2. Interpreting accounts The objective of financial statements is to provide information that is useful to a wide range of users in making economic decisions (International Accounting Standards Committee) Trends – Comparing performance one year with a previous year, eg growth in revenues, costs and profits Ratios – Allow comparisons with previous years and competitors, looking at: Liquidity (has a company got enough money) Profitability Efficiency Shareholders ratios

3. Liquidity ratios Measure of a firm’s ability to meet day to day expenditure, ie to pay bills 2 ratios measure whether a company has enough short- term assets to pay short-term debts if repayment is requested (eg a supplier demands payment): – Current ratio current assets divided by current liabilities or CA : CL General view of about 1.5 is right (less may mean not enough liquidity, more means too much money is tied up). Should be above 1 – Acid test (sometimes called quick ratio) (current assets minus inventories) divided by current liabilities Takes into account it may be hard to turn inventories into cash Much below 1 is viewed as potentially dangerous, eg 0.6

4. Calculations What is the current ratio? – 550/430 = 1.28 – Is this OK? – No, so look at acid test Acid test? – 250/430 = 0.58 – Is this OK? – No, so firm may struggle to pay bills – What should it do? £000 Non-current assets: Land and buildings 550 Equipment 600 Total non-current assets 1150 Current assets: Inventories 300 Trade receivables 200 Cash 50 Total current assets 550 Current liabilities: Trade payables250 Short-term borrowings180 Total current liabilities: 430 Net current assets 120 Non-current liabilities: Bank loans 600 Total non-current liabilities 600 Net assets 670 Equity Share capital 400 Reserves and retained profits 270 Total equity 670

5. Profitability Specification ROCE is the main measure, but in reality we need to look at other measures, particularly profit margins – Gross profit margin – Operating profit margin – a good one ROCE is (operating profit/capital employed) x 100 (CE equals non- current liabilities plus total equity)

6. Profitability ROCE – Operating profit / capital employed – Capital employed is non- current liabilities plus total equity – 300/(600+670) x 100 – So ROCE = 23.6% A good ROCE? A good ROCE – 0-5% very poor – 5-10% mediocre – 10-15% acceptable, normal – 15-20% good – Over 20% very good Non-current liabilities: Bank loans 600 Total non-current liabilities 600 Net assets 670 Equity Share capital 400 Reserves and retained profits 270 Total equity 670 £000 Revenue1050 Gross profit550 Operating profit300 Interest10 Profit before tax290 Net profit230

7. Efficiency ratios Can be used to compare with competitors, but main use is internal How efficiently is management controlling the financial operations of the business? – And how efficiently is the business being run 5 principal ratios – Asset turnover – Inventory (stock) turnover – Payables (creditor) days – Receivables (debtor) days – Gearing (not really an efficiency ratio!)

8. Efficiency ratios – Asset turnover Asset turnover – How efficiently assets are being used to generate revenue – Calculated as revenue / net assets This formula is misleading. Should be revenue / total assets or capital employed! – So 1050 / 670 = 1.57 – This means for every £1 invested in net assets, the business generates £1.57 in revenues – Higher number is better, but there is no right answer because it depends on the industry So compare over time Non-current liabilities: Bank loans 600 Total non-current liabilities 600 Net assets 670 Equity Share capital 400 Reserves and retained profits 270 Total equity 670 £000 Revenue1050 Gross profit550 Operating profit300 Interest10 Profit before tax290 Net profit230

9. Efficiency ratios – inventory turnover Inventory turnover measures how many times a business turns over its inventories in a year Measured as cost of sales / inventories So 500 / 300 = 1.67 – This means inventory is turned over (sold) 1.67 times in the year An alternative is to calculate how long inventories are held – 365 / inventory turnover, or from scratch – Inventory days = (inventories / cost of sales) x 365 – In this case, 300 / 500 x 365 = 219 days – This means on average inventories are held for 219 days, or the business has 219 days worth of inventory Appropriate inventories – Depends on the industry – bakery/fishmonger will have high turnover, whilst a furniture shop will have low turnover – Calculate for Ted Baker – what do you think £000 Revenue 1050 Cost of sales 500 Gross profit 550 Expenses 250 Operating profit 300 £000 Non-current assets: Land and buildings550 Equipment600 Total non-current assets 1150 Current assets: Inventories300 Trade receivables200 Cash50 Total current assets 550

10. Efficiency ratios – payables/receivables days These measure how quickly a company collects payments from customers, and how quickly it pays suppliers Receivables (debtor) days – (receivables/revenues) x 365 – (200/1050) x 365 = 69.5 days – Takes 69.5 days for it to receive cash from customers – Too long Payables (creditor) days – (payables/cost of sales) x 365 – (250/500) x 365 = 182.5 days (6 months) – Takes 6 months to pay suppliers which is terrible – may find it hard to continue to be supplied £000 Revenue 1050 Cost of sales 500 Gross profit 550 Expenses 250 Operating profit 300 £000 Current assets: Inventories300 Trade receivables200 Cash50 Total current assets 550 Current liabilities: Trade payables250 Short-term borrowings180 Total current liabilities: 430

11. Efficiency ratio - gearing Not really an efficiency ratio! Look at previous notes Considers what % of the capital employed in the business is from debt (loans) Formula is in the sheet in the exam and is non-current liabilities / (non- current liabilities + total equity) then x 100 to put into % 600/(600+670) x 100 = 47.2% High gearing can be risky – if interest rates rise then a business will (eventually) have to pay more in interest which it might not afford – If you had a mortgage of 500,000 and interest rates rose from 2% to 6% what happens to monthly interest payments? £000 Revenue 1050 Cost of sales 500 Gross profit 550 Expenses 250 Operating profit 300 Non-current liabilities: Bank loans600 Total non-current liabilities 600 Net assets 670 Equity Share capital400 Reserves and retained profits270 Total equity 670

12. Shareholder ratios Dividend per share (DPS) – Dividends are paid out of profits – Dividend per share measures how much a shareholder receives each year from each share held – Dividends/number of shares issued. Be careful about the units – (100/800) x 100 to be in pence =12.5p Dividend yield – How do you know if the dividend per share is good? – Compare it with the value of the shares – (DPS/share price) x 100 (in %) – This tells you how much in dividends you receive each year for every £100 you have invested in shares – (DPS/share price) x 100 – (12.5/200) x 100 = 6.25% £000 Revenue 1050 equalsGross profit 550 equalsOperating profit 300 equalsProfit before tax 290 equalsNet profit 230 minusDividends 100 equalsRetained profit 130 Non-current liabilities: Bank loans 600 Total non-current liabilities 600 Net assets 670 Equity Share capital 400 Reserves and retained profits 270 Total equity 670 Number of shares (000) 800 Share price (p) 200

13. Are shareholders happy Dividends per share – Compare with previous year Dividend yield – Compare with other shares or other investments Change in share price – Has the share price risen or fallen – Share price will generally rise when the prospects for a company are improving So sum up with total shareholder returns (TSR) – Add DPS to change in share price for the total return, then compare with price at start Price now Price 1 year ago Change in share price Share price change20016040 Dividend12.5 Total shareholder return52.5 TSR (%)32.8%

14. Are shareholders happy TSR is the best measure, because if the business is improving (faster than expected) then the share price will rise – But you may not always be given this information If you are not given the share price, then you must consider how well the business is performing – Is the business growing? What has happened to profitability? Key measures ROCE and operating profit margin