Ratio Analysis

1. Ratio Analysis Unit 5 An introduction to accounting

2. Objectives • Introduction • Interpreting final accounts • Types of Ratio • Profitability Ratios • Return On Capital Employed

3. Definitions & Assumptions • Ratio analysis is the examination of the accounting data by relating one figure to another. • This allows a more meaningful interpretation of the data and the identification of trends

4. Introduction • The function of accounting is to provide information to stakeholders • How do we judge a performance? • Is a profit of £1million good or bad? • For a small family business this would be good • This would be poor for a big company (JD Wetherspoon have sales of £200million • We need a way of judging a firm’s performance in relation to it’s size and in relation to the performance of it’s competitors • This is called Ratio Analysis

5. Introduction (2) • Financial accounts are used for three main purposes: • Financial control • Planning • Accountability • Ratio analysis can assist in achieving these objectives

6. Interpreting Financial Accounts • To analyse company accounts, a well-ordered and structured process needs to be followed • A seven point approach is often adopted: • Reason – Why are you trying to interpret the results? • Identification – Extracting the relevant figures • Process – Decide what method(s) will provide you with the most useful and meaningful results • Calculation – Calculating one figure as a ratio of another. E.g. profit as a percentage of sales revenue • Comparison – Compare the figures from this period with the last, or of competitors • Interpretation - Interpret the values in relation to what would be considered poor, average or good • Action - If certain results are worrying, initiate further Investigation & corrective action

7. Types of Ratio • The main classifications of ratios are as follows: • Profitability Ratios • Measuring the relationship between gross/net profit and sales, assets and capital employed • Efficiency Ratios • These measure how efficiently an organisation uses its resources such as stock or total assets • Liquidity Ratios • These examine the short & long term financial stability of a firm by examining the relationship between assets and liabilities

8. Profitability ratios • How does a company decide if it has made a good profit? • Which is the more successful company? • It would seem that Company B is the most successful, but is this really the case?

9. Profitability ratios (2) • With capital invested taken into account, we can see that in fact, Company has done much better than Company B

10. Gross profit X 100% Gross profit margin = Turnover (sales) Gross profit margin • This ratio examines the relationship between the profit made before allowing for overhead costs,and the level of turnover

11. £3000 X 100% Gross profit margin = £5000 Gross profit margin (2) = 60% • A furniture shop buys sofas for £200 and sells them for £500 each, making gross profit of £300 per sofa. In a week it sells 10, so its gross profit is £3000 and sales are £5000.

12. Gross profit margin (3) • The higher the profit margin the better • The level of gross profit margin will vary considerably between different markets • The amount of gross profit percentage on clothes is generally much higher than food • The result must be looked at in context of the particular industry

13. Altering the gross profit margin • The gross profit margin can be improved by: • Raising the sales revenue whilst keeping the cost of sales static • Reducing the cost if sales whilst maintaining the same level of sales revenue

14. Net profit X 100% Net profit margin = Turnover (sales) Net Profit Margin • Examines the relationship between the net profit (profit after all overheads and expenses have been deducted

15. £500 X 100% Net profit margin = £5000 Net Profit Margin (2) • The furniture shop with it £5000 sales and £3000 gross profit has overheads of £2500 per week. So its weekly net profit is £3000 - £2500 = £500. = 10%

16. Net Profit Margin (3) • As with the gross profit margin, a higher percentage result is preferred • The net profit margin establishes whether the firm has been efficient in controlling its expenses • It should be compared with previous years results and other companies in the same industry • It should also be compared to the gross profit margin – it is possible for the gross profit margin to increase, but the net profit margin decline. This would show that profits on trading are increasing, but overhead profits are rising at a greater rate

17. Altering the Net Profit Margin • The net profit margin can be improved by • Raising sales revenue whilst keeping expenses low • Reducing expenses whilst maintaining the same level of sales revenue

18. Return On Capital Employed (ROCE) • This is often considered to be the primary efficiency ratio • It measures the efficiency with which the firm generates profits from the funds invested in the business • It answers the key question anyone would ask before investing in a business – what will the annual % return on my capital will I receive?

19. Operating(net) profit X 100% ROCE = Capital employed ROCE (2) • Capital employed is long term loans plus shareholders’ funds • Capital employed = assets employed

20. ROCE (3) • The higher the value of the ration the better • ROCE measures profitability, and no shareholder will complain about huge returns • The figure needs to be compared with the previous years, and other companies to determine whether the result is satisfactory or not • Companies usually consider 20% as very satisfactory

21. Altering the ROCE • The return on capital employed can be improved by: • Increasing the level of profit generated by the same level of capital investment • Maintaining the level of profits generated but decreasing the amount of capital it takes to do so