Interpreting published accounts (Part 1)

You should now be able to :

1. Understand how to select, calculate and interpret financial ratios to assess performance.

Learning Objectives

But what is financial data used for?

nTHINK

PAIR

SHARE Inter-firm comparisons Intra-firm comparisons Trend analysis Decision-making Attract investment Monitor success/

failure

Which supermarket?

The 2006 annual accounts for Sainsbury and Tesco showed the following financial information:

Sales RevenueOperating ProfitDividend per shareAverage share price for a year

£16,061m£229m

7.8p3.17p

£39,454m£1,788m

8.63p3.50p

Based on the information above, which supermarket would you invest in and why?

What other information would be useful in helping you make an informed decision.

Ratio analysis provides the users of accounts with tools that allow for a more meaningful interpretation of published accounts.

It does this by comparing one item of financial data

to another.

Ratio Analysis

Liquidity Ratios

Liquidity measures a firms ability to meet day-to-day expenditure.

By comparing current assets and liabilities is assesses if a firm has sufficient short-term assets to cover short-term debts.

Two common measures: Current Ratio Acid Test

Used to measure how liquid or in-credit the business is:

This means that for every £1 of current liabilities , the firm has £3.00 in current assets.

Ideal is 2:1

Below – not enough cash coming in/ Above – should consider investing some of the money.

LIQUIDITY RATIOS(The Current Ratio)

Current Assets = X:1Current Liabilities

E.g: £60,000 = 3.00:1 £20,000

Similar to Current Ratio but does not include inventories (stock) in case the business cannot turn it into cash.

This means that for every £1 of current liabilities, it only has £0.70 in current assets excluding inventories.

If there is a large difference between the current ratio and the acid test then it means that there is a problem with stock.

Ideal is 2:1

LIQUIDITY RATIOS(The Acid Test)

Current Assets - Stock = X:1Current Liabilities

E.g: £33,924 = 0.70:1 £48,210

Calculate the current ratio and acid test ratio for Alquimia Plc.

Compare the results – what can you tell from the data?

What advice would you give?

Your turn!

Where does the information come

from?

Profitability Ratios

Profitability ratios allow for the analysis of a firms profits in relation to it’s trading performance, i.e. – its sales revenue, or the capital utilised in generating that profit.

Two common measures: Gross Profit Margin Operating profit margin (OPM) Return on capital employed

(ROCE)

Shows efficiency within a business.

Compares the gross profit with sales.

If % increasing then it is improving Sales (increasing) Cost of sales (decreasing)

Means that for every £1, £0.25 is gross profit after cost of sales have been paid.

PROFITABILITY RATIOS(Gross Profit Margin)

Eg: £20,000 x 100 = 25% £80,000

Gross profit x 100

Sales

Shows efficiency within a business with regard to operating (or net) profit.

Compares the net profit with sales

If % increasing then it is improving and more sales are being turned into profit Less money being spent on expenses

Means that for every £1, £0.12 profit is made after expenses have been paid.

PROFITABILITY RATIOS(Operating Profit Margin (OPM)

Eg: £10,000 x 100 = 12% £80,000

Operating Profit x 100 Sales

Shows the % of profit the business has made on the amount of money invested in the business.

If % increasing then it is improving.

Means that for every £1 capital invested, £0.14 profit was generated in that financial year.

May not be high in comparison to high street banks but some businesses may wait to become more established before getting higher returns.

PROFITABILITY RATIOS(Return on Capital Employed - ROCE)

Eg: £1250 x 100 = 14% £30,000

Operating Profit x 100Total Equity + Non-current liabilities

Calculate the Gross Profit Margin, OPM and ROCE for Alquimia Plc.

Compare the results – what can you tell from the data?

What advice would you give?

Your turn!

Where does the information come

from?

Create a question to test another student in the group.

Don’t forget to note the answer!

Create a question!

You should now be able to :

1. Understand how to select, calculate and interpret financial ratios to assess performance.

Re-cap Learning Objectives