Managing Finance and Budgets Presentation 7 Financial Ratios

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.

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

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.

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.

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

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?

The Different types of Ratio As discussed in the previous section, we will use three we different types of Ratio: 1. Profitability RatiosProfitability Ratios How successful is the business? 2. Liquidity RatiosLiquidity Ratios Is the flow of cash sufficient to meet obligations? 3. Efficiency RatiosEfficiency 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.

Three Profitability Ratios We look at three important ratios: ______________________________________________________________________________________________________________________________________________  Gross Margin% = Gross Profit x 100 Gross Margin Sales ______________________________________________________________________________________________________________________________________________  Net Margin% = Net Profit before tax & interest x 100 Net Margin Sales ______________________________________________________________________________________________________________________________________________ Return on Capital Employed (ROCE) =Return on Capital Employed (ROCE) Net Profit before tax and interest x100 (Share Capital + Reserves+ LT Loans)

Gross Margin Ratio Example of the Calculation Calculation for 2002 Gross Margin: 494,600 x 100 = 22.1% 2,240,000 DEFINITION:Gross Margin% = Gross Profit x 100 Sales Selec t

Net Margin Ratio Example of the Calculation Calculation for 2002 Net Margin: 242,600 x 100 = 10.8% 2,240,000 DEFINITION:Net Margin% = Net Profit before Tax & Interest x 100 Sales Selec t

Return on Capital Employed (ROCE) Example of the Calculation Calculation for 2002 ROCE: 242,600 x 100 = 29.2% 830,130 DEFINITION:ROCE% = Net Profit before tax and interest x 100 (Share Capital + Reserves+ LT Loans) Selec t Add Together

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

Ratios - Liquidity We look at two ratios: ____________________________________________________________________________________________________________________  Current ratio = Current Assets Current Liabilities Current ratio _______________________________________________________________________________________________________________  Acid test = Current Assets excluding stock Acid test Current Liabilities

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= = ,360

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= = ,360

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.

Efficiency Ratios Stock turnover (days) Stock turnover (days) = Average Stock Value x 365 Cost of Sales _____________________________________________________________________________________________________________________________________________ Debtors (days) Debtors (days) = Total Debtors x 365 Total Credit Sales _____________________________________________________________________________________________________________________________________________ Creditors (days) Creditors (days) = Total Creditors x 365 Credit Purchases _____________________________________________________________________________________________________________________________________________

Stock Turnover Period  Opening Stock Value£261,000  Closing Stock Value£300,000  Cost of Sales £1,745,400 Stock Turnover (Days) = ( )/2 x = 58.7 days

Average Settlement period for Debtors  Trade Debtors£240,800  Total Sales £2,240,000 Average Settlement Period for Debtors = x = 39.2 days

Average Settlement period for Creditors  Trade Creditors£191,400  Total Sales £1,804,400 Average Settlement Period = x = 38.7 days

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