Using Accounts to Interpret Performance

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1 Using s to Interpret Performance ing information is used by stakeholders to judge the performance and efficiency of a business Different stakeholders will look for different things: STAKEHOLDER Shareholders Managers Employees Customers Society Government Creditors Suppliers POSSIBLE OBJECTIVE High dividends & Increased Share Price Career Development & Opportunities Job Security & Higher Wages Good Value for Money A Responsible Business High Tax Revenues & More Jobs Healthy Cash Flow to Secure Repayment Increased Sales & Payment of Bills Business Studies Online: Slide 1

2 Using Ratio Analysis There are 5 broad categories of ratios used: SHAREHOLDER RATIOS These can be used to assess the rate of return on shares and the prospects of shareholders investment PROFITABILITY RATIOS These compare the profits of the business with sales, assets and the capital employed in the business SOLVENCY RATIOS These measure the degree to which a business is relying on long term loans. They reflect of a business s financial strategy LIQUIDITY RATIOS These measure how easily a business could meet its short term debts or liabilities. EFFICIENCY RATIOS These indicate how efficiently a business is using its resources and collecting its debts Business Studies Online: Slide 2

3 Profitability Ratios: 1) The Return on Capital Employed Return on Capital Employed (ROCE) = Net Profit Before Tax Capital Employed x 100 This compares net profit to the amount of money in the business The higher this figure is the better From Balance E.g. a ROCE of 12% means that for every 1 invested in the business, a firm makes 12 pence net profit This can be used to compare figures from previous years, or the performance of the business with the interest from a bank account Business Studies Online: Slide 3

4 Profitability Ratios: 2) The Gross Profit Margin Gross Profit Margin (%) = It compares gross profit with the value of sales revenue The higher this figure is the better E.g. a GPM of 40% means that for every 1 received in sales revenue, a firm makes 40 pence gross profit An improved GPM may be achieved as a result of: Increased turnover relative to costs A relative decrease in costs Gross Profit Turnover x 100 Generally in industries with high turnover, GPM is lower Business Studies Online: Slide 4

5 Profitability Ratios: 3) The Net Profit Margin Net Profit Margin (%) = Net Profit Turnover It compares net profit with the value of sales revenue The higher this figure is the better E.g. a NPM of 23% means that for every 1 received in sales revenue, a firm makes 23 pence net profit It is used for comparisons over time x 100 It indicates how well a firm is managing overheads Generally in industries with high turnover, GPM is lower Business Studies Online: Slide 5

6 Efficiency Ratios: 1) Stock Turnover Stock Turnover = Measured in days Stocks Cost Of Sales This measures how quickly a business sells it s stock The lower this figure is the better x 365 From TPL E.g. a stock turnover of 35 days means that on average stock is held in the business for 35 days This ratio is not relevant to service industries since they will not hold stocks From Balance Business Studies Online: Slide 6

7 Efficiency Ratios: 2) Debtors Collection Period Debt Collection Period = Measured in days Debtors Turnover x 365 This measures how quickly a business is able to get money it is owed from debtors Generally the lower this figure is the better though there is no right answer E.g. a debt collection period of 58 days means that on average debtors take 58 days to settle their bills It can be improved through better credit control From TPL From Balance Business Studies Online: Slide 7

8 Efficiency Ratios: 3) Creditor Payment Period Creditor Payment Period = Measured in days This measures how quickly a business pays the money it owes to creditors E.g. a creditor payment period of 47 days means that on average invoices are paid 58 days after receipt If the figure is too high it: Trade Creditors Turnover x 365 May indicate cash flow problems within the business May lead to poor relationships with suppliers From TPL From Balance Business Studies Online: Slide 8

9 Efficiency Ratios: 4) Asset Utilisation Turnover Asset Util isation = From Net Assets Balance This measures how much turnover is generated by the assets owned by the business Generally the higher this figure is the better though it may vary considerably between industries E.g. an asset utilisation figure of 3.75 means that every 1 invested in assets generates 3.75 of turnover It can be improved by increasing turnover without further investment in assets Business Studies Online: Slide 9

10 Liquidity Ratios: 1) The Current Ratio From Balance Current Ratio = Current Assets Current Liabilitie s The answer is shown as a ratio From Balance It measures the ability of a business to pay it s debts over the next year E.g. a current ratio of 1.78 would mean that for every 1 a business owes it has 1.78 of assets that can be used to pay it The ideal will vary from business to business, but between 1.5 and 2 is usually acceptable Business Studies Online: Slide 10

11 Liquidity Ratios: 1) The Acid Test Ratio Both From Balance Acid Test Ratio = The answer is shown as a ratio Current As sets Stock Current Liabilitie s From Balance E.g. an acid test ratio of 1.24 would mean that for every 1 a business owes it has 1.24 of assets that can be sold very quickly to pay it Stock is not included because it may not be a finished good ready for sale The ideal will vary from business to business, but generally a figure near to 1 is acceptable Business Studies Online: Slide 11

12 Solvency Ratios: 1) The Gearing Ratio From Balance The Gearing Ratio (%) = This measures how reliant a firm is on borrowed capital E.g. a gearing ratio of 34% would mean that for every 1 invested in the business 34 pence of it is borrowed A highly geared firm will have higher costs due to interest payments This may affect: The ability to pay dividends to shareholders Their ability to borrow further funds Loan Capital Capital Employed x 100 From Balance Business Studies Online: Slide 12

13 Solvency Ratios: 2) Interest Cover Interest Cover = Net Profit Before Tax & Interest Interest Paid This measures how many times a firm is able to pay it s interest costs from net profit E.g. an interest cover of 4 means that the business could pay it s interest costs 4 times from net profit This gives an indication of how affordable a firm is finding it s borrowing Business Studies Online: Slide 13

14 Shareholder Ratios: 1) Return On Equity Ratio Net Profit After Tax, Interest & Preference Share Dividends Interest Cover = x100 Share Capital + Reserves This measures the return made from money invested in the business by shareholders E.g. a return on equity ratio of 5% means that the business made 5 pence profit for every 1 invested by shareholders Shareholders do not usually receive this return From Balance Note that (Share Capital + Reserves) may be referred to as shareholders funds Business Studies Online: Slide 14

15 Shareholder Ratios: 2) Earnings Per Share Ratio Earnings Per Share = Net Profit Number of Shares From Balance This measures how much profit was made per share issued E.g. an earnings per share ratio of 0.1 means that 10 pence profit was earnt for each share issued Although this profit is available for distribution to shareholders they do not usually receive this amount Business Studies Online: Slide 15

16 Shareholder Ratios: 3) Dividend Per Share Ratio Dividends Per Share = Total Dividends Number of Shares From Balance This indicates how much shareholders will receive for each share that they hold E.g. a dividend per share ratio of 0.25 means that shareholders will receive a dividend of 25 pence for each share that they hold The total dividend will be declared by the directors Business Studies Online: Slide 16

17 Shareholder Ratios: 4) Dividend Yield Ratio Dividend Yield (%) = Dividend Per Share Market Share Price From Previous Calculation From Stock Market This indicates the return a shareholder receives at the current share price E.g. a dividend yield ratio of 6% means that the dividend paid to shareholders represents 6% of the current cost of buying the share This can be compared directly to other investments The result needs to be compared to previous years and similar businesses Business Studies Online: Slide 17

18 The Limitations Of Ratio Analysis One ratio alone is not very useful Ratios need to be compared with: Previous figures Similar businesses Such comparisons need to consider: External factors change over time Different businesses have different financial years Ratios can be calculated using slightly different formulae This makes direct comparisons very difficult Different accounting principles may be employed E.g. depreciation could be calculated differently this would affect the value of ratios Business Studies Online: Slide 18

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