Session 7 Case studies and Solutions Nursery Management Understanding and Managing Finance

The Use of Ratios  To help in the process of Analysis we can define Ratios which give a single summary figure - a snapshot of a particular type of activity or answers a particular question.  Normally, a ratio compares one figure with another, or gives a percentage.  Most ratios are straightforward, easy to understand with names which convey what they actually do, for example, “Average Stockholding Period” Is simply the average number of days we hold onto stock before it is sold.

Why Use Ratios?  They can be used as basis of comparison - e.g. other companies, other periods, targets or forecasts  They allow comparisons between and within businesses  They enable trends to be identified  They enable comparisons to be made where scale is different

The Different types of Ratio As discussed in the previous section, we will use three we different types of Ratio: 1. Profitability RatiosProfitability Ratios How successful is the business? 2. Liquidity RatiosLiquidity Ratios Is the flow of cash sufficient to meet obligations? 3. Efficiency RatiosEfficiency Ratios How is the business using its resources? In each of these cases, we will use the data taken from the M and N Manufacturing Financial Statements. These are summarised on the handout and on the spreadsheet.

Profitability Ratios  The first set of ratios we will look at, attempt to measure profitability; that is, whether or not the business is financially successful.  Note that just looking at the the amount of of profit made by a company in a particular year may give a distorted picture of the company’s position.  A £1.5m profit generated on a turnover of £10m, can look very good. The same profit on a turnover of £100m looks poor.  However there may be reasons why the first company has generated so much profit; there could be a one-off sale of assets, for example, which have increased in value.

Three Profitability Ratios We look at three important ratios: ______________________________________________________________________________________________________________________________________________  Gross Margin% = Gross Profit x 100 Gross Margin Sales ______________________________________________________________________________________________________________________________________________  Net Margin% = Net Profit before tax and interest x 100 Net Margin Sales ______________________________________________________________________________________________________________________________________________ Return on Capital Employed (ROCE) =Return on Capital Employed (ROCE) Net Profit before tax and interest x100 (Share Capital + Reserves+ LT Loans) Examine Data Used in Profitability Analysis

NOTE THAT: The data that we will use is mainly taken from the Profit and Loss Account, but other Data is extracted from the Balance Sheet NOTE THAT: The data that we will use is mainly taken from the Profit and Loss Account, but other Data is extracted from the Balance Sheet

Gross Margin Ratio Example of the Calculation Calculation for 2002 Gross Margin: 494,600 x 100 = 22.1% 2,240,000 DEFINITION:Gross Margin% = Gross Profit x 100 Sales Selec t What does this mean?

Gross Margin Ratio Explanation 2002 Gross Margin: = 22.1%  The business makes 22p on every £1.00 sales. Some of this needs to be used to pay overheads etc.  This figure is the percentage profit made on sales, only counting the costs directly incurred in making the sale.  It depends on the type of business, but if the gross margin is much below 20%, the business will be hard pressed to make a surplus.  This means that 22% is OK, but not spectacular

Net Margin Ratio Example of the Calculation Calculation for 2002 Net Margin: 242,600 x 100 = 10.8% 2,240,000 DEFINITION:Net Margin% = Net Profit before Tax and Interest x 100 Sales Selec t What does this mean?

Net Margin Ratio Explanation 2002 Net Margin: = 10.8%  After paying all costs, the business makes 11p on every £1.00 it brings in.  This figure is the percentage profit made on sales, taking into consideration all costs, direct and indirect incurred in making the sale.  Again, It depends on the type of business, but if the net margin is much below 10%, the business will be hard pressed to make a surplus.  This means that 10.8% is OK, but not spectacular

Return on Capital Employed (ROCE) Example of the Calculation Calculation for 2002 ROCE: 242,600 x 100 = 29.2% 830,130 DEFINITION:ROCE% = Net Profit before tax and interest x 100 (Share Capital + Reserves+ LT Loans) What does this mean? Selec t Add Together

Return on Capital Employed Explanation 2002 ROCE = 29.2%  The company makes 30p for every £1.00 invested.  This figure is the operating profit expressed as a percentage of all the money currently invested in the business, whether from original Capital, Retained Profits or borrowed from external sources as Long Term Loans  It is useful to compare such an amount with the current rate of interest that one might get in a Bank or Building Society – currently much less than 5%  In that light, the ROCE looks pretty good! However, investors will not actually get this money directly, as most of it will-be re-invested in the business.

Liquidity Ratios  These Ratios seek to answer the question: ‘Can the business pay its way?’  All of these ratios look at the flow of cash in the company, and try to determine whether or not, at a particular point in time, the business has enough cash to pay what it owes.  Liquidity can be interpreted as the amount of cash, stock, and debt, which can be easily converted into cash, offset by those elements which are currently owed, such as trade creditors, tax and interest etc.  Liquidity Ratios summarise the current Working Capital situation

Ratios - Liquidity We look at two ratios: ____________________________________________________________________________________________________________________  Current ratio = Current Assets Current Liabilities Current ratio _______________________________________________________________________________________________________________  Acid test = Current Assets excluding stock Acid test Current Liabilities

Opening Stock is not directly relevant to the calculation, but might be useful when we try to interpret it. The Data we use is taken from the Balance Sheet Data Used to Calculate Liquidity Ratios

Current Ratio Data  Current ratio = Current Assets Current Liabilities Add Together All these Add Together All These

Current Ratio Calculation Current Assets :  Trade Debtors£240,800  Bank Account £33,500  Closing Stock Value£300,000 £574,300 Current Liabilities:  Trade Creditors £191,400  Dividends Owing £20,100  Corporation Tax Owing £21,860 £233,360 Current Ratio= = ,360 What does this mean?

Current Ratio Explanation The Current Ratio is 2.5 N.B. This is not a percentage.  The business currently owns 2.5 times as much in readily- convertible assets (stock, cash, debtors) as it currently owes to creditors, tax etc.  The value of 2.5 is quite high, and it means that there is a lot of spare working capital in the business. The effect of this is that it will be relatively easy to acquire new stock. Perhaps with this much we might think of paying off some of our creditors, especially if they are threatening to charge interest on the amount owed, or curtail credit.

Acid Test Ratio Data  Acid Test ratio = Current Assets excluding stock Current Liabilities Add Together These two Add Together All These

Acid Test Ratio Calculation Current Assets excluding Stock :  Trade Debtors£240,800  Bank Account £33,500 £274,300 Current Liabilities:  Trade Creditors £191,400  Dividends Owing £20,100  Corporation Tax Owing £21,860 £233,360 Acid Test Ratio= = ,360 What does this mean?

Acid Test Ratio Explanation The Current Ratio is 1.2 N.B. This is not a percentage either.  The business currently owns 1.2 times as much in cash terms (cash, debtors) as it currently owes to creditors, tax etc. Stock is ignored here because it might be difficult to turn stock into cash quickly without having to sell at a loss.  The value of 1.2 is quite respectable, and it means that the business is solvent. If creditors demanded payment immediately, ways could be found to pay.

Efficiency Ratios  These ratios are concerned with the way that assets are used in an organisation.  Some of these are very useful financial management tools for example the average stock turnover and the average credit period. These can be very useful in controlling the flow of cash in an organisation.  These ratios are important measures of how effective particular changes in management practice have been.

Efficiency Ratios Stock turnover (days) Stock turnover (days) = Average Stock Value x 365 Cost of Sales _____________________________________________________________________________________________________________________________________________ Debtors (days) Debtors (days) = Total Debtors x 365 Total Credit Sales _____________________________________________________________________________________________________________________________________________ Creditors (days) Creditors (days) = Total Creditors x 365 Credit Purchases _____________________________________________________________________________________________________________________________________________

The data we use is taken from the Balance Sheet, the Profit and Loss Account and other places Data Used to Calculate Efficiency Ratios

Stock Turnover Period Data Stock turnover (days) = Average Stock Value x 365 Cost of Sales Average These Two Select

Stock Turnover Period  Opening Stock Value£261,000  Closing Stock Value£300,000  Cost of Sales £1,745,400 Stock Turnover (Days) = ( )/2 x = 58.7 days What does this mean?

Stock Turnover Period Explanation The Stock Turnover Period is 58.7 days N.B. This is not a percentage either.  On average, it takes 58.7 days to ‘turn over’ the stock.  In simple terms that can be interpreted to mean that it takes 58.7 days for all the stock which is currently held to be sold  To put it another way, it is as if we got a whole batch of stock, held onto it for 58.7 days then sold it, replacing it immediately with new stock.  58.7 days is nearly 2 months, and in the scheme of things is quite acceptable. Some industries hold stock for much longer than this (Car Spares retailers, for example expect to hold onto stock for several months.) On the other hand, some business (e.g. restaurants) would not be able to trade if their stock turnover was this long.

Average Settlement Period for Debtors Data Debtors (days) = Total Debtors x 365 Total Credit Sales Select Here we are assuming for simplicity that all sales are on credit. This may not be true in all cases

Average Settlement period for Debtors  Trade Debtors£240,800  Total Sales £2,240,000 Average Settlement Period for Debtors = x = 39.2 days What does this mean?

Average Settlement Period for Debtors Explanation The Average Settlement period is 39.2 days N.B. This is not a percentage either.  On average, it takes 39.2 days for a customer to pay their bill.  To put it simply, we can think about it as if we made a whole batch of sales on one day, made no more for 39.2 days, and then got the money. We then make immediately make some more sales.  39.2 days is over a month, but in the scheme of things is quite acceptable. However, some suppliers prefer customers to pay within 28 days, and invoke penalties (such as interest payments) if this is not done. In some industries, however, there are traditions of not paying for up to 3 months (100 days or more)

Average Settlement Period for Creditors Data Creditors (days) = Total Creditors x 365 Credit Purchases Here we have additional information about purchases on on credit. This may not be true in all cases, and you may need to assume that Cost of Sales = Purchases on Credit. Select

Average Settlement period for Creditors  Trade Creditors£191,400  Total Sales £1,804,400 Average Settlement Period = x = 38.7 days What does this mean?

Average Settlement Period for Creditors Explanation The Average Settlement period is 38.7 days N.B. This is not a percentage either.  On average, it takes 38.7 days for the business to pay its suppliers for a particular order.  Again, to put it simply, we can think about it as if we took delivery of a whole batch of items on one day, received no more for 38.7 days, and then paid the money. We then immediately take delivery of more items.  38.7 compares very favourably with 39.2 days, the time the customers take to pay their debts, and in the scheme of things is quite acceptable. As remarked earlier, some suppliers prefer customers to pay within 28 days, and invoke penalties (such as interest payments) if this is not done.