Interpreting the Accounts (Ratio Analysis)

Liquidity ratios

• Current ratio= current assets current liabilities

• Acid test= current assets - stock current liabilities

Liquidity ratios

• Ideal current ratio is 2:1• Any higher and too much money tied

up in assets which are unproductive• A low current ratio eg 0.5:1 would

mean the company has 60p for every £1 of debt and cannot cover its short term debts

• Indicates short term financial stability of the business

Liquidity ratios

• Stock deducted as the most illiquid asset – therefore a more accurate test of a firm’s liquidity

• Ideal ratio 1.1:1 showing the company has £1.10 to pay every £1

• This ratio is a more stringent test of short term stability

Gearing

Reminder: total capital employed= ordinary share

capital+pref share capital+reserves+debentures+long term loans+mortgages

Gearing= long term liabilities+pref shares*100

total capital employed

Gearing

• Gearing shows the risk involved in investing in a company

• Loans greater than 50% mean a high-geared company

• Interest paid on borrowings before dividends paid

• Ordinary share holders will receive greater return from low-geared companies

Profitability ratios

• Gross profit margin= gross profit*100

turnover

• Net profit margin= net profit*100

turnover

• ROCE = net profit*100

capital employedNB total capital employed= ordinary share

capital+pref share capital+reserves+debentures+long term loans+mortgages

Profitability ratios

• High profit margin is obviously a good thing

• Net profit margin is of particular interest to owners and managers – profit after all costs considered

• ROCE measures efficiency of funds invested in the business at generating profits

• The higher the value of the ratio the better – a higher % means owners receive a greater return

Efficiency ratios

• Stock turnover= cost of goods sold average stock

• Average Stock = (open stock+closing stock) 2

Efficiency ratios

• Debtor collection= debtors*365 credit sales

• Creditor payment period= creditors*365 credit purchases

• Return on net assets= net profit b4 tax & interest*100 net assets

Efficiency ratios

• The higher the rate of turnover the better – firm selling stock quicker, realises profit quicker

• Year on year comparisons most appropriate

• Debtor collection period shows managers/owners how effective their credit control is

• Creditor ratio less important but suppliers should not be abused

Efficiency ratios

• Return on assets relates profits made to assets used (rather than capital, as with ROCE)

• High percentage is good• again this needs to be compared

to previous years, or other companies

pay-back period on loans and owners’ investment

• Payback refers to a technique which details how long it takes for an initial investment to be repaid

• Essentially a cost of the particular capital item/fixed asset such as machinery is compared to the cash flow generated over time

• As a result, projects with faster payback can be chosen over others (see example)

what if” analysis

• What if analysis utilise computer software packages to see what could happen if circumstances change

• Best and worst case scenarios can be checked parent against the crucial financial statements such as the cash flow forecast, profit and loss account, balance sheet and break even analysis

construction of contingency plans

• Risk assessment can be carried out in a business plan to investigate all potential risks.

• Risk can be graded according to the likelihood of them happening and the potential impact.

• This might be numerical system, i.e. 1-10 for from low to medium to high

• Contingency plans need to put in place to manage any potential risks which occur

SWOT and PEST analysis

• Both techniques can be used to evaluate a potential business proposal

• Swot analysis, evaluates strengths and weaknesses opportunities and threats

• Pest analysis assesses the external environment of the business and its influence on the business idea