Interpreting Accounts Ratio analysis

Introduction The data and information presented in accounts can be very complex The data appears in Profit & Loss Accounts, Balance Sheets and Income Statements To help interpret it, and to investigate the success (or not) of a firm, we use ratio analysis There are four types of ratio Profitability Financial efficiency Liquidity Shareholders

The Ratios Profitability Ratios Gross Profit Margin Net Profit Margin Return on Capital Employed Financial Efficiency Asset Turnover Inventory Turnover Debtors Days Creditors Days Liquidity Current Ratio Acid Test Ratio Gearing  Shareholders’ Ratios Dividend Per Share Dividend Yield

1. Profitability Ratios Ratio analysis

1a) Gross Profit Margin This tells us the profit a business is making, as a percentage, when accounting for variable costs Gross Profit = Sales Revenue – Variable Costs Gross Profit Margin (%) = Gross Profit x 100 Sales Revenue Clearly a higher number is better

1b) Net Profit Margin This tells us the profit, as a percentage, when accounting for total costs Net Profit = Sales Revenue – Total Costs Net Profit Margin (%) = Net Profit x 100 Sales Revenue Net Profit Margin will always be less than Gross Profit Margin as all firms have Fixed Costs to include

1c) Return on Capital Employed (RoCE) This calculation tells us how much net profit is made by a business relative to the amount of capital (money) is invested in the firm Return on Capital = Net Profit x 100 Capital Employed This is measured as a percentage

2. Financial Efficiency Ratios Ratio analysis

2a) Asset Turnover This measures how effectively assets are being used to generate turnover Note, this is not profit Asset Turnover = Sales Revenue Net Assets Higher numbers show assets being used more efficiently

2b) Inventory Turnover This measures how many times a business turns over it’s stock in a year Inventory Turnover = Cost of Sales Inventory By Inventory we mean average stock It therefore shows how many days items stay in stock. If the turnover was 12 times, stocks would be turned over monthly

2c) Debtor Days This measures the amount of time (on average) it takes for payment to be received from customers Debtor Days = Amounts Due x 365 Sales Revenue It is measured in days The lower the number the better

2d) Creditor Days This measures the amount of time (on average) it takes for the business to pay for its supplies Creditor Days = Amounts to Pay x 365 Cost of Sales It is measured in days The key here is to meet targets or contracts

3. Liquidity Ratios Ratio analysis

3a) Current Ratio This ratio compares the business’s current assets with its current liabilities Current Ratio = Current Assets Current Liabilities It is always presented as 1:1.07 (for example) This would mean for every £1 of current liabilities this example has £1.07 of current assets

3b) Acid Test Ratio This ratio checks out how many liquid assets a firm has to meet its current liabilities Acid Test Ratio = Current Assets – Stock Current Liabilities This takes account of the fact that stock cannot necessarily be sold quickly, especially not at full price This too is always presented as 1: 1.02

3c) Gearing The gearing ratio tells us what percentage of a firm’s capital is funded by debt Gearing = Non-current liabilities X 100 Total Equity + Non-Current Liabilities If a firm had a Gearing of 72%, this would tell us that a large proportion of the firm’s assets actually have to be repaid and that interest must be paid on it. However, very low Gearing could mean a firm is too cautious

4. Shareholder Ratios Ratio analysis

4a) Dividend Per Share This is a calculation of the return that shareholders receive annually Dividend per share = Total dividend Number of shares issued What is an acceptable dividend (always stated in pence per share) will depend on risk and what returns are available elsewhere

4b) Dividend Yield This ratio shows what the return is to shareholders compared with the current market price for their shares Dividend yield = Dividend per share X 100 Market share price The answer will always be a percentage Investors can decide whether the return is good enough or whether their money would be better off invested elsewhere