Interpreting the Accounts (Ratio Analysis)

What is ratio analysis? A set of accounting ratios often used to help interested parties interpret ( make sense of) financial accounts

Liquidity ratios Current ratio= current assets current liabilities Acid test= current assets - stock current liabilities

Liquidity ratios Ideal current ratio is 2:1 Any higher and too much money tied up in assets which are unproductive A low current ratio eg 0.5:1 would mean the company has 60p for every £1 of debt and cannot cover its short term debts Indicates short term financial stability of the business

Liquidity ratios Stock deducted as the most illiquid asset – therefore a more accurate test of a firm’s liquidity Ideal ratio 1.1:1 showing the company has £1.10 to pay every £1 This ratio is a more stringent test of short term stability

Profitability ratios Gross profit margin = gross profit*100 turnover Net profit margin = net profit*100 turnover ROCE = net profit*100 capital employed NB total capital employed= ordinary share capital+pref share capital+reserves+debentures+long term loans+mortgages

Profitability ratios High profit margin is obviously a good thing Net profit margin is of particular interest to owners and managers – profit after all costs considered ROCE measures efficiency of funds invested in the business at generating profits The higher the value of the ratio the better – a higher % means owners receive a greater return

Efficiency ratios Debtor collection= debtors*365 credit sales Creditor payment period= creditors*365 credit purchases

Efficiency ratios The higher the rate of turnover the better – firm selling stock quicker, realises profit quicker Year on year comparisons most appropriate Debtor collection period shows managers/owners how effective their credit control is Creditor ratio less important but suppliers should not be abused

Who are the accounts of interest to ? customers; employees (including managers); owners and shareholders; the local community; the government; pressure groups; suppliers; financiers current and prospective investors.

customers Profit and loss – increasing sales and profit indicates a well managed business that should be able to supply goods and services in the future Balance sheet – interested in creditors and how quickly business settles debts

employees Profit and loss – increasing sales and profit indicates the business is healthy and that jobs are secure, also that wages are likely to be kept at a reasonable level Balance sheet – interested in this if they are a shareholder

owners and shareholders current and prospective investors Profit and loss – are sales increasing each year? profit affects dividends but also future profits which affect share price and future performance Balance sheet – interested in shareholders funds which influences share price (want it to be rising which will cause share prices to rise), also assets and creditors which indicate generally how the business is doing

financiers Profit and loss – high profits would indicate loans can be repaid Balance sheet – interested in cash at bank figure

the local community Profit and loss – increasing sales and profit indicates a business that should be able to supply goods and services in the future and provide employment Balance sheet – interested in creditors and how quickly business settles debts

the government Profit and loss – increasing sales and profit indicates a business which can provide jobs and contribute significant tax revenue (corporation tax – tax on business profits) Balance sheet – interested in creditors and how quickly business settles debts

pressure groups Depends on the nature of the pressure group Excessive profits may been seen as the business exploiting its customers and suppliers

suppliers Profit and loss – increasing sales and profit indicates a business that should be able to supply goods and services in the future and therefore will want supplies Balance sheet – interested in creditors and how quickly business settles debts to suppliers