16 Analysis & Interpretation of FS - Performance & Profiability Ratios

Question 1

Who are the users of ratios

Answer 1

• When considering ratios need to think about who will be using them to make sure they are useful to those users
• These users are typically the companies stakeholders
  o Shareholders
   These are main reason but can also be:
  o Suppliers, customers, lenders, management, employees, professional investment advisors, regulatory bodies, financial journalists, academic, and students
  o Both existing and potential

Question 2

What are the classifications of ratios

Answer 2

• Profitability
• Liquidity / short term solvency
• Long term financial stability / solvency
• Investor ratios
  o Some ratios can fall into multiple classifications

Question 3

What is the key things to consider when analysing ratios

Answer 3

• First consider what the ratio means
• Then what a change in that ratio shows
• Bring in supporting evidence and relevant technical knowledge to suggest what might have led to the change in the ratio

Question 4

What are profitability ratios

Answer 4

• Profit is a key measure of financial performance in businesses
• As it contributes to dividends and investments
• Financial statements contain many different measures of profit and many different profitability measures can be drawn from them, in relation to:
  o Revenue
  o Capital
  o Other variables such as assets or number of employees
• Can be divided into two categories
  o Operating management
  o Overall profitability

Question 5

What are the relevant ratios for operating management

Answer 5

• Profit margins
  o Gross profit margin
  o Operating profit margin
  o Net profit margin

Question 6

What are the relevant ratios for overall profitability

Answer 6

• Return on investment
  o Return on capital employed
  o Return on equity
  o Return on assets

Question 7

What is gross profit margin

Answer 7

• Profit on trading
• What margin are you making on pure trading
• Never really see a gross loss

GPM = (Gross profit / Revenue) × 100

• How much gross profit in pence for £1 in revenue
• Businesses ability to add value and mark up direct costs
• Shows efficiency of a firms procurement and production processes

Question 8

What are the factors that affect gross profit margin

Answer 8

Selling prices
* Are prices and volumes sold consistent
Sales mix
* Different proportions of various margin items
Purchase costs
* How are COGS changing
Production costs
* Change in cost of raw materials or direct labour

Question 9

What is operating profit margin

Answer 9

• How profitable the company is after expenses have come out

OPM = (Operating profit (PBIT) / Revenue) ×100

• Finds profit per £1 of revenue after deducting costs of operating the business
• Must not include finance or taxation expenses as that is not an operational cost
• If gross margin is high, but operating margin is low, then overhead expenses must be analysed to find any cost inefficiencies
  o Good to comment on how big the gap is and if it is changing each year

Question 10

What are the factors that affect operating profit margin

Answer 10

• Gross profit
• Expenses: admin and distribution
  o How well is the entity managing its expenses
  o Can they make savings
   Often laying people off but don’t want to get rid of too many people as then can’t operate

Question 11

What is net profit margin

Answer 11

NPM = (Net profit (PAT) / Revenue) × 100
ofit per £1 of revenue after every expense
* Includes finance costs and tax
* Will always be low
o Especially if highly geared (due to finance costs)
o If there is a big difference between OPM and NPM suggests high debt

Question 12

What is return on capital employed

Answer 12

ROCE = (Profit before interest and tax / Capital employed)×100
* Operating profit
* Finds profitability in terms of all the funds contributed by both shareholders and long term lenders
o Compared to EPS which was just shareholders financing

Question 13

What are the factors that affect return on capital employed

Answer 13

Efficiency
* If you are not turning over your assets efficiently
* Profit margin x asset turnover = ROCE
Profitability and investment
* If you invest but PBIT doesn’t move then it will fall

Question 14

How can you set up comparisons with ROCE

Answer 14

• Previous years profits
  o Be careful as if you don’t replace assets ROCE with increase
• Against targets
• Cost of borrowing
  o If the cost of borrowing is higher than ROCE, further borrowing with reduce EPS unless invested where ROCE is higher than borrowing
• Other companies in the same industry
  o But be careful as they will be using different accounting policies

Question 15

How does ROCE affect accounting policies

Answer 15

• ROCE can be significantly affected by accounting policies used
• So must use care when comparing companies
  o If assets are revalued this creates a revaluation surplus so equity will be increased, reducing ROCE
  o While revaluing property from depreciated value to market rate might look good on balance sheet but will hurt ROCE

Question 16

What is capital employed

Answer 16

Capital employed = Equity + Long term debt
(or) = Total assets - Current liabilities

Question 17

What is return on assets

Answer 17

ROA = Net profit / Total assets
* How well your working your total assets
* Can be decomposed to
ROA = (Net profit / Sales) × (Sales / Total assets)

Question 18

What is return on equity

Answer 18

ROE = (Profit attributable to shareholders / Equity) × 100
* General calculated after tax PAT
* Desirability of company’s shares
* Profit generated per £1 of assets
* Can be decomposed to:
ROE = (Net profit / Total assets) × (Total assets / Equity)
∴ ROE = ROA × Equity multiplier
* Equity multiplier is the number of £’s of assets deployed per £ of equity
* ROE is affected by gearing
o Increase in gearing will increase ROE

Question 19

What are the main driving factors for profitability ratios

Answer 19

• Profit margins are determined by sales price levels and cost levels.
• An analysis of the cost components may provide information regarding the sources of differences between companies.
• If the cost categories in the SPL are presented according to their function, the following ratios may also be helpful:
  o Cost of sales/sales
  o Marketing and sales costs/sales
  o Distribution cost/sales
  o Administrative cost/sales

Question 20

What are the relationships between ROE and stock returns

Answer 20

• It is tempting to compare the Return on Equity to the stock market return to shareholders, however, the ROE ratio calculation is based on ‘book’ amounts from the financial statements, which may mostly be based on historic-cost .
• Therefore, the ROE is not identical to market return (total shareholders’ return).