Interpretation of Accounts Ratio Analysis http://www.bized.ac.uk/compfact/ratios/index.htm
The need for ratios • To examine the profitability of the firm. • To find out the ability of the firm to meet it’s debts (liquidity). • To see how efficiently the managers of the firm uses its resources. • So that investors in the firm can see the returns on their investment.
Profitability Ratios: ROCE • Return On Capital Employed (ROCE) Net profit before tax & interest X 100 Total capital employed Expressed as a percentage
Using ROCE • Larger figures indicate higher profitability • Must be compared with previous year or similar firm to be meaningful.
Profitability Ratios: Gross Profit Margin • Shows gross profit as a percentage of sales GPR = Gross Profit X 100 Total sales revenue • Does not show the impact of overheads on profits.
Profitability Ratios: Net Profit Margin • Shows net profit as a percentage of sales. NPM = Net profit X 100 Total sales revenue • Should be compared with previous period or with similar business
Gross & Net profit margins • How are they linked? • If the NP margin goes down more than the GP margin what does this mean? • Remember, GO and NP are linked in the profit and loss account, and so they are linked here!
Liquidity Ratios • Measure the indebtedness of the firm. • Current Ratio = Current Assets Current Liabilities • Expressed as a ratio eg 3:1 • Not expressed as a percentage! • Ideal value = 1.5:1 or 2:1
Low Current Ratio: Overtrading & over-borrowing • When the ratio is too low for the firm to meet its debts. • Overtrading.
High Current Ratio • Suggests the firm is not making full use of its current assets (eg cash idle in a bank a/c)
Limitations of Current ratio • Suggests that stocks can be liquidised quickly, and at a fair value. This is not always the case. They can become obsolete or deteriorate. SO….
Acid Test Ratio • Does not treat stocks as liquid assets Acid Test Ratio = Current Assets – stocks Current Liabilities • A value of 1:1 is considered acceptable
Shareholder Ratios • Return on Equity = Profit after tax, interest & pref. dividendsX 100 Ordinary Share Capital
Shareholder Ratios (cont’d) • Earnings per Share = Net profit (after tax and Pref. dividend) Number of shares This shows how much profit each share has earned for the business. The directors will use this figure to help decide dividend payments
Shareholder Ratios (cont’d) • Dividend Yield = Dividend per shareX 100 Market value of shares
Efficiency Ratios • Stock Turnover This shows how many times over the business has sold the value of its stocks during the year. STOCK TURNOVER RATIO =Cost of Goods Sold Average Stock (Sometimes Sales is used if Cost of Goods Sold not available)
Efficiency Ratios The higher the stock turnover the better, because money is then tied up for less time in stocks. A quicker stock turnover also means that the firm gets to make its profit on the stock quicker, and so the firm should be more competitive. However, it will vary between industries and so it is important to compare within an industry, as well as from year to year.
Efficiency Ratios • Trade Debtor Collection Period = Trade Debtors X 365 Sales Revenue (Credit) A low value means that the firm is managing its debtors well. A higher value indicates that debtors are taking longer to pay. The firm would need to investigate this further.
Efficiency Ratios • Trade Creditors Payment Period = Trade Creditors X365 Total purchases A longer period means that it is taking the business longer to pay its debts to its creditors. This could be an advantage (ie free credit) or indicate a problem (lack of money to make payments!). It can also prove disastrous as it may force suppliers into bankruptcy.
Efficiency Ratios • Gearing Ratio Loan capital (+ Preference Capital)X100 Total Capital A higher % means that the firm must pay more interest on profits each year. Failure to do so could lead to insolvency. A lower % is preferable since shareholders will only be paid a dividend out of profits if the directors feel that the firm can afford it.