accounting formulas

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InternationalAccounting and

Finance

Chapter 6: Analysis of FinancialStatements: Ratios

Christopher Nobes


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This chapter was prepared for the University of London by:

Christopher Nobes, School of Management, Royal Holloway, University of London

It is part of a series of chapters developed for the module on International Accounting

and Finance by the same author, and published by the University of London. This chapter

contains some material from an earlier version prepared by Bill Ryan. We regret that the

author is unable to enter into any correspondence relating to, or arising from, this chapter.

Correspondence should be addressed to the module leader, via the WWLC.

Publications Office

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Published by the University of London Press

Royal Holloway, University of London 2011

Printed by Central Printing Service, University of London

All rights reserved. No part of this work may be reproduced in any form, or by any means,

without permission in writing from the publisher.


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Chapter 6: Analysis of Financial Statements:

Ratios

Introduction

Overview

In this chapter we are going to look at the analysis of financial statements. One method of

analysis is to use ratios, that is to put one number in the context of another number. Business

ratios of one form or another are what guide the management of business enterprises. They

are beneficial to managers as they strive to develop and direct the long-term strategies of theorganisation. Outsiders (such as shareholders, financial analysts and the bank manager) also

use ratios. The sort of data and ratios of interest inside the organisation may be different from

those of interest to, for example, the investment community who are interested on behalf of

their shareholders.

Some investment analysts make a substantial amount of money analysing the financial

statements of companies in order to provide advice to current and potential investors on

whether they should buy or sell shares in certain companies. These analysts may construct

very complex and sophisticated spreadsheets in order to analyse company financial

statements to derive their conclusions. However, no matter how sophisticated the

spreadsheet, the aim of the analysis will be the same as that which we undertake in this

chapter. It is all about assessing the companys long-term performance and short-termstability. The aim of analysing the financial statements is to build up a picture of how the

company has been performing and how it is likely to perform in future in order to take

decisions. There is a lot of information in financial statements. The financial analysis should

help the user to distil the information into a more manageable form. With financial analysis

often called ratio analysis we calculate ratios based on financial statements which can help

to simplify our analysis.

Different users of financial statements will be looking for different information from their

analysis and you should always consider what the aim of your analysis is, as that will help you

decide exactly what analysis you should undertake. Suppliers to the company are going to

want to know if the company has enough liquidity to pay them in the short-term future.

Investors are going to want to know whether they should invest in the company. Investors willprobably look at all aspects of the company, but may concentrate on profitability and any

aspects that particularly affect their share-holdings and the growth potential of their

investment. Managers of a company are going to be interested in all aspects of their

company, but mainly in the operational aspects.

The main perspective taken in this chapter will be that of the investor. We will start by giving

you some background analysis as a context for your financial analysis. Subsequently, we will

put financial analysis in an international context and highlight some of the problems of

undertaking comparative financial analysis in an international context. We will also provide

you with a self-test question to reinforce your understanding of financial analysis.


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International Accounting and Finance

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Learning Outcomes

After studying this chapter, you will be able to:

Understand the contextual environment in which we apply financial ratios

Identify the differing needs with various operational contexts for ratio analysis

Explain the calculation and application of ratios in the areas of profitability, efficiencies,liquidity, etc. and apply them to a set of financial statements

Calculate different ratios from supplied company details and interpret these ratios

Explain the different classifications of f inancial ratios

Explain the limitations of ratio analysis

Explore the results of ratio analysis in terms of what it tell us about the organisation


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Chapter 6: Analysis of Financial Statements: Ratios

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Contents

Introduction 1

Overview 1

Learning Outcomes 2

6.1 Introduction to analysis 4

The decision to invest 4

Activity 6.1.1 4

Making meaningful comparisons 4

6.2 Profitability ratios 5

Activity 6.2.1 6

Activity 6.2.2 6

6.3 Efficiency ratios 6

Activity 6.3.1 7

Industry and country impacts on ratios 7

Activity 6.3.2 8

6.4 Liquidity and gearing ratios 8

Activity 6.4.1 9

6.5 Investment ratios 11

6.6 Methods of financial analysis 11

Limitations of ratio analysis: creative accounting 12

6.7 An approach which puts financial analysis into context 12

Self-assessment activity 15

Feedback on activities 17


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6.1 Introduction to analysis

Companies need funding and the primary source for public companies is the shareholding

community. In this section we are concerned with how analysis of the company's financial

statements might affect decisions about investing and also, importantly, about operational

performance. The big issues for the interested parties are assets, profits, growth and cash

flow, all of which are interconnected.

The decision to invest

Let us begin by taking a simple example and an exercise. Try to answer the question below

from your own knowledge and experience.

Activity 6.1.1

You are faced with a company in which you could invest. It has a net profit of 34 million.

Should you invest in this company, based on this net profit figure? Obviously, you would want

to see whether 34 million was a good profit figure or a bad profit figure compared to

something. Comparison is of the essence here. You need to compare the 34 million with

something to see whether the company has done well or not.

Against what could you compare the 34 million net profit to decide whether the company

had done well?

See Feedback on Activities.

Making meaningful comparisonsIn order to make any meaningful financial analysis, some comparison is necessary, as is

some understanding of the business context in which the company is operating. A company

may have made large net profits and be seen as an attractive investment, but if all other

companies in the same sector have also made large net profits, as it is a growing market in

that sector, then looking at the company on its own as a good performer may be misleading

without looking at how it performed in comparison with other similar companies.

Types of ratio

Financial analysis is undertaken by calculating many different ratios and these can be

classified into five main groups, as summarised in Table 6.1.

Table 6.1: The different types of ratios

Type Reflects Examples

Profitability Performance of the company andits managers

Return on capital employed,and gross profit %.

Efficiency Efficiency with which certainresources have been used in thecompany

Average debtors, creditorsand stock days. Sales peremployee.

Liquidity Reflects the ability of a firm tomeet its short term obligations

Current ratio.Acid ratio.

Gearing Main issue is the degree to which

the business is financed byborrowing as against financeprovided by the owners of the firm

% of business funded by

long term loans.Interest cover ratio.


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Investment Reflects the desirability of rewardsto investors as they assess thereturns on their investments

Earnings per share.Price/Earnings ratio.Dividend yield.Dividend cover.

6.2 Profitability ratios

Financial ratios include profitability, efficiency and liquidity ratios along with some illustrative

examples. This section examines profitability.

You will find the approach to calculating these key profitability ratios well explained in your

textbook (Chapter 7) and other readings for this chapter. Here we provide summaries and we

add some comments to highlight certain aspects of the calculations.

Net profit margin

This ratio is calculated as:

Net profit margin = net profit before tax

sales

You could calculate a gross margin as:

Gross profit margin = gross profit

sales

You can also calculate narrower versions of ratios, such as:

Expenses-to-sales = expenses

sales

Inter-company comparisons of net profit margins can be very useful and it is especially

important to look at businesses within the same sector. For example, food retailing is able to

support low margins because of the high volume of sales. A manufacturing or knowledge

company would expect higher margins.

Return on capital employed (ROCE)

This ratio is calculated as:

ROCE = net profit before interest on long-term borrowings

owners equity plus long-term borrowings

It is also possible to calculate a narrower ratio: the return for the shareholders. This is called

return on equity and can be calculated as:

net profit


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ROE =

owners equity (= share capital + reserves)

The ratio shows how efficiently a business is using the resources at its disposal. If the return

is very low, the business may be better off selling all its assets and investing the proceeds in

a high interest bank deposit account. This might be an extreme view but at least the point is

made that the ratio needs improvement and/or explanation.

Once calculated, ROCE should be compared, inter alia, with the cost of borrowings. If the

cost of borrowing is 15% and the ROCE is 10%, then, if the company needs to borrow funds,

it may soon run into financial trouble.

ROCE should also be compared with other companies in the same industry. Differentindustries will tend to have different ROCEs so you should not generally compare ROCEs

across industries. However, even within an industry, care is required with such a comparison

because there may be different accounting policies (e.g. on deprecation and stock valuation)

and different ages of fixed assets. Where plant and equipment are written down to low net

book values, the ROCE will appear high.

Now is a good time to test your understanding so far. Try to use your current work experience

or knowledge to answer the following question.

Activity 6.2.1

Identify for your company what are the standard net profit margins and return on capital

employed figures for the industry in which it operates. Your company accountant should be

able to give you this information.

No feedback available for this activity.

Activity 6.2.2

In the Financial Accountingtextbook, try exercise 7.1 at the end of Chapter 7. Then, you can

check your answer by looking at Appendix D to the book.

6.3 Efficiency ratios

Your reading for this chapter (especially Chapter 7 of the Financial Accountingtextbook) will

inform you on how to undertake the calculations of these ratios. Here is a summary and

some extra points.

Efficiency, working capital and the cash operating cycle


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In a company, the efficiency with which it manages its cash operating cycle can be crucial to

the amount of cash that it needs for its operation. The investment made in working capital by

a company is largely a function of sales and, therefore, it is useful to consider the problem in

terms of a firm's cash operating cycle.

The firms cash operating cycle reflects the amount of cash tied up in the business due tothe length of time for which inventory (finished goods, work-in-progress and raw

materials) and receivables (debtors) are held, less the length of time taken to pay trade

creditors. The longer this cash operating cycle, the longer the business will need to fund

the cycle.

To put it another way, if a retail company holds inventory for 30 days before selling it; the

companys debtors take a further 40 days to pay; and trade creditors for the inventory are

paid within 20 days, the company has to fund the cash operating cycle in some way for

30+4020 days = 50 days. In that 50 days, no money from debtors will be received.

Therefore, to be efficient, a company wants to minimise this cash operating cycle. Ideally, the

company wants to have a negative cash operating cycle by receiving money from debtorsbefore it has to pay its creditors.

The faster a company can 'push' items around the operating cycle, the lower its investment in

working capital will be. However, too little investment in working capital can lose sales for the

company since customers will probably prefer to buy from suppliers who are prepared to

extend trade credit and if items are not held in stock when required by customers, sales may

be lost.

It is always worth calculating a companys cash operating cycle if there is sufficient

information, as this will give an indication as to how much investment the company needs for

its working capital.

Efficiency ratios can also be called funds management ratios. The obvious ones are:

- Debtors collection

- Creditors payment

- Inventory holding period

You will remember that debtors and creditors are often shown in balance sheets as

receivables and payables. It is particularly the amounts related to customers and suppliers

that are relevant here. These might be called trade receivables and so on.

The ratios can be defined as follows:

Debtors collection in days = Trade payables x 365

sales

Creditors payment in days = trade receivables x 365

cost of goods soldInventory holding period in days = inventory x 365

cost of sales

Activity 6.3.1

Try out your calculations on Question 7.3 at the end of Chapter 7 in the Financial Accounting

textbook. Feedback on this can be found in Appendix D at the end of that book.


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You will find that liquidity ratios are described in detail in your reading. A summary is given

here. The two most common liquidity ratios are:

Current (or working capital) ratio = current assets

current liabilities

Acid test (or quick ratio) = current assets - inventory

current liabilities

The current ratio gives an impression of whether the short-term assets are sufficient to pay

the short-term liabilities. The acid test is more careful, by excluding the inventory, which might

take some time to turn into cash.

Gearing (or leverage) is connected to the measurement of liquidity. Gearing can be defined in

several different ways. Here are two common versions:

Gearing1 = debt

equity

Gearing2= debtequity + debt

As usual, it is important to stick to the same definition from year to year or from company to

company. Either way, increased gearing means increased risk of not being able to pay

interest or loans falling due. These gearing ratios also tell you something about likely future

profitability. High gearing means that the shareholders will gain more if the company is

profitable. Consequently, gearing ratios can be included under the heading of measuring

profitability.

A connected ratio that is more clearly to do with liquidity is:

Interest cover = net profit before interest and tax

interest

A high cover shows some safety.

Activity 6.4.1

Try out Questions 7.2 and 7.4 at the end of Chapter 7 of the Financial Accountingtextbook.

The feedback for these is in Appendix D at the end of that book.

A number of points are worth emphasising here. A company's gearing ratio is considered

very important by outside analysts. This is because the more highly geareda company is, the

more risky any investment in that company is. On the other hand, a company with very little

gearing, i.e. loans, may not be using the most cost effective forms of finance. Here we will

just give you a simple arithmetical example to show why a company with higher gearing is

considered more risky, and the impact on costs of finance.


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The implications of high or low gearing

The importance of gearing for company cost of finance (through tax deduction) and risk can

be illustrated by an example as follows in box 6.A. Once you have thought through the

contents of this exercise, you should complete your reading for topic.


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Box 6.A An example of the implications of gearing

Two companies, Alpha and Beta both have capital of 10,000. All of Alphas capital is equity

shares of 1 each.

Beta has 5,000 1 equity shares and 5,000 10% debentures.

Both companies earn profits of 5,000 in year 1 and 3,000 in year 2. The corporate tax rate

is 30% and the dividend paid is 10p per share.

The position over the two years will be as follows:

Balance sheets Alpha Beta

Shares 10,000 5,000

Debentures - 5,000

10,000 10,000

Income statements Alpha Beta

Yr 1 Yr 2 Yr 1 Yr 2

Profit before tax and interest 5,000 3,000 5,000 3,000

Interest - - 500 500

5,000 3,000 4,500 2,500

Taxation (30%) 1,500 900 1,350 750

Profit after tax 3,500 2,100 3,150 1,750

Dividend (10p per share) 1,000 1,000 500 500

Retained profits 2,500 1,100 2,650 1,250

Earnings per share* 35p 21p 63p 35p

* This is the amount of profit after tax divided by the number of shares.

You can see the effect of Betas gearing as follows:

(a) The debenture interest is an allowable deduction for tax, but dividends are paid out of

profits after taxation. Therefore, though both companies have paid out 1,000 to their

finance providers (debt and share holders), Beta plc has consistently higher retained

profits than Alpha.

(b) The earnings of a highly geared company are more sensitive to profit changes. Thus,

shareholders in Beta have seen a wider swing in their earnings per share held over the

two years (from 63 pence per share to 35 pence per share). Thus a highly geared

company is seen as more financially risky.

Manipulating the gearing ratio

As gearing is such an important ratio for companies and investors, it is also a ratio that

companies may try to manipulate. A common way of manipulating gearing to give a false

impression is to keep loans off the balance sheet in some way. One way of doing this is to


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have a large number of leases that are treated as operating leases. Another is to try to

transfer liabilities to companies that are not consolidated. This was one of the tricks used by

Enron before its collapse in 2001.

6.5 Investment ratios

In this section we will review the basic investment ratios that are well covered in your reading

for this chapter, in particular Sections 7.8 and 17.2 of the Financial Accountingtextbook. Two

of the ratios are considered as crucial in any company analysis:

Earnings per share and

The P/E ratio

Earnings per share is defined as follows:

EPS = earnings for the ordinary shareholders

number of ordinary shares

The reference to ordinary shares reminds you that some shares are preference shares

(see Chapter 2 of this course). So, the earnings is after deducting any dividends for the

preference shareholders. You will remember (from Chapter 4 of this course) that there are

two sorts of income statement. The earnings is before addition of other comprehensive

income.

The price/earnings ratio is defined as:

P/E = market price of one share

EPS

Using todays market price and the latest available EPS, the ratio is a measure of how much

an investor would have to pay for a given amount of annual earnings. A high ratio suggests

that the market expects good future growth.

6.6 Methods of financial analysis

There are many suggested methods of undertaking a financial ratio analysis of a company.

We suggest you adopt something along the following lines.

1. Undertake a survey of the general business environment along the lines that we

discussed above.

2. Obtain as much information on the company as is possible.

3. Proceed to undertake as detailed an analysis as is possible of the company results.

4. Work out what has happened in the company by comparing for example, different time

periods and different elements within those time periods.

5. Write up your results.

This approach imposes a formality on your conclusions that make them worthy of

presentation to, for example, the board, or your management.

In any question involving ratio analysis, after you have calculated a ratio, you will need to

discuss your analysis. In your discussion, the following points may serve as a useful structure

for your analysis:


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(a) Why might the change in the ratio have occurred? E.g. if the current ratio has increased,

is this because the company is holding more stock?

(b) What is the norm for this ratio? E.g., you could compare the ratio with the industry

average or with the companys stated policy for that ratio.

(c) What are the limitations of the ratio? E.g. how is the ratio affected by certain accounting

policies?

Limitations of ratio analysis: Creative accounting

This is a phrase which has been used to describe the attempt by companies to improve the

presentation of their financial accounts so as to mislead users. It is not that it is (usually)

fraudulent, but as there is always some latitude in the preparation of financial accounts,

companies may make full use of this latitude. This topic is well covered in your reading and

you should make sure you have read this before proceeding.

6.7 An approach which puts financial analysis into contextThe other point to understand is that financial analysis of financial statements is only a

starting point for a further analysis of a company. For example, a decline in the gross profit to

sales ratio for a business could arise for several reasons:

The company could be offering trade discounts to its customers.

The company could have more inventory obsolescence that usual.

There could be a change in the mix of products offered.

The company may have reduced its selling price.

All these could be valid reasons for the change. Ratios point you in the direction where you

should undertake further analysis. In themselves, ratios do not give answers to why a

business performs as it does. That is why it is essential to look behind the numbers for

answers. For example, if a company had to reduce its selling price and this resulted in a drop

in profitability, it may be due to its product range becoming mature, out of date and could also

explain an amount of obsolescence. All of these indicators might steer us in the direction that

the company needs a new product. Note that the performance of an individual company must

be judged against the performance of the whole sector.

So, for an investor in a company, it is important to understand the business context in which

the company is operating. Then the investor can make more sense of the financial analysis.

Over thirty years ago, Michael Porter outlined a model to help companies formulate a strategy

by understanding the competitive situation in their industries. The basis of his model was that

potential profitability in an industrial sector is determined by five factors:

1. Ease with which new entrants can join the industry

2. Bargaining power of the industry's suppliers

3. Bargaining power of the industry's customers

4. Availability of alternative products and services which could meet the needs currently met

by the industry

5. Behaviour of existing players in the sector

The potential profit for the industry will depend, for example, on how easily other competitors

could join the industry. This approach of looking at the competitive nature of the industry can

provide a rich context to our financial analysis. Below is a checklist of the factors Porter

suggested are important in determining the importance of each of the

above aspects of industry structure1. These characteristics apply to an 1 The list is drawn from M. Porter

(1980), Competitive Strategy, Free

Press.


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industry or sector, rather than a firm, but they are very useful as a way of setting the scene for

any analysis of the firm's performance.

Threat of new entrants - barriers to entry Economies of scale

Product differentiation

Capital requirements

Switching costs

Cost disadvantages independent of size (e.g. learning curve; government subsidies)

Access to distribution channels

Government policy (e.g. re-licensing)

Bargaining power of customers(the following factors will limit profits that can beachieved in an industry)

If there is a concentration of customers (e.g. only a few)

It faces few switching costs

Standard or undifferentiated products

Product represents a significant proportion of customer's costs

Buyer is in a low-profit industry

Product is unimportant to the quality of the buyer's product or service

Buyer poses a credible threat of backward integration

Bargaining power of suppliers(the following factors will also limit the profit that can be

achieved in an industry

Supplier's industry is dominated by a few companies or is more concentrated than the

industry it is selling to

Input is unique, differentiated or has switching costs

Input cannot be easily substituted by a similar product

Supplier poses a credible threat of forward integration

Industry is not an important customer of the supplier

Threat of substitute products or services

The availability of any substitutes will limit the price and therefore potential profit in the

industry.

Intensity of rivalry among current contestants (intense rivalry, limiting the total profit

achieved by all players in an industry)will increase with the following factors:

Many players of roughly equal size

Slow rate of growth in the industry (life cycle)

Lack of differentiation or switching costs

Fixed costs represent a high proportion of total costs

Capacity that can only be increased in large increments

High exit barriers

Rivals diverse in strategy, origin and personality

This type of industry analysis provides a background to financial analysis in so far as it helps

to identify what sort of financial analysis profile you would expect to find. For example, in a


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very competitive industry you would expect to see low net profit to sales ratios. You would

want to analyse your company to see how it is coping with the competition and whether it has

any particular competitive advantage: e.g. is it the lowest cost provider in its industry?


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Self-assessment activityWe will finish this chapter with a self-test question, for you to use as revision of the ratios

Zanzo Co.

Zanzo Co. is a retail company that sells toys from its four shops. It obtains the toys from a

few, very large, suppliers. There are few other toy shops in its localities, but it is beginning to

find that there is competition from Internet-based suppliers. In the last year, Zanzo has

diversified into computer games.

Zanzo Co: Balance sheets as at 31 December

20X5 20X4

'000'000 '000 '000

Non-current assets

Land & buildings 940 762

Fixtures and fittings 125 128

1,065 890Current assets

Inventory 740 600

Receivables 420 490

Cash 80 57

1,240 1,147

Current liabilities

Trade payables 230 440

Other 147 80

Company tax due 152 130

529 650

Net current assets 711 497

Non-current assets + net current assets 1,776 1,387

Long-term liabilities

10% Debentures 500 400

1,276 987

Capital and reserves

0.50 Ordinary shares 671 609

Other reserves 80 131

Retained profits 525 247

1,276 987

Income statements Zanzo Co. for years ended 31st December

20X5 20X4

'000 '000 '000 '000

Sales 5,459 4,481

Less Cost of sales

Opening inventory 600 482

Purchases 4,284 3,608

4,884 4,090

Less closing inventory 740 4,144 600 3,490

Gross profit 1,315 991

Wages and salaries 512 460

Interest payable 52 48

Other costs 174 132


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738 640

Net profit before tax 577 351

Company tax 152 130

Net profit after tax 425 221

Add retained profits b/forward 247 106

672 327Dividends paid 147 80

Retained profit c/forward 525 247

All sales and purchases are made on credit.

The market value ofthe shares of the company was 7 at 31st December 20X5 and5 at 31st December 20X4.

The issues of equity shares during 20X5 was at the beginning of the year. Dividendsof 6.6 pence per share were paid in 20X4, and of 11 pence per share in 20X5.

Calculate the following ratios for 20X4 and 20X5 and comment on the companys

performance:

Profitability Return on Capital Employed

Gross profit margin

Net profit margin

Efficiency Inventory days (using the year end balances)

Debtors and creditors days (using the year end balances)

Liquidity Current and acid test ratios

Gearing Gearing ratio

Interest cover ratio Investment Earnings per share

Price/Earnings ratio

Dividend yield

What other "key driver" ratios would be a useful calculation for this company?

Do you think Zanzo Co. operates in a competitive industry?


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Feedback on activities

Activity 6.1.1Against what could you compare the 34 million net profit - fairly - to decide whether the

company had done well?

Here are some suggestions:

Compare against a similar-sized company in the same industry

Compare against what the company intended to do.

Compare against what the company has done in the past.

Compare the net profit to the sales of the company as a percentage to see what net profit

it generated from each sale

Compare the net profit to the net assets of the company as a percentage to see return the

company has generated from the net assets ( a little like calculating the interest rate on a

deposit account)

Activity 6.3.2

Based on this description, what do you think would be a key driver of profitability for an asset

management company?

A key driver would be the size of funds under management. The larger the funds under

management, the larger the potential profits. Thus any key efficiency indicators are likely to

be linked to the funds under management, e.g. % of admin costs to funds under

management.

Self-assessment activity

Zanzo Co.

Return on capital employed

Profit before interest and tax x 100%

Non-current assets + net current assets

20X5 20X4

577+52 x 100% = 35.4% 351+48 x 100% = 28.8%

1,776 1,387

We do not know if this is a good or bad ratio in itself, but we can say that it has improved over

the year. There are two fundamental reasons why this could have changed due to changes

in profitability and changes in utilisation of assets.


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Gross profit margin

Gross profit x 100%

Sales

20X5 20X4

1,315 x 100 = 24.1% 991 x100% = 22.1%

5,459 4,481

One normally expects this % to remain reasonably constant. Here we can see that it has

improved. This may flow from the move to computer games which may have a higher gross

margin.

Net profit margin

Net profit x100%

Sales

20X5 20X4

577+52 x 100 = 11.5% 351+48 x100%= 8.9%

5,459 4,481

This has increased. You could look into further detail to see which decrease in costs has led

to this change by calculating the % cost of each of the cost lines (wages and salaries, and

other costs) as a percentage of sales. Then, you would want to look behind the figure (e.g.,

other costs) to see what has happened to decrease these costs, relative to sales.

Efficiency ratios

Inventory days

Inventory x 365

Cost of sales

20X5 20X4740 x 365 = 65.2days 600 x 365 = 62.8days

4,144 3,490

This ratio has shown a slight increase. It may mean that the some new products are not

selling so well. Another consideration is that in the UK toy industry, one of the busiest times

of year is in the two months before Christmas. One would expect a very low inventory

turnover as stock comes in and is quickly sold. To have a stock holding ratio of 65 days at

the end of December i.e. just after Christmas, would seem to be very inefficient.


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Debtors days

Trade receivables x 365 days

Sales

20X5 20X4

420 x 365 = 28.1 490 x 365 = 39.9

5,459 4,481

This ratio has shown a marked improvement over the year. Cash from debtors/receivables is

being received a lot quicker. There would need to be some further analysis to see why this is

the case (has Zanzo set stricter credit limits? Have there been changes in the industry?)

However, even 28 days would seem to be a high ratio for a retailer where most sales would

be for cash, or near cash.

Creditors days

Trade payables x 365 days

Purchases

230 x 365 = 19.6 440 x 365 = 44.5days

4,284 3,608

Unfortunately, this has also seen a decrease over the year, which means that

creditors/payables are being paid faster. This could cause future cash flow problems if Zanzohad not also improved debtor collection. It may be that the new computer games supplier has

demanded shorter payment periods. It could also be that the few large suppliers are

extracting quick payments from Zanzo.

Liquidity Ratios

Current ratio

Current assets

Current liabilities

20X5 20X4

1,240 = 2.3 times 1,147 = 1.8 times

529 650

Acid test or quick assets ratio

Current assets - inventory

Current liabilities


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21

20X5 20X4

1,240- 740 = 0.95 times 1,147- 600 = 0.84 times

529 650

Both ratios have seen an increase over the year. This may be good news (less chance of

liquidity problems), but it may also reflect inefficient management of working capital e.g. stock

holdings. To understand whether this is a problem for Zanzo, one would have to know more

about the industry. The two ratios seem somewhat high for a retail company. Current ratios

could be less than one in the retail sector.

Gearing

Loans x 100%

Ordinary share capital + reserves + loans

20X5 20X4

500 x 100 = 28.2% 400 x 100 = 28.8%

1,276+500 987+400

This has remained constant over the year, even though more long term loans have been

taken out.

20X5 20X4

Interest cover ratio

Profit before interest and tax

Interest payable

577+52 =12.1 351+48 = 8.3

52 48

The large increase in interest cover shows that the company has plenty of interest cover.

Maybe it could safely take on more debt?

Earnings per share (EPS)

Earnings available to ordinary shareholders

Number of ordinary shares in issue

20X5 20X4

425 = 0.32 221 = 0.18

1,342 1,218

The dramatic increase in EPS reflects the increase in profit after tax, with only a small

increase in the number of shares over the year.


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P/E = Market value per share

Earnings per share

20X5 20X4

7.00 = 21.9 5.00 = 27.8

0.32 0.18

The fall in the P/E ratio could reflect the fact that the stock market does not believe that the

increase in earnings will continue. Alternatively, it could mean that here is a bargain share

with potential where its growth prospects have not been recognised by the stock market.

What other "key driver" ratios would be a useful calculation for this company?

As this is a retail company selling through stores, any measure of sales per square metre or

per employee would be very useful.

To decide whether Zanzo operates in a competitive market, you need to obtain a lot more

information about the market. However, given the way in which Zanzo only has a few large

suppliers, the way in which it is easy to enter Zanzos market (e.g. via the Internet) and the

nature of the product customers can easily switch it is probably fair to state that the

market is competitive.

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