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You owe HWK Textbook page 32 progress questions Do Q 1, 7, 11, 12 (24 marks) Interpreting Published Accounts Ratios you MUST know Profitability (ROCE). Gearing Liquidity (current and acid test ratios), Financial efficiency (asset turnover, stock turnover, creditor and debtor days),

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### You owe HWK

Textbook page 32 progress questions

Do Q 1, 7, 11, 12 (24 marks)

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)
Which is better?

Company A has

£100,000 profit

Company B has

£1m profit

Which is the more successful company?

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?

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?

Profitability ratios

Gross Profit Margin *

Operating Margin *

ROCE

* Covered in AS BUSS2

### This is one type of ratio!

… Known as ROCE

Return on Capital Employed

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

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?

Examples of ROCE (2007)

Which company looks the more impressive now?

Calculate the ROCE figure

Operating profit x100

Capital employed

Examples of ROCE (2007)
Examples of ROCE (2007)

For every £1 invested in the company, Burberry make 37p back in profits

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

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!

### Gross Profit Margin

Gross Profit Margin = Gross Profit x 100 = %

Turnover

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.

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.

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.

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.

How to improve profits?
• “Improving Profits” Business Review Nov 2008
• What can you remember?
Recap profitability ratios
• There are THREE profitability ratios..

Gross Profit Margin *

Operating Margin *

ROCE

Ratio name

Fill in the profitability ratio info for ROCE

Ratio formula

### Gearing – another ratio

A Liquidity ratio

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.
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?

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

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?

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.
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.

Fill in the gearing ratio info

Ratio name

Ratio formula

Liquidity ratios

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

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.
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
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)

### Current Ratio

A liquidity ratio

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

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

Examples of Current ratios

Should Tesco & BA panic about a ‘liquidity’ of <1?

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!
• 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!

### Acid Test Ratio

A liquidity ratio

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

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.
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
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?

Examples of Acid Test ratios

Much lower due to having so much stock!

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?

Ratio name

Ratio formula

Fill in the Liquidity ratios info

Financial efficiency ratios

Assess how effectively a business is managing its assets

Financial efficiency ratios

Asset turnover

Stock turnover

Debtor days

Creditor days

Asset Turnover
• This tells us how well the company uses all it’s assets to generate its sales

Asset turnover = Revenue (sales turnover)

Net assets*

* where net assets are Total Assets -Total liabilities

* this is also the total equity figure at the bottom of the balance sheet.

Examples of Asset turnover
• It’s very difficult to compare different industries
• This is a ratio that definitely to be used benchmarking inter-firm comparison or over a period of time with the same firm.
• For example,
• Tesco will have a high asset turnover – ‘pile them high & sell them cheap’. Meanwhile, Harrods would have a low asset turnover of lower quantity sales but with a high profit margin!

### Stock Turnover

This tells us the number of times a business will sell & replace its stock.

A fishmonger should have a HIGH stock turnover of 365 times – as it gets fresh fish delivered every day of the year!

Where as a second hand car dealer may have a stock turnover of 12 times – which is selling & replacing its cars on the forecourt once a month!

Stock Turnover
Calculating Stock Turnover

Stock Turnover = Cost of goods sold

Average stock held

• List three business that would have a high stock turnover and three that would have a low figure for stock turnover.
• A bread shop has an opening stock of £5 000 at the start of the financial year and at the end of the year its stock is £6 000.

The cost of sales for the shop is £55 000.

Calculate its stock turnover.

Factors that influence rate of stock turnover
• Nature of the product – perishable, antiques
• Importance of holding stock – in large or smaller quantities – imagine going into M&S with empty shelves! High street stores need large quantities of stock.
• The length of the product life cycle
• Stock management systems
• Variety of products being held.

### Debtor & Creditor days

Debtor Days
• Debtors are known as receivables

Debtor days = receivables x 365

revenue

• This tells us how much credit the company gives to its customers.
• Sofa companies often give ‘buy now pay later options’ – whereas at the local petrol station I have to pay immediately!
Creditor Days
• Creditors are known as payables

Creditor days = payables x 365

revenue

• This tells us how long the company takes to pay back the money it owes to its suppliers.
• Delaying payment for as long as possible can help the business!
• BUT – can cause problems with suppliers in future!
• BUT – can incur interest charges (Late Payment Act 1998!)

Ratio formula

Fill in the financial efficiency ratios info

Ratio name

### Shareholder ratios

Dividend per share

Dividend yield

Dividend per share

DPS = Total dividends

Number of shares issued

• Answer is expressed as number of pence per share
• In 2008 M&S anounced dividends of £343.6m for 1,586.48m shares 21.65p per share.
• Obviously the higher the dividend the better for shareholders! The lower the dividend per share might mean that the company is retaining profit for investments!
Dividend Yield

Dividend Yield = Dividend per share x 100

Market price of share

• So using the M&S calculation previously, if the share price was 220p on one day… the Dividend yield would be 21.65/220 x 100 = 9.48%
• You would need to compare this figure with past figures & can vary greatly with fluctuations in the stock market!

Ratio formula

Fill in the Shareholder ratios info

Ratio name

NPM of 24%

ROCE of 15%

Debtor days of 20 and Creditor days of 10.

Stock turnover of 12 times?

Dividend per share 80p

Dividend yield 5%

Acid test ratio of 1.8 : 1 ?

Acid test ratio of 0.78 : 1 ?

Gearing of 12% or Gearing of 66% - which is better for the business?

Why is it a bad situation for a company to have a gearing of 90%?

What do these ratios mean?
Textbook p169 B1 ….. Do Q3

Interpreting Ratios

Not too sure about the wobble!

You will need your ratio colour sheet & a calulator

Balance Sheet £m

Non-current assets 19550

Inventories 2375

Receivables 1170

Cash & cash equivalents 2300

Total current assets 5845

Current liabilities (8160)

Net current liabilities (2315)

Non-current liabilities (6000)

Net assets 11235

Share capital 6000

Reserves & retained earnings 5235

Total equity 11235

Income Statement £m

Revenue 35400

Cost of sales (30100)

Gross profit 5300

Expenses (720)

Operating profit 4580

Finance income 300

Finance cost (260)

Profit before tax 4620

Taxation (1109)

Profit for the year 3511

• ROCE
• Gearing
• Current Ratio
• Acid Test Ratio
• Asset Turnover
• Inventory / Stock Turnover
• Payable days (assume payables are 50% of current liabilities for your calculation)
• Receivable days

Profitability ratio

Income Statement £m

Revenue 35400

Cost of sales (30100)

Gross profit 5300

Expenses (720)

Operating profit 4580

Finance income 300

Finance cost (260)

Profit before tax 4620

Taxation (1109)

Profit for the year 3511

Balance Sheet £m

Non-current assets 19550

Inventories 2375

Receivables 1170

Cash & cash equivalents 2300

Total current assets 5845

Current liabilities (8160)

Net current liabilities (2315)

Non-current liabilities (6000)

Net assets 11235

Share capital 6000

Reserves & retained earnings 5235

Total equity 11235

ROCE

Operating profit x 100

total equity + non-current liabilities

4580 x 100

11235 + 6000

4580 x 100 = 27%

17235

For every £1 of capital employed in the business

how 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?

Gearing ratio

Balance Sheet £m

Non-current assets 19550

Inventories 2375

Receivables 1170

Cash & cash equivalents 2300

Total current assets 5845

Current liabilities (8160)

Net current liabilities (2315)

Non-current liabilities (6000)

Net assets 11235

Share capital 6000

Reserves & retained earnings 5235

Total equity 11235

Income Statement £m

Revenue 35400

Cost of sales (30100)

Gross profit 5300

Expenses (720)

Operating profit 4580

Finance income 300

Finance cost (260)

Profit before tax 4620

Taxation (1109)

Profit for the year 3511

• Gearing
• Non-Current Liabilities x 100
• total equity + non-current liabilities
• 6000 x 100
• (11235 + 6000)
• =
• 6000 x 100
• 17235
• =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 to

a business with small profit margins?

Liquidity ratios

Current Ratio

Current Assets : Current Liabilities

5845 : 8160

= 0.716 : 1

For every £1 of CL the firm owes it owns

£0.716 in CA

Balance Sheet £m

Non-current assets 19550

Inventories 2375

Receivables 1170

Cash & cash equivalents 2300

Total current assets 5845

Current liabilities (8160)

Net current liabilities (2315)

Non-current liabilities (6000)

Net assets 11235

Share capital 6000

Reserves & retained earnings 5235

Total equity 11235

Acid Test

Liquid Assets : Current Liabilities

1170 + 2300 : 8160

= 3470 : 8160

= 0.425 : 1

For every £1 of CL the firm owes it owns

£0.425 in CA

Financial Efficiency ratio

Balance Sheet £m

Non-current assets 19550

Inventories 2375

Receivables 1170

Cash & cash equivalents 2300

Total current assets 5845

Current liabilities (8160)

Net current liabilities (2315)

Non-current liabilities (6000)

Net assets 11235

Share capital 6000

Reserves & retained earnings 5235

Total equity 11235

Income Statement £m

Revenue 35400

Cost of sales (30100)

Gross profit 5300

Expenses (720)

Operating profit 4580

Finance income 300

Finance cost (260)

Profit before tax 4620

Taxation (1109)

Profit for the year 3511

• Asset Turnover
• Revenue
• Net assets
• 35400
• 11235
• = 3.15 times

For every £1 of net assets in the business

how 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?

Financial Efficiency ratio

Income Statement £m

Revenue 35400

Cost of sales (30100)

Gross profit 5300

Expenses (720)

Operating profit 4580

Finance income 300

Finance cost (260)

Profit before tax 4620

Taxation (1109)

Profit for the year 3511

Balance Sheet £m

Non-current assets 19550

Inventories 2375

Receivables 1170

Cash & cash equivalents 2300

Total current assets 5845

Current liabilities (8160)

Net current liabilities (2315)

Non-current liabilities (6000)

Net assets 11235

Share capital 6000

Reserves & retained earnings 5235

Total equity 11235

• Inventory/ Stock Turnover
• Cost of sales
• Inventory
• 30100
• 2375
• =12.67 times

On average for how long does this business

hold stock?

What type of business might have this level of

Why might it be more accurate to divide by average

inventory held rather than just inventory?

Financial Efficiency ratio

Income Statement £m

Revenue 35400

Cost of sales (30100)

Gross profit 5300

Expenses (720)

Operating profit 4580

Finance income 300

Finance cost (260)

Profit before tax 4620

Taxation (1109)

Profit for the year 3511

Balance Sheet £m

Non-current assets 19550

Inventories 2375

Receivables 1170

Cash & cash equivalents 2300

Total current assets 5845

Current liabilities (8160)

Net current liabilities (2315)

Non-current liabilities (6000)

Net assets 11235

Share capital 6000

Reserves & retained earnings 5235

Total equity 11235

Payables (Creditors) days

Payables x 365

cost of goods sold

Assumed payables are 50% of current liabilities

4080 x 365

30100

= 49 days

Receivables (Debtors) days

Receivables x 365

Revenue

1170 x 365

35400

= 12 days

Interpreting Ratios

You can calculate Net Profit and another profitability ratio!

• Dodgy scanning

Non current assets

Working Capital = CA – CL

= 280 – 200 = 80

Capital Employed = Share capital + reserves

Interpreting Ratios

ROCE = op profit / capital employed

NPM = net profit /turnover

10% of 1,460,000

180/1460 x 365 = 45 days

### HOMEWORK 2

Yellow Work booklet – 5 pages…