Ratio Analysis

Unit 5

An introduction to accounting

Objectives

Introduction Interpreting final accounts Types of Ratio Profitability Ratios Return On Capital Employed

Definitions & Assumptions

Ratio analysis is the examination of the accounting data by relating one figure to another.

This allows a more meaningful interpretation of the data and the identification of trends

Introduction

The function of accounting is to provide information to stakeholders

How do we judge a performance?– Is a profit of £1million good or bad?– For a small family business this would be good– This would be poor for a big company (JD Wetherspoon have

sales of £200million We need a way of judging a firm’s performance in

relation to it’s size and in relation to the performance of it’s competitors

This is called Ratio Analysis

Introduction (2)

Financial accounts are used for three main purposes:– Financial control– Planning– Accountability

Ratio analysis can assist in achieving these objectives

Interpreting Financial Accounts

To analyse company accounts, a well-ordered and structured process needs to be followed

A seven point approach is often adopted:1. Reason – Why are you trying to interpret the results?2. Identification – Extracting the relevant figures3. Process – Decide what method(s) will provide you with

the most useful and meaningful results4. Calculation – Calculating one figure as a ratio of another.

E.g. profit as a percentage of sales revenue5. Comparison – Compare the figures from this period with the

last, or of competitors6. Interpretation - Interpret the values in relation to what would

be considered poor, average or good7. Action - If certain results are worrying, initiate further

Investigation & corrective action

Types of Ratio

The main classifications of ratios are as follows: Profitability Ratios

– Measuring the relationship between gross/net profit and sales, assets and capital employed

Efficiency Ratios– These measure how efficiently an organisation uses its

resources such as stock or total assets Liquidity Ratios

– These examine the short & long term financial stability of a firm by examining the relationship between assets and liabilities

Profitability ratios

How does a company decide if it has made a good profit?

Company A Company B

Profit £100,000 £1million

Which is the more successful company?– It would seem that Company B is the most

successful, but is this really the case?

Profitability ratios (2)

With capital invested taken into account, we can see that in fact, Company has done much better than Company B

Company A Company B

Profit £100,000 £1million

Capital invested £200,000 £10million

Company A Company B

Profit £100,000 £1million

Capital invested £200,000 £10million

X100 (for a %) 50% 10%

Gross profit margin

This ratio examines the relationship between the profit made before allowing for overhead costs,and the level of turnover

Gross profit margin =Gross profit

Turnover (sales)X 100%

Gross profit margin (2)

= 60%

Gross profit margin =£3000

£5000X 100%

A furniture shop buys sofas for £200 and sells them for £500 each, making gross profit of £300 per sofa. In a week it sells 10, so its gross profit is £3000 and sales are £5000.

Gross profit margin (3)

The higher the profit margin the better The level of gross profit margin will vary

considerably between different markets– The amount of gross profit percentage on clothes is

generally much higher than food

The result must be looked at in context of the particular industry

Altering the gross profit margin

The gross profit margin can be improved by:– Raising the sales revenue whilst keeping the cost of

sales static– Reducing the cost if sales whilst maintaining the

same level of sales revenue

Net Profit Margin

Examines the relationship between the net profit (profit after all overheads and expenses have been deducted

Net profit margin =Net profit

Turnover (sales)X 100%

Net Profit Margin (2)

The furniture shop with it £5000 sales and £3000 gross profit has overheads of £2500 per week. So its weekly net profit is £3000 - £2500 = £500.

= 10%

Net profit margin =£500

£5000X 100%

Net Profit Margin (3)

As with the gross profit margin, a higher percentage result is preferred

The net profit margin establishes whether the firm has been efficient in controlling its expenses

It should be compared with previous years results and other companies in the same industry

It should also be compared to the gross profit margin – it is possible for the gross profit margin to increase, but the net profit margin decline. This would show that profits on trading are increasing, but overhead profits are rising at a greater rate

Altering the Net Profit Margin

The net profit margin can be improved by– Raising sales revenue whilst keeping expenses low– Reducing expenses whilst maintaining the same

level of sales revenue

Return On Capital Employed (ROCE)

This is often considered to be the primary efficiency ratio

It measures the efficiency with which the firm generates profits from the funds invested in the business

It answers the key question anyone would ask before investing in a business – what will the annual % return on my capital will I receive?

ROCE (2)

Capital employed is long term loans plus shareholders’ funds

Capital employed = assets employed

ROCE =Operating(net) profit

Capital employedX 100%

ROCE (3)

The higher the value of the ration the better ROCE measures profitability, and no shareholder will

complain about huge returns The figure needs to be compared with the previous

years, and other companies to determine whether the result is satisfactory or not

Companies usually consider 20% as very satisfactory

Altering the ROCE

The return on capital employed can be improved by:– Increasing the level of profit generated by the same

level of capital investment– Maintaining the level of profits generated but

decreasing the amount of capital it takes to do so