Chapter 12: Interpreting financial statements (ratios) Flashcards
Gross profit percentage (definition and key points)
( Gross profit / revenue ) x 100
Gross profit = revenue - cos
Used to make pricing decision - increased sales price relative to direct costs will result in an increase gross profit margin
Falling margin may be due to increased costs or decreased sales prices to increase market share
Sales volume does not affect gross profit
Operating profit percentage (definition and key points)
( Operating profit / revenue ) x 100
Operating profit = revenue - overheads
Used to make pricing decision - increased sales price relative to direct costs will result in an increase gross profit margin
Falling margin may be due to increased costs or decreased sales prices to increase market share
Differences between gross profit and operating profit allow you to establish if the changes are direct or caused by overheads
Expense/revenue percentage (Definition and key points)
Specified expense / Revenue x100
Used to measure a specific expense as a percentage of revenue. Example, a company may wish to measure its marketing expense as a percentage of revenue to judge the success of its marketing activity at generating sales
A rising expense ratio could indicate a problem with cost control
Asset turnover (net assets)
Revenue / Capital Employed
Capital employed = Total equity + non-current liabilities) = TALCL (Total assets less current liabilities)
If improves shows more efficient with investment
Expressed as a number of times
Measures how much turnover is generated by every £ of assets employed
When were new assets acquired? What are new assets used for? Are they working efficiently and or have they improved performance?
If held assets for short amount of time could decrease as hasn’t had enough time to see the benefits
Return on capital employed (ROCE)%
Operating profit / capital employed (TALCL) x100
measures how much profit is generated for every 1£ of assets employed
indicates how efficiently the company uses its assets
Different industries will have different benchmark rates
ROCE = Operating profit percentage x asset turnover
ROCE is the only ratio which compares profits to its overall size of the business and is sometimes called the primary ratio
Operating profit / capital employed
what are the Probability and efficiency ratios?
Gross profit margin
Operating profit margin
Expense/revenue percentage
Asset turnover (net assets)
Return on capital employed (ROCE)
ROCE
Asset turnover (non-current assets)
Return on shareholders funds
Asset turnover (non-current assets)
Revenue / non-current assets
return generated per £1 of non-current assets
be careful of increasing as non current assets depreciate
Return on shareholders funds %
Profit after tax / total equity x 100
Return genererated per 1£ of shareholders equity
what are the Liquidity ratios ?
Current ratio
Quick ratio
Current ratio
current assets / current liabilities
Indication on liquidity - how many times current liabilities are covered by current assets
Companies with low levels of inventory or low level of recieveables are likely to have a low current ratio
No ‘normal’ ratio, comparison to other companies in the same industry may be helpful
Quick ratio
(Current assets - inventory) / current liabilities
considered superior to the current ratio as it removes inventory which can take time to sell and covert into cash
what are the Use of resources ratios?
Inventory holding period and turnover
Receivables collection period
Payables payment period
Inventory holding period and turnover
Inventories / cos x365 days
Shows average number of days inventory is held before sold - will vary depending on industry
if opening and closing inventory figures are available then average should be used
look out for perishable goods
Cos / average inventory = number of times inventory is turned over per year
Receivables collection period
Trade reveivables / revenue x365
Opening and closing receivables are available then average should be used, if use closing
Revenue should technically only be credit sales
shows average number of days it takes customers to pay
should be compared to a companies credit terms
Payables payment period
Trade payables / cos
use average if not closing
credit purchases technically
average number of days it takes the business to pay their suppliers
can be compared to receivables days as company may have problems if paying suppliers after 7 days and getting paid by their customers after 30 days
Working capital cycle
How long a business needs to fund its purchases of goods
Inventory days + receivable days - payable days
Longer the cycle the longer the business has to find financing
Length will be different in different industries
To reduce the cycle the company needs to reduce the length of time items are kept in inventory, reduce the time taken to collect debt from customers and increase the amount of time to pay suppliers
Reducing the cycle can come with the risk of inventory outs and losing losing goodwill of suppliers
What are the financial position ratios?
Gearing
Interest cover
Gearing
Is the business financed through equity or debt
Measures the financial risk of the company
Non-current liabilities / (Equity + non-current liabilites)
Measures the percentage of debt to to the total financing
High gearing means less profit available to distribute to shareholders as profit has been reduced through high interest rates
High gearing - less likely for lenders to lend money
Higher gearing - higher risk - more reliant on debt financing
Gearing
Is the business financed through equity or debt
Measures the financial risk of the company
Non-current liabilities / (Equity + non-current liabilites)
Measures the percentage of debt to to the total financing
High gearing means less profit available to distribute to shareholders as profit has been reduced through high interest rates
High gearing - less likely for lenders to lend money
Higher gearing - higher risk - more reliant on debt financing
Interest Cover
Operating profit / finance costs
Measures how easily the company can make its interest payments out of its profit
If declining, finance costs increase or operating profit decrease
Related to gearing
Limitations of Ratio analysis
Historic information
Comparison to other companies
Window dressing
Non financial information
Markets and size
Limitation - historic information
All financial statements and hence ratios are calculated based on past information
Limits the usefulness of the information for decision making
example - change in market size or purchase of non-current assets
Limitation - Comparison to other companies
Be mindful that ratios are calculated for other companies are based on their accounts which may use different basis. May not be comparing like for like information
Eg. one companies uses the revaluation for model for its non-current assets
Limitation - Window dressing
A company may recover lots of debt just before the year end or ensure that inventory is delivered at the start of the new year.
may mean for example cash is higher than usual and receivables are lower than usual
makes your statements look better, usually made for profit to look better
Limitation - Non-financial information
ratios consider the financial impacts only
don’t consider the qualitative aspects, staff morale, the environment, the community etc
Limitation - market and size
Businesses may be in the same industry but operate in different markets, therefore ratios are not comparable
larger businesses can utilise economies of scale
