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
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 shortterm 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
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
Equipment
Total non-current assets
550
600
1150
Current assets:
Inventories
Trade receivables
Cash
Total current assets
300
200
50
Current liabilities:
Trade payables
Short-term borrowings
Total current liabilities:
250
180
550
430
Net current assets
Non-current liabilities:
Bank loans
Total non-current liabilities
120
600
600
Net assets
Equity
Share capital
Reserves and retained profits
Total equity
670
400
270
670
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 noncurrent liabilities plus total equity)
Profitability
• ROCE
£000
Revenue
– Operating profit / capital
employed
– Capital employed is noncurrent liabilities plus total
equity
– 300/(600+670) x 100
– So ROCE = 23.6%
• A good ROCE?
–
–
–
–
–
0-5% very poor
5-10% mediocre
10-15% acceptable, normal
15-20% good
Over 20% very good
1050
Gross profit
550
Operating profit
300
Interest
10
Profit before tax
290
Net profit
230
Non-current liabilities:
Bank loans
Total non-current liabilities
600
600
Net assets
Equity
Share capital
Reserves and retained profits
Total equity
670
400
270
670
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!)
Efficiency ratios – Asset turnover
£000
• Asset turnover
– How efficiently assets are being
used to generate revenue
– Calculated as revenue / net assets
Revenue
• 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
1050
Gross profit
550
Operating profit
300
Interest
10
Profit before tax
290
Net profit
230
Non-current liabilities:
Bank loans
Total non-current liabilities
600
600
Net assets
Equity
Share capital
Reserves and retained profits
Total equity
670
400
270
670
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
–
•
An alternative is to calculate how long
inventories are held
–
–
–
–
•
This means inventory is turned over (sold)
1.67 times in the year
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
1050
Revenue
Cost of sales
500
Gross profit
550
Expenses
250
Operating profit
300
£000
Non-current assets:
Land and buildings
Equipment
Total non-current assets
Current assets:
Inventories
Trade receivables
Cash
Total current assets
550
600
1150
300
200
50
550
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
Revenue
£000
1050
Cost of sales
500
Gross profit
550
Expenses
250
Operating profit
300
£000
Current assets:
Inventories
Trade receivables
Cash
Total current assets
Current liabilities:
Trade payables
Short-term borrowings
Total current liabilities:
300
200
50
550
250
180
430
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 / (noncurrent 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?
Revenue
£000
1050
Cost of sales
500
Gross profit
550
Expenses
250
Operating profit
300
Non-current liabilities:
Bank loans
Total non-current liabilities
600
600
Net assets
Equity
Share capital
Reserves and retained profits
Total equity
670
400
270
670
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
•
Revenue
£000
1050
equals
Gross profit
550
equals
Operating profit
300
equals
Profit before tax
290
equals
Net profit
230
minus
Dividends
100
equals
Retained profit
130
Number of shares (000)
800
Share price (p)
200
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%
Non-current liabilities:
Bank loans
Total non-current liabilities
600
600
670
Net assets
Equity
Share capital
Reserves and retained profits
Total equity
400
270
670
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 1
Price now year ago
Share price
change
Dividend
Total
shareholder
return
TSR (%)
200
160
Change in
share price
40
12.5
52.5
32.8%
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