Interpreting financial ratios

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Interpreting financial ratios AO4: Assess information to enable stakeholders to make decisions about the financial performance of an enterprise Recap: In pairs take it in turns to explain the following terms: Income statement Gross profit Operating profit Statement of financial position Assets Liabilities Working capital Equity Interpreting financial ratios

Interpreting financial ratios In this topic you will learn about Profitability gross profit margin operating profit ROCE Solvency current ratio acid-test ratio gearing Activity inventory (stock) turnover trade receivables (debt) collection period trade payables (creditor) payment period asset turnover The strengths and limitations of financial information for decision making.

Interpreting financial ratios Allows for a more meaningful analysis of published accounts Shows relationship between figures Used for comparisons over time Inter and intra business comparisons Intra means between businesses e.g. to compare performance to competitors or to benchmark Inter means within a business e.g. over time within one organisation or between branches What is meant by the term benchmark? http://corporate.marksandspencer.com/investors/key-facts Why are numbers so important when understanding a business’ performance? View M&S key facts.

Profitability Profitability measures the financial performance of a business by comparing profits achieved to a second variable e.g. revenue There are 3 profitability ratios Gross profit margin Operating profit margin Return on capital employed (ROCE)

Profitability Gross profit margin (GPM) is a measure of a firm’s profitability by looking at the relationship between gross profit and sales revenue If GPM is low or falling this may indicate that a firm is not managing its cost of sales effectively e.g. are the cost of raw materials increasing? sales are in decline Calculated as: Gross profit x 100 Sales revenue Example: Sales revenue = £35 000 Cost of sales = £15 750 Gross profit = £19 250 ( £35 000 - £15 750) Gross profit margin = £19 250/£35 000 x 100 = 55%

Profitability Operating profit margin (OPM) is a measure of a firm’s profitability by looking at the relationship between net profit and sales revenue If OPM is low or falling this may indicate that a firm is not managing its expenses effectively e.g. wages are increasing or overheads are going up sales are in decline Calculated as: Operating profit x 100 Sales revenue Example: Sales revenue = £35 000 Gross profit = £19 250 Expenses = £ 5 950 Operating profit = £13 300 Operating profit margin = £13 300/£35 000 x 100 = 38%

View full income statement. Practice question Using the extract from SuperGroup Plc’s income statement calculate: Gross profit margin Operating profit margin Comment on the financial performance of SuperGroup Plc. View full income statement. http://annualreport2014.supergroup.co.uk/financial-statements/group-statement-of-comprehensive-income

Profitability Return on Capital Employed (ROCE) A measure of how efficiently a business is using capital employed to generate profits Capital employed = total equity + non-current liabilities i.e. all the money invested in the business from: Share capital Reserves Long term loans Formula: Operating profit x 100 Total equity + non-current liabilities Challenge: Capital employed can also be calculated as total assets minus current liabilities. Can you explain why?

Return on capital employed Statement of financial position £m Non-current assets 19550 Inventories 2375 Receivables 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235 Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Income statement £m Revenue 35400 Cost of sales (30100) Gross profit 5300 Expenses (720) Operating profit 4580 Finance income 300 Finance cost (260) Profit before tax 4620 Taxation (1109) Profit for the year 3511 Operating profit x 100 4580 x 100 Total equity + non-current liabilities 11235 + 6000 4580 x 100 = 27% 17235

Interpretation of ROCE 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? Return on capital employed Operating profit x 100 total equity + non-current liabilities 4580 X 100 = 27% 17235 For every £1 of capital employed in the business 27 pence is generated in operating profit.

Liquidity is calculated using the: Current ratio Acid-test ratio Solvency Solvency/liquidity A measure of a businesses’ ability to survive in the short term i.e. its ability to meet short term debts and day to day expenses If a business can not meet current liabilities from current assets then it is at risk of failure if creditors demand immediate payment of debts Liquidity is calculated using the: Current ratio Acid-test ratio Define current assets and current liabilities. http://www.bbc.co.uk/news/business-36592776 Why might a business be placed in administration?

Solvency - Current ratio Statement of financial position £m Non-current assets 19550 Inventories 2375 Receivables 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235 Share capital 7000 Reserves & retained earnings 4235 Total equity 11235 Current ratio is calculated as: Current assets Current liabilities Current assets : current liabilities 5845 : 8160 = 0.716 : 1 For every £1 of CL the business owes it owns £0.716 (72 pence) in CA. Do you think this business has enough short term assets to meet its short term debts?

Solvency - Acid-test ratio Acid-test ratio is calculated as: Current assets - inventories Current liabilities Current assets : current liabilities (5845 – 2375) : 8160 = 3470: 8160 0.425 : 1 For every £1 of CL the business owes it owns £0.425 (42 pence) in liquid assets. The acid-test is a tougher measure of solvency as it excludes inventory (stock). This is because stock is thought to be the hardest of the current assets to turn into cash quickly. Statement of financial position £m Non-current assets 19550 Inventories 2375 Receivables 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235 Share capital 7000 Reserves & retained earnings 4235 Total equity 11235 Formula can also be shown as: Liquid assets Current liabilities

Non-current liabilities x 100 Total equity + non-current liabilities Solvency - Gearing Gearing (%) Measures what proportion of a business’ capital is funded through long term loans Loans are “compulsory interest bearing” i.e. you have to pay interest on them even if profits are low or non-existent A highly geared business is of greater risk if interest rates are likely to increase Non-current liabilities x 100 Total equity + non-current liabilities Explain where interest rates would appear on an income statement and which profit figure would be affected. http://www.bbc.co.uk/news/business-36972666 Interest rates are currently very low in the UK.

Solvency- Gearing Non-current liabilities x 100 Statement of financial position £m Non-current assets 19550 Inventories 2375 Receivables 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235 Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Non-current liabilities x 100 Total equity + non-current liabilities 6000 x 100 11235 + 6000 6000 x 100 = 35% 17235 For every £1000 invested in this business how much of it is from long term loans? Why might a high gearing ratio be more of a concern to a business with small profit margins?

Solvency What is the relationship between cash flow and solvency? What is working capital and how is it calculated? A business with low solvency is in danger if short term creditors demand payment quickly e.g. the bank recalls an overdraft Business may therefore seek to improve solvency: Increase current assets and/or reduce current liabilities Sell assets that are no longer being used i.e. turn them from a non-current asset to a current asset (cash) Move cash balances from current accounts to high interest bearing accounts so its value increases more rapidly Switch to long term sources of finance Monitor debtors to avoid bad debts

Practice question Using the extract from SuperGroup Plc’s statement of financial position calculate: Current ratio Acid test Working capital Gearing Comment on the solvency of SuperGroup Plc. View full statement of financial position. http://annualreport2014.supergroup.co.uk/financial-statements/balance-sheets

Activity ratios Activity ratios assess the internal management of a business i.e. how efficient are managers in controlling the current assets Activity ratios look at the management of cash and assets Inventory (stock) turnover Trade receivables (debt) collection period Trade payables (creditor) payment period Asset turnover

Inventory turnover Inventory turnover Average inventory held can be calculated by finding the average of inventory at the start and end of the year You therefore also need the previous year’s balance sheet Alternatively you can just divide cost of sales by inventory Measures how frequently a business turns over its inventory in a year Will vary depending upon the nature of the firm Hot dog stand (hopefully daily!) Fashion retailer (at least each season) New car showroom (maybe twice a year) Cost of sales Average inventory held

On average for how long does this business hold stock? Inventory turnover Income Statement £m Revenue 35400 Cost of sales (30100) Gross profit 5300 Expenses (720) Operating profit 4580 Finance income 300 Finance cost (260) Profit before tax 4620 Taxation (1109) Profit for the year 3511 Statement of financial position £m Non-current assets 19550 Inventories 2375 Receivables 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235 Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Cost of sales 30100 = 12.67 times Average inventory held 2375 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?

Activity ratios Trade receivables (debt) collection period A measure of how long it takes, on average, for customers to pay the business for goods or services it has purchased on credit The customer is a debtor of the business A business may try to have a shorter receivables days to ease cash flow problems Receivables x 365 Sales revenue

Trade receivables collection period Income statement £m Revenue 35400 Cost of sales (30100) Gross profit 5300 Expenses (720) Operating profit 4580 Finance income 300 Finance cost (260) Profit before tax 4620 Taxation (1109) Profit for the year 3511 Statement of financial position £m Non-current assets 19550 Inventories 2375 Receivables 1170 Cash & cash equivalents 2300 Total current assets 5845 Payables (4160) Short term loans (4000) Total current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235 Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Receivables x 365 1170 x 365 = 12 days Sales revenue 35400 This shows that on average it takes 12 days to receive payment for goods and services sold on credit.

Trade payables payment period A measure of how long it takes, on average, for the business to pay for supplies it has purchased on credit A business may try to have a longer payables days ratio to ease cash flow problems A short payables days may result in discounts from suppliers Payables x 365 Cost of sales

Trade payables Payment period Income statement £m Revenue 35400 Cost of sales (30100) Gross profit 5300 Expenses (720) Operating profit 4580 Finance income 300 Finance cost (260) Profit before tax 4620 Taxation (1109) Profit for the year 3511 Statement of financial position £m Non-current assets 19550 Inventories 2375 Receivables 1170 Cash & cash equivalents 2300 Total current assets 5845 Payables (4160) Short term loans (4000) Total current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235 Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Payables x 365 4160 x 365 = 50 days Cost of sales 30100 Why might a business be willing to have a payables payment period of 60 – 90 days?

Show your understanding Trade payables payment period was 50 days and trade receivables collection period 12 days. Should this business be concerned? Justify your answer. Trade payables are compared to cost of sales and trade receivables to revenue. Use business terminology to explain the relationship between these variables. 3) What might be the expected trade receivables collection period of A high street coffee chain A commercial print company Justify your answers.

Activity ratio - Asset turnover Measures how efficiently the assets of the business are being utilised to generate revenue Helps identify whether the business is operating efficiently A capital intensive industry may have a lower asset turnover than a labour intensive one Revenue Net assets

The business generates 3 times its net assets in sales each year. Asset turnover Income statement £m Revenue 35400 Cost of sales (30100) Gross profit 5300 Expenses (720) Operating profit 4580 Finance income 300 Finance cost (260) Profit before tax 4620 Taxation (1109) Profit for the year 3511 Statement of financial position £m Non-current assets 19550 Inventories 2375 Receivables 1170 Cash & cash equivalents 2300 Total current assets 5845 Payables (4160) Short term loans (4000) Total current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235 Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Revenue 35400 = 3.15 times Net assets 11235 The business generates 3 times its net assets in sales each year.

Strengths and limitations of financial information for decision making Possibility that accounts have been window dressed Need to consider reasons behind ratios e.g. is ROCE lower than previous years because of an investment programme Quantitative information only Strengths Provides a tool for the interpretation of accounts Structure from which comparisons can be made Overtime With other businesses Aids decision making Internally Externally by investors What other quantitative information could be used to assess the performance of a business? What other qualitative information could be used to assess the performance of a business?

Activity – interpreting published accounts In pairs choose 2 businesses who operate in the same industry e.g. 2 supermarkets, 2 football clubs Go on the internet and print off the statement of financial position and income statement (Google company name/investors) The layout will vary from company to company but you should be able to identify the key information Prepare a presentation comparing the performance of the two businesses over time and in comparison to each other Present your findings to the rest of the class

Interpreting financial ratios In this topic you have learnt about Profitability gross profit margin operating profit ROCE Solvency current ratio acid-test ratio gearing Activity inventory (stock) turnover trade receivables (debt) collection period trade payables (creditor) payment period asset turnover The strengths and limitations of financial information for decision making.