Nursery Management Understanding and Managing Finance Session 7

Analysing Accounts Now that we have a reasonable grasp on the standard financial statements used by businesses, we can use that knowledge to obtain information as to whether or not the business is functioning effectively. Today we will look at the Balance Sheets and Profit and Loss accounts of one fictional manufacturing Company to analyse its performance over the past two years. What we learn here can be applied to real companies whose financial reporting has been made public.

These figures show financial summaries of the Balance Sheets for M and N Manufacturing over the past three years. In our analysis, here, we will concentrate on the figures from 2002 and 2003

Analysing The Balance Sheet Normally, you will require two Balance sheets in successive years, and you should look out for any large proportional changes to items within:  Fixed Assets  Current Assets  Current Liabilities  Long Term Liabilities  Capital and Reserves

Interpreting Large Upward Changes Fixed Assets: The business may have bought new plant, machinery or transport. This might be part of a deliberate strategy Current Assets: The business may holding higher stock levels, carrying more debtors or simply have more cash in the bank. Current Liabilities: The business may owe more to its creditors Long Term Liabilities: The business may have taken out an additional Long Term Loan Profit and Reserves: The business may have made a large profit over the year.

Interpreting Large Downward Changes Fixed Assets: The business may have sold plant, machinery or transport. Again, this might be part of a deliberate strategy Current Assets: The business may holding lower stock levels, carrying fewer debtors or simply have less cash in the bank. Current Liabilities: The business may owe less to its creditors Long Term Liabilities: The business may have paid back a Long Term Loan Profit and Reserves: The business may have made a loss over the year.

Activity 1 1.Examine the Balance Sheet, and note down any large proportional changes from 2002 to What do you think these changes might mean? 1.Examine the Balance Sheet, and note down any large proportional changes from 2002 to What do you think these changes might mean?

Increase in Fixed Assets Small Increase in Trade Debtors Increase in Stock Large Increase in Trade Creditors Large Decrease in Long Term Loans Large Increase in Reserves

Activity 1 Interpretation Fixed Assets: The business has probably bought some new machinery or transport. This is not a large increase, and is probably not significant, especially when viewed in the light of the previous year’s larger increase. Current Assets: The business is now holding higher stock levels, and levels of trade debtors. This is not normally a good thing unless Turnover ( see P and L) has increased. Current Liabilities: The business owes a lot more more to its creditors than last year. In general this is a bad idea, as creditors may withdraw credit arrangements. Long Term Liabilities: The business has probably paid back a loan. Profit and Reserves: The business has made a profit over the year (confirmed by P and L account- see later)..

Analysing The Profit and Loss Account Some information can be obtained simply on the basis of one year’s Profit and Loss Account, but it helps very much to see the comparison with the previous year. The main headings to look at are:  Turnover ; Compare to Cost of Sales  Gross profit; Compare to Overheads  Net Profit (called the Operating Profit)  Earned Surplus

What to look out for on the Profit and Loss Account  Has the business increased its Turnover ?  How big a proportion of the Turnover is taken up by Cost of Sales?  How big a proportion of the Gross Profit is taken up by Overheads?  Has the business made a Net Profit (called the Operating Profit). Has this increased from last year?  Has the business made an overall profit (Earned Surplus)? Has this increased from last year?  Can you identify the main reason for the overall profit or loss?

Activity 2 1.Examine the Profit and Loss Account note any large changes from 2002 to What do you think these changes might mean? 1.Examine the Profit and Loss Account note any large changes from 2002 to What do you think these changes might mean?

Activity 2 Solution Increase in turnover but also in Costs Increase in gross profit, but very large increase in Overheads Small increase in net profit Small Increase in earned surplus

Activity 2 Interpretation  The business has increased its Turnover by over £600,000. This looks good.  However there has been a corresponding increase in Cost of Sales by about £500,000. This is not so good!  When we note that Overheads have risen by around £100,000, that all but wipes out the increase in Turnover, and our Net Profit is almost the same as in the previous year.  There has been an increase in Earned Surplus of around £9,000, which looks OK, but this is actually all due to the fact that we had less interest on loans to pay this year. If that had not been the case there would actually have been a decrease in Earned Surplus from last year’s figures.

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

Sample Ratios  Retail Sales per square metre  Sales Cost per £1000 loaned  Food cost per patient  % Bed Occupancy  % of sales spent on advertising (or anything)  Cost of water (electricity) per kilo manufactured  Average number of students per class  Expenditure on books per student  Cost per outcome for different departments

Activity 3 Discuss the following:  Imagine you are the proprietor of a nursery. Identify a series of key ratios which would help you to monitor on a day to day basis how well the business is performing.

Activity 3 - Solutions Key ratios to monitor how well a hotel is performing. These might include:  % place occupied  Average customer payment  Reservations as a % of total paces taken up  Cleaning Costs per room  Average direct cost per child  Total Overheads bill per day’s operation  Total Salaries as a percentage of turnover  % food wastage per day … and many more!

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?

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)