FINANCIAL STRATEGIES AND ACCOUNTS
INTERPRETING PUBLISHED ACCOUNTS
“Short-term can be terminal.”
Mark McCormack
“Sometimes you have to pay a high price for an opportunity.”
Rupert Murdoch
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INTERPRETING PUBLISHED ACCOUNTS
IN THIS TOPIC YOU WILL LEARN ABOUT:
Conducting ratio analysis: the selection, calculation and interpretation of ratios to measure financial performance
Assessing the value and limitations of ratio analysis in measuring a business’ performance
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RATIO ANALYSIS
Allows for a more meaningful analysis of published accounts Shows relationship between figures
Inter and intra firm comparisons Ratios are used to measure the following
financial indicators: Liquidity Profitability Financial Efficiency Gearing Shareholders
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RATIO ANALYSIS - LIQUIDITY
Liquidity A measure of a firms short term survival i.e. its ability
to meet short term debts Liquidity
Current ratioCurrent assets : current liabilities
Acid testLiquid assets : current liabilities
Liquid assets = Receivables + cash Inventory is not included in current assets as it is deemed the hardest to turn into cash
quickly The acid test ratio is a tougher measure of
liquidity
You will need access to the internet to watch this clip
Why is liquidity crucial for survival?
Liquidity ratios Balance Sheet £mNon-current assets 19550Inventories 2375Receivables 1170Cash & cash equivalents 2300Total current assets 5845Current liabilities (8160)Net current liabilities (2315)Non-current liabilities (6000)Net assets 11235
Share capital 6000Reserves & retained earnings 5235Total equity 11235
Current RatioCurrent Assets : Current Liabilities
5845 : 8160= 0.716 : 1
For every £1 of CL the firm owes it owns £0.716 in CA
Acid TestLiquid Assets : Current Liabilities
1170 + 2300 : 8160= 3470 : 8160
= 0.425 : 1For every £1 of CL the firm owes it owns
£0.425 in CA
Do you think this business has enough short term assets to meet its short term debts?
Why is the acid test a more demanding measure?
Liquid assets has been calculated as:Receivables + Cash & cash equiv.
Explain an alternative way of calculating liquid assets.
RATIO ANALYSIS - PROFITABILITY Profitability
ROCEA measure of how efficiently a business is using capital employed to generate profits
Capital employed = total equity + non-current liabilities
i.e. all the money invested in the business from Share capital Reserves Long term loans
Operating profit x 100 total equity + non-current liabilities
Recap AS: Profitability can also be measured by Gross and Net Profit Margins
Profitability ratioBalance Sheet £mNon-current assets 19550Inventories 2375Receivables 1170Cash & cash equivalents 2300Total current assets 5845Current liabilities (8160)Net current liabilities (2315)Non-current liabilities (6000)Net assets 11235
Share capital 6000Reserves & retained earnings 5235Total equity 11235
ROCEOperating profit x 100total equity + non-current liabilities
4580 x 10011235 + 6000
4580 x 100 = 27%17235
Income Statement £mRevenue 35400Cost of sales (30100)Gross profit 5300Expenses (720)Operating profit 4580Finance income 300Finance cost (260)Profit before tax 4620Taxation (1109)Profit for the year 3511
For every £1 of capital employed in the businesshow 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?
RATIOS ANALYSIS – FINANCIAL EFFICIENCY
Financial efficiencyAsset turnover
Revenue net assets Measures how efficiently the assets of the business are being utilised to generate revenue
Helps identify whether the business is operating efficiently
A capital intensive industry may have a lower asset turnover than a labour intensive one
Financial Efficiency ratioBalance Sheet £mNon-current assets 19550Inventories 2375Receivables 1170Cash & cash equivalents 2300Total current assets 5845Current liabilities (8160)Net current liabilities (2315)Non-current liabilities (6000)Net assets 11235
Share capital 6000Reserves & retained earnings 5235Total equity 11235
Asset Turnover
RevenueNet assets
3540011235=3.15 times
Income Statement £mRevenue 35400Cost of sales (30100)Gross profit 5300Expenses (720)Operating profit 4580Finance income 300Finance cost (260)Profit before tax 4620Taxation (1109)Profit for the year 3511
For every £1 of net assets in the businesshow 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?
RATIOS ANALYSIS – FINANCIAL EFFICIENCY
Financial efficiency Inventory (stock) turnover
Cost of sales average inventory held Average inventory held can be calculated by finding the
average of inventory at the start and end of the year You therefore also need the previous year’s balance
sheet Alternatively you can just divide cost of sales by
inventory Measures how frequently a business turns over its
inventory in a year Will vary depending upon the nature of the firm
Hot dog stand (hopefully daily!) Fashion Retailer (at least each season) New car showroom (maybe twice a year)
Financial Efficiency ratioBalance Sheet £mNon-current assets 19550Inventories 2375Receivables 1170Cash & cash equivalents 2300Total current assets 5845Current liabilities (8160)Net current liabilities (2315)Non-current liabilities (6000)Net assets 11235
Share capital 6000Reserves & retained earnings 5235Total equity 11235
Inventory Turnover
Cost of sales Inventory
301002375
=12.67 times
Income Statement £mRevenue 35400Cost of sales (30100)Gross profit 5300Expenses (720)Operating profit 4580Finance income 300Finance cost (260)Profit before tax 4620Taxation (1109)Profit for the year 3511
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?
RATIOS ANALYSIS – FINANCIAL EFFICIENCY
Financial efficiencyPayables (creditors) days
Payables x 365 cost of goods sold A measure of how long it takes on average for the business to pay for supplies it has purchased on credit
A business may try to have a longer payables day to ease cash flow problems
A short payables day may result in discounts from suppliers
In December 2008 300 non-food suppliers were told by Tesco that they would be increasing payment terms,which would mean they would only pay their suppliers within 60 days, instead of 30.
To what extent do you think this is a strategy to improve Tesco’s cash flow situation?Analyse the possible reasons why Tesco can take such action.
Financial Efficiency ratio
Balance Sheet £mNon-current assets 19550Inventories 2375Receivables 1170Cash & cash equivalents 2300Total current assets 5845Current liabilities (8160)Net current liabilities (2315)Non-current liabilities (6000)Net assets 11235
Share capital 6000Reserves & retained earnings 5235Total equity 11235Payables (Creditors) days
Payables x 365 cost of goods soldPayables is not shown as a separate figure on this balance sheet.
I am therefore going to assume it is 50% of current liabilities.In an examination a figure would be given
4080 x 36530100
=49 days
Assume payables is the only current liability, how would this alter the
payables days?
Why might a business be willing to havea payables days of 60 – 90 days?
Income Statement £mRevenue 35400Cost of sales (30100)Gross profit 5300Expenses (720)Operating profit 4580Finance income 300Finance cost (260)Profit before tax 4620Taxation (1109)Profit for the year 3511
RATIOS ANALYSIS – FINANCIAL EFFICIENCY
Financial efficiencyReceivables (debtors) days
Receivables x 365 revenueA measure of how long it takes on average for customers to pay the business for products or services it has purchased on credit
The customer is a debtor of the businessA business may try to have a shorter receivables day to ease cash flow problems
Financial Efficiency ratio
Balance Sheet £mNon-current assets 19550Inventories 2375Receivables 1170Cash & cash equivalents 2300Total current assets 5845Current liabilities (8160)Net current liabilities (2315)Non-current liabilities (6000)Net assets 11235
Share capital 6000Reserves & retained earnings 5235Total equity 11235
Receivables (Debtors) days
Receivables x 365 Revenue
1170 x 36535400
=12 days
Payables are compared to cost of sales and receivables to revenue.
Use Business Studies terminology to explain the relationship between these variables.
What might be the expected receivables days ofa) A high street coffee chain
b) A commercial print companyJustify your answers.
Income Statement £mRevenue 35400Cost of sales (30100)Gross profit 5300Expenses (720)Operating profit 4580Finance income 300Finance cost (260)Profit before tax 4620Taxation (1109)Profit for the year 3511
RATIO ANALYSIS - GEARING Gearing
Gearing (%) Non-current liabilities x 100 total equity plus non-current liabilities Measures what proportion of a business’ capital is
funded through long term loans Loans are “compulsory interest bearing”
You have to pay interest on them even if profits are low or non-existent
A high gearing is of greater risk if interest rates are likely to increase
Interest rates are a cost to a business
Explain how this is different to equity capital
Explain where interest rates would appear on an income statementand which profit figure(s) would be affected.
Gearing ratio
Balance Sheet £mNon-current assets 19550Inventories 2375Receivables 1170Cash & cash equivalents 2300Total current assets 5845Current liabilities (8160)Net current liabilities (2315)Non-current liabilities (6000)Net assets 11235
Share capital 6000Reserves & retained earnings 5235Total equity 11235Gearing
Non-Current Liabilities x 100total equity + non-current liabilities
6000 x 100(11235 + 6000)
=6000 x 10017235
=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 toa business with small profit margins?
Income Statement £mRevenue 35400Cost of sales (30100)Gross profit 5300Expenses (720)Operating profit 4580Finance income 300Finance cost (260)Profit before tax 4620Taxation (1109)Profit for the year 3511
RATIO ANALYSIS - SHAREHOLDERS
ShareholderDividend per share (in pence)
Total dividends number of issued ordinary shares The return paid to shareholders’ for their investment Money paid in dividends reduces retained profit Will be influenced by financial objectives
If a dividend of £600m was paid out to a total of 750m shareholdersthe dividend per share would be:
£600m / 750m = 0.80pFor every 1 share owned the shareholder would receive 80p in dividends
You will need access to the internet to watch this clip
RATIO ANALYSIS - SHAREHOLDERS Shareholder
Dividend yield Ordinary share dividend (in pence) x 100
current market price (in pence)o Measures the return on the investment as a percentage
of current market priceo Market price fluctuates on a regular (constant basis)o Allows for a more accurate comparison of the value of
the shareholders’ investment compared to other investment opportunities
If dividend per share is 80p and the current market share price £15the dividend yield is:
0.80 / 15.00 x 100 = 5.3%Do you consider this to be a good return?
How does this compare to savings accounts, ISAs, other share options?
Value and Limitations of Ratio Analysis
Value Provides a tool for the
interpretation of accounts
Structure from which comparisons can be made
Aids decision making Internally Externally by
investors
Limitation Possibility that accounts
have been window dressed
Need to consider reasons behind ratios E.g. is ROCE lower
than previous year because of an investment programme
Quantitative information only
Activity – Interpreting published accounts
In pairs choose 2 businesses who operate in the same industry e.g. 2 supermarkets, 2 football clubs
Go onto the internet and print off their Balance Sheet and Income Statement (Google company name/investors)
The layout will vary from company to company but you should be able to identify the key information
Prepare a presentation comparing the performance of the two businesses
Present your findings to the rest of the class
