UNSW FOUNDATION STUDIES Introductory Accounting TOPIC: Financial Reports and Ratio Analysis LECTURE 2: Ratio Analysis COMMONWEALTH OF AUSTRALIA Copyright Regulations 1969 WARNING This material has been reproduced and communicated to you by and on behalf of the University of New South Wales pursuant to Part VA of the Copyright Act 1968 (the Act). The material in this communication may be subject to copyright under this Act. Any further copying or communication of this material by you may be the subject of copyright or performers’ protection under the Act. Do not remove this notice. Ratio Analysis This lecture uses the Financial reports printed in the last topic of your Supplementary Notes Ratio Analysis A method to analyse the relative position and performance of a business Uses information from financial reports - Balance Sheet - Income (Profit and Loss) Statement Profitability Measures the ability of the business to generate income as compared to expenses Did the business generate a good profit over the accounting period? Profit should provide an adequate return on investment Profitability: Net Profit Ratio NPR Examines sales revenue that produces net profit Net Profit Ratio = net profit x 100 sales Kingsford Trading Income Statement For the month of July 2012 Net Profit Ratio Sales 6840 Less Sales returns (740) Net sales 6100 Less cost of Goods Sold: Opening stock 3500 Purchases 9700 Less Purchases returns (650) Net Purchases Less Closing stock 9050 (9200) 3350 Gross Profit 2750 Add Other operating income: Discount received 10 2760 Less Other Operating Expenses: Advertising expense Depreciation of MV expense Discount allowed 26 250 20 Stationery expense 100 Wages expense 680 Net profit (1076) 1684 NPR = net profit x 100 sales Kingsford Trading Income Statement For the month of July 2012 Sales 6840 Less Sales returns (740) Net sales 6100 NPR = net profit x 100 sales Less cost of Goods Sold: Opening stock 3500 Purchases 9700 Less Purchases returns (650) Net Purchases Less Closing stock 9050 (9200) 3350 Gross Profit NPR 2750 Add Other operating income: Discount received 10 2760 Less Other Operating Expenses: Advertising expense Depreciation of MV expense Discount allowed 26 250 20 Stationery expense 100 Wages expense 680 Net profit (1076) 1684 1684 x 100 = Kingsford Trading Income Statement For the month of July 2012 NPR = net profit x 100 Sales 6840 Less Sales returns sales (740) Net sales 6100 Less cost of Goods Sold: Opening stock 3500 Purchases 9700 Less Purchases returns (650) Net Purchases Less Closing stock 9050 (9200) 3350 Gross Profit NPR 2750 Add Other operating income: Discount received 10 2760 Less Other Operating Expenses: Advertising expense Depreciation of MV expense Discount allowed 26 250 20 Stationery expense 100 Wages expense 680 Net profit (1076) 1684 1684 x 100= 6840 Kingsford Trading Income Statement For the month of July 2012 Sales NPR = net profit x 100 6840 Less Sales returns sales (740) Net sales 6100 Less cost of Goods Sold: Opening stock 3500 Purchases 9700 Less Purchases returns (650) Net Purchases Less Closing stock 9050 (9200) 3350 Gross Profit 2750 NPR Add Other operating income: Discount received 10 2760 Less Other Operating Expenses: Advertising expense Depreciation of MV expense Discount allowed 26 250 20 Stationery expense 100 Wages expense 680 Net profit (1076) 1684 1684 x 100= 24.62% 6840 Interpreting NPR NPR is a valid instrument for comparison between firms in the same industry between different years of the same firm More than one NPR result required for thorough analysis Observe the direction NPR is moving - A declining ratio may indicate expenses have increased or sales are insufficient Interpreting NPR Example: Compare two years NPR (year 1) =1684 x 100 = 24.62% 6840 NPR (year 2) = 600 x100 = 20% 3000 Comment on NPR NPR (year 1) = 24.62% NPR (year 2) = 20% In this example a falling NPR is a concern Why? Expenses have increased more than sales Management Efficiency Measures the efficiency of the business to earn profit Did the business turnover a good amount of stock over the accounting period? Management Efficiency: Stock Turnover Ratio Examines the number of times stock is sold and replaced in the accounting period Stock Turnover Ratio COGS = Average stock balance Average stock balance = opening stock + closing stock 2 Kingsford Trading Income Statement For the month of July 2012 Stock Turnover Ratio Sales 6840 Less Sales returns (740) Net sales 6100 Opening stock 3500 Purchases 9700 Less Purchases returns (650) Less Closing stock 9050 (9200) 3350 Gross Profit 2750 Add Other operating income: Discount received 10 2760 Less Other Operating Expenses: Advertising expense Depreciation of MV expense Discount allowed 26 250 20 Stationery expense 100 Wages expense 680 Net profit COGS Average stock balance Less cost of Goods Sold: Net Purchases = (1076) 1684 Kingsford Trading Income Statement For the month of July 2012 Stock Turnover Ratio Sales 6840 Less Sales returns (740) Net sales 6100 Opening stock 3500 Purchases 9700 Less Purchases returns (650) Less Closing stock 9050 (9200) 3350 Gross Profit 2750 Add Other operating income: Discount received 10 2760 Less Other Operating Expenses: Advertising expense Depreciation of MV expense Discount allowed 26 250 20 Stationery expense 100 Wages expense 680 Net profit COGS Average stock balance Less cost of Goods Sold: Net Purchases = (1076) 1684 = 3350 Kingsford Trading Income Statement For the month of July 2012 Stock Turnover Ratio Sales 6840 Less Sales returns (740) Net sales 6100 Less cost of Goods Sold: Opening stock 3500 Purchases 9700 Less Purchases returns (650) Net Purchases Less Closing stock = COGS Average stock balance 9050 (9200) 1350 Gross Profit 2750 Add Other operating income: Discount received = 3350 (3500+ 9200 / 2) 10 2760 = 3350 6350 Less Other Operating Expenses: Advertising expense Depreciation of MV expense Discount allowed 26 250 20 Stationery expense 100 Wages expense 680 Net profit (1076) 1684 Stock Turnover Ratio = Kingsford Trading Income Statement For the month of July 2012 Sales 6840 Less Sales returns (740) Net sales 6100 Less cost of Goods Sold: Opening stock 3500 Purchases 9700 Less Purchases returns (650) Net Purchases Less Closing stock COGS average stock balance 9050 (9200) 3350 Gross Profit = 3350 (3500+ 9200 / 2) 2750 Add Other operating income: Discount received 10 2760 Less Other Operating Expenses: Advertising expense Depreciation of MV expense Discount allowed 26 250 20 Stationery expense 100 Wages expense 680 Net profit = 3350 6350 = 0.53 times a year (1076) 1684 Interpreting Stock Turnover Ratio The generally accepted standard is 7 times for most businesses Comment on Stock Turnover Ratio Stock Turnover Ratio = 0.53 times a year In this example a low stock turnover ratio is a concern Why? Too much stock, some obsolete stock, poor liquidity or a planned build up in anticipation of a big selling season Liquidity Measures the ability to repay off current loans as due Can the business meet short term debts from disposal of Current Assets ? Liquidity: Working Capital Working Capital examines the absolute dollar size of the excess of short term liquidity (cash) Working Capital = Current Assets - Current Liabilities Liquidity: Working Capital Example: Current Assets = $30,000 Current Liabilities = $25,000 Working Capital = Current Assets - Current Liabilities = $5,000 After paying all current debt, there will be an excess of $5000 cash for the business Liquidity: Current Ratio (Working Capital Ratio) = Current Assets Current Liabilities Current Ratio = Current Assets Current Liabilities Kingsford Trading Balance Sheet as at 31 July 2012 Current Liabilities Current Assets Cash at bank 1940 Accounts Payable Stock 9200 Accrued Wages Accounts Receivable 3110 Stationery Supplies 30 Prepaid Advertising 104 Non-current Assets Less Accum. Depc. 100 21050 14384 Owner’s Equity Capital Motor vehicle 20950 Add Net Profit 12900 1684 14584 21800 (550) 21250 35634 35634 Current Ratio = Current Assets Current Liabilities Kingsford Trading Balance Sheet as at 31 July 2012 Current Liabilities Current Assets Cash at bank 1940 Accounts Payable Stock 9200 Accrued Wages Accounts Receivable 3110 Stationery Supplies 30 Prepaid Advertising 104 Non-current Assets Less Accum. Depc. 100 21050 14384 Owner’s Equity Capital Motor vehicle 20950 Add Net Profit = 14384 12900 1684 14584 21800 (550) 21250 35634 35634 Current Ratio = Current Assets Current Liabilities Kingsford Trading Balance Sheet as at 31 July 2012 Current Liabilities Current Assets Cash at bank 1940 Accounts Payable Stock 9200 Accrued Wages Accounts Receivable 3110 Stationery Supplies 30 Prepaid Advertising 104 Non-current Assets Less Accum. Depc. 100 21050 14384 Owner’s Equity Capital Motor vehicle 20950 Add Net Profit 12900 1684 14584 21800 (550) 21250 35634 35634 = 14384 21050 Current Ratio = Current Assets Current Liabilities Kingsford Trading Balance Sheet as at 31 July 2012 Current Assets Current Liabilities Cash at bank 1940 Accounts Payable Stock 9200 Accrued Wages Accounts Receivable 3110 Stationery Supplies Prepaid Advertising 104 14384 Non-current Assets Less Accum. Depc. 100 21050 30 Owner’s Equity Capital Motor vehicle 20950 Add Net Profit 12900 1684 14584 = 14384 21050 21800 (550) 21250 35634 35634 = 0.68 Comment on Working Capital Ratio Working capital ratio = 0.68 In this example a low working capital ratio is a concern Why? Every $1 owing in current debt is covered by only $0.68 worth of current assets, indicating a problem meeting debts Solvency Examines the financing mix of the firm: liabilities (debt finance) versus equity finance What proportion of the value of the assets are borrowed? The higher the debt, the more highly geared and at risk the business is Solvency: Debt Equity Ratio Examines the financing mix of the firm: liabilities (debt) versus equity finance Debt Equity Ratio total debts x 100 = owner’s equity Debt Equity Ratio Kingsford Trading Balance Sheet as at 31 July 2012 Current Assets Current Liabilities Cash at bank 1940 Accounts Payable Stock 9200 Accrued Wages Accounts Receivable 3110 Stationery Supplies 30 Prepaid Advertising 104 Non-current Assets Less Accum. Depc. 20950 100 21050 14384 Owner’s Equity Capital Motor vehicle = total debts x 100 owner’s equity Add Net Profit 12900 1684 14584 21800 (550) 21250 35634 35634 Debt Equity Ratio Kingsford Trading Balance Sheet as at 31 July 2012 Current Assets Current Liabilities Cash at bank 1940 Accounts Payable Stock 9200 Accrued Wages Accounts Receivable 3110 Stationery Supplies 30 Prepaid Advertising 104 Non-current Assets Less Accum. Depc. 20950 100 21050 14384 Owner’s Equity Capital Motor vehicle = total debts x 100 owner’s equity Add Net Profit 12900 1684 14584 21800 (550) 21250 35634 35634 = 21050 x 100 Debt Equity Ratio Kingsford Trading Balance Sheet as at 31 July 2012 Current Assets Current Liabilities Cash at bank 1940 Accounts Payable Stock 9200 Accrued Wages Accounts Receivable 3110 Stationery Supplies 30 Prepaid Advertising 104 Non-current Assets Less Accum. Depc. 20950 100 21050 14384 Owner’s Equity Capital Motor vehicle = total debts x 100 owner’s equity Add Net Profit 12900 1684 14584 21800 (550) 21250 35634 35634 = 21050 x 100 14584 Debt Equity Ratio Kingsford Trading Balance Sheet as at 31 July 2012 Current Assets Current Liabilities Cash at bank 1940 Accounts Payable Stock 9200 Accrued Wages Accounts Receivable 3110 Stationery Supplies 30 Prepaid Advertising 104 Non-current Assets Less Accum. Depc. 20950 100 21050 14384 Owner’s Equity Capital Motor vehicle = total debts x 100 owner’s equity Add Net Profit 12900 1684 14584 21800 (550) = 21050 x 100 14584 21250 35634 35634 = 1.44 Comment on Debt Equity ratio Debt Equity Ratio = 1.44 In this example a ratio > 1 is a concern Why? A ratio higher than 1 indicates borrowings are greater than the owner’s contribution, hence risk is high. The business is highly geared. Debt is considered more risky than equity. Limitations of Financial Analysis Results are dependent on the quality/limitations of the financial information provided Ratios require a basis for comparison. Yet no two businesses are alike Ratios based on the Balance Sheet may not be representative of the whole financial year as the Balance Sheet is only a snapshot of the business on a particular day Inclusion of any abnormal/extraordinary items distort results This concludes this lecture You are now expected to attempt the accompanying questions in this module Then attempt the questions provided in your tutorial book
