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**Resources for lesson This is a two lesson resource**

Students will need colour handout Calculators 2nd lesson – students will need yellow ratio work-booklet

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**Interpreting Published Accounts**

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**Ratios you MUST know Profitability (ROCE). Gearing**

Liquidity (current and acid test ratios), Financial efficiency (asset turnover, stock turnover, creditor and debtor days), Shareholder ratios (dividend per share and dividend yield)

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**Which is the more successful company?**

Which is better? Company A has £100,000 profit Company B has £1m profit Which is the more successful company?

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**Which is better? Company A has**

£100,000 profit, where £200,000 was the capital invested Company B has £1m profit, where £10m was the capital invested Which is the more successful company?

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**Which is better? Company A has**

£100,000 profit, where £200,000 was the capital invested Company B has £1m profit, where £10m was the capital invested 100,000/200,000 x100 = 50% 100,000/200,000 x 100 = 50% where Co B has 1/10 x 100 = 10% 1m / 10m x100 = 10% How can you use % calculation to see the differences?

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**Profitability ratios Gross Profit Margin * Operating Margin * ROCE**

* Covered in AS BUSS2 7

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**This is one type of ratio!**

… Known as ROCE Return on Capital Employed

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**Profitability Ratios The ‘primary ratio….’**

ROCE – return on capital employed This tells us how efficient the company is by looking at their profits & comparing it to the funds invested in the business. ROCE = Operating profit x 100 Capital employed

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**Examples of ROCE (2007) Company Annual operating profit**

Capital employed ROCE Burberry £157m B.P. $32,352m Tesco £2,648m Cadbury Schweppes £796m Which company do you think might be the most efficient at generating profits? Remember to consider the reasons why? Which company looks the more impressive just on raw profit figure?

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**Which company looks the more impressive now?**

Examples of ROCE (2007) Company Annual operating profit Capital employed ROCE Burberry £157m £419.3m B.P. $32,352m $158,845m Tesco £2,648m £16,655m Cadbury Schweppes £796m £6,706m Which company looks the more impressive now?

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**Calculate the ROCE figure**

Operating profit x100 Capital employed Examples of ROCE (2007) Company Annual operating profit Capital employed ROCE Burberry £157m £419.3m B.P. $32,352m $158,845m Tesco £2,648m £16,655m Cadbury Schweppes £796m £6,706m

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**Examples of ROCE (2007) Company Annual operating profit**

Capital employed ROCE Burberry £157m £419.3m 37.44% B.P. $32,352m $158,845m 20.37% Tesco £2,648m £16,655m 15.90% Cadbury Schweppes £796m £6,706m 11.87% For every £1 invested in the company, Burberry make 37p back in profits

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**ROCE % Evaluating ROCE Higher % is better Watch for trend over time**

Watch out for low quality profit which boosts ROCE Leased equipment will not be included in capital employed

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**Other profitability ratios…**

At AS you looked at… Gross profit margin & Net profit margin, and in A2 you will be given credit for looking at this profitability ratio again!

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**Gross Profit Margin Gross Profit Margin = Gross Profit x 100 = %**

Turnover Remember: Turnover = sales Gross Profit = Turnover – Cost of Sales The Gross Profit margin ratio tells us the profit a business makes on its cost of sales or cost of goods sold. It is a very simple idea and it tells us how much gross profit per £1 of turnover the business is earning. For example, A 40% GPM means for every £1 sold 40p equates to gross profit A 14% GPM means for every £1 sold 14p equates to gross profit Gross Profit is the profit we earn before we take off any administration costs, selling costs and so on. So we should have a much higher gross profit margin than net profit margin.

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Gross Profit Margin Here are a few examples of the gross profit margins from different businesses. Leisure & Hotel International Airline Manufacturer Retailer Discount Airline Refining Pizza Restaurants Accounting Software Gross Profit 9.64% 5.62% 35.14% 11.41% 27.46% 12.63% 47.52% 89.55% What does the Gross Profit Margin also tell us about the cost of sales? The Gross Profit Margins may vary from business to business and industry to industry. For example, the International Airline has a gross profit of 5.62% yet the Accounting Software business has 89.55% If a company’s raw materials and factory wages go up a lot, the gross profit margin will go down unless the business increases its selling prices at the same time.

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**Compare Ryanair with BA management structures.**

Net Profit Margin Net Profit Margin = Net Profit x 100 = % Turnover Remember Net Profit = Gross Profit – overheads + income earnt The Net profit margin ratio tells us of net profit per £1 of turnover. That is, after taking into account the cost of sales, administration costs, the selling and distribution costs, the net profit is the profit that is left, out of which they will pay interest, tax, dividends and so on. Leisure & Hotel International Airline Manufacturer Retailer Discount Airline Refining Pizza Restaurants Accounting Software Net Profit 7.36% 4.05% -10.48% 1.63% 10.87% 11.99% 7.55% 27.15% Just like the gross profit margins, the net profit margins also vary from business to business and industry to industry. When we compare the gross and net margins we can gain a good impression of their non-production and non-direct costs such as administration, marketing and finance costs. We saw that the International airline’s gross profit margin was the lowest of the 8 industries at 5.62% but its net profit margin is 4.05%, only a little bit lower. On the other hand, the discount airline gross profit margin is 27.46% but its net profit margin is 10.87% These comparisons give us a great insight into the cost structure of these businesses. Compare Ryanair with BA management structures.

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**Comparing Gross to Net Profit Margins**

Leisure & Hotel International Airline Manufacturer Retailer Discount Airline Refining Pizza Restaurants Accounting Software Gross Profit 9.64% 5.62% 35.14% 11.41% 27.46% 12.63% 47.52% 89.55% Leisure & Hotel International Airline Manufacturer Retailer Discount Airline Refining Pizza Restaurants Accounting Software Net Profit 7.36% 4.05% -10.48% 1.63% 10.87% 11.99% 7.55% 27.15% So what’s happened to Manufacturing? Look at the software business – a very high GPM of 89.55% but a NPM of 27.15% . This is still high, but we can see that the administrations costs are very high while the costs of sales are very low.

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How to improve profits? Remember your hwk recently to read article on profitability? “Improving Profits” Business Review Nov 2008 What can you remember?

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**Recap profitability ratios**

There are THREE profitability ratios.. Gross Profit Margin * Operating Margin * ROCE

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**To help you learn all of this**

Ratio name Fill in the profitability ratio info for ROCE Ratio formula

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**Gearing – another ratio**

A Liquidity ratio

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Gearing This tells us how much of the company’s finance is through debt! A highly geared business is funded heavily through long term debts A low geared business is funded mainly through its owners/shareholders.

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**Which is in the better position?**

Gearing A company with 80% gearing…. has 80% of funds through long term debts and 20% through owners/shareholders. A company with 35% gearing… has 35% of funds through long term debts and 75% through owners/shareholders. Which is in the better position?

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**Calculating Gearing Gearing = non current liabilities x 100**

total equity & non current liabilities* Aka capital employed So if a company has £280 in non current liabilities and £1,000 in capital employed Gearing = x 100 = 22%

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Examples of Gearing (2007) Company Date of balance sheet Non current liabilities Capital employed Gearing BA 31/3/08 £4,646m £7,679m 60.50% Tesco 23/2/08 £7,999m £19,901m 40.20% Morrisons 29/7/08 £1,356m £5,773m 23.49% Which company looks the more impressive just on the figures? Which is in the better position? Why could the differences in dates be important?

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**Benefits of high gearing**

With low interest rates – highly geared companies benefit from cheap finance…. But when Interest rates go back up… Relatively few shareholders – easier to keep control of the company. Fewer shareholders could mean that the business has less dividend pressure, and could retain profit for future investments.

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**Benefits of low gearing**

Most of the capital is ‘permanent’ and does not have to be ‘repaid’ with interest! Less risky where creditors can not force the business into liquidation (think Woolies!) Easier to borrow more in the future if the company wants to expand.

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**To help you learn all of this**

Fill in the gearing ratio info Ratio name Ratio formula

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Liquidity ratios Assess whether a business has sufficient cash or equivalent current assets to be able to pay its debts as they fall due 31

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**Liquidity ratios. What is liquidity?**

Liquidity is an asset's ability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value. Money in the bank or cash on hand, is the most liquid asset.

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Liquidity Ratio These tell us how healthy the business is in the SHORT TERM It tells us whether the working capital is sufficient to cover the immediate debts! Current Ratio Acid Test Ratio

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Quick recap… What is the money owed to a business from customers called on the balance sheet? Receivables (from debtors) What are the other ‘current assets’? Cash Inventories (stock)

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Current Ratio A liquidity ratio

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**Current Ratio = current assets : current liabilities**

or Current Ratio = Current assets Current liabilities So what do you think a current ratio of 2:1 means? The company has £2 of assets for every £1 of debt

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**Examples of Current ratios**

Which company looks the more impressive just on the figures? Company Balance sheet date Current assets Current liabilities Current ratio BA 31/3/08 £3,148m £3,244m Tesco 23/2/08 £6,300m £10,263m Tate & Lyle £1,695m £1,204m Burberry £588.4m £436.2m Calculate their Current Assets ratio… = current assets / current liabilities Written as ? : 1

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**Examples of Current ratios**

Should Tesco & BA panic about a ‘liquidity’ of <1? Company Balance sheet date Current assets Current liabilities Current ratio BA 31/3/08 £3,148m £3,244m 0.97:1 Tesco 23/2/08 £6,300m £10,263m 0.61:1 Tate & Lyle £1,695m £1,204m 1.41:1 Burberry £588.4m £436.2m 1.35:1

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**What can they do to improve Current ratio?**

Sell under used non current assets – but is this really wise?) BA is grounding 22 planes this winter! Raising more share capital (what the banks have done!) Increase long term borrowing! (OK when IR’s are soo low!) Postpone planned investments – eg Stelios disagreement over Easyjet!

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**Good video link http://news.bbc.co.uk/1/hi/uk/8178474.stm**

About BA & how ‘well it’s positioned’ to survive the current crisis – looks at reducing CA, increasing N-CL & gearing all in one clip!

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Acid Test Ratio A liquidity ratio

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Acid Test Ratio This ratio looks at comparing assets with liabilities BUT with removing stock figures ACID TEST RATIO =(current assets – inventories) : Current liabilities Or ACID TEST RATIO = Current assets – inventories Current liabilities

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**Why remove the inventories?**

Stock is THE MOST illiquid asset of the business It can take a long time to convert inventories (stock) into cash It can ‘depreciate’ if sold as 2nd hand rather than ‘produced’ into final product.

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**Acid Test Ratio So another way of calculating the Acid Test Ratio**

= Cash & receivable (debtors) Current liabilities So what would an Acid Test Ratio of 1.5:1 mean? The company has £1.50 worth of liquid assets to every £1 of debt! The ideal situation is an Acid Test ratio of 1:1

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Quick Q If Tesco has a current ratio of 0.61:1, what do you think their Acid Test Ratio will be? Will it be higher or lower than this?

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**Examples of Acid Test ratios**

Company Balance sheet date Current assets Current liabilities Current ratio BA 31/3/08 £3,148m £3,132m Tesco 23/2/08 £3,870m £10,263m Tate & Lyle £1,133m £1,204m Burberry £318.4m £436.2m

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**Examples of Acid Test ratios**

Much lower due to having so much stock! Company Balance sheet date Current assets Current liabilities Current ratio BA 31/3/08 £3,148m £3,132m 1.01 :1 Tesco 23/2/08 £3,870m £10,263m 0.38 :1 Tate & Lyle £1,133m £1,204m 0.94 :1 Burberry £318.4m £436.2m 0.73:1

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**Why is 1:1 ideal? Why is the acid test ideal 1:1?**

If a company has a ratio of 2:1 – what does this mean? Why is that not the most efficient use of its liquidity? If a company has a ratio of 0.1 : 1 – what does this mean? What does this suggest about the company’s financial strength?

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**So use your colour sheet**

Ratio name Ratio formula Fill in the Liquidity ratios info

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**Financial efficiency ratios**

Assess how effectively a business is managing its assets 50

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**Financial efficiency ratios**

Asset turnover Stock turnover Debtor days Creditor days 51

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**Asset turnover = Revenue (sales turnover)**

This tells us how well the company uses all it’s assets to generate its sales Asset turnover = Revenue (sales turnover) Net assets* * where net assets are Total Assets -Total liabilities * this is also the total equity figure at the bottom of the balance sheet.

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**Examples of Asset turnover**

It’s very difficult to compare different industries This is a ratio that definitely to be used benchmarking inter-firm comparison or over a period of time with the same firm. For example, Tesco will have a high asset turnover – ‘pile them high & sell them cheap’. Meanwhile, Harrods would have a low asset turnover of lower quantity sales but with a high profit margin!

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Stock Turnover

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Stock Turnover This tells us the number of times a business will sell & replace its stock. A fishmonger should have a HIGH stock turnover of 365 times – as it gets fresh fish delivered every day of the year! Where as a second hand car dealer may have a stock turnover of 12 times – which is selling & replacing its cars on the forecourt once a month!

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**Calculating Stock Turnover**

Stock Turnover = Cost of goods sold Average stock held List three business that would have a high stock turnover and three that would have a low figure for stock turnover. A bread shop has an opening stock of £5 000 at the start of the financial year and at the end of the year its stock is £6 000. The cost of sales for the shop is £ Calculate its stock turnover.

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**Factors that influence rate of stock turnover**

Nature of the product – perishable, antiques Importance of holding stock – in large or smaller quantities – imagine going into M&S with empty shelves! High street stores need large quantities of stock. The length of the product life cycle Stock management systems Variety of products being held.

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Debtor & Creditor days

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**Debtor Days Debtors are known as receivables**

Debtor days = receivables x 365 revenue This tells us how much credit the company gives to its customers. Sofa companies often give ‘buy now pay later options’ – whereas at the local petrol station I have to pay immediately!

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**Creditor Days Creditors are known as payables**

Creditor days = payables x 365 revenue This tells us how long the company takes to pay back the money it owes to its suppliers. Delaying payment for as long as possible can help the business! BUT – can cause problems with suppliers in future! BUT – can incur interest charges (Late Payment Act 1998!)

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**So use your colour sheet**

Ratio formula Fill in the financial efficiency ratios info Ratio name

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**Dividend per share Dividend yield**

Shareholder ratios Dividend per share Dividend yield

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**Dividend per share DPS = Total dividends Number of shares issued**

Answer is expressed as number of pence per share In 2008 M&S anounced dividends of £343.6m for 1,586.48m shares p per share. Obviously the higher the dividend the better for shareholders! The lower the dividend per share might mean that the company is retaining profit for investments!

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**Dividend Yield Dividend Yield = Dividend per share x 100**

Market price of share So using the M&S calculation previously, if the share price was 220p on one day… the Dividend yield would be 21.65/220 x 100 = 9.48% You would need to compare this figure with past figures & can vary greatly with fluctuations in the stock market!

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**So use your colour sheet**

Ratio formula Fill in the Shareholder ratios info Ratio name

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**What do these ratios mean?**

NPM of 24% ROCE of 15% Debtor days of 20 and Creditor days of 10. Stock turnover of 12 times? Dividend per share 80p Dividend yield 5% Acid test ratio of 1.8 : 1 ? Acid test ratio of 0.78 : 1 ? Gearing of 12% or Gearing of 66% - which is better for the business? Why is it a bad situation for a company to have a gearing of 90%?

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**Not too sure about the wobble!**

Interpreting Ratios Textbook p169 B1 ….. Do Q3 Which business would you buy based on the quantitative factors? Not too sure about the wobble!

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**Your set of calulations**

You will need your ratio colour sheet & a calulator

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**Your go – Calculate ratios…**

Balance Sheet £m Non-current assets Inventories Receivables Cash & cash equivalents Total current assets Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets Share capital Reserves & retained earnings Total equity Income Statement £m Revenue Cost of sales (30100) Gross profit Expenses (720) Operating profit Finance income Finance cost (260) Profit before tax Taxation (1109) Profit for the year Asset Turnover Inventory / Stock Turnover Payable days (assume payables are 50% of current liabilities for your calculation) Receivable days ROCE Gearing Current Ratio Acid Test Ratio

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Answers

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**Profitability ratio Income Statement £m Balance Sheet £m Revenue 35400**

Cost of sales (30100) Gross profit Expenses (720) Operating profit Finance income Finance cost (260) Profit before tax Taxation (1109) Profit for the year Balance Sheet £m Non-current assets Inventories Receivables Cash & cash equivalents Total current assets Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets Share capital Reserves & retained earnings Total equity ROCE Operating profit x 100 total equity + non-current liabilities x 100 4580 x 100 = 27% 17235 For every £1 of capital employed in the business how much is being generated in profit? Why would it be meaningful to compare this to the current rate of interest? Why might a high street retailer compare ROCE between individual stores? 71

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**Gearing ratio Income Statement £m Revenue 35400 Balance Sheet £m**

Non-current assets Inventories Receivables Cash & cash equivalents Total current assets Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets Share capital Reserves & retained earnings Total equity Income Statement £m Revenue Cost of sales (30100) Gross profit Expenses (720) Operating profit Finance income Finance cost (260) Profit before tax Taxation (1109) Profit for the year Gearing Non-Current Liabilities x 100 total equity + non-current liabilities x 100 ( ) = x 100 17235 =35% For every £1000 invested in this business how much of it is from long term loans? Why might a high gearing be more of a concern to a business with small profit margins? 72

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**Liquidity ratios Current Ratio Current Assets : Current Liabilities**

5845 : 8160 = : 1 For every £1 of CL the firm owes it owns £0.716 in CA Balance Sheet £m Non-current assets Inventories Receivables Cash & cash equivalents Total current assets Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets Share capital Reserves & retained earnings Total equity Acid Test Liquid Assets : Current Liabilities : 8160 = 3470 : 8160 = : 1 For every £1 of CL the firm owes it owns £0.425 in CA 73

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**Financial Efficiency ratio**

Income Statement £m Revenue Cost of sales (30100) Gross profit Expenses (720) Operating profit Finance income Finance cost (260) Profit before tax Taxation (1109) Profit for the year Balance Sheet £m Non-current assets Inventories Receivables Cash & cash equivalents 2300 Total current assets Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets Share capital Reserves & retained earnings Total equity Asset Turnover Revenue Net assets 35400 11235 = 3.15 times For every £1 of net assets in the business how much is being generated in revenue? What is meant by the term sweating your assets? Why might asset turnover help a business assess operational efficiency between factories? 74

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**Financial Efficiency ratio**

Income Statement £m Revenue Cost of sales (30100) Gross profit Expenses (720) Operating profit Finance income Finance cost (260) Profit before tax Taxation (1109) Profit for the year Balance Sheet £m Non-current assets Inventories Receivables Cash & cash equivalents Total current assets Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets Share capital Reserves & retained earnings Total equity Inventory/ Stock Turnover Cost of sales Inventory 30100 2375 =12.67 times On average for how long does this business hold stock? What type of business might have this level of inventory turnover? Justify your answer Why might it be more accurate to divide by average inventory held rather than just inventory? 75

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**Financial Efficiency ratio**

Income Statement £m Revenue Cost of sales (30100) Gross profit Expenses (720) Operating profit Finance income Finance cost (260) Profit before tax Taxation (1109) Profit for the year Balance Sheet £m Non-current assets Inventories Receivables Cash & cash equivalents Total current assets Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets Share capital Reserves & retained earnings Total equity Payables (Creditors) days Payables x 365 cost of goods sold Assumed payables are 50% of current liabilities 4080 x 365 30100 = 49 days Receivables (Debtors) days Receivables x 365 Revenue 1170 x 365 35400 = 12 days 76

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**You can calculate Net Profit and another profitability ratio!**

Interpreting Ratios You can calculate Net Profit and another profitability ratio! Dodgy scanning Non current assets Marcouse p73 (different marks awarded) Working Capital = CA – CL = 280 – 200 = 80 Capital Employed = Share capital + reserves

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**Interpreting Ratios ROCE = op profit / capital employed**

NPM = net profit /turnover 10% of 1,460,000 180/1460 x 365 = 45 days

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