What do the Accounts Mean
Ratio Analysis
Financial statements, profit and
loss accounts and balance sheets are designed to present historical data in particular form to the owners of a business.
They are not designed to enable detailed analysis of the performance of the
business. In the light of this warning extreme care must be applied in using
financial statements for analysing company performance and in doing ratio
analysis. The probability of coming to the wrong conclusion is very high. At
best, ratio analysis enables the analyst to determine areas where awkward
questions can be asked or further information sought.
Ratio analysis has the following
components:
· Trends
– a gross profit ratio that is below industry average but is getting better may
be more hopeful than a ratio that is above average but is getting worse.
· Similar
companies – clearly it is helpful to compare a company with other similar
companies. However caution has to be taken as no two companies are exactly
alike or use the same accounting policies.
· Industry
averages – if these are available from inter firm comparisons or other
sources.
·
Budgets –
a company may have intended ratios and a comparison with the actual will give
some objective standard for comparison.
The persons or
institutions who might apply ratio analysis to a company may include actual or
potential:
·
Management
·
Owners/shareholders
·
Lenders
·
Customers
·
Suppliers
·
Employees
·
Competitors
And also
·
Companies contemplating takeovers
· Government agencies including the taxman and
those concerning the control and regulation of business
·
The public especially those who belong to
pressure groups.
Their purpose in doing an
analysis will of course differ and the particular ratio chosen will also
differ.
Stubby Computers Ltd
Trading and Profit and Loss Account
For the years ending 31 December
|
|
20x1
|
20x2
|
|
|
£’000
|
£’000
|
|
Sales
|
980
|
1170
|
|
Cost of goods sold
|
600
|
750
|
|
Gross profit
|
380
|
420
|
|
Occupancy costs
|
25
|
34
|
|
Employee costs
|
110
|
111
|
|
Advertising
|
30
|
40
|
|
Administrative costs
|
31
|
34
|
|
Directors salaries
|
40
|
45
|
|
Depreciation
|
30
|
30
|
|
|
266
|
294
|
|
Net profit before interest
|
114
|
126
|
|
Interest
|
30
|
35
|
|
Net profit after interest
|
84
|
91
|
|
Corporation tax
|
23
|
28
|
|
Net profit after tax
|
61
|
63
|
|
Dividends
|
30
|
35
|
|
Retained profit for year
|
31
|
28
|
|
|
|
|
Balance sheet as at 31 December
|
|
20x1
|
20x2
|
|
Premises
|
200
|
188
|
|
Equipment & shop fittings
|
80
|
92
|
|
Vehicles
|
50
|
40
|
|
|
330
|
320
|
|
Current assets
|
|
|
|
Stocks
|
85
|
120
|
|
Debtors
|
90
|
87
|
|
|
175
|
207
|
|
Creditors amounts falling due
within one year
|
|
|
|
Creditors
|
70
|
90
|
|
Overdraft
|
20
|
32
|
|
Corporation tax
|
23
|
28
|
|
VAT and PAYE
|
18
|
20
|
|
Dividend
|
30
|
35
|
|
|
161
|
205
|
|
Net current assets
|
14
|
2
|
|
Total assets less current
liabilities
|
344
|
322
|
|
Creditors amounts falling due
in more than one year
|
|
|
|
15% Bank loan
|
150
|
100
|
|
|
194
|
222
|
|
Capital and reserves
|
|
|
|
Called up share capital
|
100
|
100
|
|
Profit and Loss Account
|
94
|
122
|
|
|
194
|
222
|
|
|
|
|
The mean ratios supplied by the
interfirm comparison are:
Gross
profit ratio 35%
Net
profit to sales 10%
Overhead
to sales 25%
Asset
utilisation ratio 2.8
times
Annual
sales growth 11%
Occupancy
costs to sales 6%
Employee
costs to sales 8%
Advertising
costs to sales 3%
Return on
capital employed 25%
Return on
shareholders funds 32%
Dividend cover 1.9
Gearing ratio 40%
Stock turnover 65 days
Debtors
average payment time 70 days
Creditors
average payment time 60 days
Current ratio 1.6
Acid test
ratio 1.1
Operating
cycle 75
days
Before calculating any
ratios we should extract as much information from the accounts as we can
without ratios. The following points may be made:
1. The company owns its own premises. The property is
being depreciated and has not been revalued. Therefore the market value is not
known.
2. Equipment
increased during the year despite depreciation. The company is investing in
improved facilities.
3.
Vehicles declined in the year presumably as a result of
depreciation. There were no investment in new vehicles.
4.
The company have borrowed at some time in the past from
the bank on a fixed interest loan. This was probably in order to buy the
premises. £50,000 has been repaid. The remaining £100,000 is in creditors
falling due after more than one year so is not payable until at least 19x4.
Analysis of the various
ratios
Gross Profit Ratio
This is Gross Profit/Sales X
100, so for 20x1 the ratio is 380/980 x 100 = 39%
And for 20x2: 36%
This is a key ratio and shows
the relationship between the input prices paid by the company and prices
obtained from customers. 39% means that on average every £1 of sales, the
product sold cost 61p giving 39p to pay overheads and give a profit. The
reduction from 20x1 to 20x2 may be due to:
·
failure to pass on higher
prices from suppliers
·
a change in sales mix to lower
margin products
·
competitive pricing to combat
competition or to get sales
·
a change in the type of
customer.
The ratio achieved by the
company is better than the industry average.
Net profit to sales
This
ratio shows the extent to which sales have resulted in a profit.
In this case the ratio
for 20x1 is 114/980 x 100 = 11.6%
and for 20x2 10.8%. A drop of 3%
in the gross profit ratio would usually lead to a drop of 3% in the net profit
ratio. In this case the drop is only 0.8% so the company have actually done
well despite the 0.8% drop.
They also have a better return
than the industry average.
Overheads to sales ratio
The ratio for 20x1 is 266/980 x 100 = 27%
and for 20x2 25%.
The improvement in this ratio has enabled the net profit to sales ratio to fall
only 0.8 % despite the fall of 3% in gross profit ratio. Probably the overheads
were too high in 20x1 as the ratio has now come down to the industry average.
Asset utilisation ratio
This shows to what extent the
assets used in the business have generated sales.
It is calculated as
Sales/Operating Assets
Operating assets are usually
defined as total assets less current liabilities. We will take the figures at
the year ends.
So for 20x1 the ratio is: 980/344 = 2.8 and for 20x2 3.6.
This is a big improvement. We
could say that the business managed to generate a substantial sales increase
with an actual reduction in net operating assets. It is also better than the
industry average.
Annual sales growth
Sales
growth for 20x2 is 1,170-980 = 190 (in £'000) so sales growth a percentage is 190/980
x 100 =19%
Sales growth has to be compared
with inflation which was running at 8% in 20x2 so that there has been an
increase of 11 % in real terms compared with an industry growth of 11% in money
terms and 3% in real terms. Prices of computer products actually fell in 20x2
so that the growth in volume is actually greater than 11%.
However the sales growth was
accompanied by a reduction of gross profit ratio, so a possible hypothesis is
that sales were obtained by price reductions.
Occupancy costs to sales
Occupancy costs include rent,
rates, heat and light, repairs to premises, fire insurance etc.
The ratio for 20x1 is 25/980 X
100 = 2.5% and for 20x2 2.9%. The ratio has worsened but cannot be compared
with the industry average as the industry average probably includes rent and
our company owns its own property. Be warned against comparing unlike figures.
An alternative ratio for this
industry might be sales per square foot but we have no data on this.
Employee costs to sales
This ratio tells us how
effective the staff are.
In this case the ratio for 20x1
is 110/980 x 100 = 11% and for 20x2 9.5%.
Despite inflation of 8% and
presumably corresponding pay increases the company have held their wage bill
constant so that we can presume staffing levels have actually reduced. Hence
the reduction in this ratio. It is however still well above the industry
average and further action to reduce staff seems possible.
An alternative ratio might be
sales per employee but we have no data on the number of employees.
Advertising costs to sales
This ratio for 20x1 is 30/980 x
100 = 3% and 3.4%. The appropriate amount of advertising is clearly difficult
to determine but in this case is about the industry average. It has increased
in 20x2 and sales have also increased but any connection must be speculative.
Return on capital employed
This is often seen as the key
success indicator. The theory is that management have been entrusted with the
net assets of the enterprise with a duty to make a profit from them.
There are problems of
definition. We shall take the return as being the net profit before interest
and the capital employed as total assets less current liabilities.
In our case the ROCE for 20x1 is
114/344 x 100 = 33%
and for 20x2 39%. This seems
very good in comparison with the industry average of 25% and the gross return
available from for example building society investments.
However there are many
difficulties in making comparisons here including:
·
Profit does not include any
increase in value of the property over the year.
·
Assets include the property at
cost less depreciation when its market value may be higher or of course, lower.
·
Profit measurement includes
property depreciation based on historical cost.
Return on shareholders funds
This ratio measures how well the
management have turned the return on capital employed into a return on the
funds invested by the shareholders.
The return is the net profit
after tax and the shareholders funds are the total capital and reserves.
The ratio for 20x1 is 61/194 x
100 = 31% and for 20x2 28%. The ratio has
Declined in both years was less
than the industry average. However note that it is an after tax ratio whereas
the return on capital employed was a before tax ratio.
The remarks about valuation
difficulties apply to this ratio also.
Dividend cover
This ratio measures the extent
to which profits are distributed to shareholders in the form of dividends.
The calculation is simply: Net
profit after tax/Dividends
In our case the ratio for 20x1
is 2.03 and for 20x2 1.8.
You can interpret the ratio by
saying the in 20x1 just under half the profits were distributed but in 20x2,
just over half were distributed. The ratio is in line with the industry
average.
Gearing ratio
Gearing is also called leverage. Gearing measures the extent to
which the company is financed by borrowings as against equity. Equity is the investment by shareholders.
The calculation is: Long term loans/Total capital employed x 100
In this case the ratio for 20x1 is 150/344 x 100 = 44% and for 20x2
31%.
The theory is that some borrowings (usually called debt) are a good
thing as the company can earn a rate of return on capital employed (in our case
39% in 20x2) above the cost of borrowing (15% in this case). However excessive
debt can dangerously increase risk as interest and debt repayment have to be
made even in times of recession. The company decreased its gearing in 20x2 by
repaying part of its long term loan and the gearing ratio is now below the
industry average.
Stock (Inventory) turnover
Stock is necessary in this as in all retailing companies. Too much
stock carries risk of deterioration and obsolescence and also has costs of
storage and financing. Too little stock may cause loss of sales. The stock
turnover ratio measures the amount of stock in relation to its throughput.
Its measurement is Stock/Cost of goods sold x 365
In our case the ratio is 85/600 x 365
= 52 days and 58 days in 20x2 against an industry average
of 65 days.
The ratio indicates that the average item was in stock for 52 days
in 20x1 and 58 days in 20x2. It seems that the company either have excellent
stock control or frequently lose sales by not having stock. The ratio is often
difficult to interpret as year ends are chosen when stock is low to facilitate
counting and some companies postpone purchases for the few days around
stocktaking so a true average stock is not determined. Also a large stock may
seem to be a good service to customers but may hide shortages of frequently
wanted items together with surpluses of obsolete and slow moving items.
Debtors (Receivables) average
This
ratio measures the ability of the company to collect debts from its customers.
In practice debt collection is a major problem with many large companies being
very slow payers.
The ratio is measured by:
Debtors/Credit sales x 365
We are not given the credit sales but we shall assume that 50% of
the sales in both years are on credit and 50% for cash.
With our company the ratio is: 90/490 X 365 = 67 days in 20x1 and 54
days in 20x2 against an industry average of 70 days.
Our company seem to be very good at credit control and collecting
debts.
Creditors (Payables) average
This is the critical liquidity ratio. It measures the average time
taken to pay suppliers. Firms normally take more time to pay than strictly
allowed by their suppliers but taking excessive time (say three months or more)
usually indicates inability to pay more quickly and may sooner or later cause
the company to fail.
It is calculated by:
Creditors/purchases x 365
In this case purchases are not
given but can be deduced as opening stock + purchases - closing stock = cost of
goods sold. Three of these variables are known for 20x2 but only two for 20x1.
If stocks are not radically different at each year end then an approximation
is to use cost of goods sold which is usually available knowledge.
Thus for 20x1 the time is 70/600
x 365 is 42 days and for 20x2 44 days. This is relatively quick and the company
might well take longer to pay and reduce their overdraft accordingly. The
industry average is 60 days.
Current ratio
This is simply current assets
over current liabilities and for our company it is for
20x1: 175/161 = 1.1 and for 20x2
1.0. With industry average at 1.6, our company's
ratio is significantly different.
Some writers suggest that any
variation from industry average should be subject to enquiry but general
feeling now is that this ratio has no value whatever.
Acid test or liquidity ratio
This ratio is defined as
(current assets less stock) over current liabilities. In 20x1 it was: 90/161 =
0.6 and in 20x2 0.4
As with the current ratio, I can
attach no significance to it.
Operating cycle
This is defined as stock
turnover + debtors average payment time - creditors average payment time. The
idea is that it measures the time taken between cash being paid for goods and
the receipt of the proceeds of sale of those goods.
In our case the time is 52 + 67
- 42 = 77 days for 20x1 and 68 days in 20x2 as against an industry average of
75 days. We seem to be doing well.
Investment ratios
Analysts apply some additional
statistics and ratios to companies whose shares
are listed or quoted on the stock exchange.
These include:
Ž
dividends per share
Ž
dividend per yield
Ž
earnings per share
Ž
price earnings ratio
To consider these items we will
select Stubby Group plc and its abbreviated accounts:
Profit and Loss account
£’000
Net profit after tax 1,420
Dividends 700
Retained profits 720
Earnings per share 4.06p
Balance Sheet
Net assets 12,700
Share capital (20p shares) 7,000
Share premium 1,000
Reserves 4,700
12,700
Remember that reserves are not
assets but an explanation of how the company acquired its assets of £12,700,000
for example by retaining profits or by revaluing its property.
Dividend per share
This is calculated by:
Total
dividend
Number of
shares
In this case each share has a
nominal value of 20p and the share capital is given in £s. So the number of shares is 5 x 7,000,000 and
the dividend per share is
Dividend yield
The dividend per share cannot be
compared with other companies but the dividend yield can be. The dividend yield is calculated by:
Dividend per share x 100
Quoted price per share
The quoted share price varies all
the time but we will assume it to be 68p.
The yield is thus 2.5 x 100 = 3.7%
68
This is much below the gross rate
obtainable on building society deposits but remember that the dividend per
share in Stubby plc is expected to grow.
Earnings per share
This statistic is calculated as:
Net profit after tax
Number of issued shares
In our case it is £1,420,000 = 4.06.
35,000,000
In practice the calculation is
not always this easy and the last line of the profit and loss account of quoted
companies gives it. It cannot be
compared with other companies but a year on year comparison is very useful.
Price earnings ratio
This is calculated as:
Quoted price per share
Earnings per share
In Stubby’s case it is 68p
= 16.7
4.06p
The serious papers give the PE
ratio for all quoted companies daily.
Its meaning is difficult to assess but in general higher PE ratios imply
expected growth and a low PE implies a stagnant company. However a company that has a particularly
poor profit in a year will show high PE.
