1. Finance and Accounts 2
Analysing Accounts

2. Accounting and Finance
Key Terms:
Assets: the resources a business owns -
Fixed Assets – those lasting more than one year and not used up in production – equipment, machinery, buildings, etc.
Freehold assets – where the business has full ownership of the assets
Leasehold assets – agreement permitting the leaseholder the right to use the asset for a fixed period in exchange for a regular payment
Goodwill – the difference between the audited value and the market value of a business – the image, brand name, the existence of patents or trademarks, etc.
Current Assets – assets used up during production and which will realise cash within a year – debtors, raw materials, stock, etc.

3. Accounting and Finance
Liabilities:
The financial obligations of a business – what a business owes
Loans, shareholders funds, creditors, tax liability, interest owing
Current liabilities – those obligations the business has to meet within a year

4. Accounting and Finance
The Purpose of Accounts:
To provide information for stakeholders
Shareholders – progress of their investment
Government – tax liability
Suppliers – credit worthiness
Customers – long term future of the business
Prospective Investors – decision making
Potential bidders in acquisition activity
Trade Unions – negotiations with the company
Management – monitor performance of the business
Employees – their position in the business (they may well also be shareholders!)

5. Accounting and Finance
Types of Information:
Profit and Loss Account – the revenue and costs of a business over a time period
Balance Sheet – the assets and liabilities of a business at a specific point in time
Use these sources to give ratios – the relationship between different aspects of the business

6. Ratio Analysis Key types:
Profitability ratios - a measure of how much profit its activities generate
Liquidity ratios – ability of a business to meet its debts
Investment ratios – a measure of the performance of the business

7. Ratio Analysis Profitability Ratios
Profit Margin – relates profit to turnover (sales revenue)
In general the higher the profit margin the better
A profit margin of 10% means that the firm makes 10p profit for every £1 of goods sold
Narrow margins – tend to be on products/services which are high volume, mass market products which are highly competitive
Wide margins – tend to be on products/services that are low volume, high value with relatively high degree of monopoly power
Stock markets rely on key financial data
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8. Ratio Analysis Gross Profit: Total Revenue – Variable (Direct) Costs
Gross Profit Margin = x 100
Turnover
Net Profit: Total revenue – Total Costs (VC+FC)
Net Profit
Net Profit Margin = x 100

9. Ratio Analysis Other profitability ratios Retained Profit
Retained Profit Margin = x Turnover
Profit
Profit Mark up = x100
Cost

10. Ratio Analysis Return on capital employed (ROCE)
A measure of the efficiency of the firm in using its capital to generate profit.
A ROCE of 15% suggests that the firm uses every £1 of capital to generate profits of 15p

11. Ratio Analysis Example:
Assume two firms produce identical products and have identical capital structures:
Firm A – Capital Assets = £1,000,000
Profit = £250,000
Firm B – Capital Assets = £1,000,000
Profit = £100,000
Easy to see in this instance that firm A is the more efficient as every £1 of capital generates 25p in profit whereas for Firm B, every £1 of capital only generates 10p profit
ROCE allows us to have a measure of efficiency for firms with different capital structures

12. Ratio Analysis Profit for the Year
ROCE = x100
Equity Shareholders' Funds
Generally – the higher the ratio, the more effective the firm is in using its capital assets

13. Ratio Analysis Liquidity Ratios:
Look at the ability of a firm to meet its expenditure and how much cash is tied up in the business available to pay for that expenditure
Careful management of its income and expenditure is important to its cash flow and its ultimate long term survival
More firms fail through cash flow problems than any other reason

14. Liquidity Ratios
Working Capital – having sufficient funds at the right time to be able to meet liabilities
Working capital management is crucial to the success of a firm
Working capital = the difference between current assets and current liabilities

15. Liquidity Ratios
The Current Ratio – the proportion of assets to liabilities.
A current ratio of 2:1 means the firm has sufficient liquidity to cover its liabilities twice over
A current ratio of 0.75:1 would suggest that the firm is unable to meet its liabilities and could be in a weak financial position
A ratio below 1 does not mean the firm will collapse but it will be in a vulnerable position

16. Liquidity Ratios Acid Test Ratio =
(Current Assets - Stocks) : Current Liabilities
The Acid Test Ratio gives an indication whether a firm can meet its liabilities without having to dispose of its stocks. It gives a clear and quick indication of the state of the firm’s liquid assets.
Comparing the Current ratio and the Acid Test ratio therefore gives an indication of the relative size of the stock holdings of a firm.

17. Investment Ratios
Measure the performance of the firm and are of interest to potential investors
Gearing Ratio – measures the proportion of share capital to loan capital
A high gearing ratio suggests high proportion of loans to share capital
Gearing ratio important in looking at a firm’s capital structure and the impact of interest rate changes

18. Investment Ratios Other key investment ratios:
Earnings per share=    Profit available to equity shareholders    
Average number of issued equity shares
The average profit earned per ordinary share
Dividends per share=    Dividends paid to equity shareholders    
The average dividend received per ordinary share

19. Investment Ratios Dividend yield= Latest annual dividends
Current market share price
A comparison of the dividend received with the current market value of the shares
Dividend cover=    Net profit available to equity shareholders    
Dividends paid to equity shareholders
The ability of the firm to meet its dividend payments from its profits
Price/earnings or p/e ratio=    Current market share price    
Earnings per share
The length of time for earnings to cover the cost of the initial investment – key investor ratio used to estimate degree of risk involved in the investment.

20. Ratio Analysis
Limitations of Ratio Analysis:
Usefulness dependent on the accuracy of the figures – Enron, Parmalat?
Only a part of the jig-saw – needs other information to make full judgement
What has happened in the past is not necessarily a pointer to what will happen in the future!
Statistics always have a limitation in that it depends when they are used and how they are used.
No two businesses are fully comparable as the differences between them will always influence the performance of the business
Ratios do not always reflect the degree of ‘intuition’/’genius’ that may influence the performance of a business
The Crooked E – ironic logo of Enron. Statistics do have their limitations!
Source: reubing, stock xchng