1. Understanding and Managing Finance 7
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2. Managing Finance and Budgets
Presentation 7
Financial Ratios

3. Session 7 - Financial Ratios
Learning outcomes:
Understand how financial data contained within the Balance Sheet and Profit & Loss Account can be used to analyse the effectiveness of a business.
To be able to calculate and interpret ratios in the following areas:
Profitability
Liquidity
Efficiency

4. Financial Ratios Menu Content: A: Analysing Accounts
B: A Focussed Approach
C: The Different Types of Ratio
1. Profitability Ratios
2. Liquidity Ratios
3. Efficiency Ratios
D: Preparation for Seminar 7

5. A: Analysing Accounts

6. Analysing Accounts
Now that we have a reasonable grasp on the standard financial statements used by businesses, we can use that knowledge to obtain information as to whether or not the business is functioning effectively.
Today we will look at the Balance Sheets and Profit & Loss accounts of one fictional manufacturing Company to analyse its performance over the past two years. What we learn here can be applied to real companies whose financial reporting has been made public.

7. These figures show financial summaries of the Balance Sheets for M & N Manufacturing over the past three years.
In our analysis, here, we will concentrate on the figures from 2002 & 2003

8. Analysing The Balance Sheet
Normally, you will require two Balance sheets in successive years, and you should look out for any large proportional changes to items within:
Fixed Assets
Current Assets
Current Liabilities
Long Term Liabilities
Capital & Reserves

9. Interpreting Large Upward Changes
Fixed Assets: The business may have bought new plant, machinery or transport. This might be part of a deliberate strategy
Current Assets: The business may holding higher stock levels, carrying more debtors or simply have more cash in the bank.
Current Liabilities: The business may owe more to its creditors
Long Term Liabilities: The business may have taken out an additional Long Term Loan
Profit & Reserves: The business may have made a large profit over the year.

10. Interpreting Large Downward Changes
Fixed Assets: The business may have sold plant, machinery or transport. Again, this might be part of a deliberate strategy
Current Assets: The business may holding lower stock levels, carrying fewer debtors or simply have less cash in the bank.
Current Liabilities: The business may owe less to its creditors
Long Term Liabilities: The business may have paid back a Long Term Loan
Profit & Reserves: The business may have made a loss over the year.
SAQ 7.1

11. SAQ 7.1
Examine the Balance Sheet, and note down any large proportional changes from 2002 to 2003.
2. What do you think these changes might mean?
Answer
Answer

12. Increase in Fixed Assets
Small Increase in Trade Debtors
Increase in Stock
Large Increase in Trade Creditors
Large Decrease in Long Term Loans
Large Increase in Reserves

13. SAQ 7.1 Interpretation
Fixed Assets: The business has probably bought some new machinery or transport. This is not a large increase, and is probably not significant, especially when viewed in the light of the previous year’s larger increase.
Current Assets: The business is now holding higher stock levels, and levels of trade debtors. This is not normally a good thing unless Turnover ( see P & L) has increased.
Current Liabilities: The business owes a lot more more to its creditors than last year. In general this is a bad idea, as creditors may withdraw credit arrangements.
Long Term Liabilities: The business has probably paid back a loan.
Profit & Reserves: The business has made a profit over the year (confirmed by P & L account- see later)..

14. Analysing The Profit & Loss Account
Some information can be obtained simply on the basis of one year’s Profit & Loss Account, but it helps very much to see the comparison with the previous year.
The main headings to look at are:
Turnover ; Compare to Cost of Sales
Gross profit; Compare to Overheads
Net Profit (called the Operating Profit)
Earned Surplus

15. What to look out for on the Profit & Loss Account
Has the business increased its Turnover ?
How big a proportion of the Turnover is taken up by Cost of Sales?
How big a proportion of the Gross Profit is taken up by Overheads?
Has the business made a Net Profit (called the Operating Profit) . Has this increased from last year?
Has the business made an overall profit (Earned Surplus)? Has this increased from last year?
Can you identify the main reason for the overall profit or loss?
SAQ 7.2

16. SAQ 7.2
Examine the Profit & Loss Account note any large changes from 2002 to 2003.
2. What do you think these changes might mean?
Answer
Answer

17. SAQ 7.2 Solution Increase in turnover but also in Costs
Increase in gross profit, but very large increase in Overheads
Small increase in net profit
Small Increase in earned surplus

18. SAQ 7.2 Interpretation
The business has increased its Turnover by over £600,000. This looks good.
However there has been a corresponding increase in Cost of Sales by about £500,000. This is not so good!
When we note that Overheads have risen by around £100,000, that all but wipes out the increase in Turnover, and our Net Profit is almost the same as in the previous year.
There has been an increase in Earned Surplus of around £9,000, which looks OK, but this is actually all due to the fact that we had less interest on loans to pay this year. If that had not been the case there would actually have been a decrease in Earned Surplus from last year’s figures.

19. B: A Focussed Approach

20. A Focussed Approach
As we have seen, we can look at accounts and make some sense of them, but it is clear that we need a much more focussed approach
First of all, we need to concentrate on areas where the financial statements can give strong insights into how effectively the business is being managed:
Three of these are:
Profitability
Liquidity
Efficiency

21. Profitability
This means examining not only whether a business is profitable, but where does that profit come from, and is it possible that with better management or financial controls that profitability can be improved.
Clearly, where a business is loss-making, such an analysis is crucial

22. Liquidity
Liquidity looks a the Current Assets compared to the Current Liabilities.
The difference between these two is called the ‘Working Capital’, and we will look at this in more detail in the next two lectures.
This is important, because without a good Working Capital, a business cannot pay its way, and will get into very serious Cash Flow problems.

23. Efficiency
Efficiency basically means the manner in which all the elements of Working Capital are being utilised
This means looking at specifically:
How long are we holding onto stock?
How long are our customers taking to pay us?
How long are we taking to pay our suppliers?.

24. Other Aspects
If you read Chapter 7 in McLaney & Atrill, you will see that there are two other areas:
Financing (how the business raises money)
Investment (whether outsiders, such as shareholders & banks would find the business a secure and profitable place to invest their money)
You can read these for interest, but these areas do not form part of this course.

25. The Use of Ratios
To help in the process of Analysis we can define Ratios which give a single summary figure - a snapshot of a particular type of activity or answers a particular question.
Normally, a ratio compares one figure with another, or gives a percentage.
Most ratios are straightforward, easy to understand with names which convey what they actually do,
for example,
“Average Stockholding Period”
Is simply the average number of days we hold onto stock before it is sold.

26. Why Use Ratios?
They can be used as basis of comparison - e.g. other companies, other periods, targets or forecasts
They allow comparisons between and within businesses
They enable trends to be identified
They enable comparisons to be made where scale is different

27. Sample Ratios Retail Sales per square metre
Sales Cost per £1000 loaned
Food cost per patient
% Bed Occupancy
% of sales spent on advertising (or anything)
Cost of water (electricity) per kilo manufactured
Average number of students per class
Expenditure on books per student
Cost per outcome for different departments
SAQ 7.3

28. Discuss the following:
SAQ 7.3
Discuss the following:
Imagine you are the proprietor of a hotel and restaurant. Identify a series of key ratios which would help you to monitor on a day to day basis how well the hotel is performing.
Answer

29. Activity Solutions
Key ratios to monitor how well a hotel is performing.
These might include:
% Room occupancy
Average customer payment
Reservations as a % of total occupancy
Cleaning Costs per room
Average direct cost per room occupancy
Total Overheads bill per day’s operation
Total Salaries as a percentage of turnover
% food wastage per day
… and many more!

30. C: The Different Types of Ratio

31. The Different types of Ratio
As discussed in the previous section, we will use three we different types of Ratio:
1. Profitability Ratios
How successful is the business?
2. Liquidity Ratios
Is the flow of cash sufficient to meet obligations?
3. Efficiency Ratios
How is the business using its resources?
In each of these cases, we will use the data taken from the M & N Manufacturing Financial Statements. These are summarised on the handout and on the spreadsheet.

32. Profitability Ratios

33. Profitability Ratios
The first set of ratios we will look at, attempt to measure profitability; that is, whether or not the business is financially successful.
Note that just looking at the the amount of of profit made by a company in a particular year may give a distorted picture of the company’s position.
A £1.5m profit generated on a turnover of £10m, can look very good. The same profit on a turnover of £100m looks poor.
However there may be reasons why the first company has generated so much profit; there could be a one-off sale of assets, for example, which have increased in value.

34. Three Profitability Ratios
Examine Data Used in Profitability Analysis
Three Profitability Ratios
We look at three important ratios:
______________________________________________________________________________________________________________________________________________
Gross Margin% = Gross Profit x 100
Sales
Net Margin% = Net Profit before tax & interest x 100
Return on Capital Employed (ROCE) =
Net Profit before tax and interest x100
(Share Capital + Reserves+ LT Loans)
SAQ 7.4

35. NOTE THAT:
The data that we will use is mainly taken from the Profit & Loss Account, but other Data is extracted from the Balance Sheet

36. Gross Margin Ratio Example of the Calculation
DEFINITION: Gross Margin% = Gross Profit x 100
Sales
Select
Select
What does this mean?
Calculation for 2002 Gross Margin:
494,600 x = 22.1%
2,240,000

37. Gross Margin Ratio Explanation
The business makes 22p on every £1.00 sales. Some of this needs to be used to pay overheads etc.
This figure is the percentage profit made on sales, only counting the costs directly incurred in making the sale.
It depends on the type of business, but if the gross margin is much below 20%, the business will be hard pressed to make a surplus.
This means that 22% is OK, but not spectacular

38. Net Margin Ratio Example of the Calculation
DEFINITION: Net Margin% = Net Profit before Tax & Interest x 100
Sales
Select
Select
What does this mean?
Calculation for 2002 Net Margin:
242,600 x = 10.8%
2,240,000

39. Net Margin Ratio Explanation
After paying all costs, the business makes 11p on every £1.00 it brings in.
This figure is the percentage profit made on sales, taking into consideration all costs, direct and indirect incurred in making the sale.
Again, It depends on the type of business, but if the net margin is much below 10%, the business will be hard pressed to make a surplus.
This means that 10.8% is OK, but not spectacular

40. Return on Capital Employed (ROCE) Example of the Calculation
DEFINITION: ROCE% = Net Profit before tax and interest x 100
(Share Capital + Reserves+ LT Loans)
Select
Add Together
What does this mean?
Calculation for 2002 ROCE:
242,600 x = 29.2%
830,130

41. Return on Capital Employed Explanation
2002 ROCE = 29.2%
The company makes 30p for every £1.00 invested.
This figure is the operating profit expressed as a percentage of all the money currently invested in the business, whether from original Capital, Retained Profits or borrowed from external sources as Long Term Loans
It is useful to compare such an amount with the current rate of interest that one might get in a Bank or Building Society – currently much less than 5%
In that light, the ROCE looks pretty good! However, investors will not actually get this money directly, as most of it will-be re-invested in the business.

42. Activities 7.4 a,b,c & d
Use the data on the Ratio Analysis Handout for Profitability to calculate the three financial ratios for 2003:
a Gross Margin for 2003
b Net Margin for 2003
c ROCE for 2003
d Comment on the differences between the 2002 ratios
and the 2003 ratios.
Solution to Parts a,b,c
Solution to Part d

43. Solution to 7.4 a,b,c 7.4a Calculation for 2003 Gross Margin:
599,200 x = 20.8%
2,881,2000
7.4b Calculation for 2003 Net Margin:
247,800 x = 8.6%
2,881,200
7.4c Calculation for 2003 ROCE:
247,800 x = 29.7%
833,410

44. 7.4d Explanation
The Gross Margin has been reduced by 1.3%. It is still acceptable, but the increase in Turnover seems to have generated some very large costs.
The Net Margin has been reduced by 2.2% This is more worrying, since the operating margin is now in single figures. The element mainly responsible for this is the overheads.
The ROCE has increased by 0.5%. This is a good sign that the business is using its capital more effectively. The main reason for this is the pay back of about £140,000 worth of loan during the year, and therefore have lower interest payments.

45. Liquidity Ratios

46. Liquidity Ratios
These Ratios seek to answer the question: ‘Can the business pay its way?’
All of these ratios look at the flow of cash in the company, and try to determine whether or not, at a particular point in time, the business has enough cash to pay what it owes.
Liquidity can be interpreted as the amount of cash, stock, and debt, which can be easily converted into cash, offset by those elements which are currently owed, such as trade creditors, tax & interest etc.
Liquidity Ratios summarise the current Working Capital situation

47. Examine Data Used in Liquidity Analysis
Ratios - Liquidity
We look at two ratios:
____________________________________________________________________________________________________________________
Current ratio = Current Assets Current Liabilities
_______________________________________________________________________________________________________________
Acid test = Current Assets excluding stock
Current Liabilities
SAQ 7.5

48. Data Used to Calculate Liquidity Ratios
The Data we use is taken from the Balance Sheet
Opening Stock is not directly relevant to the calculation, but might be useful when we try to interpret it.

49. Current Ratio Data Current ratio = Current Assets Current Liabilities
Add Together
All these
Add Together
All These

50. Current Ratio Calculation
Current Assets :
Trade Debtors £240,800
Bank Account £33,500
Closing Stock Value £300,000
£574,300
Current Liabilities:
Trade Creditors £191,400
Dividends Owing £20,100
Corporation Tax Owing £21,860
£233,360
Current Ratio = =
233,360
What does this mean?

51. Current Ratio Explanation
The Current Ratio is 2.5
N.B. This is not a percentage.
The business currently owns 2.5 times as much in readily-convertible assets (stock, cash, debtors) as it currently owes to creditors, tax etc.
The value of 2.5 is quite high, and it means that there is a lot of spare working capital in the business. The effect of this is that it will be relatively easy to acquire new stock. Perhaps with this much we might think of paying off some of our creditors, especially if they are threatening to charge interest on the amount owed, or curtail credit.

52. Acid Test Ratio Data Acid Test ratio = Current Assets excluding stock
Current Liabilities
Add Together
These two
Add Together
All These

53. Acid Test Ratio Calculation
Current Assets excluding Stock :
Trade Debtors £240,800
Bank Account £33,500
£274,300
Current Liabilities:
Trade Creditors £191,400
Dividends Owing £20,100
Corporation Tax Owing £21,860
£233,360
Acid Test Ratio = =
233,360
What does this mean?

54. Acid Test Ratio Explanation
The Current Ratio is 1.2
N.B. This is not a percentage either.
The business currently owns 1.2 times as much in cash terms (cash, debtors) as it currently owes to creditors, tax etc. Stock is ignored here because it might be difficult to turn stock into cash quickly without having to sell at a loss.
The value of 1.2 is quite respectable, and it means that the business is solvent. If creditors demanded payment immediately, ways could be found to pay.

55. Activities 7.5 a, b & c
Use the data on the Ratio Analysis Handout for Liquidity to calculate the three financial ratios for 2003:
a Current Ratio for 2003
b Acid Test Ratio for 2003
c Comment on the differences between the 2002 ratios
and the 2003 ratios.
Solution to Parts a & b
Solution to Part c

56. Solution to 7.5 a & b 7.4a Calculation for Current Ratio 662,060 = 2.0
662,060 =
233,360
7.4b Calculation for Acid Test Ratio:
247,800 =
307,960

57. 7.5c Explanation
The Current Ratio has reduced from 2.5 to 2.0. As it was previously quite high, this might be seen as being positive; however if one looks at how this has been achieved, it is through increasing the amount owed to creditors and holding onto more stock. Neither of these strategies is healthy in the long term.
The Acid Test Ratio has reduced from 1.2 to 0.9. Here we see in stark terms the effect of the change. We can no longer pay our way comfortably, and there is not enough readily available cash to pay all that we owe. There is a small potential here for cash flow problems.

58. Efficiency Ratios

59. Efficiency Ratios
These ratios are concerned with the way that assets are used in an organisation.
Some of these are very useful financial management tools for example the average stock turnover and the average credit period. These can be very useful in controlling the flow of cash in an organisation.
These ratios are important measures of how effective particular changes in management practice have been.

60. Examine Data Used in Efficiency Analysis
Efficiency Ratios
Stock turnover (days) = Average Stock Value x 365
Cost of Sales
_____________________________________________________________________________________________________________________________________________
Debtors (days) = Total Debtors x 365
Total Credit Sales
Creditors (days) = Total Creditors x 365
Credit Purchases
SAQ 7.6

61. Data Used to Calculate Efficiency Ratios
The data we use is taken from the Balance Sheet , the Profit & Loss Account and other places

62. Stock Turnover Period Data
Stock turnover (days) = Average Stock Value x 365
Cost of Sales
Average
These Two
Select

63. Stock Turnover Period Stock Turnover (Days)
Opening Stock Value £261,000
Closing Stock Value £300,000
Cost of Sales £1,745,400
Stock Turnover (Days)
= ( )/2 x 365
= days
What does this mean?

64. Stock Turnover Period Explanation
The Stock Turnover Period is 58.7 days
N.B. This is not a percentage either.
On average, it takes 58.7 days to ‘turn over’ the stock.
In simple terms that can be interpreted to mean that it takes 58.7 days for all the stock which is currently held to be sold
To put it another way, it is as if we got a whole batch of stock, held onto it for 58.7 days then sold it, replacing it immediately with new stock.
58.7 days is nearly 2 months, and in the scheme of things is quite acceptable. Some industries hold stock for much longer than this (Car Spares retailers, for example expect to hold onto stock for several months.) On the other hand, some business (e.g. restaurants) would not be able to trade if their stock turnover was this long.

65. Average Settlement Period for Debtors Data
Debtors (days) = Total Debtors x 365
Total Credit Sales
Select
Select
Here we are assuming for simplicity that all sales are on credit. This may not be true in all cases

66. Average Settlement period for Debtors
Trade Debtors £240,800
Total Sales £2,240,000
Average Settlement Period for Debtors
= x 365
= days
What does this mean?

67. Average Settlement Period for Debtors Explanation
The Average Settlement period is 39.2 days
N.B. This is not a percentage either.
On average, it takes 39.2 days for a customer to pay their bill.
To put it simply, we can think about it as if we made a whole batch of sales on one day, made no more for 39.2 days, and then got the money. We then make immediately make some more sales.
39.2 days is over a month, but in the scheme of things is quite acceptable. However, some suppliers prefer customers to pay within 28 days, and invoke penalties (such as interest payments) if this is not done. In some industries, however, there are traditions of not paying for up to 3 months (100 days or more)

68. Average Settlement Period for Creditors Data
Creditors (days) = Total Creditors x 365
Credit Purchases
Select
Select
Here we have additional information about purchases on on credit. This may not be true in all cases, and you may need to assume that Cost of Sales = Purchases on Credit.

69. Average Settlement period for Creditors
Trade Creditors £191,400
Total Sales £1,804,400
Average Settlement Period
= x 365
= days
What does this mean?

70. Average Settlement Period for Creditors Explanation
The Average Settlement period is 38.7 days
N.B. This is not a percentage either.
On average, it takes 38.7 days for the business to pay its suppliers for a particular order.
Again, to put it simply, we can think about it as if we took delivery of a whole batch of items on one day, received no more for 38.7 days, and then paid the money. We then immediately take delivery of more items.
38.7 compares very favourably with 39.2 days, the time the customers take to pay their debts, and in the scheme of things is quite acceptable. As remarked earlier, some suppliers prefer customers to pay within 28 days, and invoke penalties (such as interest payments) if this is not done.

71. Activities 7.6 a, b, c & d
Use the data on the Ratio Analysis Handout to calculate the three financial ratios for 2003:
a Stock Turnover (Days) for 2003
b Debtor (Days) for 2003
c Creditor (Days) for 2003
d Comment on the differences between the 2002 ratios
and the 2003 ratios.
Solution to Parts a, b & c
Solution to Part d

72. Solution to 7.6 a,b,c 7.6a Calculation for 2003 Stock Turnover (Days):
( )/2 x 365 = days
2,282,000
7.6b Calculation for 2003 Debtor (Days):
250,100 x = days
2,881,200
7.6c Calculation for 2003 Creditor (Days):
258,800 x = days
2,142,800

73. 7.6d Explanation
Both the Stock Turnover Period and the Debtor Payment Period have reduced (Stock by 7.4 days, and Debtors by 7.5 days). This reduction is a good thing, since this releases cash, and provides the business with a greater flexibility of Working Capital.
The Trade Creditor Period has increased by 5.4 days. This means that the business is taking longer to pay; again, the effect of this is to release more cash, and provide a greater flexibility of Working Capital.

74. Seminar 7- Activities Preparation: read Chapter 7 (M & A 2nd Edition)
You should make sure that you have calculated all the ratios within this presentation, and have completely understood all the explanations.
Complete the Ratios Activity Spreadsheet
Further Exercises:
M & A (2nd Ed.) Exercise 7.3 (pages )
M & A (2nd Ed.) Exercise 7.5 (pages )