Interpreting Published Accounts

1. Interpreting Published Accounts

2. Ratios you MUST know • Profitability (ROCE). • Gearing • Liquidity (current and acid test ratios), • Financial efficiency (asset turnover, stock turnover, creditor and debtor days), • Shareholder ratios (dividend per share and dividend yield)

3. Which is better? Company A has £100,000 profit Company B has £1m profit Which is the more successful company?

4. Which is better? Company A has £100,000 profit, where £200,000 was the capital invested Company B has £1m profit, where £10m was the capital invested Which is the more successful company?

5. Which is better? Company A has £100,000 profit, where £200,000 was the capital invested Company B has £1m profit, where £10m was the capital invested 100,000/200,000 x100 = 50% 1m / 10m x100 = 10% How can you use % calculation to see the differences?

6. Profitability ratios Gross Profit Margin * Operating Margin * ROCE * Covered in AS BUSS2

7. This is one type of ratio! … Known as ROCE Return on Capital Employed

8. Profitability Ratios • The ‘primary ratio….’ • ROCE – return on capital employed • This tells us how efficient the company is by looking at their profits & comparing it to the funds invested in the business. • ROCE = Operating profit x 100 Capital employed

9. Examples of ROCE (2007) Which company do you think might be the most efficient at generating profits? Remember to consider the reasons why? Which company looks the more impressive just on raw profit figure?

10. Examples of ROCE (2007) Which company looks the more impressive now?

11. Calculate the ROCE figure Operating profit x100 Capital employed Examples of ROCE (2007)

12. Examples of ROCE (2007) For every £1 invested in the company, Burberry make 37p back in profits

13. Evaluating ROCE Higher % is better Watch for trend over time ROCE % Watch out for low quality profit which boosts ROCE Leased equipment will not be included in capital employed

14. Other profitability ratios… • At AS you looked at… • Gross profit margin • & • Net profit margin, and in A2 you will be given credit for looking at this profitability ratio again!

15. Gross Profit Margin = Gross Profit x 100 = % Turnover Gross Profit Margin Remember: Turnover = sales Gross Profit = Turnover – Cost of Sales The Gross Profit margin ratio tells us the profit a business makes on its cost of sales or cost of goods sold. It is a very simple idea and it tells us how much gross profit per £1 of turnover the business is earning. For example, A 40% GPM means for every £1 sold 40p equates to gross profit A 14% GPM means for every £1 sold 14p equates to gross profit Gross Profit is the profit we earn before we take off any administration costs, selling costs and so on. So we should have a much higher gross profit margin than net profit margin.

16. Gross Profit Margin Here are a few examples of the gross profit margins from different businesses. What does the Gross Profit Margin also tell us about the cost of sales? The Gross Profit Margins may vary from business to business and industry to industry. For example, the International Airline has a gross profit of 5.62% yet the Accounting Software business has 89.55% If a company’s raw materials and factory wages go up a lot, the gross profit margin will go down unless the business increases its selling prices at the same time.

17. Net Profit Margin Net Profit Margin = Net Profit x 100 = % Turnover Remember Net Profit = Gross Profit – overheads + income earnt The Net profit margin ratio tells us of net profit per £1 of turnover. That is, after taking into account the cost of sales, administration costs, the selling and distribution costs, the net profit is the profit that is left, out of which they will pay interest, tax, dividends and so on. Just like the gross profit margins, the net profit margins also vary from business to business and industry to industry. When we compare the gross and net margins we can gain a good impression of their non-production and non-direct costs such as administration, marketing and finance costs. We saw that the International airline’s gross profit margin was the lowest of the 8 industries at 5.62% but its net profit margin is 4.05%, only a little bit lower. On the other hand, the discount airline gross profit margin is 27.46% but its net profit margin is 10.87% These comparisons give us a great insight into the cost structure of these businesses. Compare Ryanair with BA management structures.

18. Comparing Gross to Net Profit Margins So what’s happened to Manufacturing? Look at the software business – a very high GPM of 89.55% but a NPM of 27.15% . This is still high, but we can see that the administrations costs are very high while the costs of sales are very low.

19. How to improve profits? • Remember your hwk recently to read article on profitability? • “Improving Profits” Business Review Nov 2008 • What can you remember?

20. Recap profitability ratios • There are THREE profitability ratios.. Gross Profit Margin * Operating Margin * ROCE

21. To help you learn all of this Ratio name Fill in the profitability ratio info for ROCE Ratio formula

22. Gearing – another ratio A Liquidity ratio

23. Gearing • This tells us how much of the company’s finance is through debt! • A highly geared business is funded heavily through long term debts • A low geared business is funded mainly through its owners/shareholders.

24. Gearing • A company with 80% gearing…. • has 80% of funds through long term debts and 20% through owners/shareholders. • A company with 35% gearing… • has 35% of funds through long term debts and 75% through owners/shareholders. Which is in the better position?

25. Calculating Gearing Gearing = non current liabilities x 100 total equity & non current liabilities* • Aka capital employed So if a company has £280 in non current liabilities and £1,000 in capital employed Gearing = 280 x 100 = 22% 1000+ 280

26. Examples of Gearing (2007) Which company looks the more impressive just on the figures? Which is in the better position? Why could the differences in dates be important?

27. Benefits of high gearing • With low interest rates – highly geared companies benefit from cheap finance…. But when Interest rates go back up… • Relatively few shareholders – easier to keep control of the company. • Fewer shareholders could mean that the business has less dividend pressure, and could retain profit for future investments.

28. Benefits of low gearing • Most of the capital is ‘permanent’ and does not have to be ‘repaid’ with interest! • Less risky where creditors can not force the business into liquidation (think Woolies!) • Easier to borrow more in the future if the company wants to expand.

29. To help you learn all of this Fill in the gearing ratio info Ratio name Ratio formula

30. Liquidity ratios Assess whether a business has sufficient cash or equivalent current assets to be able to pay its debts as they fall due

31. Liquidity ratios. • What is liquidity? • Liquidity is an asset'sability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value. • Money in the bank or cash on hand, is the most liquid asset.

32. Liquidity Ratio • These tell us how healthy the business is in the SHORT TERM • It tells us whether the working capital is sufficient to cover the immediate debts! • Current Ratio • Acid Test Ratio

33. Quick recap… • What is the money owed to a business from customers called on the balance sheet? • Receivables (from debtors) • What are the other ‘current assets’? • Cash • Inventories (stock)

34. Current Ratio A liquidity ratio

35. Current Ratio Current Ratio = current assets : current liabilities or Current Ratio = Current assets Currentliabilities • So what do you think a current ratio of 2:1 means? • The company has £2 of assets for every £1 of debt

36. Which company looks the more impressive just on the figures? Examples of Current ratios Calculate their Current Assets ratio… = current assets / current liabilities Written as ? : 1

37. Examples of Current ratios Should Tesco & BA panic about a ‘liquidity’ of <1?

38. What can they do to improve Current ratio? • Sell under used non current assets – but is this really wise?) BA is grounding 22 planes this winter! • Raising more share capital (what the banks have done!) • Increase long term borrowing! (OK when IR’s are soo low!) • Postpone planned investments – eg Stelios disagreement over Easyjet!

39. Good video link • http://news.bbc.co.uk/1/hi/uk/8178474.stm • About BA & how ‘well it’s positioned’ to survive the current crisis – looks at reducing CA, increasing N-CL & gearing all in one clip!

40. Acid Test Ratio A liquidity ratio

41. Acid Test Ratio • This ratio looks at comparing assets with liabilities BUT with removing stock figures • ACID TEST RATIO • =(current assets – inventories) : Current liabilities Or • ACID TEST RATIO = Current assets – inventories Current liabilities

42. Why remove the inventories? • Stock is THE MOST illiquid asset of the business • It can take a long time to convert inventories (stock) into cash • It can ‘depreciate’ if sold as 2nd hand rather than ‘produced’ into final product.

43. Acid Test Ratio • So another way of calculating the Acid Test Ratio = Cash & receivable (debtors) Current liabilities • So what would an Acid Test Ratio of 1.5:1 mean? • The company has £1.50 worth of liquid assets to every £1 of debt! • The ideal situation is an Acid Test ratio of 1:1

44. Quick Q • If Tesco has a current ratio of 0.61:1, what do you think their Acid Test Ratio will be? • Will it be higher or lower than this?

45. Examples of Acid Test ratios

46. Examples of Acid Test ratios Much lower due to having so much stock!

47. Why is 1:1 ideal? • Why is the acid test ideal 1:1? • If a company has a ratio of 2:1 – what does this mean? • Why is that not the most efficient use of its liquidity? • If a company has a ratio of 0.1 : 1 – what does this mean? • What does this suggest about the company’s financial strength?

48. So use your colour sheet Ratio name Ratio formula Fill in the Liquidity ratios info

49. Financial efficiency ratios Assess how effectively a business is managing its assets

50. Financial efficiency ratios Asset turnover Stock turnover Debtor days Creditor days