1. 5.5.1 Analysing Financial Statements Using Ratio analysis
Accounts
5.5.1 Analysing Financial Statements Using Ratio analysis

2. Learning Outcomes
To be able to interpret Financial Statements by calculating and analysing the following ratios:
Gross Profit Margin
Profit Margin
Return on Capital Employed
Current Ratio
Acid Test Ratio

3. Ratio analysis Used to analyse the financial security of a business
Two types:
Profitability
Liquidity

4. 1. Profitability ratios 2. Liquidity ratios
Accounts
1. Profitability ratios
2. Liquidity ratios

5. 1. Profitability ratios
These help to show how well a business is doing against its objectives
Gross Profit Margin
Net Profit Margin
Return on Capital Employed

6. a. Gross profit margin (gross profit to sales ratio)
Turnover (sales)
x 100 = ?%
GPM =
Shows the percentage of sales revenue which is gross profit
A high percentage indicates relatively low cost of sales compared to turnover
Ignores indirect costs (overheads)

7. a. Gross profit margin example
GPM =
Gross profit
Turnover (sales)
x 100 = ?%
Oddball Ltd’s trading account for 2006 is as follows:
Complete the table
Calculate the Gross Profit Margin
Last year, the Gross Profit Margin was 50%. Has it improved or worsened?
900
360
Turnover
Cost of sales
(540)
Gross profit
It has worsened. Gross profit is a smaller fraction of turnover
Gross Profit Margin
= 360 ÷ 900 x 100 = 40%

8. b. Profit Margin (net profit to sales ratio)
Turnover (sales)
x 100 = ?%
PM =
Shows the percentage of sales revenue which is net profit
A high percentage indicates that the business has a tight control over costs
Includes all business costs (direct and indirect) and is thus more useful than GPM
Needs to be compared with previous years or similar businesses

9. b. Profit Margin example
PM =
Net profit
Turnover (sales)
x 100 = ?%
E.g. For Oddball Ltd above:
Complete the table
Calculate the Profit Margin
Last year, the Profit Margin was 5%. Has it improved or worsened?
900
540
Turnover
Cost of sales
Gross profit
360
Overheads (+ other income)
(270)
Net profit 90
It has improved. Net profit is a larger fraction of turnover. Since the GPM worsened, the business must have tightened up on overhead spending
Net Profit Margin
= 90 ÷ 900 x 100 = 10%

10. c. Return on Capital Employed (ROCE)
Net profit
Capital Employed
x 100 = ?%
ROCE =
Where will you find Capital Employed?
Measures the rate of return being generated by the money invested in the business
A high percentage indicates that the business is well managed
Needs to be compared with previous years or similar businesses
On the Balance Sheet – it’s the balancing number – at the very bottom (the same as the assets employed figure)

11. c. Return on Capital Employed (ROCE)
Net profit
Capital Employed
x 100 = ?%
E.g. On Oddball Ltd’s balance sheet Capital Employed is £1,800 (net profit is £90)
Calculate the ROCE
Last year, the ROCE was 7%. What has happened?
ROCE
= 90 ÷ 1,800 x 100 = 5%
It has worsened. The business is generating a lower profit from its assets

12. Task Bimbam Ltd
Bimbam makes plastic recycling bins, selling them to local councils
2004
2005
2006
Sales
124,500
129,950
142,050
Gross Profit
72,145
73,255
78,435
Net profit
12,500
14,350
19,250
Capital employed
256,500
266,350
278,550
GPM
58%
56%
55%
NPM
10%
11%
14%
ROCE
4.9%
5.4%
6.9%
Describe the changes in profitability over the 3 years
Why do you think these changes have taken place?

13. 1. Profitability ratios 2. Liquidity ratios
Accounts
1. Profitability ratios
2. Liquidity ratios

14. 2. Liquidity ratios These look at a firm’s ability to pay its debts
The faster an asset can be turned into cash, the more ‘liquid’ it is

15. a. Current ratio Current Assets = ? : 1 Current Liabilities
A measure of short-term solvency
It indicates the extent to which money owed in the short term is covered by liquid assets
A prudent ratio is at least 1.5 : 1 (i.e. for every £1 of current liabilities there is £1.50 of current assets) however more than 3 : 1 suggests an inefficient use of assets

16. a. Current ratio Oddball Ltd example
Current Assets
Current Liabilities
= ? : 1
Current assets:
Stock 20
Debtors 10
Cash  5
Current liabilities:
Creditors 15
Net current assets 35 20
Current ratio
= 35 ÷ 15 = 2.3 : 1
It has gone down. This is probably a good thing as last year’s figure was too high – the business was holding too many current assets
Complete the table
Calculate the current ratio
Last year, the Current ratio was 3 : 1. What has happened?

17. b. Acid test ratio Current Assets - stock = ? : 1 Current Liabilities
A much better test of the immediate solvency of a business because of the length of time necessary to convert stocks into cash (via sales and debtors)
Should typically be around 1 : 1

18. b. Acid test ratio Oddball Ltd example
Current Assets - Stock
Current Liabilities
= ?:1
Current assets:
Stock 20
Debtors 10
Cash  5
Current liabilities:
Creditors 15
Net current assets 35
Acid test ratio
= (35 – 20) ÷ 15 = 1:1 20
It has got better. 0.8:1 was a little low (there was previously only 80p of current assets – excluding stock – for every £1 of current liabilities)
Calculate the acid test ratio
Last year, the Acid test ratio was 0.8 : 1. What has happened?

19. Task Bimbam Ltd
Bimbam makes plastic recycling bins, selling them to local councils
2004
2005
2006
Stock
12,840
19,520
26,450
Current assets
39,425
43,420
44,375
Current liabilities
28,095
28,565
26,980
Calculate the following:
Current ratio
1.4 : 1
1.5 : 1
1.6 : 1
Acid test ratio
0.9 : 1
0.8 : 1
0.7 : 1
Describe the changes in liquidity over the 3 years
Why do you think these changes have taken place?

20. Accounts
Uses of ratio analysis

21. Uses of ratio analysis
Ratio analysis compares one piece of financial information with another
Allows managers, shareholders and potential investors to analyse and evaluate the financial position of a business
Used to:
Compare the same ratio for two different businesses
Compare the same ratio for one business over time
Compare business with a yardstick or ideal value for the ratio

22. Limitations of ratio analysis
Ratios are based upon past results and may not indicate how the business will perform in the future
Accounting results are affected by inflation
Comparisons with previous years can be misleading
You would expect different ratios from different industries
e.g. you would expect a supermarket chain to have more stock than a football club

23. Ratio analysis
Task – Cornwall plc

24. Cornwall plc task
Cornwall plc takes out a long term loan for £200,000 on top of its share capital of £400,000. With it, it buys a derelict warehouse for £50,000 and a block of offices for £350,000. It also buys a fleet of vans for £100,000 and stock of £50,000, for which £20,000 is paid in cash and the rest is on credit
List the different aspects of the information above under the following headings as appropriate:
Fixed assets
Current assets
Current liabilities
Long term liabilities
Share capital
Produce a full balance sheet for Cornwall plc
Calculate and comment upon the following ratios:
Current ratio
Acid test ratio

25. Cornwall plc takes out a long term loan for £200,000 on top of its share capital of £400,000. With it, it buys a derelict warehouse for £50,000 and a block of offices for £350,000. It also buys a fleet of vans for £100,000 and stock of £50,000, for which £20,000 is paid in cash and the rest is on credit
Cornwall plc answers
List the different aspects of the information
Fixed assets
Current assets
Current liabilities
Long term liabilities
Share capital

26. Cornwall plc answers £’000 £’000 Fixed assets Warehouse 50 Offices 350
Van
100
500
Current assets
Stocks 50
Cash 80
130
Less: Current liabilities
Trade creditors 30
Net Current Liabilities
100
Assets Employed
600
Financed by:
Share capital
400
Bank loans
200
Capital Employed
600

27. Well above the benchmark of 2 : 1 so too high – holding too much cash
Cornwall plc answers
Current ratio =
Current Assets
Current Liabilities
= ? : 1
Current ratio
Acid test
Current ratio = 130 ÷ 30 = 4.3 : 1
Well above the benchmark of 2 : 1 so too high – holding too much cash
Acid Test =
Current Assets - Stock
Current Liabilities
= ?:1
Acid test = 80 ÷ 30 = 2.7 : 1
Well above the benchmark so too high again. Since it is significantly different from the current ratio it suggests that stock levels are also too high

28. Ratio analysis
Southampton FC task

29. Southampton FC task
Investigate the profit and loss account and balance sheet of Southampton FC using appropriate financial ratios

30. Southampton FC profit and loss account – year ended 30 June 2006
£’000
£’000
Turnover
25,696
Less: Cost of Sales
(31,363)
Gross loss
5,667
Administrative expenses
(6,861)
Interest payable
(2,008)
Profit on sale of players
11,241
(2,372)
Net profit
(4,380)
Less: Taxation
(953)
Loss after tax
(2,342)
Dividends paid
Retained profit
(2,342)

31. Southampton FC balance sheet – at 30 June 2006
£’000
£’000
£’000
Fixed assets
Land and buildings
35,191
Equipment and vehicles
675
Intangible assets
3,757
39,623
Current assets
Stocks
404
Debtors
6,466
Cash
4,700
11,570
Less: Current liabilities
Creditors
9,282
Bank overdraft
2,012
11,294
Net Current Liabilities
276
Assets Employed
39,899
Financed by:
Share capital
5,795
Retained profit
2,959
Bank loans
31,145
Capital Employed
39,899

32. Task
Explain why someone thinking of buying shares in a company would find the published accounts of that company useful

33. Ratio Analysis Bingo! task
Test your understanding of accounts terminology and your knowledge of ratio analysis calculations
An alternative Bingo game, focusing on ratio analysis calculations and interpretation of the numbers