Managing Finance and Budgets Presentation 7 Financial
Ratios
Slide 2
Analysing Accounts Now that we have a reasonable grasp on the
standard financial statements used by businesses, we can use that
knowledge to obtain information as to whether or not the business
is functioning effectively. Today we will look at the Balance
Sheets and Profit & Loss accounts of one fictional
manufacturing Company to analyse its performance over the past two
years. What we learn here can be applied to real companies whose
financial reporting has been made public.
Slide 3
Analysing The Balance Sheet Normally, you will require two
Balance sheets in successive years, and you should look out for any
large proportional changes to items within: Fixed Assets Current
Assets Current Liabilities Long Term Liabilities Capital &
Reserves
Slide 4
Interpreting Large Upward Changes Fixed Assets: The business
may have bought new plant, machinery or transport. This might be
part of a deliberate strategy Current Assets: The business may
holding higher stock levels, carrying more debtors or simply have
more cash in the bank. Current Liabilities: The business may owe
more to its creditors Long Term Liabilities: The business may have
taken out an additional Long Term Loan Profit & Reserves: The
business may have made a large profit over the year.
Slide 5
Interpreting Large Downward Changes Fixed Assets: The business
may have sold plant, machinery or transport. Again, this might be
part of a deliberate strategy Current Assets: The business may
holding lower stock levels, carrying fewer debtors or simply have
less cash in the bank. Current Liabilities: The business may owe
less to its creditors Long Term Liabilities: The business may have
paid back a Long Term Loan Profit & Reserves: The business may
have made a loss over the year.
Slide 6
Analysing The Profit & Loss Account Some information can be
obtained simply on the basis of one years Profit & Loss
Account, but it helps very much to see the comparison with the
previous year. The main headings to look at are: Turnover ; Compare
to Cost of Sales Gross profit; Compare to Overheads Net Profit
(called the Operating Profit) Earned Surplus
Slide 7
What to look out for on the Profit & Loss Account Has the
business increased its Turnover ? How big a proportion of the
Turnover is taken up by Cost of Sales? How big a proportion of the
Gross Profit is taken up by Overheads? Has the business made a Net
Profit (called the Operating Profit). Has this increased from last
year? Has the business made an overall profit (Earned Surplus)? Has
this increased from last year? Can you identify the main reason for
the overall profit or loss?
Slide 8
The Different types of Ratio As discussed in the previous
section, we will use three we different types of Ratio: 1.
Profitability RatiosProfitability Ratios How successful is the
business? 2. Liquidity RatiosLiquidity Ratios Is the flow of cash
sufficient to meet obligations? 3. Efficiency RatiosEfficiency
Ratios How is the business using its resources? In each of these
cases, we will use the data taken from the M & N Manufacturing
Financial Statements. These are summarised on the handout and on
the spreadsheet.
Slide 9
Three Profitability Ratios We look at three important ratios:
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Gross Margin% = Gross Profit x 100 Gross Margin Sales
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Net Margin% = Net Profit before tax & interest x 100 Net Margin
Sales
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Return on Capital Employed (ROCE) =Return on Capital Employed
(ROCE) Net Profit before tax and interest x100 (Share Capital +
Reserves+ LT Loans)
Slide 10
Gross Margin Ratio Example of the Calculation Calculation for
2002 Gross Margin: 494,600 x 100 = 22.1% 2,240,000 DEFINITION:Gross
Margin% = Gross Profit x 100 Sales Selec t
Slide 11
Net Margin Ratio Example of the Calculation Calculation for
2002 Net Margin: 242,600 x 100 = 10.8% 2,240,000 DEFINITION:Net
Margin% = Net Profit before Tax & Interest x 100 Sales Selec
t
Slide 12
Return on Capital Employed (ROCE) Example of the Calculation
Calculation for 2002 ROCE: 242,600 x 100 = 29.2% 830,130
DEFINITION:ROCE% = Net Profit before tax and interest x 100 (Share
Capital + Reserves+ LT Loans) Selec t Add Together
Slide 13
Liquidity Ratios These Ratios seek to answer the question: Can
the business pay its way? All of these ratios look at the flow of
cash in the company, and try to determine whether or not, at a
particular point in time, the business has enough cash to pay what
it owes. Liquidity can be interpreted as the amount of cash, stock,
and debt, which can be easily converted into cash, offset by those
elements which are currently owed, such as trade creditors, tax
& interest etc. Liquidity Ratios summarise the current Working
Capital situation
Slide 14
Ratios - Liquidity We look at two ratios:
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Current ratio = Current Assets Current Liabilities Current ratio
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Acid test = Current Assets excluding stock Acid test Current
Liabilities
Slide 15
Current Ratio Calculation Current Assets : Trade Debtors240,800
Bank Account 33,500 Closing Stock Value300,000 574,300 Current
Liabilities: Trade Creditors 191,400 Dividends Owing 20,100
Corporation Tax Owing 21,860 233,360 Current Ratio= 574300= 2.5
233,360
Slide 16
Acid Test Ratio Calculation Current Assets excluding Stock :
Trade Debtors240,800 Bank Account 33,500 274,300 Current
Liabilities: Trade Creditors 191,400 Dividends Owing 20,100
Corporation Tax Owing 21,860 233,360 Acid Test Ratio= 274300 = 1.2
233,360
Slide 17
Efficiency Ratios These ratios are concerned with the way that
assets are used in an organisation. Some of these are very useful
financial management tools for example the average stock turnover
and the average credit period. These can be very useful in
controlling the flow of cash in an organisation. These ratios are
important measures of how effective particular changes in
management practice have been.
Slide 18
Efficiency Ratios Stock turnover (days) Stock turnover (days) =
Average Stock Value x 365 Cost of Sales
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Debtors (days) Debtors (days) = Total Debtors x 365 Total Credit
Sales
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Creditors (days) Creditors (days) = Total Creditors x 365 Credit
Purchases
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Slide 19
Stock Turnover Period Opening Stock Value261,000 Closing Stock
Value300,000 Cost of Sales 1,745,400 Stock Turnover (Days) =
(261000+300000)/2 x 365 1745400 = 58.7 days
Slide 20
Average Settlement period for Debtors Trade Debtors240,800
Total Sales 2,240,000 Average Settlement Period for Debtors =
240800 x 365 2240000 = 39.2 days
Slide 21
Average Settlement period for Creditors Trade Creditors191,400
Total Sales 1,804,400 Average Settlement Period = 191400 x 365
1804400 = 38.7 days
Slide 22
Seminar 7- Activities Preparation: read Chapter 7 (M & A 2
nd Edition) You should make sure that you have calculated all the
ratios within this presentation, and have completely understood all
the explanations. Exercises: M & A (2 nd Ed.) Exercise 7.3
(pages 239-240) M & A (2 nd Ed.) Exercise 7.5 (pages
241-242)