Finance and Accounts Ratio Analysis

Ratio Analysis The function of accounting is to provide information to stakeholders on how a business has performed over a period of time

Ratio Analysis This is an examination of accounting data by relating one factor to another. Usually the information is taken from the final accounts and will hopefully identify a trend. The information will then be used as a basis for a decision i.e. should we do business or invest in this business.

Ratio Analysis Accounting ratios are very easy to calculate and they enable a business to highlight which areas of its finances are weak and therefore require immediate attention.

Ratio Analysis Profitability ratios, these analyse the profit made over the last year. Activity/efficiency ratios, these analyse the efficiency of the business in terms of the use of its resources Shareholders’ ratios, these measure the strength of the company, its share price and its dividends Liquidity ratios, these measure the businesses ability to meet short-term debts. Gearing ratio, this compares the proportion of the money the business has borrowed to it’s share Capital

Who uses Ratio Analysis Managers They wish to know how well they have done and what needs to be improved Employees Interested in their long term prospects and useful when negotiating pay increases Shareholders Prospective and present shareholders use it to assess if they should hold or sell shares

Who uses Ratio Analysis Creditors They wish to know if the business will be able to pay them Bankers If the business requires additional finance is it in a position to repay any borrowings? Competitors How are we doing in comparison it our opponents Government

The Ratio Analysis process 1 Reason- What are needing to find out? 2 Identify- Find the figures you will need 3 Process- What calculations will you need? 4 Calculation 5 Comparison- Compare with other information 6 Interpretation- What does the info tell you? 7 Action- What do we need to do?

Profitability ratios These analyse the profit made over the last year or previous years. It may compare profit with those of a competitor, B&Q v Homebase There are 3 ratios you need to know: Gross Profit Ratio Net Profit Ratio Return on Capital Employed

Gross Profit Ratio Gross profit is the difference between sales turnover and the cost of goods sold. So comparing the Gross Profit to sales is a simple measure of a businesses performance. Gross Profit Ratio= Gross Profit/Salesx100% GP= £15m. Sales= £45m. 15/45x100= 33.33%

Gross Profit Ratio For any ratio to mean anything it has to be compared to other businesses or years Company B Gross Profit= £16m. Sales £64 Company C Gross Profit= £18m. Sales £45 Who has done best A,B or C?

The effectiveness of G.P.R. As you are probably aware Gross profit is only the first measure of profit so to rely too heavily on it would be wrong. It is better to use a firm’s final profit figure to make a comparison. If a business wants to improve it’s GPR it must seek to reduce the cost of it’s goods sold as a percentage of the sales price

Net Profit Ratio Taking the final profit figure gives a much better measure of a businesses performance. The Net Profit Ratio is calculated: Net Profit/ Sales x 100% Sales= £100,000 Net Profit = £25,000 NPR= 25,000/100,000 x 100%= 25%

Example Company A Sales 600,000 Cost of Sales 150,000 Gross Profit 450,000 Operating Expenses 250,000 Net Profit 200,000 GPR= 75% Net Profit Ratio=200/600 = 33.3% Company B Sales 800,000 Cost of Sales 200,000 Gross Profit 600,000 Operating Expenses 300,000 Net Profit 300,000 GPR= 75% Net Profit Ratio=300/800 = 37.5%

Net profit Ratio If a business is trying to improve it’s Net profit ratio it must seek to reduce it’s operating expenses. So it must seek to reduce it’s wage costs or use of electricity. Making workers more efficient through training or better equipment might help

Return on Capital Employed This is often referred to as the ‘primary accounting ratio’ and it expresses the annual percentage return that an investor would receive on their capital. For example, if a business had a net profit of £2.2m and a capital employed of £7.6m, then the Return on Capital Employed figure would be : = 28.9% Man Utd have a Net profit of £39.4m is this good or bad?

Return on Capital Employed (ROCE) Company A Sales 600,000 Capital invested £1.2m Operating Expenses 250,000 Net Profit 200,000 Net Profit Ratio=33.3% ROCE= Net profit/Capitalx100% 200,000/1.2m x 100= =16.67% Company B Sales 800,000 Capital invested £1.9m Operating Expenses 300,000 Net Profit 300,000 Net Profit Ratio=37.5% ROCE= Net profit/Capitalx100% 300,000/1.9m x 100= =15.79%

Return on Capital Employed (ROCE)

Return on Capital Employed (ROCE)

Return on Capital Employed (ROCE) To mean anything ROCE needs to be compared to previous financial information or to other businesses Firm A Profit Capital Employed Yr1 0.30m Yr1 1.5m Yr2 0.65m Yr2 1.6m Yr3 0.60m Yr3 1.7m Yr4 0.50m Yr4 1.7m

Return on Capital Employed (ROCE) To mean anything ROCE needs to be compared to previous financial information or to other businesses Firm A Profit Capital Employed Yr1 0.30m Yr1 1.5m 20% Yr2 0.65m Yr2 1.6m 41% Yr3 0.60m Yr3 1.7m 35% Yr4 0.50m Yr4 1.7m 29%

Improving Return on Capital Employed To do this a business has to be ruthless, they must Ensure assets are being used well Think seriously about any money invested Don’t hesitate to get rid of assets/ investments giving a high enough return- Scottish and Newcastle Breweries have recently sold off all their pubs

Activity Ratios Once you have analysed the profit situation you may then find you wish to delve deeper into a businesses records. What are it’s strengths or weaknesses. As a manager what do you have to make the the business do better. These ratios look at different aspects of the businesses operations

Stock Turnover Ratio We have already said in other parts of the course that holding too much stock is bad for a business This ratio simply calculates how many times the business sells it’s stock in a year Stock turnover = Cost of Sales Stock The figures come from the trading Account and Balance sheet

Stock Turnover Ratio = Cost of Sales Stock The result will be a figure like 4 or 5 or 6, it simply means they have sold their stock and bought in new stock 6 times. Some use the formula -Cost of Sales Average Stock ( Op. Stock+ Cl. Stock)/2

Stock Turnover Ratio

Stock Turnover Ratio

Stock Turnover Ratio Obviously the more times you can turnover your stock the better, Companies like McDonald’s would aim to do so very often. Their low profit margins mean they have to. A firm selling luxury cars or jewellery would not have to have as high a stock turnover as they can make a big profit from relatively few sales. Stock turnover is something a Manager may choose to target.

Assets Turnover This simply compares the businesses Net Assets to the Sales the business has achieved. Sainsbury’s may have a Asset Turnover of 4.5 whereas Tesco’s of 5.1. This means that Tesco’s are generating more sales from their assets than Sainsbury’s Or to put it another way Tesco’s generate £5.10 from every £1 of Net Assets whereas Sainsbury’s generate £4.50

Assets Turnover Ratio Net Assets can be found in the Balance sheet and it is: Fixed Assets + Current Assets- Current Liabilities Assets Turnover = Sales Net Assets £5,000,000 800,000+(75,000- 25,000) = 5,000,000/850,000= 5.88 times

Assets Turnover Ratio

Assets Turnover Ratio

How to improve your Asset Turnover This simply means making your assets work harder A football club might hold concerts or international matches A restaurant may open for Breakfast and Lunch Supermarkets trade for longer hours or sell different products- Tesco’s Bank, Insurance Easyjet or Ryanair ensure their planes spend the maximum time in the air

Debtors Collection Period 2 out of 3 businesses fail from a lack of cash to pay their bills. The Government recently had it’s credit rating downgraded for slowness paying it’s debts. The faster any business gets paid the faster it can then use the money to generate more sales. This ratio measures how quickly a business gets it’s money = Debtors/ Sales x 365 days 120/600=0.2 x 365= 73 days

Assets Turnover Ratio

Assets Turnover Ratio

Debtors Collection Period How to improve the collection period? If faced with problems the business might resort to: Factoring Being more selective about customers Offering terms for quick payment Employing staff to chase debts

Shareholders ratios A range of ratios calculated from share and dividend information to calculate how well the business has done: Dividend per share Dividend yield

Shareholders ratios Dividend per share This is calculated by dividing the dividend paid by the number of shares issued. Dividend Paid £500,000=25p Shares Issued 2million

Shareholders ratios The problem with Dividend per share is it ignores the actual price of the share If you paid £3.00 for a £1 share then 25p is not a good return

Shareholders ratios Dividend Yield gets round this, it takes into account the market price of the share: Dividend yield = Dividend x 100% Market Price 25/3.00x100= 8.33%

Shareholders ratios

Liquidity Ratios As we have already said the importance of cash flow to any firm cannot be overstated. For that reason there are 2 ratios that focus on a firms liquidity The Current Ratio The Acid Test Ratio

The Current Ratio This ratio measures the businesses ability to pay it’s debts. To do this you need to take 2 pieces of information from the Balance Sheet the Current Assets and Current Liabilities Current Ratio = Current Assets 100 = 1.25:1 Current Liabilities 80 This business has £1.25 of C.Assets for £1 of Debt, which is good

The Current Ratio

The Current Ratio

The Current Ratio Most businesses want to keep their current ratio at about 1:1, although some industries may differ. Falling below this ratio could be seen as being bad. Our business started about .93:1 and improves to as high as 1.1:1

Acid Test Ratio As we have already highlighted holding too much stock is bad for a business. If your creditors were to demand payment on the same day they would be disappointed as they might not want 6 cases of Fairy liquid or boxes of Tayto crisps. The Acid Test ratio removes Stock from the previous formula

Acid Test Ratio Current Ratio = Current Assets - Stock Current Liabilities 100-25= .9375:1 80 Here the business has £0.93.75 cash for each pound of debt.

Acid Test Ratio

Acid Test Ratio

Acid Test Ratio It is generally accepted that a business with a ratio of 0.8 : 1 is safe The previous businesses ratio rises from about 0.81 to .91 If a business wishes to improve it’s Acid Test Ratio it needs to Manage it’s Stockholding better Manage it’s credit control

Gearing Ratios Put simply this is the ratio of borrowed funds to owners own funds. Think of it as a mortgage, if you have a 100% mortgage you are heavily in debt. Whereas someone with a 50% mortgage owns half the building. If a business is highly geared it has to pay a lot in interest and this can be dangerous

Gearing Ratios Gearing is calculated: Long-term liabilities+ Preference shares X 100 Total Capital Employed (from balance sheet) Preference shares= Shares that have a guaranteed payback if the business goes bust. (Ordinary shares do not have this assurance)

Gearing Ratio

Gearing Ratio

Gearing Ratios Once a businesses gearing gets above 50% this can be be seen as being dangerous in the 1990’s when interest rates went up to 15% many highly geared firms struggled Bankers, investors and Directors take a keen interest in Gearing Ratios. Investors and bankers are reluctant to put extra money into a highly geared firm.

Summary Ratio Analysis is like a medical check up for a business. It can tell an expert where the problems are. Hopefully they should then be able to take action to improve things.