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Interpretation of Company

Accounts

Wendy Wild
w.wild@chester.ac.uk
Objectives of the Session

By the end of the session you will be able to

• Calculate various financial ratios
• Critically evaluate different financial ratios
• Consider which method is suitable for different
scenarios
• Use ratios to interpret a set of company accounts for
different user groups
Interpretation of Company
Accounts
• Users and user focus
• Introduction to ratios
• Performance
• Short term liquidity
• Efficiency
• Long term solvency
• Investors ratios
• Considerations
• Limitations
Users and user focus

• Users

– Present and potential investors
– Employees
– Lenders
– Suppliers and other trade creditors
– Customers
– Governments and their agencies
– The public
Introduction to ratios

• Summarise financial information and make
understandable

• No use in isolation – need a COMPARISION
– Previous years
– Other companies
– Industry averages
– Budgeted figures

• A means to an end, not an end in themselves
Introduction to ratios

• Ratios divide into the following main areas

– Performance
– Short-term liquidity
– Efficiency
– Long-term solvency
– Investors
Performance ratios

• Ratios include

– Gross profit margin

– Operating profit margin

– Asset turnover

– Return on Capital Employed (ROCE)
Gross Profit Margin

• Indicates how profitable the products are

• Profit purely from trading, before taking into
account of any running expenses

• Formula = Gross Profit / Revenue x 100%
Gross Profit Margin

Possible reasons why it could have changed??
Operating Profit Margin

• Indicates the profits of the business after taking
into account all of the day to day running
expenses

• Formula = Operating profit (PBIT) / Revenue x
100%
Operating Profit Margin

Possible reasons why it could have changed?
Asset Turnover

• How efficient the company is at creating revenue
based on the money it has invested in it

• Formula = Revenue/Share capital and
reserves + Loans + Overdraft
Asset Turnover

• Possible reasons why it could have changed:
Return on Capital Employed
(ROCE)

• How efficient the company is at creating profits
based on the money it has invested in it.

• Formula = Operating profit (PBIT)/Share
capital and reserves + Loans+ Overdraft

• ROCE can be sub-divided into operating profit
margin, and asset turnover.
Return on Capital Employed
(ROCE)

ROCE Operating profit Asset turnover

Operating profit Operating profit Revenue /
(PBIT)/ (PBIT) / Share capital +
Share capital + Revenue X reserves + loans +
reserves+ = overdraft
loans + overdraft
Return on Capital Employed
(ROCE)
• Profit margin = quality of the products or services
• Asset turnover = quantity of products being sold

• Trade off may exist

• Low margin businesses (e.g. food retailer) usually have
high asset turnover
• Capital intensive manufacturing businesses usually
have relatively low asset turnover, but higher profit
margins
Return on Capital Employed
(ROCE)
• Therefore two completely different strategies can
achieve the same ROCE;

– Sell goods at a low profit margin with a very high sales
volume (Primark)

– Sell goods at a high profit margin with sales volume
remaining low (Chanel)
Short-term liquidity ratios

• Ratios include

– Current ratio

– Quick (acid test or liquidity) ratio
Current ratio

• Measures the adequacy of current assets to over
current liabilities

• Formula: Current assets/Current liabilities
(usually expressed as X:1)
Quick (acid test or liquidity) ratio

• Better measure of short-term liquidity

• Removes slowest moving current asset,
inventories

• Formula: Current assets - Inventories/Current
liabilities (usually expressed as X:1)
Current and Quick ratios

• A low ratio could suggest liquidity problems

• A high ratio could suggest poor use of company funds

• Need to investigate constituent parts of ratio (see
efficiency ratios)

• Possible manipulation
Efficiency ratios

• Ratios include

– Inventory days (Stock Turnover)

– Trade receivable days (Debtor Days)

– Trade payable days (Creditor Days)
Inventory Days (Stock Turnover)

• Measures the efficiency of managing inventory levels
relative to demand

• Formula: Inventories/Cost of Sales x 365

• Sometimes called inventory or stock turnover
Inventory Days

Reasons why it could have changed?
Trade Receivable (or Debtor) Days

• Measures in days the period of credit taken by the
company’s customers

• Formula: Trade receivables/Revenue x 365

• Sometimes called Debtor Days
Trade Receivable Days

• Reasons why it could have changed:
Trade Payable (or Creditor) Days

• This measures the number of days credit taken by the
company from suppliers

• Formula: Trade payables/Cost of Sales x 365

• Sometimes called Creditor Days
Trade Payable Days

• Reason why it could have changed:
Long-term solvency ratios

• Ratios include

– Gearing

– Interest cover
Gearing

• Measures the relationship between a company’s
borrowings and its share capital and reserves.

• Formula: Debt/Equity

• Possible reasons for change?
Interest Cover

• Looks at how many times the interest could be paid
out of the profits a company has to pay it with - it looks
at how safe the interest payment is

• Formula: Operating profit (PBIT)/Interest
Investors Ratios

• The main ratios are:

– Earnings per share

– Dividend yield

– Dividend cover

– Price Earnings ratio
Earnings per share

• This tells shareholders the amount of profit a single
share is earning

• Formula: Profit after tax/Number of ordinary shares
Dividend yield

• Compares the dividend of a share to the price of a
share – it gives you the current rate of return

• Formula: Dividend per share/Price per share x 100

• High yield good, but......
• High yield may be caused by falling price
• Low yield caused by increasing price
Dividend cover

• This looks at how many times a dividend could be
paid out f the profits available to pay it. It tells
shareholders how safe the dividend is.

• Formula: Profit after tax/Total dividend or Earnings
Per Share/Dividend Per Share
Price/Earnings ratio (P/E ratio)

• Indicates whether shares appear expensive or cheap in
terms of how many years of current earnings investors
are willing to pay for

• Often used by the financial press to compare
businesses
Price/Earnings ratio (P/E ratio)

• High P/E ratio usually indicates investors expect
significant future earnings growth

• Therefore, prepared to pay a large multiple of historic
earnings

• Low P/E ratios often indicate that investors consider
growth prospects to be poor
Considerations

• Economic events

• Business issues

• Accounting choices

• Industry analysis
Economic events

• State of the economy

• Interest rates

• Foreign exchange rates

• Government policies
Business issues

• Type of business

• Quality of management

• Market conditions

• Management actions

• Changes in the business
• Method of growth
Accounting choices

• Depreciation methods and periods

• Asset revaluation

• Capitalisation of borrowing costs

• Inventory valuation methods

• Lease or buy assets
Industry analysis

• Financial ratios not always suitable

• Some ratios common place in specific industries
– Mobile phone – number of subscribers
– Retailers – sales per square meter
– Retailers – like for like sales
– Airlines – seat occupancy rates
– Hotels – bed occupancy rates
Limitations of Ratio Analysis

• Ratios provide clues, but more information is needed to
provide quality analysis

• Use historic data
• Seasonal factors
• Can be manipulated
• Accounting policies
• Comparison can be difficult because of different
resource structures
• Need to look at related ratios to get the try picture along
with other influencing factors