Notesale: Turn your study into money

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Chapter 4: Interpreting Published Accounts
The concept of ratio analysis
- based mainly on data extracted from the firm’s financial accounting records
...

- Ratio analysis allows us to compare two sets of data in order to try to draw more meaningful
conclusions
...

- can also be used to compare the relative efficiency of different parts of a business e
...

departments, stores and factories
- however, no two businesses/departments operate in identical circumstances, so at best, ratio
analysis can only act as a guide to performance
...
Identify the reason for the investigation
2
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What will help to achieve the purpose of the user/s?
3
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Interpret the ratio/s
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Make appropriate comparisons in order to understand the significance of the ratio/s
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Take action in accordance with the results of the investigation
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Apply the above process again, to measure success of actions taken in 6
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A firm should select firms with which
it has more in common
...
Similar areas
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Comparisons over time- whatever basis is used, a company’s ratios should be compared over
time in order to register trends in efficiency and to allow for exceptional circumstances
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As profit is often the
primary aim of a company, these ratios are often described as
performance ratios
...
Although profit shows long-term success, it is vital that firms
hold sufficient liquidity to avoid difficulties in paying debts
...
They are used to assess the efficiency of the firm in its
management of its assets and short-term liabilities
These focus on drawing conclusions about whether shareholders are likely
to benefit financially from their shareholding in a company
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To find out whether the firm can afford wage rises and see if profits are being
allocated fairly
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Compare performance against rival firms and discover their relative strengths and
weaknesses
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To know if the firm and guarantees/after-sales servicing agreements are secure
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Using ratios
- majority of ratios are based on information from the income statement and the balance sheet
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Return on capital employed
- ROCE ratio shows the operating profit as a percentage of capital employed; capital employed
equates to the value of the capital that a business has at its disposal
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- profit before tax is used because tax rates vary between countries
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Current ratio
current assets: current liabilities (2:1)
Acid test ratio
(current assets – inventories): current liabilities (1:1)

Gearing
- examines capital structure of a firm and its likely impact on the firm’s ability to stay solvent
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- non-current liabilities/total equity + non-current liabilities
- low gearing: 25% (ideal)
- neutral: 50%
- high: 75%
Benefits of high capital gearing
- relatively few shareholders, easier for existing shareholders to keep control of the company
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- in times of high profit, interest payments are usually much lower than the shareholders’ dividend
requirements, allowing the company to retain much more profit for future expansion
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- a low geared company avoids the problem of having to pay high levels of interest on its borrowed
capital when interest rates are high
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Financial efficiency ratios
- measures the efficiency with which a business manages specific assets and liabilities
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Asset turnover
- this ratio measures how well a company uses its assets in order to achieve sales revenue
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- a negative figure shows the business is not
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- a positive figure shows stock is sold quickly, bringing more money in quicker
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Factors influencing the rate of stock turnover
- nature of the product
- importance of holding stock
- length of the product lifecycle/fashion
- stock management systems
- variety of products
Receivables (debtors) days
- shows the number of days it takes to convert receivables into cash
- formula: receivables/revenue x365
Payables (creditors) days
- shows number of days it takes to pay back any payables owned by a business
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Shareholders’ ratios
- shareholders will judge a business based on its ability to reward them for their input into it
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- other stakeholders may not see a ‘favourable’ shareholders’ ratio as a positive sign
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- formula: total dividends paid/number of ordinary shares issued
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- formula: dividend per share/ market price per share x 100
- shows annual percentage return on the money needed to purchase the share
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Limitations of ratio analysis
Reliability of information
- data on which ratios are based may be unreliable
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- different accounting methods may be employed
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- a firm’s financial situation changes daily, and it may manipulate its accounts to provide a
favourable view on the date in which they are prepared
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Historical issues
- accounts indicate where a company has been, rather than where it is going
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Comparisons
- ratios rely on comparisons, but they always involve difficulties because no two businesses or
divisions face identical circumstances
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- HUMAN RELATIONS: a company may experience a high rate of labour turnover and low levels of
productivity if it does not meet the needs of its employees
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- PRODUCT QUALITY: reducing quality as part of a cost-cutting exercise may lead to a decline in
number of customers
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External factors
- stage of economic cycle (e
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boom or recession)
- government legislation, which may add costs or create markets
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- new technology leading to new products/processes in the market
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- it is vital that these and other factors are considered before conclusions are drawn
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- they are an excellent guide to performance
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Ratio analysis: choosing the right ratio(s)

RATIO

MAIN PURPOSE

ROCE (%)

-to assess whether a business is making a satisfactory level of profit from the
capital available to it
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-to see if a cash flow problem might occur in the short-term
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-to see whether a cash flow problem might occur in the short term, especially if
the business cannot rely on receiving cash from selling its inventories
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-to study the likely impact on the costs of a business and if there are any changes
in interest rates
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-to calculate how many times a year a business is able to sell its stock
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-to discover the time taken for receivables to pay their debts to the business
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-discover time taken for a business to pay its debts to its payables
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-calculate direct financial reward that a shareholder will receive from the
company every 6 months, in return for owning its shares
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Return can be compared to current interest rates or savings in
banks
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Current ratio: current assets: current liabilities
2
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ROCE: operating profit/ total equity + non-current liabilities x 100
4
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Inventory turnover: cost of goods sold/average inventories held
6
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Receivable days: receivables/revenue x 365
8
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Dividend per share: total dividends/ number of ordinary shares issued
10

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