1. 7 Analysing the strategic position of a business
Recap Year 1:
What is the difference between profit and profitability?
State 3 measures of profitability.
What is meant by return on investment?
What is meant by the proportion of long term funding that is debt?
7.2 Analysing the existing internal position of a business to assess strengths and weaknesses: financial ratio analysis

2. 7.2 Analysing the existing internal position of a business to assess strengths and weaknesses: financial ratio analysis
In this topic you will learn about
How to assess the financial performance of a business using balance sheets, income statements and financial ratios
Financial ratio analysis to include:
profitability (return on capital employed)
liquidity (current ratio)
gearing
efficiency ratios: payables days, receivables days, inventory turnover
The value of financial ratios when assessing performance
Data may be analysed over time or in comparison with other businesses

3. Assessing financial performance
PLCs have a legal obligation to publish their annual accounts
The format is governed by International Financial Reporting Standards (IFRS)
This format has altered some of the terminology used by UK businesses to comply with standard practices across the world
Financial data can be used to assess performance and potential

4. Write down the formula for calculating each type of profit.
Published accounts
The financial performance of a business can be assessed using two key financial reports:
Balance sheet
A formal financial document that summarises the net worth of a business at a given point in time
It balances net assets with total equity
Income statement
A formal financial document that summarises a business’ trading activities and expenses to show whether the business has made a profit or a loss over a specified period of time
Recap Year 1:
Write down the formula for calculating each type of profit.

5. Balance Sheet – The terminology
Assets: Items of value owned by a business.
Liabilities: Money a business owes i.e. debts.
Non – current assets
Likely to be kept by the business for more than one year e.g.
Vehicles
Premises
Machinery
Current assets
Likely to be turned into cash within a year e.g.
Inventories
Receivables
Cash and cash equivalents
Non – current liabilities
Debts that the business has more than one year to repay e.g.
Bank loans
Mortgages
Current liabilities
Debts that the business may have to repay within one year e.g.
Overdrafts
Payables

6. Balance sheet Non-current assets Long term or fixed assets
Short term assets
Inventories
The value of stock held
Receivables
Cash owing from credit sales
Cash and cash equivalents
Cash in hand or at the bank
Total current assets
All current assets added together
Current liabilities
Money owed to be repaid in the short term
Net current assets
Total current assets minus current liabilities
Non current liabilities
Long term debts
Net assets
The net worth of the business’ assets
Share capital
Finance raised from the sale of shares
Retained profit and reserves
Cumulative profits kept in the business
Total equity
The value of shareholders’ funds

7. Balance Sheet £ms Calculations Non-current assets 19 550
Inventories
2 375
Receivables
1 170
Cash and cash equivalents
2 300
Total current assets
5 845
Current liabilities
8 160
Net current assets
(2 315)
Non current liabilities
(6 000)
Net assets
11 235
(2 315)
Share capital
6 000
Retained profit and reserves
5 235
Total equity

8. Income statement Income statement Explanation Sales revenue
Money coming in from sales
Quantity sold x selling price
Cost of sales
Costs directly linked to the production of the goods or services sold e.g. raw materials
Gross profit
Sales revenue – cost of sales
Expenses
All other costs associated with the trading of the business e.g. salaries and marketing expenditure
Operating profit
Gross profit – expenses
Interest
Interest paid on debt or received on positive balances
Profit for the year
Operating profit – interest (tax is still to be deducted)

9. Income Statement £ms Calculations Revenue 35 400 Cost of sales 30 100
Gross Profit
5 300
– = 5 300
Expenses
720
Operating profit
4 580
5 300 – 720 = 4 580
Finance income
300
Finance cost
(260)
Profit before tax
4 620
– 260 = 4 620
Interest
1 109
Profit for the year
3 511
4 620 – = 3 511

10. What is meant by the term benchmark?
Ratio Analysis
Allows for a more meaningful analysis of published accounts
Shows relationship between figures
Used for comparisons over time
Inter and intra business comparisons
Intra means between businesses e.g. to compare performance to competitors or to benchmark
Inter means within a business e.g. over time within one organisation or between branches
What is meant by the term benchmark?
Why are numbers so important when understanding a business’ performance? View M&S key facts.

11. Ratio Analysis - Profitability
Return on Capital Employed (ROCE)
A measure of how efficiently a business is using capital employed to generate profits
Capital employed = total equity + non-current liabilities i.e. all the money invested in the business from:
Share capital
Reserves
Long term loans
Formula:
Operating profit x 100
Total equity + non-current liabilities
Challenge:
Capital employed can also be calculated as total assets minus current liabilities. Can you explain why?

12. Return on capital employed
Balance Sheet £m
Non-current assets
Inventories
Receivables
Cash & cash equivalents
Total current assets
Current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets
Share capital
Reserves & retained earnings
Total equity
Income Statement £m
Revenue
Cost of sales (30100)
Gross profit
Expenses (720)
Operating profit
Finance income
Finance cost (260)
Profit before tax
Taxation (1109)
Profit for the year
Operating profit x x 100
Total equity + non-current liabilities
x 100 = 27%
17235

13. Interpretation of ROCE
Why would it be meaningful to compare this
to the current rate of interest?
Why might a high street retailer compare
ROCE between individual stores?
Return on capital employed
Operating profit x 100
total equity + non-current liabilities
X 100 = 27%
17235
For every £1 of capital employed in the business 27 pence is generated in operating profit.

14. Ratio Analysis - Liquidity
Define current assets and current liabilities.
Liquidity
A measure of a businesses’ ability to survive in the short term i.e. its ability to meet short term debts and day to day expenses
If a business can not meet current liabilities from current assets then it is at risk of failure if creditors demand immediate payment of debts
Liquidity is calculated using the current ratio
Current assets
Current liabilities
A second measure of liquidity is the acid test. It is useful to understand this although it will not be explicitly examined. Research what is meant by the acid test.
Why might a business be placed in administration?

15. Current ratio Current assets : current liabilities 5845 : 8160
Balance Sheet £m
Non-current assets
Inventories
Receivables
Cash & cash equivalents
Total current assets
Current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets
Share capital
Reserves & retained earnings
Total equity
Current assets : current liabilities
5845 : 8160
= : 1
For every £1 of CL the business owes it owns
£0.716 (72 pence) in CA.
Do you think this business has enough short
term assets to meet its short term debts?

16. Liquidity
What steps could a business take to improve cash flow?
What is the relationship between cash flow and liquidity?
A business with low liquidity is in danger if short term creditors demand payment quickly e.g. the bank recalls an overdraft
Business may therefore seek to improve liquidity:
Increase current assets and/or reduce current liabilities
Sell assets that are no longer being used i.e. turn them from a non-current asset to a current asset (cash)
Move cash balances from current accounts to high interest bearing accounts so its value increases more rapidly
Switch to long term sources of finance
Monitor debtors to avoid bad debts

17. Discussion List 5 reasons why businesses need cash on a regular basis
Do you agree with these quotes?
“Sales for vanity, profit for sanity but cash is king”
“Profitable businesses can still go under if they run out of cash at a critical moment. Forecasting is the most focused method of avoiding that obstacle.”
Peter Jones

18. Practice question
Using the extract from SuperGroup Plc’s balance sheet calculate:
Current ratio
Acid test (extension activity)
Comment on the liquidity of SuperGroup Plc.
View full statement of financial position.

19. Ratio Analysis - Gearing
Measures what proportion of a business’ capital is funded through long term loans
Loans are “compulsory interest bearing” i.e. you have to pay interest on them even if profits are low or non-existent
A highly geared business is of greater risk if interest rates are likely to increase
Non-current liabilities x 100
Total equity + non-current liabilities
Explain where interest rates would appear on an income statement
and which profit figure(s) would be affected.

20. Ratio Analysis - Gearing
Balance Sheet £m
Non-current assets
Inventories
Receivables
Cash & cash equivalents
Total current assets
Current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets
Share capital
Reserves & retained earnings
Total equity
Non-current liabilities x 100
Total equity + non-current liabilities
x 100
x = 35%
17235
For every £1000 invested in this business how
much of it is from long term loans?
Why might a high gearing ratio be more of a concern to a business with small profit margins?

21. Efficiency ratios
Efficiency ratios assess the internal management of a business i.e. how efficient are managers in controlling the current assets
Efficiency ratios look at the management of cash and inventory
Payables days
Receivables days
Inventory turnover

22. Payables days
Payables days
A measure of how long it takes, on average, for the business to pay for supplies it has purchased on credit
A business may try to have a longer payables days ratio to ease cash flow problems
A short payables days may result in discounts from suppliers
Payables x 365
Cost of sales

23. Payables days Payables x 365 4160 x 365 = 50 days Cost of sales 30100
Income Statement £m
Revenue
Cost of sales (30100)
Gross profit
Expenses (720)
Operating profit
Finance income
Finance cost (260)
Profit before tax
Taxation (1109)
Profit for the year
Balance Sheet £m
Non-current assets
Inventories
Receivables
Cash & cash equivalents
Total current assets
Payables (4160)
Short term loans (4000)
Total current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets
Share capital
Reserves & retained earnings
Total equity
Payables x x 365 = 50 days
Cost of sales
Why might a business be willing to have
a payables days of 60 – 90 days?

24. Efficiency ratios
Receivables days
A measure of how long it takes, on average, for customers to pay the business for goods or services it has purchased on credit
The customer is a debtor of the business
A business may try to have a shorter receivables days to ease cash flow problems
Receivables x 365
Sales revenue

25. Receivables days Income Statement £m Balance Sheet £m Revenue 35400
Cost of sales (30100)
Gross profit 5300
Expenses (720)
Operating profit 4580
Finance income 300
Finance cost (260)
Profit before tax 4620
Taxation (1109)
Profit for the year 3511
Balance Sheet £m
Non-current assets
Inventories
Receivables
Cash & cash equivalents
Total current assets
Payables (4160)
Short term loans (4000)
Total current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets
Share capital
Reserves & retained earnings
Total equity
Receivables x x = 12 days
Sales revenue
This shows that on average it takes 12 days to receive payment for goods and services sold on credit.

26. Show your understanding
Payables days was 50 days and receivables days 12 days. Should this business be concerned? Justify your answer.
Payables are compared to cost of sales and receivables to revenue. Use business terminology to explain the relationship between these variables.
3) What might be the expected receivables days of
A high street coffee chain
A commercial print company
Justify your answers.

27. Inventory turnover Inventory turnover
Average inventory held can be calculated by finding the average of inventory at the start and end of the year
You therefore also need the previous year’s balance sheet
Alternatively you can just divide cost of sales by inventory
Measures how frequently a business turns over its inventory in a year
Will vary depending upon the nature of the firm
Hot dog stand (hopefully daily!)
Fashion retailer (at least each season)
New car showroom (maybe twice a year)
Cost of sales
Average inventory held

28. On average for how long does this business hold stock?
Inventory turnover
Income Statement £m
Revenue
Cost of sales (30100)
Gross profit
Expenses (720)
Operating profit
Finance income
Finance cost (260)
Profit before tax
Taxation (1109)
Profit for the year
Balance Sheet £m
Non-current assets
Inventories
Receivables
Cash & cash equivalents
Total current assets
Current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets
Share capital
Reserves & retained earnings
Total equity
Cost of sales = times
Average inventory held
On average for how long does this business hold stock?
What type of business might have this level of inventory turnover? Justify your answer.
Why might it be more accurate to divide by average inventory held rather than just inventory?

29. Value of financial ratios when assessing performance
Limitations
Possibility that accounts have been window dressed
Need to consider reasons behind ratios
e.g. is ROCE lower than previous years because of an investment programme
Quantitative information only
Value
Provides a tool for the interpretation of accounts
Structure from which comparisons can be made
Overtime
With other businesses
Aids decision making
Internally
Externally by investors
What other quantitative information could be used to assess the performance of a business?
What other qualitative information could be used to assess the performance of a business?

30. Activity – interpreting published accounts
In pairs choose 2 businesses who operate in the same industry e.g. 2 supermarkets, 2 football clubs
Go on the internet and print off the balance sheet and income statement (Google company name/investors)
The layout will vary from company to company but you should be able to identify the key information
Prepare a presentation comparing the performance of the two businesses over time and in comparison to each other
Present your findings to the rest of the class

31. 7.2 Analysing the existing internal position of a business to assess strengths and weaknesses: financial ratio analysis
In this topic you have learnt about
How to assess the financial performance of a business using balance sheets, income statements and financial ratios
Financial ratio analysis to include:
profitability (return on capital employed)
liquidity (current ratio)
gearing
efficiency ratios: payables days, receivables days, inventory turnover
The value of financial ratios when assessing performance
Data may be analysed over time or in comparison with other businesses