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Ratio Analysis Introduction to Business Accounting Week 4 Ratio Analysis – What is it? Ratios are Mathematical formulae that simplify financial information for the non-financial specialist whose responsibility is to understand, analyse, and act upon reported financial information

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Ratio Analysis

Introduction to Business Accounting

Week 4


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Ratio Analysis – What is it?

  • Ratios are

  • Mathematical formulae that simplify financial information for the non-financial specialist whose responsibility is to understand, analyse, and act upon reported financial information

  • Advantages of ratios

  • Trends

  • Comparison

  • Extrapolation


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Groups of Ratios

  • Different Classes of ratios are available for different classes of user

  • Profitability

  • Efficiency

  • Liquidity

  • Gearing

  • Investor ratios


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Liquidity Ratios

  • Current ratio

  • Current assets

  • Current liabilities

  • Means : There are sufficient current assets to cover current Liabilities as they fall due

  • Acid test ratio

  • Current assets (less stock)

  • Current liabilities

  • Means : Coverage of current liabilities by “liquid”

    assets

  • Ratios are often expressed as percentages

  • Liquidity ratios usually are not


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2001 liquidity ratios for Somerfield

  • Current ratio

  • 576.4 = 1 : 0.88

  • 651.6

  • Quick (acid test) ratio

  • 576.4 – 329.9 = 1 : 0.38

  • 651.6

  • In short for every £1 of current liabilities (bills to be paid) Somerfield has 88p of assets to pay them with!

  • As stock takes a while to convert to cash

  • If we ignore that then Somerfield has only 38p of “liquid” assets to pay every £1 of short term liabilities.

  • Is this desperate?



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Tesco 2003 liquidity ratios

  • Current ratio

  • 2440 = 1 : 0.45

  • 5372

  • Quick (acid test) ratio

  • 2440 – 1140 = 1 : 0.24

  • 5372



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Avon Rubber liquidity ratios 2003

  • Current ratio

  • 84578 = 1 : 1.05

  • 80292

  • Quick (acid test) ratio

  • 84578 – 20611 = 1 : 0.80

  • 80292


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Conclusions

  • Somerfield not that bad

  • Industry type is important – “average” ratios will vary depending on the type of business

  • The size of a business is made irrelevant as we are not interested in total figures in the accounts but the relationship between one part of the accounts and another

  • The numbers on the face of the accounts can tell us some things but

  • We need techniques to supplement this information

  • Think who are these accounts aimed at?


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Conclusions

  • These ratios would be important to

  • Suppliers – can they pay me?

  • Lenders – can they pay interest? Why do they want a loan?

  • Employees – is my job safe?

  • Competitors – benchmarks and comparisons


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Do ratios give you the full story?

  • Well, no but they provide another dimension.

  • Also its how you INTERPRET them.

  • Levels of interpretation

  • (1) Calculate ratios

  • (2) 1 and say this is good/bad

  • (3) 1 & 2 and compare over time or to competitor/industry average

  • (4) All the above and provide explanation of WHY changes have occurred


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Level 4 example – general

  • Gross Profit Margin

  • Gross profit X 100

  • Sales

  • Means : Difference between sales and cost of sales and therefore profitability in buying or producing and selling goods.

  • There are a range of potential reasons why the gross profit margin might change….

  • Link_5.ppt


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Level 4 example – specific

  • Changes in ratios could point to all sorts of things going on under the surface

  • Chairman’s statement

  • Executives’ reviews

  • Notes to the accounts

  • Can all provide a source of information to help interpret the results of ratios

  • Hence “ratio analysis”

  • Financial press and the internet can also provide up to date information to support analysis


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Stock turnover period

  • Cost of sales = n times per year

    Average stock held (or closing stock)

  • Means : Number of times stock is “turned over” each year

  • What’s Hot : The shorter time, the better.

  • Means less funds being tied up in stock.

  • Note often the average stock is not used but simply the stock figure in the balance sheet


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Somerfield Stock & Cost of Sales

  • Stock in Balance Sheet

  • 2000 – 372.6

  • 2001 – 329.9

  • Cost of Sales from P&L

  • 2000 – 5415.5

  • 2001 – 4523.5


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Applying the ratios

  • 2001

  • 4523.5 = 13.7 times in the year

  • 329.9

  • 2000

  • 5415.5 = 14.5 times in the year

  • 372.6


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Diagnosis

  • Clearly deteriorating

  • Why?

  • Is management aware?

  • Are they doing anything about it?


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Prognosis

  • Stock availability

  • When basic items are not available on the shelves, it is frustrating for any shopper. For Kwik Save’s target market, who keep relatively small stocks at home, it is particularly frustrating and encourages them to shop elsewhere. We have sharply increased the availability of everyday and promotional items through improvements in distribution and stores’ internal replenishment procedures.

  • During October, we reappraised the frozen food lines that we stock, simplifying the offer to ensure high availability and good presentation for the most popular products. This worked well, and we are now applying the same principles elsewhere in the store – making ranges simpler and more disciplined while still providing the choice that today’s consumers require.

  • We are also increasing the focus on brands, taking Kwik Save back to its roots by offering the biggest brands at lowest prices.

  • To give customers a lower-cost choice we have been offering Somerfield own-label products, but this has confused many customers. We are phasing this policy out, replacing all Somerfield lines with value alternatives by this Autumn.


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Prognosis

  • Investing behind the scenes

  • We are investing in our IT and distribution systems to achieve higher availability and service to stores at lower cost.

  • Our IT strategy is to simplify and clarify our systems – focusing investment initially on updating our distribution and Kwik Save store systems. By June this year, all Kwik Save units were linked into our store IT system.

  • During the year we opened a completely rebuilt and enlarged distribution depot near York. The depot is over 500,000 sq ft in size and handles ambient, chilled and frozen products. It is operated by an outsourced logistics specialist. The new year will see the increasing use of multi-temperature vehicles, significantly increasing both depot and store productivity. In the South West we outsourced some of our logistics operations, ensuring that staff transferred to the outsourcing organisations on equivalent terms.


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Did it work?

  • Calculating ratios for the next 2 years

  • 2002 report – 13.9 times per year

  • 2003 report – 15.6 times per year


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None the wiser, but better informed

  • Well that’s great I’m glad I came along.

  • Most text books give you formulae for ratios, right?

  • So all I need is a list of formulae (like the one helpfully attached to the handout), a balance sheet and a P&L account and away I go?

  • Not quite……


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Some terms in the text books aren’t found in published accounts

  • Book - Sales

  • Accounts - Turnover or sometimes retailers use sales to mean turnover including VAT, then show turnover. You want turnover.

  • Book - Credit sales/credit purchases

  • Accounts - Not reported – use turnover or purchases

  • Hang about, I can’t find “purchases”

  • True, it might not be there, use cost of sales??!!

  • Hang about, I can’t find cost of sales either…

  • Look in the notes.

  • Against almost every line in BS and P&L there is a note number.

  • Always look to the notes for more explanation

  • Eg

  • In BS creditors – you will need “trade creditors” which is just one class of creditors

  • The detail will be in the notes


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Profitability Ratios accounts

  • Return on Capital Employed (ROCE)

    Net profit before interest and tax X 100

    Share capital + reserves + long term loans

    A ratio that indicates the efficiency and profitability of a company's capital investments.

    ROCE should always be higher than the rate that the company borrows at, otherwise any increase in borrowings will reduce shareholders' earnings


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Net Profit Margin accounts

  • Net profit before interest and tax X 100

  • Sales

  • Relationship between turnover and “controllable” profit. How are management controlling business expenses?


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Efficiency Ratios accounts

  • Average settlement period for debtors

  • Trade debtors X 365

  • Credit sales

  • Means : How quickly an average debtor takes to pay. Shown in days.

  • The quicker debtors pay up the better.

  • Normal terms .v. actuality


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Efficiency Ratios accounts

  • Average settlement period for creditors

  • Trade creditors X 365

  • Credit purchases

  • Means : How long, on average, it takes a business to pay its trade creditors in days

  • Deferring paying creditors is free credit


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Gearing (leverage) Ratios accounts

  • Gearing ratio

  • Long term liabilities X 100

  • Share capital + reserves + long term liabilities

  • Means : contribution of long-term lenders to the long-term capital structure


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Gearing Ratios accounts

  • Interest Cover

  • Profit before interest and tax

  • Interest payable

  • Means : Amount of profit available to cover interest payments

  • What’s Hot : the higher, the more funds available to meet interest payments.

  • So long term lenders more secure


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Investor Ratios accounts

  • Dividends per share

  • Dividends announced during period

  • Number of shares in issue

  • Means : cash return an investor can expect from shares held in a company

  • Tip: Frequently shown in notes to accounts


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Investor Ratios accounts

  • Dividend payout ratio

  • Dividends announced for the year X 100

  • Earnings for the year available for dividends

  • Means : Proportion of earnings paid out to shareholders as dividends


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Investor Ratios accounts

  • Earnings per Share (EPS)

  • Earnings available to ordinary shareholders

  • Number of ordinary shares in issue

  • The earnings of a company is its profit, and so if we change the wording of earnings per share to profit per share the meaning should become a lot clearer.

  • It is literally the amount of profit that has on average been earned by each share.


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FRS 14 accounts

  • FRS 14 requires that EPS is shown as a footnote to the profit and loss account of a quoted company.

  • FRS 14 defines EPS as: “Basic earnings per share should be calculated by dividing the net profit or loss for the period attributable to ordinary shareholders by the weighted average number of shares outstanding during the period.”

  • The trend of EPS is a better indicator of progress than the trend in profit. In order to maintain EPS at the same level after a share issue a company must deploy the proceeds of the issue at least as profitably as the original capital


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Investor Ratios accounts

  • Price/Earnings ratio (P/E ratio)

  • Market value of shares

  • EPS

  • Means : compares market value of the share with its earnings.

  • What’s Hot : A high figure shows the market’s confidence in the future earnings potential of the company.

  • The higher the confidence, the more investors will be prepared to pay for shares in relation to the current earnings level.


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Can we predict potential bankruptcy? accounts

  • Edward Altman (1968 & 1981)

  • Calculation of Z-Score

  • Historic Basis

  • Key ratios + weightings = Z-Score

  • Note: use as part of an evaluation



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The Interpretation of Z Score: accounts

  • Z-SCORE ABOVE 3.0

  • The company is safe based on these financial figures only.

  • Z-SCORE BETWEEN 2.7 and 2.99

  • Grey area/ Zone of ignorance.

  • This zone is an area where one should exercise caution.

  • Z-SCORE BETWEEN 1.8 and 2.7

  • Grey area/ Zone of ignorance.

  • Good chances of the company going bankrupt within 2 years of operations from the date of financial figures given.

  • Z-SCORE BELOW 1.80

  • Probability of financial embarrassment is very high.


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Worked Example – Somerfield 2001 accounts

  • Return on Assets

  • 11.6/1509.3 = 0.0077X3.3 = 0.0254

  • Sales to Total Assets

  • 4612.5/1509.3 – 3.0561X0.999 = 3.0530

  • Equity to Debt

  • 1509.3/800 = 1.8866 X 0.6 = 1.1317

  • Working Capital to Total Assets

  • (75.2)/1509.3 = (0.0498) X 1.2 = (0.0598)

  • Retained Earning to Total Assets

  • 548.9/1509.3 = 0.3637 X 1.4 = 0.5092

  • Total of Weighted Scores = 4.6595


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