Interpretation of Accounts

1
Interpretation of Accounts

• Ratio Analysis
• http//www.bized.ac.uk/compfact/ratios/index.htm

2
The need for ratios

• To examine the profitability of the firm.
• To find out the ability of the firm to meet its
  debts (liquidity).
• To see how efficiently the managers of the firm
  uses its resources.
• So that investors in the firm can see the returns
  on their investment.

3
Profitability Ratios ROCE

• Return On Capital Employed (ROCE)
• Net profit before tax interest X 100
• Total capital employed
• Expressed as a percentage

4
Using ROCE

• Larger figures indicate higher profitability
• Must be compared with previous year or similar
  firm to be meaningful.

5
Profitability Ratios Gross Profit Margin

• Shows gross profit as a percentage of sales
• GPR Gross Profit X 100
• Total sales revenue
• Does not show the impact of overheads on profits.

6
Profitability Ratios Net Profit Margin

• Shows net profit as a percentage of sales.
• NPM Net profit X 100
• Total sales revenue
• Should be compared with previous period or with
  similar business

7
Gross Net profit margins

• How are they linked?
• If the NP margin goes down more than the GP
  margin what does this mean?
• Remember, GO and NP are linked in the profit and
  loss account, and so they are linked here!

8
Liquidity Ratios

• Measure the indebtedness of the firm.
• Current Ratio Current Assets
• Current Liabilities
• Expressed as a ratio eg 31
• Not expressed as a percentage!
• Ideal value 1.51 or 21

9
Low Current Ratio Overtrading over-borrowing

• When the ratio is too low for the firm to meet
  its debts.
• Overtrading.

10
High Current Ratio

• Suggests the firm is not making full use of its
  current assets (eg cash idle in a bank a/c)

11
Limitations of Current ratio

• Suggests that stocks can be liquidised quickly,
  and at a fair value. This is not always the case.
  They can become obsolete or deteriorate.
• SO.

12
Acid Test Ratio

• Does not treat stocks as liquid assets
• Acid Test Ratio Current Assets stocks
• Current Liabilities
• A value of 11 is considered acceptable

13
Shareholder Ratios

• Return on Equity
• Profit after tax, interest pref. dividends X
  100
• Ordinary Share Capital

14
Shareholder Ratios (contd)

• Earnings per Share
• Net profit (after tax and Pref. dividend)
• Number of shares
• This shows how much profit each share has earned
  for the business. The directors will use this
  figure to help decide dividend payments

15
Shareholder Ratios (contd)

• Dividend Yield
• Dividend per share X 100
• Market value of shares

16
Efficiency Ratios

• Stock Turnover
• This shows how many times over the business has
  sold the value of its stocks during the year.
• STOCK TURNOVER RATIO Cost of Goods Sold
  Average Stock
• (Sometimes Sales is used if Cost of Goods Sold
  not available)

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Efficiency Ratios

• The higher the stock turnover the better, because
  money is then tied up for less time in stocks. A
  quicker stock turnover also means that the firm
  gets to make its profit on the stock quicker, and
  so the firm should be more competitive.
• However, it will vary between industries and so
  it is important to compare within an industry, as
  well as from year to year.

18
Efficiency Ratios

• Trade Debtor Collection Period
• Trade Debtors X 365
• Sales Revenue (Credit)
• A low value means that the firm is managing its
  debtors well. A higher value indicates that
  debtors are taking longer to pay. The firm would
  need to investigate this further.

19
Efficiency Ratios

• Trade Creditors Payment Period
• Trade Creditors X365
• Total purchases
• A longer period means that it is taking the
  business longer to pay its debts to its
  creditors. This could be an advantage (ie free
  credit) or indicate a problem (lack of money to
  make payments!). It can also prove disastrous as
  it may force suppliers into bankruptcy.

20
Efficiency Ratios

• Gearing Ratio
• Loan capital ( Preference Capital) X100
• Total Capital
• A higher means that the firm must pay more
  interest on profits each year. Failure to do so
  could lead to insolvency. A lower is preferable
  since shareholders will only be paid a dividend
  out of profits if the directors feel that the
  firm can afford it.