equity of a company at a specific point in time It tells us what the company owns (total assets) and owes (total liabilities), including how much shareholders have invested in the company (equity)

Example: Profit and Loss Account for McDonald’s In Thousands $ For Year Ending 12/31/2014 Sales 27,441,300 Cost of Goods Sold 16,250,000 Gross Profit 11,191,300 Expenses 3,083,700 Net Profit before interest and tax 8,107,600 Interest Expense - Net Profit before tax 8,107,600 Tax Expense 3,450,000 Net Profit after interest and tax 4,657,600 Dividends - Retained Earnings 4,657,600 Gross Profit = Sales – Cost of Goods Sold Net Profit before interest and tax = Gross Profit - Expenses Net Profit before tax = net profit before interest and tax - interest Net Profit after interest and tax = net profit before tax – tax expense Retained earnings or profit = net profit after interest and tax – dividends

Example: Balance Sheet for McDonald’s As of 12/31/14 Fixed Assets 26,557,500 Intangible Assets 2,846,900 Current Assets: Cash 3,082,400 A/R 1,214,400 Inventory 110,000 Other 783,200 Total Current Assets 5,190,000 Current Liabilities: A/P 2,747,900 Other - Total Current Liabilities 2,747,900 Working Capital 2,442,100 LT Loans 12,881,500 Net Assets 18,965,000 Equity: Share Capital 4,736,000 Retained earnings 14,229,000 Total Equity 18,965,000 Fixed assets are long term assets that last a business more than 12 months. For e.g. buildings, equipment, machinery, etc. Current assets are short term assets that last a business for up to 12 months. For e.g. cash, accounts receivable (debt that is yet to be paid to the business), inventory, etc. Long term liabilities are long term debts payable after 12 months Current liabilities are short term debts payable within 12 months Working capital = total current assets – total current liabilities Net assets = fixed assets + working capital – long term liabilities Total Equity = share capital + retained earnings Bottom line: Net assets = Equity!!!

Ratio Analysis Profitability ratios: assess the performance of a firm in terms of its profit-generating ability Gross Profit Ratio Net Profit Ratio Efficiency ratios: assess how well a firm internally utilizes its assets and liabilities Return on Capital Employed Liquidity ratios: measure the ability of a firm to pay off its short term debt obligations Current Ratio Acid Test (Quick) Ratio

Gross Profit Ratio Gross profit ratio = Gross Profit x 100 Sales Revenue Result is a percentage % Indication of profit available to pay for expenses Solution for low ratio: Increase sales without increasing COGS, by increasing the sale price or finding ways to cut COGS (new suppliers). May impact quality. Things to consider: Is the business labor or capital intensive? This may impact the amount of cost of goods sold

Net Profit Ratio Net Profit Ratio = Net profit before Interest & Taxx 100 Sales Revenue Result is a percentage % Measures how much of each dollar of sales represents net profit Rule of Thumb: 10% is usually a minimum Solution for low ratio: Generate higher levels of Gross profit, or cut other costs such as salaries or energy costs without reducing sales. An investment in advertising may also lead to higher sales. May impact quality. Things to consider: Increased expenses may be due to growth plans

Return on Capital Employed (ROCE) ROCE = Net Profit Before Interest & Tax x 100 Capital Employed Result is a percentage % Capital employed = Loan capital (or long-term liabilities) + share capital + retained profit Measures how much profit the business is generating as a percentage from its main sources of finance Rule of Thumb: Should be greater than current interest rates if an investor was to put money into the bank (for example, 5%). Bank investment significantly less risk, so ROCE should be several percent more. Solutions for low ratio: Same as net profit solutions. Could also reduce amounts payable to lenders by repaying loans, returning share capital to investors or pay dividends to reduce the retained profits. Need cash to be able to do these. Things to consider: If the business has recently received a large amount of finance, it may not have had time to generate profit from it yet.

Current Ratio Current Ratio = Current assets _ Current liabilities Result is a ratio X:1 Measures the ability of the business to cover (pay) its debts in the next 12 months. Rule of thumb: Should be about 2:1. Anywhere between 1.5: :1 acceptable. If too low business unable to pay liabilities. Too high, current assets not used adequately to increase profits Solution: Increase current assets such as cash at bank or debtors by increasing sales or taking a loan; or decrease liabilities by reducing creditors (however this will require cash) Things to consider: Business may not be able to get more cash through borrowing if already highly geared

Acid Test (Quick) Ratio Acid Test (Quick) Ratio = Current assets – stock Current liabilities Result is a ratio X:1 Measures the ability of the firm to cover (pay) immediate debt obligations (next month) Rule of Thumb: Should be above 1:1. below 1:1 business at high risk (not able to cover current liabilities) Solution: Increase cash held by holding lower levels of stock when possible. Decrease current liabilities by reducing creditors. Things to consider: Nature of business may require higher levels of stock to meet fluctuating demand.

Question: Natura Cosméticos Natura Cosméticos is a Brazilian company that manufactures and sells a range of cosmetic products including shampoo, soap, make-up and creams that protect against the sun. Excerpt from the profit and loss accounts for Natura Cosméticos for the years ended 31 May 2006 and 2007: From the profit and loss accounts provided: i.calculate the missing values X for 2006 and ii.calculate the gross profit margin and the net profit margin for 2006 and Sales revenue Cost of goods sold891X Gross profitX2131 ExpensesX1453 Net profit before interest and tax 644X Interest3490 Tax149156