Interpreting Accounts

Part of an accountants work is to analyse the financial performance of the business. Ratio Analysis looks at the pairing of financial data in order to get a picture of the performance of the organisation

Ratios allow a business to identify aspects of their performance to help decision making

Ratio Analysis allows you to compare performance between departments and over time

Four different types of ratios can be used to measure:

• 1. Profitability – how profitable the firm is
• 2. Liquidity – the businesses ability to pay
• 3. Investment/shareholders – allows businesses to look at risk and potential earnings of investments
• 4. Gearing – looks at the balance between loans and shares in a business

Profitabilty Ratios

Gross Profit Ratio

Profitability measures look at how much profit the firm generates. Profit is the number one objective of most firms

Gross profit = total revenue– variable costs (cost of sales)

Gross profit looks at how much of the sales revenue is converted into profit

Gross Profit Margin = Gross profit / turnover x 100

The higher the better. Allows the firm to assess the impact of its sales and how much it cost to generate (produce) those sales.  A gross profit margin of 35% means that for every £1 of sales, the firm makes 35p in gross profit

Net Profit Ratios

Net profit looks at how much of the sales revenue is left as net profit

Net Profit = Gross profit – overheads

Net Profit Margin = Net Profit / Turnover x 100

Includes overheads / fixed costs. Net profit is more important than gross profit for a business as all costs are included.A business would like to see that this ratio has improved over tim

Return on Capital Employed

Another profitability ratio. Looks at operating profit and capital employed by the business

Return on Capital Employed (ROCE) = Profit / capital employed x 100

Typically should be 20-30%. Need to compare to previous years and competitors to get a clear picture. Can improve this by increasing profits without increasing fixed assets / capital.

Liquidity Ratio

Acid Test Ratio

It has been argued that stock takes a while to convert to cash so a more realistic ratio would ignore stock

(Current assets – stock) : liabilities

1:1 seen as ideal

• Again if it is too high means that the business is very liquid – may be able to use the cash for other activities to increase performance.
• If it is too low then the business may face working capital problems.

Some types of business need more cash than others so acid test would be expected to be higher.

Current Ratio

Looks at the ratio between Current Assets and Current Liabilities

Current Ratio = Current Assets : Current Liabilities

Ideal level – approx 1.5 : 1. Need enough current assets to cover current liabilities

• If its too high means too many current assets e.g. might have too much stock, could use the money tied up in current assets more effectively.
• If its too low you run the risk of not being able to meet current liabilities and you could have liquidity problems

Efficiency Ratios

Asset Turnover Ratio

Looks at a businesses sales compared to the assets used to generate the sales

Asset turnover = sales (turnover) / net assets

Net assets = Total assets – current liabilities

The value will vary with the type of business:

• Businesses with a high value of assets who have few sales will have a low asset turnover ratio
• If a business has a high sales and a low value of assets it will have a high asset turnover ratio
• Businesses can improve this by either increasing sales performance or getting rid of any addit

Stock Turnover Ratio

Looks at how efficiently a company converts stock to sales

Stock turnover ratio = cost of sales / stock

• High stock turnover means increased efficiency. However it depends on the type of business
• Low stock turnover could mean poor customer satisfaction as people might not be buying the stock

Debtors Collection Period

This looks at how long it takes for the business to get back money it is owed

Debtors collection ratio = debtors x 365 / turnover

• The lower the figure the better as get cash more quickly. However sometimes need to offer credit terms to customers so this may increase it
• Need to ensure keep track of any changes in credit terms as these should impact this ratio

Gearing

This is an efficiency ratio. Looks at the relationship between borrowing and fixed assets

Gearing Ratio = Long term loans / Capital employed x 100

The higher it is the greater the risk the business is under if interest rates increase.