BUSS3 Chapter 4 interpreting published accounts

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Income statement revision test http://www.tutor2u.net/blog/index.php/business-studies/comments/revision-quiz-the-income-statement http://www.tutor2u.net/business/quiz/balancesheet/quiz.html

Chapter 4 Interpreting published account:

Chapter 4 Interpreting published account At the end of this chapter you will be able to Select, calculate and interpret financial ratios Analyse the value and limitations of ratio analysis in assessing business performance

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Setting the scene Read Which Supermarket? Look at the discussion points and make notes Class discussion

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Conducting ratio analysis Potential users of published accounts of plcs are investors, lenders, managers, employees, customers, the government and local community Ratio analysis gives these users a tool to interpret the information A ratio compares one item of financial data with another Open book to Page 23

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Liquidity ratios Liquidity is a measure of whether a firm is able to meet day to day expenditure It compares a firm’s current assets (those assets that could be relatively quickly turned into cash) to its current liabilities (debt that has to be paid within the next 12 months) There are two measures of liquidity Current ratio Acid test ratio Current ratio = Current assets ÷ Current liabilities How would we work out Alquimia plc’s current ratio? 252 ÷ 219 = 1 :1.15 What does this mean? This means that for every £1 of current liabilities, it has £1.15 in current assets The minimum that we would like to see is 1:1 The Alquimia result seems positive but we would need to compare it with others in the industry If a firm has liquidity problems it may have to close down and sell all of its inventories to try to raise cash

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Liquidity ratios Acid test ratio This is a more stringent test on liquidity because it removes stock (inventories) It removes them because it is quite difficult for a firm to turn its inventories into cash Acid test ratio = (Current assets – Inventories) ÷ Current liabilities For Alquimia plc the current ratio is? (252- 42) ÷ 219 = 1 :0.95 This means? that for every £1 of current liabilities, it has £0.95 in current assets excluding inventories So even with inventories taken out of the equation Alquimia has a ratio close to 1:1 Current assets minus inventories is also referred to as liquid assets If a firm does not have enough short term assets to cover its short term debts and immediate repayment was demanded it would need to turn other assets e.g. fixed assets into cash and this would threaten the existence of the business

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Liquidity ratios There is not ideal number above which a business is deemed to have a healthy liquidity It will depend on the type of industry and other variable The minimum should be 1:1 The higher the ratio the more liquid a business but this could mean that the firm is failing to find a suitable/profitable way of using its cash Complete the Thomas Cook case study P25 Examiner tip – in the examination you will be given a formula sheet so that you don’t have to memorise all the formula You could well be asked to calculate, analyse and assess the importance of the results

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Profitability ratios The ratios compare the amount of profit with sales revenue or the capital that is used to generate that profit Two common measures of profitability are Operating profit margin (OPM) and Return on Capital employed (ROCE) Operating Profit Margin Plcs use the term ‘operating profit’ instead of ‘net profit’ Operating profit margin % = Operating profit ÷ Sales revenue x 100 At Alquimia the OPM is? 545/1,390 x 100 = 39% This means? that for every £1 of sales 39p is left as profit after expenses have been paid You cannot say this is high or low until you compare it with other firms in the same industry Firms will compare this with competitors They will also use it to judge their own performance compared with other years A declining OPM may mean that a firm is not managing its cost effectively or that sales are declining without a fall in costs Operating profit margin % = Operating profit ÷ Sales revenue x 100

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Profitability ratios Return on Capital Employed (ROCE) This is also known as the primary efficiency ratio because it shows how efficiently the firm is using its capital It measures how efficiently management is able to use the capital tied up in the business to generate profits ROCE % = Operating profit ÷ (Total equity + non current liabilities) x 100 At alquimia plc the ROCE is? 545/3034 x 100 = 17.9% This means? that for every £1 of capital invested a profit of £0.179 was being generated in that financial year This can be compared with ROCEs of other years It can also be compared with the ROCE of other firms in the same industry The number alone does not say anything; it has to be compared. Examiner tip – ROCE may be low if capital has been invested in new technology that may take time to start generating returns. It is therefore useful when reading a case study to look out for any new items of capital expenditure ROCE measures how efficiently management is able to use the capital tied up in the business to generate profits

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Recap Why do we use ratios? What do liquidity ratios test? Current and acid Why is the acid ratio used? What would we like to see? Which ones do we need to use? What profitability ratios do we use? OPM and ROCE When we are asked if a ratio is good what do we say? Turn to page 23 again

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Financial efficiency ratios These ratios are mostly used internally to assess how efficiently management are controlling the financial operations of the business We look at four efficiency ratios Asset turnover Inventory turnover Creditor days Debtor days Asset turnover Asset Turnover = Sales ÷ Net Assets At Alquimia plc the asset turnover is? 1390/1300 = 1.07 This means? that for every £1 invested in assets the business will generate sales of £1.07 in one year (note the mistake in the book) This figure will vary widely depending on how capital intensive the industry is A highly technical business which have a lower asset turnover than a firm in a service industry Asset turnover is good to compare firms within the same industry – to compare operational efficiency Or to compare branches/divisions within the same company Asset Turnover measures how effectively a business is using its assets to generate sales

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Financial efficiency ratios Inventory or Stock Turnover measures how many times per year a business turns over its stock through sales A high number shows that a firm is selling its stock quickly to generate revenue It does very much depend on the nature of the firm For example a fish monger may have a turnover of over 300 times – it will go to market each day and sell its entire stock Inventory turnover = cost of sales ÷ Inventory At Alquimia plc the inventory turnover is? 582/42 = 13.5 This means? that the business is selling its inventory 13.5 times per year i.e. on average it holds inventories for less than one month Inventory Turnover measures how many times per year a business turns over its stock through sales Complete the activity on P27

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Next lesson

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Financial efficiency ratios Payables (creditor) days a measure of the average number of days taken to pay suppliers Payable days = (payables x 365 days ÷ credit purchases If credit purchases are not available we use cost of sales At Alquimia plc the payable days are? 219 x 365/845 = 94 days This means? On average it takes Alquimia 94 days (3 months) to pay its suppliers When negotiating a contract with a supplier they will be interested in a firm’s payable days If a firm is saying that it will pay within 30 days and the payables show different the supplier may be reluctant to deal with them or may not offer such good payment terms. Long credit payment terms are often negotiated to help cash flow Payables (creditor) days is a measure of the average number of days taken to pay suppliers

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Financial efficiency ratios Receivables (debtor) days a measure of the average number of days taken by a business to collect its debts from customers Receivables days = (receivables x 365 days ÷ revenue At Alquimia plc the receivables days are? 135 x 365/1390 = 35 days This means? On average it takes Alquimia 35 days (1 month) to receive payment after the sale has taken place Businesses often look to reduce payment terms to increase cash flow Some will offer discount for prompt payment Often small businesses dealing with larger businesses will have to accept longer payment terms For Alquimia its creditor days are much longer than its debtors days which is good for cash flow Money is coming in faster than it is going out Receivables (debtor) days is a measure of the average number of days taken by a business to collect its debts from customers Examiner’s tip If possible try to look at creditor and debtor days in relation to each other. Businesses will normally aim for their debtor days to be lower than their creditor days

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Gearing ratio tells us how much of the firm’s capital is financed by long term loans – they may be at risk if interest rates are high Gearing ratio % = Non current liabilities ÷ (total equity + non-current liabilities) x 100 At Alquimia plc the gearing ratio is? 1734/3253 x 100 = 53% This means? For every £1 invested in the business 53p of it is from a long term liability (loan) where interest rates are compulsory If a firm has high gearing and has taken loans with a variable rate and the interest rate increases the business could be at risk (they will be paying more for their loans) If a firm has low gearing it might be that it is being overly cautious and missing out on potential investment opportunities An appropriate gearing will depend on Stability of interest rates Age of the business Policy of the owners Nature of the firm and product Gearing ratio tells us how much of the firm’s capital is financed by long term loans – they may be at risk if interest rates are high

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Shareholder ratios These ratios measure the value of the return to the shareholder Dividend per share Dividend yield Dividend per share (DPS) Dividend per share = Total dividends ÷ number of issued shares At Alquimia plc the DPS is? £ 300m/450 = 66.7p This means? For each share owned a shareholder will receive 66.7p They will be paid at the end of the year or on an interim basis (quarterly or six monthly) A shareholder might be happy to accept a lower dividend if the profits are being reinvested for the long term good of the business Shareholder ratios help measure the value of the return received by the shareholders Dividend per share is the number of pence per share received by the shareholder

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Shareholder ratios Dividend yield Dividend yield = (Dividend per share ÷ market share price) x 100 At Alquimia plc the dividend yield is? 0.667/10.22 = 6.5% This means? that if a dividend of £1 was received the expected value of the share would be £6.50 A shareholder could compare this to other share dividend yields and also the rate of interest they would get if they just put the money in the bank rather than buying the shares The dividend yield will go up and down even when the dividend paid remains constant because the market share price will go up and down on the Stock Exchange Shareholder ratios help measure the value of the return received by the shareholders Dividend yield is the measure of the dividend received as a rate of return compared to the current market share price

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Value and limitations of ratio analysis Ratio analysis is good because Provides structure for analysis and put figures into some context Good way of making comparisons between companies in the same industry (competitors) Can be used to compare branches/divisions within the company Provide management with a tool to compare performance and set targets There are limitations because The sources of information may have been window dressed The balance sheet is only a snapshot and so the figures are only true on the day the sheet was drawn up The balance sheet does not give a breakdown of departments and so overall good performance may disguise underperforming departments It does not inform a potential investor, supplier or customer about the firm’s ethical behaviour, future plans or green credentials

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Case Study Persimmon Homes P30 Answer all questions Complete Summary Questions Learn the key terms To be completed for homework by Sunday 4th July

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