7 Analysing the strategic position of a business Recap Year 1: What is the difference between profit and profitability? State 3 measures of profitability. What is meant by return on investment? What is meant by the proportion of long term funding that is debt? 7.2 Analysing the existing internal position of a business to assess strengths and weaknesses: financial ratio analysis

7.2 Analysing the existing internal position of a business to assess strengths and weaknesses: financial ratio analysis In this topic you will learn about How to assess the financial performance of a business using balance sheets, income statements and financial ratios Financial ratio analysis to include: profitability (return on capital employed) liquidity (current ratio) gearing efficiency ratios: payables days, receivables days, inventory turnover The value of financial ratios when assessing performance Data may be analysed over time or in comparison with other businesses

Assessing financial performance PLCs have a legal obligation to publish their annual accounts The format is governed by International Financial Reporting Standards (IFRS) This format has altered some of the terminology used by UK businesses to comply with standard practices across the world Financial data can be used to assess performance and potential

Write down the formula for calculating each type of profit. Published accounts The financial performance of a business can be assessed using two key financial reports: Balance sheet A formal financial document that summarises the net worth of a business at a given point in time It balances net assets with total equity Income statement A formal financial document that summarises a business’ trading activities and expenses to show whether the business has made a profit or a loss over a specified period of time Recap Year 1: Write down the formula for calculating each type of profit.

Balance Sheet – The terminology Assets: Items of value owned by a business. Liabilities: Money a business owes i.e. debts. Non – current assets Likely to be kept by the business for more than one year e.g. Vehicles Premises Machinery Current assets Likely to be turned into cash within a year e.g. Inventories Receivables Cash and cash equivalents Non – current liabilities Debts that the business has more than one year to repay e.g. Bank loans Mortgages Current liabilities Debts that the business may have to repay within one year e.g. Overdrafts Payables

Balance sheet Non-current assets Long term or fixed assets Short term assets Inventories The value of stock held Receivables Cash owing from credit sales Cash and cash equivalents Cash in hand or at the bank Total current assets All current assets added together Current liabilities Money owed to be repaid in the short term Net current assets Total current assets minus current liabilities Non current liabilities Long term debts Net assets The net worth of the business’ assets Share capital Finance raised from the sale of shares Retained profit and reserves Cumulative profits kept in the business Total equity The value of shareholders’ funds

Balance Sheet £ms Calculations Non-current assets 19 550 Inventories 2 375 Receivables 1 170 Cash and cash equivalents 2 300 Total current assets 5 845 2 375 + 1 170 + 2 300 Current liabilities 8 160 Net current assets (2 315) 5 845 - 8 160 Non current liabilities (6 000) Net assets 11 235 19 550 + (2 315) - 6 000 Share capital 6 000 Retained profit and reserves 5 235 Total equity 6 000 + 5 235

Income statement Income statement Explanation Sales revenue Money coming in from sales Quantity sold x selling price Cost of sales Costs directly linked to the production of the goods or services sold e.g. raw materials Gross profit Sales revenue – cost of sales Expenses All other costs associated with the trading of the business e.g. salaries and marketing expenditure Operating profit Gross profit – expenses Interest Interest paid on debt or received on positive balances Profit for the year Operating profit – interest (tax is still to be deducted)

Income Statement £ms Calculations Revenue 35 400 Cost of sales 30 100 Gross Profit 5 300 35 400 – 30 100 = 5 300 Expenses 720 Operating profit 4 580 5 300 – 720 = 4 580 Finance income 300 Finance cost (260) Profit before tax 4 620 4 580 + 300 – 260 = 4 620 Interest 1 109 Profit for the year 3 511 4 620 – 1 109 = 3 511

What is meant by the term benchmark? Ratio Analysis Allows for a more meaningful analysis of published accounts Shows relationship between figures Used for comparisons over time Inter and intra business comparisons Intra means between businesses e.g. to compare performance to competitors or to benchmark Inter means within a business e.g. over time within one organisation or between branches What is meant by the term benchmark? http://corporate.marksandspencer.com/investors/key-facts Why are numbers so important when understanding a business’ performance? View M&S key facts.

Ratio Analysis - Profitability Return on Capital Employed (ROCE) A measure of how efficiently a business is using capital employed to generate profits Capital employed = total equity + non-current liabilities i.e. all the money invested in the business from: Share capital Reserves Long term loans Formula: Operating profit x 100 Total equity + non-current liabilities Challenge: Capital employed can also be calculated as total assets minus current liabilities. Can you explain why?

Return on capital employed Balance Sheet £m Non-current assets 19550 Inventories 2375 Receivables 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235 Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Income Statement £m Revenue 35400 Cost of sales (30100) Gross profit 5300 Expenses (720) Operating profit 4580 Finance income 300 Finance cost (260) Profit before tax 4620 Taxation (1109) Profit for the year 3511 Operating profit x 100 4580 x 100 Total equity + non-current liabilities 11235 + 6000 4580 x 100 = 27% 17235

Interpretation of ROCE Why would it be meaningful to compare this to the current rate of interest? Why might a high street retailer compare ROCE between individual stores? Return on capital employed Operating profit x 100 total equity + non-current liabilities 4580 X 100 = 27% 17235 For every £1 of capital employed in the business 27 pence is generated in operating profit.

Ratio Analysis - Liquidity Define current assets and current liabilities. Liquidity A measure of a businesses’ ability to survive in the short term i.e. its ability to meet short term debts and day to day expenses If a business can not meet current liabilities from current assets then it is at risk of failure if creditors demand immediate payment of debts Liquidity is calculated using the current ratio Current assets Current liabilities A second measure of liquidity is the acid test. It is useful to understand this although it will not be explicitly examined. Research what is meant by the acid test. http://www.bbc.co.uk/news/business-36592776 Why might a business be placed in administration?

Current ratio Current assets : current liabilities 5845 : 8160 Balance Sheet £m Non-current assets 19550 Inventories 2375 Receivables 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235 Share capital 7000 Reserves & retained earnings 4235 Total equity 11235 Current assets : current liabilities 5845 : 8160 = 0.716 : 1 For every £1 of CL the business owes it owns £0.716 (72 pence) in CA. Do you think this business has enough short term assets to meet its short term debts?

Liquidity What steps could a business take to improve cash flow? What is the relationship between cash flow and liquidity? A business with low liquidity is in danger if short term creditors demand payment quickly e.g. the bank recalls an overdraft Business may therefore seek to improve liquidity: Increase current assets and/or reduce current liabilities Sell assets that are no longer being used i.e. turn them from a non-current asset to a current asset (cash) Move cash balances from current accounts to high interest bearing accounts so its value increases more rapidly Switch to long term sources of finance Monitor debtors to avoid bad debts

Discussion List 5 reasons why businesses need cash on a regular basis Do you agree with these quotes? “Sales for vanity, profit for sanity but cash is king” “Profitable businesses can still go under if they run out of cash at a critical moment. Forecasting is the most focused method of avoiding that obstacle.” Peter Jones

Practice question Using the extract from SuperGroup Plc’s balance sheet calculate: Current ratio Acid test (extension activity) Comment on the liquidity of SuperGroup Plc. View full statement of financial position. http://annualreport2014.supergroup.co.uk/financial-statements/balance-sheets

Ratio Analysis - Gearing Measures what proportion of a business’ capital is funded through long term loans Loans are “compulsory interest bearing” i.e. you have to pay interest on them even if profits are low or non-existent A highly geared business is of greater risk if interest rates are likely to increase Non-current liabilities x 100 Total equity + non-current liabilities Explain where interest rates would appear on an income statement and which profit figure(s) would be affected.

Ratio Analysis - Gearing Balance Sheet £m Non-current assets 19550 Inventories 2375 Receivables 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235 Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Non-current liabilities x 100 Total equity + non-current liabilities 6000 x 100 11235 + 6000 6000 x 100 = 35% 17235 For every £1000 invested in this business how much of it is from long term loans? Why might a high gearing ratio be more of a concern to a business with small profit margins?

Efficiency ratios Efficiency ratios assess the internal management of a business i.e. how efficient are managers in controlling the current assets Efficiency ratios look at the management of cash and inventory Payables days Receivables days Inventory turnover

Payables days Payables days A measure of how long it takes, on average, for the business to pay for supplies it has purchased on credit A business may try to have a longer payables days ratio to ease cash flow problems A short payables days may result in discounts from suppliers Payables x 365 Cost of sales

Payables days Payables x 365 4160 x 365 = 50 days Cost of sales 30100 Income Statement £m Revenue 35400 Cost of sales (30100) Gross profit 5300 Expenses (720) Operating profit 4580 Finance income 300 Finance cost (260) Profit before tax 4620 Taxation (1109) Profit for the year 3511 Balance Sheet £m Non-current assets 19550 Inventories 2375 Receivables 1170 Cash & cash equivalents 2300 Total current assets 5845 Payables (4160) Short term loans (4000) Total current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235 Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Payables x 365 4160 x 365 = 50 days Cost of sales 30100 Why might a business be willing to have a payables days of 60 – 90 days?

Efficiency ratios Receivables days A measure of how long it takes, on average, for customers to pay the business for goods or services it has purchased on credit The customer is a debtor of the business A business may try to have a shorter receivables days to ease cash flow problems Receivables x 365 Sales revenue

Receivables days Income Statement £m Balance Sheet £m Revenue 35400 Cost of sales (30100) Gross profit 5300 Expenses (720) Operating profit 4580 Finance income 300 Finance cost (260) Profit before tax 4620 Taxation (1109) Profit for the year 3511 Balance Sheet £m Non-current assets 19550 Inventories 2375 Receivables 1170 Cash & cash equivalents 2300 Total current assets 5845 Payables (4160) Short term loans (4000) Total current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235 Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Receivables x 365 1170 x 365 = 12 days Sales revenue 35400 This shows that on average it takes 12 days to receive payment for goods and services sold on credit.

Show your understanding Payables days was 50 days and receivables days 12 days. Should this business be concerned? Justify your answer. Payables are compared to cost of sales and receivables to revenue. Use business terminology to explain the relationship between these variables. 3) What might be the expected receivables days of A high street coffee chain A commercial print company Justify your answers.

Inventory turnover Inventory turnover Average inventory held can be calculated by finding the average of inventory at the start and end of the year You therefore also need the previous year’s balance sheet Alternatively you can just divide cost of sales by inventory Measures how frequently a business turns over its inventory in a year Will vary depending upon the nature of the firm Hot dog stand (hopefully daily!) Fashion retailer (at least each season) New car showroom (maybe twice a year) Cost of sales Average inventory held

On average for how long does this business hold stock? Inventory turnover Income Statement £m Revenue 35400 Cost of sales (30100) Gross profit 5300 Expenses (720) Operating profit 4580 Finance income 300 Finance cost (260) Profit before tax 4620 Taxation (1109) Profit for the year 3511 Balance Sheet £m Non-current assets 19550 Inventories 2375 Receivables 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235 Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Cost of sales 30100 = 12.67 times Average inventory held 2375 On average for how long does this business hold stock? What type of business might have this level of inventory turnover? Justify your answer. Why might it be more accurate to divide by average inventory held rather than just inventory?

Value of financial ratios when assessing performance Limitations Possibility that accounts have been window dressed Need to consider reasons behind ratios e.g. is ROCE lower than previous years because of an investment programme Quantitative information only Value Provides a tool for the interpretation of accounts Structure from which comparisons can be made Overtime With other businesses Aids decision making Internally Externally by investors What other quantitative information could be used to assess the performance of a business? What other qualitative information could be used to assess the performance of a business?

Activity – interpreting published accounts In pairs choose 2 businesses who operate in the same industry e.g. 2 supermarkets, 2 football clubs Go on the internet and print off the balance sheet and income statement (Google company name/investors) The layout will vary from company to company but you should be able to identify the key information Prepare a presentation comparing the performance of the two businesses over time and in comparison to each other Present your findings to the rest of the class

7.2 Analysing the existing internal position of a business to assess strengths and weaknesses: financial ratio analysis In this topic you have learnt about How to assess the financial performance of a business using balance sheets, income statements and financial ratios Financial ratio analysis to include: profitability (return on capital employed) liquidity (current ratio) gearing efficiency ratios: payables days, receivables days, inventory turnover The value of financial ratios when assessing performance Data may be analysed over time or in comparison with other businesses