1. 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

2. 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.

3. 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?
Why are numbers so important when understanding a business’ performance? View M&S key facts.

4. 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)

5. 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 = £ ( £ £15 750)
Gross profit margin = £19 250/£ x 100
= 55%

6. 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/£ x 100
= 38%

7. 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.

8. 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?

9. Return on capital employed
Statement of financial position £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
Operating profit x x 100
Total equity + non-current liabilities
x 100 = 27%
17235

10. 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
X 100 = 27%
17235
For every £1 of capital employed in the business 27 pence is generated in operating profit.

11. 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.
Why might a business be placed in administration?

12. Solvency - Current ratio
Statement of financial position £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
Current ratio is calculated as:
Current assets
Current liabilities
Current assets : current liabilities
5845 : 8160
= : 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?

13. 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
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
Formula can also be shown as:
Liquid assets
Current liabilities

14. 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.
Interest rates are currently very low in the UK.

15. Solvency- Gearing Non-current liabilities x 100
Statement of financial position £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
Non-current liabilities x 100
Total equity + non-current liabilities
x 100
x = 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?

16. 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

17. 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.

18. 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

19. 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

20. On average for how long does this business hold stock?
Inventory turnover
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
Statement of financial position £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
Cost of sales = times
Average inventory held
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?

21. 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

22. Trade receivables collection period
Income statement £m
Revenue
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
Inventories
Receivables
Cash & cash equivalents
Total current assets
Payables (4160)
Short term loans (4000)
Total current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets
Share capital
Reserves & retained earnings
Total equity
Receivables x x = 12 days
Sales revenue
This shows that on average it takes 12 days to receive payment for goods and services sold on credit.

23. 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

24. Trade payables Payment period
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
Statement of financial position £m
Non-current assets
Inventories
Receivables
Cash & cash equivalents
Total current assets
Payables (4160)
Short term loans (4000)
Total current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets
Share capital
Reserves & retained earnings
Total equity
Payables x x 365 = 50 days
Cost of sales
Why might a business be willing to have
a payables payment period of 60 – 90 days?

25. 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.

26. 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

27. The business generates 3 times its net assets in sales each year.
Asset turnover
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
Statement of financial position £m
Non-current assets
Inventories
Receivables
Cash & cash equivalents
Total current assets
Payables (4160)
Short term loans (4000)
Total current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets
Share capital
Reserves & retained earnings
Total equity
Revenue = 3.15 times
Net assets
The business generates 3 times its net assets in sales each year.

28. 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?

29. 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

30. 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.