#3198 - Interpreting Accounts - Business Accounts

EXAM Technique:

1. Identify the ratio

2. What is the formula

3. What is the ratio trying to measure

4. Compare 2 different years

5. Is the result going up or down

6. Is this good or bad? What does it mean?

7. Comment / Observation – be sensible – look at the accounts as a WHOLE!

Gross Profit Percentage (margin)

• Tells us how well the business is operating.

• It indicates the % of sales which compromises profit

• Higher the GPP = Higher the profitability of the company’s products.

• Good to have a high percentage

ANALYSIS:

• Does the figure fluctuate?

• Look at ALL the figures (has sales increased / cost of sales / stock (including work in progress) / new machinery? – has this caused a big / little increase in the GPP – if not – why not – use the above table to suggest reasons why.

• If GPP is too low – options include putting up prices and / or cutting cost of sales.

• REMEMBER – profitability is not the same as solvency!

Net Profit Percentage

• Tells us how efficiently the company (or business) is operating – it indicates the profitability of a company after taking into account those expenses EXCEPT loan / debenture interest payments / and tax.

• More useful than GPP

• Good to keep as HIGH as possible.

• Calculating PBIT = add interest back into the figure for profit before tax. (OR add interest and tax to the profit after tax).

• Have expenses increased whilst sales have not? [Look at any fixed assets bought / machinery – is rent or depreciation on reducing basis the reason for increase in expense?].

Return on capital employed (ROCE)

• Indicates the return a company is making on the capital invested.

• Capital employed = shareholder funds and LT liabilities)

• Good to have as high as possible

• Tells us how much profit there is before interest and taxation – showing value for money

• Shows how much your business makes on the capital invested in it.

Asset Turnover

• Tells us about the volume of sales being generated by the amount of capital employed. Shows sales in relation to capital employed.

• E.g. Is Asset turnover is 2 = every 1 invested is converted into 2 of turnover.

• If figure is increasing – analyze why? Is it achieved by the acquisition of other businesses or through trading activity?

• Good to keep high

• Food retailers have a higher asset turnover than many sectors

Current Ratio

• Does the business have enough money to pay its way?

• MUST be more than 1 (this means all current liabilities can be met by realising all current assets)

• Goal – around 1.5 is good [depends on nature of the industry / levels of stock / profit margin]

• If too low – the business has a liquidity problem (but consider stock or cash flow)

• If too high – funds are tied up in working capital.

Acid Test Ration

• Provides a more accurate picture about liquidity of business – by removing stock (because stock can be difficult to shift – it is the lease liquid of current assets [i.e. it takes longer to convert stock into cash].

• Acceptable ratio = 0.8 [but always consider what kind of business it is]

• EXAM: Is the ratio improving or deteriorating over the years?

• Is the business a retailer – maybe acid text ratio is less relevant.

• Compare to the current ratio – has the figure dropped significantly – if yes this means the company does not have many current assets (other than stock) to pay off the current liabilities.

Trade debtor days

• Provides the number of days CREDIT given to customers [i.e. how long the business must wait to get paid by debtors]

• AIM – keep as low as possible (e.g. 40 days est.) – BECAUSE it is important for cash flow reasons.

• Gives an idea of how effective the company is in dealing with trade debtors.

• The fewer the days the greater the liquidity of the business.

• How to reduce – write off bad debt.

• Always consider the NATURE of the business – supermarket (will be low) or antiques store (much higher)?

Trade Creditor days

• Provides number of days it takes business to pay money to its creditors.

• Keep average as HIGH as possible! The more days – the greater the liquidity of the business. Business advantage!

• However – a VERY high number of days may indicate a lack of funds to pay creditors – so beware!

Stock Days

• Provides detail on the turnover of stock – how long is stock hanging around

• The fewer days – the greater the liquidity of the business

• Aim to keep LOW

• What is the NATURE of the business (supermarket or antiques?) This will effect stock days. CONTEXT is key!

• Generally – businesses seek to keep stock days low because it maximizes profits, reduces storage costs and minimizes perishability and obsolescence.

• If figure goes UP – stock remains on premises for longer [but is there any hope for future – e.g. new machinery bought which will get this figure down again?]

Gearing

• Compares the amount of finance borrowed with the amount of finance provided by the owners (equity v debt). The ratio measures the extent to which the company is financed by debt (LT liabilities) as compares to equity capital.

• Gearing identifies how risky an investment is in the ordinary shares of a company. [it is a measure of risk]

• General rule – the more highly geared a company, the greater the risk to ordinary shareholders:

1. Ordinary shareholders may not receive dividends if there is insufficient profit after the interest has been paid

2. If the company is unable to pay its interest obligations and capital repayments as they fall due – the loan creditors may force the company into liquidation.

• HOWEVER – if the company is going well and it is highly geared = ordinary shareholders stand to reap disproportionate rewards [because of the increased profits generated by the borrowing].

• A business relying too heavily on borrowed funds = “overgeared”.

• UK - the norm is low geared companies [more emphasis on short-term planning]

• Increase = greater risk