Unit 5 An introduction to accounting Ratio Analysis Unit 5 An introduction to accounting

Objectives Introduction Interpreting final accounts Types of Ratio Profitability Ratios Return On Capital Employed

Definitions & Assumptions Ratio analysis is the examination of the accounting data by relating one figure to another. This allows a more meaningful interpretation of the data and the identification of trends

Introduction The function of accounting is to provide information to stakeholders How do we judge a performance? Is a profit of £1million good or bad? For a small family business this would be good This would be poor for a big company (JD Wetherspoon have sales of £200million We need a way of judging a firm’s performance in relation to it’s size and in relation to the performance of it’s competitors This is called Ratio Analysis

Introduction (2) Financial accounts are used for three main purposes: Financial control Planning Accountability Ratio analysis can assist in achieving these objectives

Interpreting Financial Accounts To analyse company accounts, a well-ordered and structured process needs to be followed A seven point approach is often adopted: Reason – Why are you trying to interpret the results? Identification – Extracting the relevant figures Process – Decide what method(s) will provide you with the most useful and meaningful results Calculation – Calculating one figure as a ratio of another. E.g. profit as a percentage of sales revenue Comparison – Compare the figures from this period with the last, or of competitors Interpretation - Interpret the values in relation to what would be considered poor, average or good Action - If certain results are worrying, initiate further Investigation & corrective action

Types of Ratio The main classifications of ratios are as follows: Profitability Ratios Measuring the relationship between gross/net profit and sales, assets and capital employed Efficiency Ratios These measure how efficiently an organisation uses its resources such as stock or total assets Liquidity Ratios These examine the short & long term financial stability of a firm by examining the relationship between assets and liabilities

Profitability ratios How does a company decide if it has made a good profit? Company A Company B Profit £100,000 £1million Which is the more successful company? It would seem that Company B is the most successful, but is this really the case?

Profitability ratios (2) Company A Company B Profit £100,000 £1million Capital invested £200,000 £10million With capital invested taken into account, we can see that in fact, Company has done much better than Company B Company A Company B Profit £100,000 £1million Capital invested £200,000 £10million X100 (for a %) 50% 10%

Gross profit margin This ratio examines the relationship between the profit made before allowing for overhead costs,and the level of turnover Gross profit margin = Gross profit Turnover (sales) X 100%

Gross profit margin (2) A furniture shop buys sofas for £200 and sells them for £500 each, making gross profit of £300 per sofa. In a week it sells 10, so its gross profit is £3000 and sales are £5000. Gross profit margin = £3000 £5000 X 100% = 60%

Gross profit margin (3) The higher the profit margin the better The level of gross profit margin will vary considerably between different markets The amount of gross profit percentage on clothes is generally much higher than food The result must be looked at in context of the particular industry

Altering the gross profit margin The gross profit margin can be improved by: Raising the sales revenue whilst keeping the cost of sales static Reducing the cost if sales whilst maintaining the same level of sales revenue

Net Profit Margin Examines the relationship between the net profit (profit after all overheads and expenses have been deducted Net profit margin = Net profit Turnover (sales) X 100%

Net Profit Margin (2) The furniture shop with it £5000 sales and £3000 gross profit has overheads of £2500 per week. So its weekly net profit is £3000 - £2500 = £500. Net profit margin = £500 £5000 X 100% = 10%

Net Profit Margin (3) As with the gross profit margin, a higher percentage result is preferred The net profit margin establishes whether the firm has been efficient in controlling its expenses It should be compared with previous years results and other companies in the same industry It should also be compared to the gross profit margin – it is possible for the gross profit margin to increase, but the net profit margin decline. This would show that profits on trading are increasing, but overhead profits are rising at a greater rate

Altering the Net Profit Margin The net profit margin can be improved by Raising sales revenue whilst keeping expenses low Reducing expenses whilst maintaining the same level of sales revenue

Return On Capital Employed (ROCE) This is often considered to be the primary efficiency ratio It measures the efficiency with which the firm generates profits from the funds invested in the business It answers the key question anyone would ask before investing in a business – what will the annual % return on my capital will I receive?

ROCE (2) Operating(net) profit X 100% ROCE = Capital employed Capital employed is long term loans plus shareholders’ funds Capital employed = assets employed

ROCE (3) The higher the value of the ration the better ROCE measures profitability, and no shareholder will complain about huge returns The figure needs to be compared with the previous years, and other companies to determine whether the result is satisfactory or not Companies usually consider 20% as very satisfactory

Altering the ROCE The return on capital employed can be improved by: Increasing the level of profit generated by the same level of capital investment Maintaining the level of profits generated but decreasing the amount of capital it takes to do so