Unit 2 Financial & Management Accounting RATIO ANALYSIS Mr. Barry A-level Accounting Year 12

What this presentation covers Why a business needs to be analysed How a business is analysed using ratios and percentages Areas of financial statements that need to be analysed Stakeholders – people who need to know about the financial ratios Mr. Barry A-level Accounting Year 12

The financial health of a business Ratios assess the financial health of business in three main areas: Profitability – this indicates the level of return and earning power of the business Liquidity – this measures the resources the business has in the short-term to meet its immediate debts Capital structure – this shows the reliance of the business on long-term external finance compared with its own capital Mr. Barry A-level Accounting Year 12

Stakeholders – who needs to know? Business managers and owners – looking at performance and making decisions Shareholders – investors in large companies to ensure they will get a good and safe return on their money Lenders – banks, to make sure they will get their money back Employees – to make sure their job is safe in the future Mr. Barry A-level Accounting Year 12

A-level Accounting Year 12 Assessing the financial statements Sales and profitability how do they compare? What are the trends? Income Statement Examine the current assets and current liabilities to assess short-term resources Balance Sheet Examine long-term borrowing and capital to assess financial strength This assessment is carried out by examining key figures in the financial statements and using financial ratios. Mr. Barry A-level Accounting Year 12

A-level Accounting Year 12 What is a ratio? A ratio compares the size of two numbers, example 2 : 1 Current Assets £200,000 : Current Liabilities £100,000 The ratio is 2 : 1 Financial indicators can be written as ratios, but they are often also written as percentages: A ratio of 2 : 1 converted into a percentage becomes: (2 x 100) ÷ 1 = 200% Current Assets to current liabilities of 1.5 : 1 becomes: (1.5 x 100) ÷ 1 = 150% We will now explain the ratios which assess business profitability, liquidity and capital strength. Mr. Barry A-level Accounting Year 12

A-level Accounting Year 12 Profitability Ratios Mr. Barry A-level Accounting Year 12

1. Gross profit percentage/ margin gross profit % = gross profit x 100 - sales Income Statement £ Sales 500,000 Cost of Sales 250,000 Gross Profit 250,000 Expenses 125,000 Net Profit 125,000 250,000 x 100 500,000 = 50% This percentage - also known as ‘gross margin’ - measures the gross profit in relation to sales, before all expenses have been deducted. Mr. Barry A-level Accounting Year 12

A-level Accounting Year 12 2. Gross profit mark up gross profit mark up = gross profit x 100 - cost of sales Examiner tip: Please be able to distinguish between mark up and margin formula’s Mr. Barry A-level Accounting Year 12

3. Net profit percentage/ margin Also known as profit in relation to revenue net profit % = net profit x 100 - sales Income Statement £ Sales 500,000 Cost of Sales 250,000 Gross Profit 250,000 Expenses 125,000 Net Profit 125,000 125,000 x 100 500,000 = 25% This percentage measures the ‘bottom line’ level of profit (after all expenses have been deducted) in relation to sales. Mr. Barry A-level Accounting Year 12

A-level Accounting Year 12 A-level Accounting Year 12 4. Return on capital employed Return on capital employed (ROCE) = operating profit* x 100 - capital employed** Operating Profit 125,000 *Profit before interest and tax ** Equity + Non-current Liabilities Balance Sheet Non-current Assets 2,450,000 Current Assets 150,000 Less Current Liabilities 100,000 50,000 2,500,000 Less Long-term loan 500,000 2,000,000 Financed by: Capital and Reserves 2,000,000 125,000 x 100 2,000,000 + 500,000 = 5% This percentage shows the return the business is making on its long-term capital. Mr. Barry Mr. Barry A-level Accounting Year 12 A-level Accounting Year 12

A-level Accounting Year 12 gross profit x 100 - sales 1. Gross profit percentage = Profit related to selling the product net profit x 100 - sales 2. Net profit percentage = Profit made after all expenses have been deducted 3. Return on capital employed (ROCE) = operating profit x100 capital employed Return on long-term capital Mr. Barry A-level Accounting Year 12

A-level Accounting Year 12 Liquidity Ratios Mr. Barry A-level Accounting Year 12

A-level Accounting Year 12 What is liquidity? The liquidity of a business is based on the short-term resources it has: cash in the bank, money due from debtors, stock it can sell - these are current assets Liquidity is needed to pay off short-term debts: short-term loans, tax bills, money due to creditors - these are current liabilities The liquidity of a business = current assets minus current liabilities: this is known as ‘working capital’ or ‘net current assets’ A business that has little or no liquidity could easily fail, so it is important to be able to measure the liquidity Mr. Barry A-level Accounting Year 12

A-level Accounting Year 12 1. Current ratio Liquidity ratios are based on the current assets and current liabilities of a business current assets current liabilities 150,000 100,000 Current Assets Inventory 40,000 Debtors 72,000 Bank 38,000 150,000 Less Current Liabilities Creditors 100,000 Net Current Assets 50,000 = 1.5 : 1 (or 150%) The current ratio is an indicator of the ability of a business to meet its short-term liabilities. Mr. Barry A-level Accounting Year 12

A-level Accounting Year 12 2. Liquid capital ratio/ Acid test ratio The liquid capital ratio is the current ratio with stock deducted from the current assets current assets - stock current liabilities 150,000 - 40,000 100,000 Current Assets Inventory 40,000 Debtors 72,000 Bank 38,000 150,000 Less Current Liabilities Creditors 100,000 Net Current Assets 50,000 = 1.1 : 1 (or 110%) The liquid capital ratio is more demanding: stock is deducted because it may not be sold so easily or quickly. Mr. Barry A-level Accounting Year 12

A-level Accounting Year 12 3. Inventory turnover There are further indicators which relate to liquidity; some are quoted in days/ times rather than percentages This can be calculated in two ways: average inventory x 365 days cost of sales cost of sales average inventory OR Trading Account Sales 500,000 Opening inv. 60,000 Add Purchases 230,000 290,000 Less Closing inv. 40,000 Cost of Sales 250,000 Gross Profit 250,000 Average stock = (60,000 + 40,000) ÷ 2 = 50,000 50,000 250,000 = 73 days Mr. Barry A-level Accounting Year 12

4. Receivable/ debtor days The debtor collection period is the average number of days debtors take to pay their invoices The debtor collection period can affect the liquidity of a business: slow payers can cause a shortage of cash The formula is: debtors x 365 days credit sales Current Assets Inventory 40,000 Debtors 72,000 Bank 38,000 150,000 72,000 x 365 days 436,000 = 60 days 30 to 60 days is often an acceptable figure. Too many overdue debts may cause liquidity problems. Trading Account Sales: on credit 436,000 cash sales 64,000 Mr. Barry A-level Accounting Year 12

A-level Accounting Year 12 5. Payables/ creditor days The creditor payment period is the average number of days taken to pay supplier invoices The creditor payment period can affect the liquidity of a business: paying too quickly can cause a shortage of cash The formula is: creditors x 365 days credit purchases 100,000 x 365 days Current Liabilities Creditors 100,000 220,000 = 166 days Trading Account Purchases: on credit 220,000 cash purchases 10,000 30 to 60 days is often an acceptable figure; 166 days shows slow payment to creditors. Mr. Barry A-level Accounting Year 12

A-level Accounting Year 12 Summary of liquidity ratios Current ratio compares current assets and current liabilities to provide a basic indicator of liquidity Liquid capital ratio takes the current ratio and deducts stock from current assets to provide an indicator of short-term liquidity Stock turnover calculates the average number of days for which stock is held; an unusually high figure may indicate a business unable to sell its stock Debtor collection period indicates the average number of days debtors take to pay their invoices; an unusually high figure indicates a business that is poor at credit control Creditor payment period indicates the average number of days taken to pay supplier invoices; an unusually high figure indicates a business that has liquidity problems Mr. Barry A-level Accounting Year 12

A-level Accounting Year 12 Gearing Ratio Mr. Barry A-level Accounting Year 12

A-level Accounting Year 12 Measuring the financial strength A business that is too reliant on long-term external finance, e.g. bank loans, can become vulnerable A business that is financially strong will have substantial capital and reserves from accumulated profit Non- current Liabilities x 100 Equity Capital The formula is: Balance Sheet Fixed Assets 2,450,000 Current Assets 150,000 Less Current Liabilities 100,000 50,000 2,500,000 Less Long-term loan 500,000 2,000,000 Financed by: Capital and Reserves 2,000,000 500,000 2,000,000 = 0.25 : 1 or 25% Gearing over 1 : 1 or 100% is not a good sign because the business is too reliant on external finance. Mr. Barry A-level Accounting Year 12

A-level Accounting Year 12 Measuring the financial strength A business that is too reliant on long-term external finance, e.g. bank loans, can become vulnerable You can also use capital employed to calculating gearing: Non- current Liabilities x 100 Capital Employed The formula is: Please be able to explain the results of the gearing ratio as it could be a possible exam question this year Mr. Barry A-level Accounting Year 12

An introduction for May 2017 Analysing Ratios An introduction for May 2017 Mr. Barry A-level Accounting Year 12

Gross Profit margin and Mark up What does the result of these ratios tell you about business performance? GPM * How much GP as a proportion of sales * How much GP in pence to every £1 of sales Mark Up * GP in relation to cost of sales * for every £1 of cost of sales how much GP (in pence) is being made Mr. Barry A-level Accounting Year 12

Gross Profit margin and Mark up (Both ratios) What if the % is increasing? Either that the business has changed its pricing policy and has put up selling price Or the business is paying less for it’s cost of sales (Both ratios) Changed pricing policy and put down it’s selling price Or the business is paying more for it’s goods it buys in and sells on. Mr. Barry A-level Accounting Year 12

Net Profit margin/ profit in relation to revenue What does NPM and Overheads/ turnover %’s tell us about business performance? NPM % tells us: How much net profit is being made in relation to sales How much net profit is being made for every £1 of sales If the % increases: Either the business is making more Gross Profit Or that costs have been held at a previous level or reduced Or some combination of these factors If the % is decreasing: Either the business is making LESS gross profit Or that costs have risen above previous levels Mr. Barry A-level Accounting Year 12

Overheads in relation to revenue The overhead / turnover % tells you: How much is being spent on an overhead in relation to turnover For each £1 of sales how much in pence is being paid for an overhead Mr. Barry A-level Accounting Year 12

Net Profit margin and Overheads / turnover ratios If % is increasing: The business is less efficient than it was previously in regard to controlling costs If the % is decreasing: The business is more efficient than it was previously in regard to controlling costs Mr. Barry A-level Accounting Year 12

Return on Capital Employed The ROCE ratio % measures: Net profit in relation to capital employed How much profit (in pence) is made for every £1 of capital employed If the ROCE ratio is increasing: Either the business is making more net profit Or the business has employed less capital Or some combination of both these factors That every business is using its resources (in the form of assets) more effectively Mr. Barry A-level Accounting Year 12

Return on Capital Employed If the ROCE ratio is decreasing: Either the business is making less profit Or the business has employed more capital Or a combination of the above That the resources it uses are done so less effectively You can compare this figure with other businesses for investment, return and efficiency purposes, as well as investigating the level of risk involved in investing (instead of saving) Mr. Barry A-level Accounting Year 12

A-level Accounting Year 12 Examiner’s Tip Approach data in a simple way to start with, for example: What’s happened to turnover? What has happened to the ratios? Is there a pattern of change in the ratios a good or bad thing for the business. Then try to see if you can deduce any important information from the data that can help make a judgement about a business’s success. Try to explain what may have caused the changes in the ratio Have a clear view point as to whether the business performance is improving or not Mr. Barry A-level Accounting Year 12