21 - Interpreting company accounts Flashcards
what is the purpose of interpreting ratios in a business environment
stakeholders use financial statements to make decisions
ratio analysis enables better understanding and interpretation of accounts
ratios calculated depend on needs of users and must be made on a year to year basis
who use financial statements the most
the main providers of finance are the most important users
investors use them to assess profit generated and performance
what is profitability
measures the relationship between income and expenses and profit or losses measured against investment in the business
what is liquidity
focuses on relationship between assets and liabilities and ability of company to settle its obligations as they fall due
what is risk
analyses the long term financial stability of the company
how important are ratios
they compare one figure with another
on their own, have minimal impact so they must be compared with other data
what are some comparisons that ratio can be used for
- previous years financial statements (gross profit margin better or worse?)
- budgeted financial statements (gross profit higher or lower than forecast?)
- financial statements of another company (gross profit margin stronger/weaker than competitor?)
- average figures for the industry (how profitable is company compared to industry as whole?)
what does gross profit margin show
measures how well a company is running its core operations
what is gross profit margin formula
gross profit / revenue x 100 = X%
what factors cause a gross profit margin to vary
- change in sales price
- change in sales mix (eg selling higher markup items)
- change in purchase price or production costs (eg from discounts or efficiencies)
what is the formula for operating profit margin
profit from operations / revenue x 100 = x%
what is profit from operations
= profit before finance charges and tax (PBIT, profit before interest and tax)
difference between operating margin and gross profit margin
the operating profit shows how well the company is controlling its overheads
why does operating profit margin vary
- one off non-recurring expenses
- rapid expansion
- efficiency savings (economies of scale)
what is the net profit margin formula
profit for the year / revenue x 100 = x%
net profit margin implications from business finances
net profit margin is higher for a business mainly financed by equity investment (interest is lower)
relative to a company with significant borrowings and a similar operating profit margin
return on capital employed formula
profit from operations / total equity + non current liabilities
X 100 = x%
what does return on capital employed show
profit in relation to capital employed to generate profit
measures how efficiently a company uses its capital to generate profits
how does return on capital employed change
IMPROVES
if profits from operations increase, or capital employed remains unchanged
DECREASES
if profit from operations remains the same, and capital employed increases
non current asset turnover formula
revenue / non current assets = x times
what does non current asset turnover mean
this ratio measures productivity of non current assets in generating revenue
assessment of no of dollars/pounds of revenue generated per dollar of non current assets employed by the company
how does non current asset turnover change and what causes it to change
where non current assets have been purchased, ideally non current asset turnover ratio will increase
if assets are acquired late in the year, they may not have had sufficient time to create revenue = ratio will fall
current ratio (working capital ratio) formula
= current assets / current liabilities = x:1
what does current ratio (working capital ratio) measure
measures the relationship between current assets and current liabilities on the statement of financial position
how can current ratio (working capital ratio) be utilised
a company shouldn’t operate at a level too low - it won’t have enough assets to cover debt
a company also shouldn’t operate at level too high - increases working capital required by the business
why does current ratio (working capital ratio) increase or decrease
INCREASE
if current assets increase in proportion to current liabilities
DECREASE
if current liabilities increase in proportion to current assets
how may industry affect current ratio (working capital ratio)
supermarkets have lower current ratio relative to other businesses
this is because they have low receivables, low inventory and high payables
quick ratio (acid test ratio) formula
current assets - inventories / current liabilities = x:1
how is quick ratio (acid test ratio) different from current ratio
it excludes the inventories figure from current assets because they are highly illiquid
quick ratio is more reliable measure of liquidity bc businesses wont be able to use inventories to pay off payables quickly
inventory turnover formula
cost of sales / inventories = x times
what does inventory turnover show
shows on average how many times a company is able to sell its inventory in a year
what is the ideal level of inventory turnover
most aim to keep it high as this means stock flows through the warehouse at a reasonable rate = reduces risk of obsolete stock
what is the trade receivables collection period days formula
average trade receivables / revenue x 365 = x days
what does trade receivables collection period days show
this ratio shows how long it takes credit customers to settle the amount owed to the business
the collection period should be compared to previous yr
how does trade receivables collection period change
trade receivables collection period will increase where credit customers are taking longer to settle the amount owed to the business
how is average trade receivables in trade receivables collection period formula calculated
calculated by taking opening and closing trade receivables balances and dividing by two to obtain the average figure
what is the formula for trade payables payment period (days)
average trade payables / cost of sales x 365 = X days
what does trade payables payment period (days) measure
measures the average time it takes the business to settle amounts owed to credit suppliers
how does trade payables payment period (days) change
may increase when a business delays paying credit suppliers, indicating cash flow issues
how is average trade payables calculated for trade payables payment period (days) formula
taking the opening and closing trade payables balances and dividing by two to obtain average
inventory period (days) formula
average inventory / cost of sales x 365 = X days
what does inventory period (days) indicate
indicates the average number of days that items of inventory are held for
what does the level of inventory period (days) show and how does it change
increasing inventory days from one year to next = indicates slow down in trading
the lower the inventory days, the better but this needs to be balanced with factors like expected volume of customer orders and bulk buying discounts
how is average inventory obtained for inventory period (days) formula
takes opening and closing inventory balances and dividing by two
what does the length of the working capital cycle indicate
working capital cycle has to be financed
the longer the cycle = the more financing required and higher risk of insolvency
so it is important for businesses to have short inventory days and receivables collection periods, and longer payables payment periods
what is the formula for gearing
non current liabilities / total equity + non current liabilities
x 100 = x%
what is gearing and what does it measure
is concerned with the long term financial stability of the company
the process of looking at how much the company is financed by debt
what does the level of gearing indicate
the higher the gearing ratio, the less secure the financing of the company and possibly companys future
gearing increases when companys loan finance increases by more than equity finance
what is the formula for interest cover
profit from operations / finance costs = x times
what does interest cover show
interest cover ratio considers no of times a company could pay its interest payments using profits from operations
why might interest cover change
where profit from operations rises and interest charges are unchanged, interest cover increases because there is additional profit to cover interest charges
working capital cycle formula
inventory period (days) + receivables collection period (days) - payables payment period (days)
