Download A2BS 3.3 Ratio Analysis

Who is taller?
A Maltese or Dutch man?
6’ 0”
6’ 0”
Friday, 07 July 2017
Looking beyond the
headlines…
3.1 Interpreting Published Accounts
Objectives;
Understand
how to select,
calculate and interpret liquidity
ratios to assess business
performance; current and acid
test ratios
Explain
the value and limitations
of liquidity ratio analysis in
measuring a business’s
performance
Basic Concepts

Ratio analysis enables performance to be measured
by comparing one piece of financial information
with another…

Remember, a ratio at a point in time might be
interesting, but the TREND over a number of points
in time is most important!
Trends Over Time
Value of Acid Test Ratio
2
1
0
2003
2004
2005
2006
2007
2008
2009
Here we see that the value of the acid test ratio for a firm in 2003 was 1.0
Sounds like it might be OK then. Or is it…
Trends Over Time
Value of Acid Test Ratio
2
1
0
2003
2004
2005
2006
2007
Now we see that the ratio has been declining for three years!
So we can see that there might in fact be a serious problem
2008
2009
Internal and External Focus

Ratio analysis may be conducted with an internal or
external focus

With an internal focus, the idea is to check the
performance of OUR company over time

With an external focus, the idea is to compare OUR
performance against COMPETITORS over time
Four Areas of Ratio Analysis

The four main areas of ratio analysis are:




Liquidity: How well can we pay our way?
Efficiency: Are we using assets efficiently?
Profitability: How well are we making profit?
Shareholders: How well are our shares performing?
Liquidity
Place these items in the order of liquidity – in the order of ease with
which they could be turned into cash.
Put the easiest first and the most difficult last
1. A part built nuclear submarine
2. A box full of iPhones
3. £500 worth of Premium Bond certificates
4. An extensive collection of signed Rolf Harris posters
5. The complete collection of “Strictly Come Dancing” VHS videos (the
entire first three series)
6. A rare collection of 1956 Hearts FC mugs with the league winning team
on them
Measuring Liquidity
Current Ratio
=Current Assets
Current Liabilities
Acid Test
(Quick) Ratio
Gearing
=Current Assets – Inventories
Current Liabilities
=Non-Current liabilities
Total Equity + Non-Current
Liabilities
“A measurement of a
businesses ability to pay its
short to medium term
debts” (taken from the BS)
“A measurement of a
businesses ability to pay its
very short term debts,
discounting stock” (taken
from the BS)
x100
“A measurement of
the long-term liquidity
of a business and
how it is funded”
(taken from the BS)
Colour Key: data taken from the Balance Sheet and Profit and Loss Account
Activity

Remember Cornes, Fox and Bowles??

Calculate the current ratio, acid test ratio
and gearing. What do these figures tell us
about the business?
Interpreting Liquidity
Current Ratio
 Shows how many £’s of CA a firm has to pay its CL, e.g. 2:1
shows £2 of CA to every £1 of CL

High Current Ratio;



Low Current Ratio;



Holding too much cash? Could be reinvested to N-CA
Retail / Wholesaler / Manufacturer (so carry lots of stock thus CA)
Poor liquidity position?
Consider nature of business, e.g. Banks have no stock
Can be improved by converting N-CA to CA, e.g. sale of assets
to generate cash
Interpreting Liquidity
Acid Test Ratio (“Quick Ratio”)



As current ratio but removes stock due to lower
level of liquidity – focuses on 2-3 months liquidity
position
Tesco (considering significance of stock) operates
on a very low Acid Test Ratio (<0.5:1), stock IS
liquid for them
Long cash cycle (e.g. manufacturer) may
necessitate higher level (>1:1)
Interpreting Liquidity
Gearing

Highly Geared business (>50%);




Susceptible to interest rate changes
Less attractive to investors (profits lost in interest
payments)
More acceptable if a fast growing and high-profit
business
Low Geared business (<50%);


Risk averse
Little focus on growth
Burger Van
Burger Café
Which of the two businesses above is
performing better if they make average daily
sales of £500?
Measuring Profitability
We have already looked at these in our AS studies…
Gross Profit Margin
=Gross Profit
x100
“A measurement of
profitability of a
companies products &
services” (taken from
the P&L)
x100
“A measurement of the
overall profitability and
cost management of a
business” (taken from the
P&L)
x100
“A measurement of the
profit returned from the
resources invested into
a business” (taken from
the P&L + BS)
Sales Revenue
Net Profit Margin
=Net Profit before Tax
Sales Revenue
Return on Capital
Employed (ROCE)
=Operating Profit
Total Equity + NonCurrent Liabilities
Colour Key: data taken from the Balance Sheet and Profit and Loss Account
Small storeroom for
stock
Stock warehouse
Which of the two businesses (selling identical
goods) above is performing better if they make
average daily sales of £5000?
Measuring Efficiency
Asset Turnover
Ratio
=Sales Revenue
Net Assets
Inventory
=Cost of Goods Sold [“COGS”]
Turnover
Ratio
Average inventories held
Receivables
(Debtor) Days
Payables
(Creditors)
Days
=Receivables [“Debtors”] x365
Revenue
=Payables [“Creditors”] x365
Cost of sales
“A measurement of how
much sales a company can
generate from its net
assets” (taken from the
P&L + BS)
“A measurement of how
many times a year a
company sells and
replaces its stock” (taken
from the P&L + BS)
“A measurement of how
long the business takes to
collect debts from
customers” (taken from the
P&L + BS)
“A measurement of how
quickly the company pays
its suppliers for purchases
on credit” (taken from the
P&L + BS)
Colour Key: data taken from the Balance Sheet and Profit and Loss Account
Interpreting Efficiency
Asset Turnover

FMCG sales will show a high value (but low profit
margin

Antiques dealer may have significant assets but
few sales (however more profitable)

Can be improved by better utilising or disposing of
assets
Interpreting Efficiency
Inventory Turnover

How quickly stock is used up and replaced

Rare record stockist may take over a year to sell stock


Butcher will sell stock in a few days


Old or obsolete stock not shifting?
Sell out and dissatisfy customers?
Can be improved by holding lower stocks or
increasing sales
Interpreting Efficiency
Debtor Days

Lower figure preferred (although could be
marketing advantage not to)
Creditor Days


Liquidity improved by delaying payments
Interest payments may be relevant
Comparing debtor and credit days allows liquidity to be gauged…
Measuring Investment
Performance
Dividend per
=Total Dividends
Share
Number of Issued
Shares
Dividend Yield
=Dividend per Share
Market Price per Share
“A measurement of the
dividend payment for each
share held” (taken from the
P&L + BS)
x100
“A measurement of the
return investors receive on
each share” (information
from the stock market is
needed)
Colour Key: data taken from the Balance Sheet and Profit and Loss Account
Interpreting Shareholder Ratios
Dividend Per Share

In relation to retained profits;
 Higher figures, attractive to short-term investors
 Lower figures, attractive as suggests long term investment
and growth
 If share price is low – acceptable for lower DPS
Dividend Yield



Allows comparability of the return on shares
If greater than interest rate, worth investing
Again acceptable if retaining profit for future ‘harvest’ or
profit
Over to you…

Calculate all ratios for Doh! Nuts! (Page 69)
Putting all the ratio’s together…

Use the BIZED webpage listed below to identify
the performance of a company of your choice…
http://www.bized.co.uk/compfact/ratios/index.htm

Review for homework and come back to present
on the area you found most challenging
Limitations of Ratio Analysis

Accounting information is historic in nature

Not easy to make accurate projections of future performance from the data

Only focused on monetary items – what about changes in staff / strength of
product portfolio / future new product pipeline / age of key assets etc

Does not take into account the nature of the business: the ‘qualitative factors’

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Size
Market position
Business Activity
Objectives
Take a look too at the Chairman’s and Directors’ reports for further guidance
Remembering what the ratio’s
tell us…

Create a tool to help you (and others) to
remember the importance and relevance of a
ratio;




A mnemonic
A picture
A poem / limerick
Etc…