1. Resources for lesson This is a two lesson resource
Students will need colour handout
Calculators
2nd lesson – students will need yellow ratio work-booklet

2. Interpreting Published Accounts

3. Ratios you MUST know Profitability (ROCE). Gearing
Liquidity (current and acid test ratios),
Financial efficiency (asset turnover, stock turnover, creditor and debtor days),
Shareholder ratios (dividend per share and dividend yield)

4. Which is the more successful company?
Which is better?
Company A has
£100,000 profit
Company B has
£1m profit
Which is the more successful company?

5. Which is better? Company A has
£100,000 profit, where £200,000 was the capital invested
Company B has
£1m profit, where £10m was the capital invested
Which is the more successful company?

6. Which is better? Company A has
£100,000 profit, where £200,000 was the capital invested
Company B has
£1m profit, where £10m was the capital invested
100,000/200,000 x100
= 50%
100,000/200,000 x 100 = 50% where Co B has 1/10 x 100 = 10%
1m / 10m x100
= 10%
How can you use % calculation to see the differences?

7. Profitability ratios Gross Profit Margin * Operating Margin * ROCE
* Covered in AS BUSS2 7

8. This is one type of ratio!
… Known as ROCE
Return on Capital Employed

9. Profitability Ratios The ‘primary ratio….’
ROCE – return on capital employed
This tells us how efficient the company is by looking at their profits & comparing it to the funds invested in the business.
ROCE = Operating profit x 100
Capital employed

10. Examples of ROCE (2007) Company Annual operating profit
Capital employed
ROCE
Burberry
£157m
B.P.
$32,352m
Tesco
£2,648m
Cadbury Schweppes
£796m
Which company do you think might be the most efficient at generating profits?
Remember to consider the reasons why?
Which company looks the more impressive just on raw profit figure?

11. Which company looks the more impressive now?
Examples of ROCE (2007)
Company
Annual operating profit
Capital employed
ROCE
Burberry
£157m
£419.3m
B.P.
$32,352m
$158,845m
Tesco
£2,648m
£16,655m
Cadbury Schweppes
£796m
£6,706m
Which company looks the more impressive now?

12. Calculate the ROCE figure
Operating profit x100
Capital employed
Examples of ROCE (2007)
Company
Annual operating profit
Capital employed
ROCE
Burberry
£157m
£419.3m
B.P.
$32,352m
$158,845m
Tesco
£2,648m
£16,655m
Cadbury Schweppes
£796m
£6,706m

13. Examples of ROCE (2007) Company Annual operating profit
Capital employed
ROCE
Burberry
£157m
£419.3m
37.44%
B.P.
$32,352m
$158,845m
20.37%
Tesco
£2,648m
£16,655m
15.90%
Cadbury Schweppes
£796m
£6,706m
11.87%
For every £1 invested in the company, Burberry make 37p back in profits

14. ROCE % Evaluating ROCE Higher % is better Watch for trend over time
Watch out for low quality profit which boosts ROCE
Leased equipment will not be included in capital employed

15. Other profitability ratios…
At AS you looked at…
Gross profit margin
&
Net profit margin,
and in A2 you will be given credit for looking at this profitability ratio again!

16. Gross Profit Margin Gross Profit Margin = Gross Profit x 100 = %
Turnover
Remember: Turnover = sales Gross Profit = Turnover – Cost of Sales
The Gross Profit margin ratio tells us the profit a business makes on its cost of sales or cost of goods sold. It is a very simple idea and it tells us how much gross profit per £1 of turnover the business is earning.
For example,
A 40% GPM means for every £1 sold 40p equates to gross profit
A 14% GPM means for every £1 sold 14p equates to gross profit
Gross Profit is the profit we earn before we take off any administration costs, selling costs and so on. So we should have a much higher gross profit margin than net profit margin.

17. Gross Profit Margin
Here are a few examples of the gross profit margins from different businesses.
Leisure & Hotel
International Airline
Manufacturer
Retailer
Discount Airline
Refining
Pizza Restaurants
Accounting Software
Gross Profit
9.64%
5.62%
35.14%
11.41%
27.46%
12.63%
47.52%
89.55%
What does the Gross Profit Margin also tell us about the cost of sales?
The Gross Profit Margins may vary from business to business and industry to industry.
For example, the International Airline has a gross profit of 5.62% yet the Accounting Software business has 89.55%
If a company’s raw materials and factory wages go up a lot, the gross profit margin will go down unless the business increases its selling prices at the same time.

18. Compare Ryanair with BA management structures.
Net Profit Margin
Net Profit Margin = Net Profit x 100 = %
Turnover
Remember Net Profit = Gross Profit – overheads + income earnt
The Net profit margin ratio tells us of net profit per £1 of turnover. That is, after taking into account the cost of sales, administration costs, the selling and distribution costs, the net profit is the profit that is left, out of which they will pay interest, tax, dividends and so on.
Leisure & Hotel
International Airline
Manufacturer
Retailer
Discount Airline
Refining
Pizza Restaurants
Accounting Software
Net Profit
7.36%
4.05%
-10.48%
1.63%
10.87%
11.99%
7.55%
27.15%
Just like the gross profit margins, the net profit margins also vary from business to business and industry to industry. When we compare the gross and net margins we can gain a good impression of their non-production and non-direct costs such as administration, marketing and finance costs.
We saw that the International airline’s gross profit margin was the lowest of the 8 industries at 5.62% but its net profit margin is 4.05%, only a little bit lower. On the other hand, the discount airline gross profit margin is 27.46% but its net profit margin is 10.87% These comparisons give us a great insight into the cost structure of these businesses.
Compare Ryanair with BA management structures.

19. Comparing Gross to Net Profit Margins
Leisure & Hotel
International Airline
Manufacturer
Retailer
Discount Airline
Refining
Pizza Restaurants
Accounting Software
Gross Profit
9.64%
5.62%
35.14%
11.41%
27.46%
12.63%
47.52%
89.55%
Leisure & Hotel
International Airline
Manufacturer
Retailer
Discount Airline
Refining
Pizza Restaurants
Accounting Software
Net Profit
7.36%
4.05%
-10.48%
1.63%
10.87%
11.99%
7.55%
27.15%
So what’s happened to Manufacturing?
Look at the software business – a very high GPM of 89.55% but a NPM of 27.15% . This is still high, but we can see that the administrations costs are very high while the costs of sales are very low.

20. How to improve profits?
Remember your hwk recently to read article on profitability?
“Improving Profits” Business Review Nov 2008
What can you remember?

21. Recap profitability ratios
There are THREE profitability ratios..
Gross Profit Margin *
Operating Margin *
ROCE

22. To help you learn all of this
Ratio name
Fill in the profitability ratio info for ROCE
Ratio formula

23. Gearing – another ratio
A Liquidity ratio

24. Gearing
This tells us how much of the company’s finance is through debt!
A highly geared business is funded heavily through long term debts
A low geared business is funded mainly through its owners/shareholders.

25. Which is in the better position?
Gearing
A company with 80% gearing….
has 80% of funds through long term debts and 20% through owners/shareholders.
A company with 35% gearing…
has 35% of funds through long term debts and 75% through owners/shareholders.
Which is in the better position?

26. Calculating Gearing Gearing = non current liabilities x 100
total equity & non current liabilities*
Aka capital employed
So if a company has £280 in non current liabilities and £1,000 in capital employed
Gearing = x 100 = 22%

27. Examples of Gearing (2007)
Company
Date of balance sheet
Non current liabilities
Capital employed
Gearing BA
31/3/08
£4,646m
£7,679m
60.50%
Tesco
23/2/08
£7,999m
£19,901m
40.20%
Morrisons
29/7/08
£1,356m
£5,773m
23.49%
Which company looks the more impressive just on the figures?
Which is in the better position?
Why could the differences in dates be important?

28. Benefits of high gearing
With low interest rates – highly geared companies benefit from cheap finance…. But when Interest rates go back up…
Relatively few shareholders – easier to keep control of the company.
Fewer shareholders could mean that the business has less dividend pressure, and could retain profit for future investments.

29. Benefits of low gearing
Most of the capital is ‘permanent’ and does not have to be ‘repaid’ with interest!
Less risky where creditors can not force the business into liquidation (think Woolies!)
Easier to borrow more in the future if the company wants to expand.

30. To help you learn all of this
Fill in the gearing ratio info
Ratio name
Ratio formula

31. Liquidity ratios
Assess whether a business has sufficient cash or equivalent current assets to be able to pay its debts as they fall due 31

32. Liquidity ratios. What is liquidity?
Liquidity is an asset's ability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value.
Money in the bank or cash on hand, is the most liquid asset.

33. Liquidity Ratio
These tell us how healthy the business is in the SHORT TERM
It tells us whether the working capital is sufficient to cover the immediate debts!
Current Ratio
Acid Test Ratio

34. Quick recap…
What is the money owed to a business from customers called on the balance sheet?
Receivables (from debtors)
What are the other ‘current assets’?
Cash
Inventories (stock)

35. Current Ratio
A liquidity ratio

36. Current Ratio = current assets : current liabilitiesor
Current Ratio = Current assets
Current liabilities
So what do you think a current ratio of 2:1 means?
The company has £2 of assets for every £1 of debt

37. Examples of Current ratios
Which company looks the more impressive just on the figures?
Company
Balance sheet date
Current assets
Current liabilities
Current ratio BA
31/3/08
£3,148m
£3,244m
Tesco
23/2/08
£6,300m
£10,263m
Tate & Lyle
£1,695m
£1,204m
Burberry
£588.4m
£436.2m
Calculate their Current Assets ratio…
= current assets / current liabilities
Written as ? : 1

38. Examples of Current ratios
Should Tesco & BA panic about a ‘liquidity’ of <1?
Company
Balance sheet date
Current assets
Current liabilities
Current ratio BA
31/3/08
£3,148m
£3,244m
0.97:1
Tesco
23/2/08
£6,300m
£10,263m
0.61:1
Tate & Lyle
£1,695m
£1,204m
1.41:1
Burberry
£588.4m
£436.2m
1.35:1

39. What can they do to improve Current ratio?
Sell under used non current assets – but is this really wise?) BA is grounding 22 planes this winter!
Raising more share capital (what the banks have done!)
Increase long term borrowing! (OK when IR’s are soo low!)
Postpone planned investments – eg Stelios disagreement over Easyjet!

40. Good video link http://news.bbc.co.uk/1/hi/uk/8178474.stm
About BA & how ‘well it’s positioned’ to survive the current crisis – looks at reducing CA, increasing N-CL & gearing all in one clip!

41. Acid Test Ratio
A liquidity ratio

42. Acid Test Ratio
This ratio looks at comparing assets with liabilities BUT with removing stock figures
ACID TEST RATIO
=(current assets – inventories) : Current liabilities Or
ACID TEST RATIO = Current assets – inventories
Current liabilities

43. Why remove the inventories?
Stock is THE MOST illiquid asset of the business
It can take a long time to convert inventories (stock) into cash
It can ‘depreciate’ if sold as 2nd hand rather than ‘produced’ into final product.

44. Acid Test Ratio So another way of calculating the Acid Test Ratio
= Cash & receivable (debtors)
Current liabilities
So what would an Acid Test Ratio of 1.5:1 mean?
The company has £1.50 worth of liquid assets to every £1 of debt!
The ideal situation is an Acid Test ratio of 1:1

45. Quick Q
If Tesco has a current ratio of 0.61:1, what do you think their Acid Test Ratio will be?
Will it be higher or lower than this?

46. Examples of Acid Test ratios
Company
Balance sheet date
Current assets
Current liabilities
Current ratio BA
31/3/08
£3,148m
£3,132m
Tesco
23/2/08
£3,870m
£10,263m
Tate & Lyle
£1,133m
£1,204m
Burberry
£318.4m
£436.2m

47. Examples of Acid Test ratios
Much lower due to having so much stock!
Company
Balance sheet date
Current assets
Current liabilities
Current ratio BA
31/3/08
£3,148m
£3,132m
1.01 :1
Tesco
23/2/08
£3,870m
£10,263m
0.38 :1
Tate & Lyle
£1,133m
£1,204m
0.94 :1
Burberry
£318.4m
£436.2m
0.73:1

48. Why is 1:1 ideal? Why is the acid test ideal 1:1?
If a company has a ratio of 2:1 – what does this mean?
Why is that not the most efficient use of its liquidity?
If a company has a ratio of 0.1 : 1 – what does this mean?
What does this suggest about the company’s financial strength?

49. So use your colour sheet
Ratio name
Ratio formula
Fill in the Liquidity ratios info

50. Financial efficiency ratios
Assess how effectively a business is managing its assets 50

51. Financial efficiency ratios
Asset turnover
Stock turnover
Debtor days
Creditor days 51

52. Asset turnover = Revenue (sales turnover)
This tells us how well the company uses all it’s assets to generate its sales
Asset turnover = Revenue (sales turnover)
Net assets*
* where net assets are Total Assets -Total liabilities
* this is also the total equity figure at the bottom of the balance sheet.

53. Examples of Asset turnover
It’s very difficult to compare different industries
This is a ratio that definitely to be used benchmarking inter-firm comparison or over a period of time with the same firm.
For example,
Tesco will have a high asset turnover – ‘pile them high & sell them cheap’. Meanwhile, Harrods would have a low asset turnover of lower quantity sales but with a high profit margin!

54. Stock Turnover

55. Stock Turnover
This tells us the number of times a business will sell & replace its stock.
A fishmonger should have a HIGH stock turnover of 365 times – as it gets fresh fish delivered every day of the year!
Where as a second hand car dealer may have a stock turnover of 12 times – which is selling & replacing its cars on the forecourt once a month!

56. Calculating Stock Turnover
Stock Turnover = Cost of goods sold
Average stock held
List three business that would have a high stock turnover and three that would have a low figure for stock turnover.
A bread shop has an opening stock of £5 000 at the start of the financial year and at the end of the year its stock is £6 000.
The cost of sales for the shop is £
Calculate its stock turnover.

57. Factors that influence rate of stock turnover
Nature of the product – perishable, antiques
Importance of holding stock – in large or smaller quantities – imagine going into M&S with empty shelves! High street stores need large quantities of stock.
The length of the product life cycle
Stock management systems
Variety of products being held.

58. Debtor & Creditor days

59. Debtor Days Debtors are known as receivables
Debtor days = receivables x 365
revenue
This tells us how much credit the company gives to its customers.
Sofa companies often give ‘buy now pay later options’ – whereas at the local petrol station I have to pay immediately!

60. Creditor Days Creditors are known as payables
Creditor days = payables x 365
revenue
This tells us how long the company takes to pay back the money it owes to its suppliers.
Delaying payment for as long as possible can help the business!
BUT – can cause problems with suppliers in future!
BUT – can incur interest charges (Late Payment Act 1998!)

61. So use your colour sheet
Ratio formula
Fill in the financial efficiency ratios info
Ratio name

62. Dividend per share Dividend yield
Shareholder ratios
Dividend per share
Dividend yield

63. Dividend per share DPS = Total dividends Number of shares issued
Answer is expressed as number of pence per share
In 2008 M&S anounced dividends of £343.6m for 1,586.48m shares p per share.
Obviously the higher the dividend the better for shareholders! The lower the dividend per share might mean that the company is retaining profit for investments!

64. Dividend Yield Dividend Yield = Dividend per share x 100
Market price of share
So using the M&S calculation previously, if the share price was 220p on one day… the Dividend yield would be 21.65/220 x 100 = 9.48%
You would need to compare this figure with past figures & can vary greatly with fluctuations in the stock market!

65. So use your colour sheet
Ratio formula
Fill in the Shareholder ratios info
Ratio name

66. What do these ratios mean?
NPM of 24%
ROCE of 15%
Debtor days of 20 and Creditor days of 10.
Stock turnover of 12 times?
Dividend per share 80p
Dividend yield 5%
Acid test ratio of 1.8 : 1 ?
Acid test ratio of 0.78 : 1 ?
Gearing of 12% or Gearing of 66% - which is better for the business?
Why is it a bad situation for a company to have a gearing of 90%?

67. Not too sure about the wobble!
Interpreting Ratios
Textbook p169 B1 ….. Do Q3
Which business would you buy based on the quantitative factors?
Not too sure about the wobble!

68. Your set of calulations
You will need your ratio colour sheet & a calulator

69. Your go – Calculate ratios…
Balance Sheet £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
Asset Turnover
Inventory / Stock Turnover
Payable days (assume payables are 50% of current liabilities for your calculation)
Receivable days
ROCE
Gearing
Current Ratio
Acid Test Ratio

70. Answers

71. Profitability ratio Income Statement £m Balance Sheet £m Revenue 35400
Cost of sales (30100)
Gross profit
Expenses (720)
Operating profit
Finance income
Finance cost (260)
Profit before tax
Taxation (1109)
Profit for the year
Balance Sheet £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
ROCE
Operating profit x 100
total equity + non-current liabilities
x 100
4580 x 100 = 27%
17235
For every £1 of capital employed in the business
how much is being generated in profit?
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? 71

72. Gearing ratio Income Statement £m Revenue 35400 Balance Sheet £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
Gearing
Non-Current Liabilities x 100
total equity + non-current liabilities
x 100
( ) =
x 100
17235
=35%
For every £1000 invested in this business how
much of it is from long term loans?
Why might a high gearing be more of a concern to
a business with small profit margins? 72

73. Liquidity ratios Current Ratio Current Assets : Current Liabilities
5845 : 8160
= : 1
For every £1 of CL the firm owes it owns
£0.716 in CA
Balance Sheet £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
Acid Test
Liquid Assets : Current Liabilities
: 8160
= 3470 : 8160
= : 1
For every £1 of CL the firm owes it owns
£0.425 in CA 73

74. Financial Efficiency ratio
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
Balance Sheet £m
Non-current assets
Inventories
Receivables
Cash & cash equivalents 2300
Total current assets
Current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets
Share capital
Reserves & retained earnings
Total equity
Asset Turnover
Revenue
Net assets
35400
11235
= 3.15 times
For every £1 of net assets in the business
how much is being generated in revenue?
What is meant by the term sweating your assets?
Why might asset turnover help a business assess
operational efficiency between factories? 74

75. Financial Efficiency ratio
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
Balance Sheet £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
Inventory/ Stock Turnover
Cost of sales
Inventory
30100
2375
=12.67 times
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? 75

76. Financial Efficiency ratio
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
Balance Sheet £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
Payables (Creditors) days
Payables x 365
cost of goods sold
Assumed payables are 50% of current liabilities
4080 x 365
30100
= 49 days
Receivables (Debtors) days
Receivables x 365
Revenue
1170 x 365
35400
= 12 days 76

77. You can calculate Net Profit and another profitability ratio!
Interpreting Ratios
You can calculate Net Profit and another profitability ratio!
Dodgy scanning 
Non current assets
Marcouse p73 (different marks awarded)
Working Capital = CA – CL
= 280 – 200 = 80
Capital Employed = Share capital + reserves

78. Interpreting Ratios ROCE = op profit / capital employed
NPM = net profit /turnover
10% of 1,460,000
180/1460 x 365 = 45 days