Academy 2019/2020 Advanced Financial …...Advanced Financial Accounting Lecture 21 16 Current Ratio...

Advanced Financial AccountingLecture 21

Professional, Practical, Proven

Academy 2019/2020


Ratio Analysis

1) Ratio Analysis – an overview

▪ Profitability Ratios (5)

▪ Liquidity Ratios (2)

▪ Efficiency Ratios (3)

▪ Gearing Ratios (2)

▪ Investment Ratios (5)

2) Summary Formulas

3) Recommended Work

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The purpose of using Ratios

Evaluating a company’s financial position

Determining whether the content of information is favourable or unfavourable

Reveal areas that need further investigation

Compare and Contrast

Decision Making

Evaluation of opportunities

Business Management

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Limitations of using Ratios

Based on historical financial statements (Ever–changing environment)

These statements are based on particular financial judgements e.g. companies may use different accounting standards or adopt different approaches.

Companies in the same industry may not be comparable.

Reality of the business may be based on non-quantifiable factors, management quality etc.

Mainly based on the SOFP; does not take full account of the full year realities.

Vulnerable to errors, omissions, manipulation etc of financial accounting.

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Examinable at FA2 Level:

• Profitability Ratios

• Liquidity Ratios

• Efficiency Ratios

• Gearing Ratios

• Investment Ratios

Make sure you know the formulas for each, for the Exams!

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Profitability Ratios

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Profitability Ratios:

Gross Profit Percentage/Margin

Gross Profit Percentage = Gross Profit X 100Sales 1

Example:I sell 100 teddy bears for €10 eachThey cost me €4 each

My COS = €400,My profit margin = €600

Express this profit element as a % 600 X 100 = 60%1,000 1

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Cost of Sales Percentage

Cost of Sales Percentage = Cost of Sales X 100Sales 1

Example:I sell 100 teddy bears for €10 eachThey cost me €4 each

My COS = €400,My profit margin = €600

Express the COS element as a % 400 X 100 = 40%1,000 1

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Gross Profit Percentage100%


The ratios for Gross Profit Margin measure profit earned on sales and monitors buying and selling prices.

A high gross profit percentage (and low COS %) is favourable, i.e. a gross profit of 60% means that 60c of every € earned is profit.

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Net Profit Percentage

Net Profit Percentage = Net Profit X 100Sales 1

Example:I sell 100 teddy bears for €10 eachThey cost me €4 eachOverhead costs were €3 per unit

My net profit margin = €300

Express the net profit as a % 300 X 100 = 30%1,000 1

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There are a number of definitions of net profit (e.g. PBIT etc)

Make sure that you refer to the Exam Question!

A high net profit percentage is favourable, i.e. a net profit of 30% means that 30c of every € earned is profit that is available to the owner/shareholders.

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Expenses Percentage

Expenses Percentage = Admin &/or Distribution Exps X 100Sales 1

The higher the COS and expenses ratios the lower the net profit percentage will be.

Therefore a low expenses ratio will be favourable.

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NB: Return on Capital Employed

ROCE = Net Profit (before interest & Tax) X 100Capital Employed* 1

i.e. Capital Employed = Capital investment in the business(Be careful about the definition of Capital employed). * Total of capital and reserves plus total non-current liabilities

ROCE measures the return earned by the owners of the business from funds invested in the business.

ROCE is profit expressed as a percentage of capital employed.

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Liquidity Ratios

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Liquidity refers to the Cash position of a business.

Is there a good ratio between what the business owes and owes in the short term?

Can the immediate debts of the business be covered by its short term assets? (By cash or items that are readily convertible to cash)

The current Ratio (aka the Working Capital ratio) is an attempt to measure the liquidity of a firm i.e. it is the ratio of current assets to current liabilities.

Current Ratio = current assets e.g. 2:1, 1:1, etccurrent liabilities

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Current Ratio = current assetscurrent liabilities

It would appear prudent to have a ratio of 1:1 or even 2:1 to ensure that the business has enough working capital to meet its commitments in the short term.

However, consider the following:

What problems might be indicated by a ‘too good’ current ratio?

•Risk of Stock obsolescence•Storage Costs•Difficulty of readily converting stocks to cash•Finite life span on inventory may mean that it needs to be sold at a reduced price•Stock may have to be sold on credit, further delay•Bad debt risk associated with a high Receivables figure•Excess cash could be more usefully employed

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The Acid test ratio (aka the Quick ratio) excludes Closing Inventory and therefore excludes the problems associated with the asset ‘Inventory’.

Acid Test Ratio = Current Assets – Closing InventoryCurrent Liabilities

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A – Construction Company B – Supermarket

Current Assets 92,000 53,500

Current Liabilities 19,500 29,950

Working 92,000/19,500 53,500/29,950

Current Ratio 4.7:1 1.8:1

Example: (Current Ratio)

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A – Construction Company B - Supermarket


Closing Inventory 75,500 19,500


Example: (Acid Test Ratio)

Liquidity Ratios

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A – Construction Company B - Supermarket


Closing Inventory 75,500 19,500


Working 16,500/19,500 34,000/29,950

Quick Ratio 0.8:1 1.1:1

Example: (Acid Test Ratio)

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Efficiency Ratios

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1) How many days does it take to sell inventory?

Inventory Turnover Period

2) How many days does it take for receivables to pay?

Receivables Days Ratio

3) How many days does it take to pay payables?

Payables Days Ratio

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Inventory Turnover Period:

Average Inventory x 365Cost of Sales

*Average Inventory = Opening inventory + Closing Inventory2

Alternative Method: Cost of Sales = e.g. 2.56 timesAverage Inventory

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Receivables Days Ratio:

Receivables Days = Receivables x 365Credit Sales

Expresses in Days the average length of credit being taken by customers

Payables Days Ratio:

Payables Days = Payables x 365Credit Purchases

Expresses in days the average length of credit being taken by the business in settling its debts

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THE WORKING CAPITAL CYCLE

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• Buy inventory on credit from Supplier

Payables

• Sell Inventory on credit to customers

Receivables

• Pay the Supplier for stock

Receivables

• Get paid by Customer

Inventory In Inventory

out

Payables

Inventory Days

Payables Days

Receivables Days

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Gearing Ratios

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Gearing (aka Leverage):

Non-current Liabilities x 100Share Capital (Pref & Ord) + Reserves + Non Current Liabilities 1

Indicates how heavily (or not) the business has borrowed in order to finance its activities.

The calculation is derived by dividing the debt financing by total financing.

A low gearing ratio is preferable because:

• Greater flexibility (Greater potential/capacity for borrowing)• Reduced interest on debt• Increased profit available to shareholders.

Advantages:• Interest is tax deductible• Ownership may be less diluted

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interest Cover:

e.g. How many times profits can cover the annual interest charge:

Net Profit (before Interest and Tax)Interest on Non current liabilities

Most banks would look for an interest cover in excess of 3-5 times.

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Investment Ratios

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Dividend per Share:

Ordinary Dividends for the Year (if any)Number of Ordinary Shares in Issue

Reveals the ordinary dividend value per share.

Dividend Cover:

Profit after interest, tax and preference dividendOrdinary Share Dividend

Illustrates how many times the available profits can cover the ordinary share dividend.

Dividend Yield Ratio:

Dividend per Share x 100Market Value of a Share 1

Relates the cash return from a share to its current market value

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Earnings per Share:

Earnings Available to ordinary ShareholdersNumber of Ordinary Shares in Issue

Measures the Company profitability per Share

Price Earnings per Share:

Market Value per ShareEarnings per Share

Relates the market value of the share to the earnings per Share

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Summary

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Profitability Ratios

Gross Profit Percentage

Gross Profit x 100Sales 1


Net Profit x 100Sales 1


Cost of Sales x 100Sales 1

Expenses Percentage

Admin &/or Dist Exp x 100Sales 1

ROCEPBIT x 100

Capital Employed 1

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Liquidity

Ratios

Current RatioCurrent Assets

Current Liabilities

Acid Test Ratio

Current Assets (-Closing Inv)Current Liabilities

Efficiency

Ratios

InventoryTurnover Period

Average Inventory x 365Cost of Sales

Payables DaysPayables x 365

Credit Purchases

Receivables DaysReceivables x 365Credit Sales

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Gearing

Ratio

Non Current Liabilities x 100Share Capital + Reserves + Non Current Liabilities 1

Interest Cover Net profit before interest and taxation

Interest charge for the year

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Investment

Ratios

Dividend per Share

Ordinary Dividends for the Year No of Ordinary Shares in Issue

Dividend CoverProfit after Int, Tax & Pref Dividend

Ordinary Share Dividend

Dividend Yield RatioDividend per Share x 100 Market Value of Share 1

Earning per Share (EPS)

Earnings available to Ord ShareholdersNo. of ord shares in issue

Price earnings RatioMarket Value per Share

Earning per Share

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Notes:

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Ratio analysis involves producing ratios from information contained in the

financial statements that may indicate weaknesses and/or strengths in the

company’s affairs – which may highlight the need for correction or

adjustment.

The key to Ratio analysis is comparison!

i.e. From year – to – year (Over Time)

In consideration of industry norms

In comparison to other specific companies

The theory section may prompt you to suggest remedial or corrective action

where the ratios have indicated an unfavourable or deteriorating scenario.

Ratio Analysis – making commentary…

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Increases Good – Decreases Bad!

ROCE shows the % return on funds invested in the business.

Efficiency Ratios:

Examine how long it takes to sell inventories,

collect receivables and pay payables.

Credit Control

Credit Terms

Discounts

Risks associated with inventory levels


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Gearing Ratios:

Looks at the balance between how the company is financed

between (1) Equity e.g. Share Capital etc. and

(2) Debt i.e. Bank Borrowings.

Interest Rates

Company Control

Potential for borrowing

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Benefits of Ratio Analysis

➢ Ratio analysis summarises the financial statement into comparative

figures, helping the management to compare and evaluate the financial

position of the firm and the results of their decisions.

➢ Simplifies the accounting statements and financial data into operating

efficiency, financial efficiency, solvency, long-term positions etc.

➢ Ratios will help pinpoint problems and validate or disprove management’s

opinion/decisions.

➢ Allows the company to conduct comparisons with other firms, industry

standards, intra-firm comparisons etc.


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Consider/mention the limitations of Ratio Analysis

➢ Is it a like-for-like comparism?

➢ SOFP is a ‘snapshot’

➢ Does not consider intangible factors

➢ Many ratios are calculated using historical costs, and they overlook the

changes in price level between the periods.

➢ If a user of accounting information focuses too much attention on one

particular ratio the user may get a distorted picture of the business’s

performance.

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Class Activity

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Academy 2019/2020 Advanced Financial …...Advanced Financial Accounting Lecture 21 16 Current Ratio...

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