NOTES ON RATIOS: Variance Analysis was one form of control we have looked. We discovered that one way of judging how well a section or a company had performed was to look at the Actual Costs against the Budgeted Costs. This unit will look into financial ratios which investors, managers and bank will use to judge organisations. We will look at three distinct groups of ratios, but we will start this unit with a general session on relevant ratios which could be used to judge an eclectic mix of organisations. After all the sessions I have numerous question for you to try which will test your understanding behind the figures. Section 1 Ratios used to judge a mix of organisations Section 2 Profitability Ratios Section 3 Liquidity Ratios Section 4 Activity Ratios Section 1 Ratios used to judge a mix of organisations In this session we will look at what non-financial ratios could be used to judge various organisations. You are probably familiar with many of them as the government have forced many organisations to publish them. Many others are only too happy to publish statistics about themselves to shame their competition. Question At work how could you measure your performance? Possible Answer This is easy if you are involved in manufacturing. In a previous job my performance was measured by how many carpets/mats I fitted into Marina cars/vans without any flaws. However, in most non-manufacturing jobs how do you measure the work that has been produced? Think about these occupations. 1) Social Worker 2) Doctor 3) Policewoman PICTURES OF THESE THREE PEOPLE OPPOSITE THEM However, targets (Key Performance Indicators) are normally set so that when they are appraised, they can also be judged. You may have target set annually and your wage rise/bonus may depend upon you reaching these targets. It is vital to an organisation to judge how well it is doing and to see if it could implement some strategy to try and improve performance where needed. These can range from Financial to Non-Financial ratios. Non-Financial ratios for various organisations 1 No of trainees a care home has compared to fully qualified carers. 2 No of new products a company has compared to old products. 3 The percentage of books a library has with larger font. 4 No of days an organisation takes to answer a written complaint. 5 No of police officers from a particular ethnic background. 6 No of times a telephone can ring before being answered. 7 Time taken before seen by a doctor at A&E. 8 Percentage of female candidates for a particular party at General Election. 9 Percentage of flights arriving on schedule. 10 Staff turnover in an organisation Reflection Look at the above list and state why these may be important to organisations. In the next three sessions we will look into Financial Ratios. Financial Ratios We can either use these ratios to compare one organisation from year to year, two different organisations in the same industry, or our results against the industry benchmark. To calculate these, we have to have both the Income Statement (Profit & Loss Account) and The Statement of Financial Position (Balance Sheet). Financial ratios fall into five main categories Profitability RatiosLiquidity RatiosEfficiency (Activity) RatiosGearing ratios (not covered in this section)Investor ratios (not covered in this section) Section 2 Profitability Ratios In this section we will calculate the main profitability ratios and state what is meant by these figures and how organisations use them to monitor performance. We can either use these ratios to compare one organisation from year to year, two different organisations in the same industry, or our results against the industry benchmark. To calculate these, we have to have both the Income Statement (Profit & Loss Account) and The Statement of Financial Position (Balance Sheet) Profitability Ratios There are 3 main ratios that could be used here. Gross Profit % or Gross Profit MarginNet Profit % or Net Profit MarginReturn on Capital Employed For the first two ratios all we require is an Income Statement (Profit & Loss Account) Income Statement of R Mancini For Year Ended 31/12/2012 Sales revenue 120,000 Less Cost of goods sold* (30,000) Gross profit 90,000 Less expenses (15,000) Net profit / operating profit 75,000 *Cost of goods sold = Opening Inventory 8,000 Add Purchases 34,000 Less Closing Inventory (12,000) 30,000* Gross Profit % = Gross Profit/Sales x 100 90,000/120,000 x 100 = 75% Question What does 75% represent? For every £1 of Sale 75p are costsEvery article is sold for 75pFor every £1 of Sale, 75p is the Gross ProfitEvery article is sold for 25p ANSWER The answer is c) …..for every £1 worth of Sale 75p is the Gross Profit. 2. Net Profit % = Net Profit/Sales *100 75,000/120,000*100 = 62.5% Question What does 62.5% represent? a) For every £1 of Sale 62.5p are costs b) Every article is sold for 75p c) For every £1 of Sale, 37.5p are all the costs d) The business is now making a loss ANSWER The answer is c) For every £1 of Sale the Total costs incurred are 37.5p making a 62.5% Net Profit Margin. 3. Return on Capital Employed = Net Profit /Capital Employed x 100 *** 75,000/(208,000 + 10,000) x 100 = 34.4% CAPITAL EMPLOYED = Total Money Mancini has put into business (£208,000) plus the Long-Term Loan (£10,000) *** There are numerous definitions for this ratio so always show the examiner which one you are using. For companies the formula you would use would be Net profit before interest and tax Equity + long term loans To calculate this ratio, we require the Income Statement & the Statement of Financial Position. Income Statement of R Mancini Ltd for the year ended 31/12/2012 Sales revenue 120,000 Less Cost of goods sold* (30,000) Gross profit 90,000 Less expenses (15,000) Net profit / operating profit 75,000 Statement of Financial Position of R Mancini Ltd as at 31st December 2012 Non-Current Assets Motor Vehicles 200,000 45,000 155,000 PPE 100,000 60,000 40,000 300,000 105,000 195,000 Current Assets Inventory 12,000 Trade Receivables 8,000 Bank 15,000 Cash 2,000 37,000 TOTAL ASSETS 232,000 Equity & Liabilities Equity* 208,000 Non-Current Liabilities Bank Loan 10,000 Current Liabilities Trade Payables 12,000 Vat Owing 2,000 Total Equity and Liabilities 232,000 Equity* = Share Capital + Retained Profit Question What does the 34.4% mean? Mancini made a profit of 34.4p for every £ of SaleFor every £1 Mancini put into business, it makes 63.56pFor the total amount invested in Mancini’s business the return is 63.56pMancini makes a return of 65.6p ANSWER c) The return is 34.4p for the total amount invested into the business ie. Macini’s £208,00 plus the £10,000 long term loan. b) This is close but incorrect as to make that profit Mancini needed to borrow £10,000 …it wasn’t just his own money Discussion What is the normal Net Profit % for a UK supermarket?What is the normal Net Profit % for a UK high street Travel Agency?What is the normal Gross Profit % for a high street restaurant? PICTURES OF THE 3 TYPES OF BUSINESSES HERE PLEASE ANSWER The main UK supermarkets have a Net Profit % of roughly 6%, high street travel agencies about 2% and the Gross Profit % of a high street restaurant is about 70% (the last one will vary greatly depending upon the chain) Section 3 Liquidity Ratios In this section we will look at the two liquidity ratios which are vitally important to organisations. We discovered that Profitability without Liquidity wasn’t a recipe for success in an earlier unit. Liquidity Ratios Current RatioAcid Test (also known as Quick or Liquid Ratio) For these ratios we only require the Statement of Financial Position. Statement of Financial Position of R Mancini Ltd as at 31st December 2012 Non-Current Assets Motor Vehicles 200,000 45,000 155,000 PPE 100,000 60,000 40,000 300,000 105,000 195,000 Current Assets Inventory 12,000 Trade Receivables 8,000 Bank 15,000 Cash 2,000 37,000 TOTAL ASSETS 232,000 Equity & Liabilities Equity* 208,000 Non-Current Liabilities Bank Loan 10,000 Current Liabilities Trade Payables 12,000 Vat Owing 2,000 Total Equity and Liabilities 232,000 1) Current Ratio = Current Assets/Current Liabilities = 37,000/14,000 = 2.64:1 These means that for every £1 of Current Liability we have £2.64 of Current Assets to pay. So, supposing all of our Trade Payables (£12,000) wanted payment right now and our VAT owing of £2,000 was due at the same time, then we would have ample resources to pay them. From the above Statement of Financial Position, we have £2,000 in Cash and a further £15,000 in the Bank. The reality is that we would spread our Trade Payables out so that in any one month only a small percentage would need paying. Question/Reflection When do YOU pay your Car Insurance, Car Tax, House Insurance, MOT, Health Insurance, Football club Season Ticket, AA subscription etc? Answer. Probably all spread out throughout the year as it would be far too much in any given month Question What is the best Current Ratio from the following options? 100:1 10:1 2:1 0.5:1 Answer At first glance we would probably pick a) as it sounds really good to have £100 of Current Assets for every £1 of Current Liabilities. However, should we have ALL these resources in Current Assets Let’s take a trip to our factory PICTURE OF FACTORY – NO ROOF & POOR MACHINERY. As we can see although we have £100 of Current Assets for every £1 of Current Liabilities, our factory roof needs repairs, and we could also update our machinery to a more productive model instead of having it tied up in Current Assets. PICTURE OF NEW FACTORY /MACHINERY By using some of our resources here we have become more productive and hopefully more profitable. The answer is c) The Optimum Current Ratio is 2:1 For every £1 of Current Liability we have we should have £2 of Current Assets. So, consider the following Statement of Financial Position of A Ferguson Ltd (EXTRACT) As at 31/12/12 Current Assets Inventory 900 Trade Receivables 170 Bank 20 Cash 10 1100 Current Liabilities Trade Payables 550 550 Working Capital 550 Current Ratio = Current Assets/Current Liabilities = 1,100/550 = 2:1 Question Is this position ideal? Answer Although the actual ratio works at 2:1, we are not in the ideal position as we would not be able to pay our Trade Payables even if only 1/12 of them came for payment (550/12= £45.83). So, although we say the ideal ratio is 2:1 YOU MUST always look at the composition of the Current Assets. In our example, most of our current assets are tied up in Inventories. If the Trade Payables demanded payment and we require Cash quickly the inventories may have to be sold off at rock bottom prices! Not the ideal position. Acid Test Ratio = Current Assets- Inventory/Current Liabilities Question From Mancini’s Statement of Financial Position (PAGE 8) calculate the Acid Test Ratio 2.64:13.08:12.08:11.79:1 Answer The correct answer is (37,000 – 12,000) = 25,000/14,000 = 1.79:1 It is all the Current Assets minus your Inventories divided by all of your Current Liabilities. Reflection What does that ration (1.79:1) mean? Answer For every £1 of Current Liability we have £1.79 of fairly liquid Current Assets. We have taken Inventories out of the equation as these are the most illiquid (takes longest to turn into cash) of the Current Assets The ideal ratio for the Acid Test is 1:1, meaning that we have £1 of fairly liquid assets for every £1 of current liabilities. The ratio is always lower than the Current Ratio as we have taken inventories out of the equation. However, if you look at any supermarkets’ financial statements you should find that they operate at a much lower level. www.sainsburys.co.uk www.tesco.co.uk Question Why can supermarkets operate at a much lower Acid Test than the ideal ratio of 1:1 Answer The main reasons that they are able to operate at say 0.4:1 (meaning that they have only 40p of fairly liquid assets for every £1 of current liabilities are Trade Receivables……Have you ever said to the checkout operator ‘Can I pay you next week?’Trade Payables……Is it likely that one of their big suppliers (Heinz) would threaten a supermarket to pay their bill or they would stop supplying them? Supermarkets’ terms to suppliers…. You supply us today and we’ll pay you in 90 days…….take it or leave it! Section 4 Efficiency/Activity Ratios In this session we are going to look at three of the Activity Ratios that businesses can use to judge their efficiency. We will also look at the limitations of judging a business by the use of ratios and we will finish off with appropriate tasks to test your learning. Activity Ratios The three ratios we will look into here are Inventory Turnover or Inventory Turnover DaysTrade Receivable DaysTrade Payable Days a) Inventory Turnover This ratio indicates how many times we ‘turnover our inventory/stock in a period. Alternatively, it also shows how long we hold on to our inventory before selling them. Inventory turnover period = Inventory x 365 Cost of sales Giving us our answer in days, the number of days, stock typically remained in stock Inventory x 12 Cost of sales This would give us the answer in months and if we changed the 12 into 52 the answer would be in weeks. Question How many days should you have your stock before you sell it? Answer This is really impossible to answer as it depends upon which type of business we are talking about. A milk delivery person would hope stock turns over daily whereas a second-hand car salesperson would hope for stock to turn over every month. The key to using this ratio is to compare one year’s figures to the next or to the industry benchmark. There is no point in comparing the milk industry to that of second-hand car sales! For the three activity ratios we will need the Income Statement and the Statement of Financial Position. Income Statement of R Mancini for the year ended 31/12/2012 Sales revenue 120,000 Less Cost of goods sold* (30,000) Gross profit 90,000 Less expenses (15,000) Net profit / operating profit 75,000 *Cost of goods sold = Opening Inventory 8,000 Add Purchases 34,000 Less Closing Inventory (12,000) 30,000* Statement of Financial Position Of R Mancini as at 31st December 2012 Non-Current Assets Motor Vehicles 200,000 45,000 155,000 PPE 100,000 60,000 40,000 195,000 Current Assets Inventory 12,000 Trade Receivables 8,000 Bank 15,000 Cash 2,000 37,000 TOTAL ASSETS 232,000 Equity & Liabilities Equity* 208,000 Non-Current Liabilities Bank Loan 10,000 Current Liabilities Trade Payables 12,000 Vat Owing 2,000 Total Equity and Liabilities 232,000 Inventory turnover period = Inventory x 365 Cost of sales = 12,000 x 365 30,000 = 146 days Question What does 146 days represent On average it takes 146 days to sell an item of stockThe minimum time period to sell an item of stock is 146daysThe maximum time period to sell an item of stock is 146daysAll sales take place after 146 days Answer On average it takes 146 days to sell an item of stock. Some may sell in 7 days; others 35 days and some items of stock may take 300 days but on Average it takes 146days.b) c) &d) these answers could be theoretically correct if all goods were sold 146 days after being purchased but incorrect in reality. Question As we have used Closing Inventory figure (the inventory figure as at 31/12/12), what might this do to the calculation? Answer As we pick a specific date for inventory in our calculation, this could be totally unrepresentative of our stock figures during the year. Walls Ice Cream…stock figures in July and December. Standard Fireworks …. stock figures in early October and February. So, this is a useful tool in trying to judge whether a business is improving by looking at its Inventory Turnover. However, consider the following example. Khan sells the famous ‘xyz’ machine and figures for this are shown for two years in the table below. Khan & Company 2011 Khan & Company 2012 Selling Price£100£95Cost£80£80Profit per item£20£15No of units sold500520 Question Has Khan done better in 2012 than 2011? Answer If we just looked at the last figure in the table, we would say that Khan has got a much greater turnover (in units). It has risen by 20/500 * 100 = 4%. However, this has been achieved by a reduction in price (5%) and Total Profit for that product has fallen from 500 * £20 =£10,000 to 520 * £15 = £7,800. Profit has fallen by £2,200 but have a greater market share. b) Trade Payable Days = Trade payables x 365 Purchases From Mancini’s Financial Statements. ASSUMPTION …. All Purchases are on credit. 12,000 x 365 34,000 =128.82 Days It is taking us on average 128 days (just over 4 months) to pay our suppliers. Again, we would monitor this figure and compare it to previous years. At first glance it sounds good that we are receiving supplies and not having to pay our suppliers for four months. It surely is better to be able to hang onto our cash. However, the only provision may be that if we continue to delay our payments beyond an acceptable level then our suppliers may get fed up dealing with us and contracts may terminate. c) Trade Receivable Days = Trade Receivables x 365 Sales From Mancini’s Financial Statements. ASSUMPTION ….. All Sales are on credit. 8,000 x 365 120,000 = 24.3 days It is taking on average only 24 days for our customers to pay their invoices. This figure suggests that we have an excellent Credit Control Department. As with all the other ratios, you would monitor these from year to year to judge whether the organisation was working efficiently or not. The use of Ratios We can calculate ratios using the accounts to help analysis relationships, and changes within the business. eg Is GP% improving?We can calculate ratios and compare with similar businesses to assess how the business is doing. Eg Is our NP% better or worse than the industry average? Limitations They are calculated at a specific moment in time (in our example 31/12/2012) What could these figures look like on 7/1/13? Just because an organisation has had a specific ratio eg NP% of 40% over the last 3 years this does not guarantee anything for the future. We are looking at historical data.Organisations may ‘window dress’ the figures to attain a specific ratio. Eg To improve a liquidity ratio sell some Non-Current Assets but this would affect your production capacity. What good would a farmer be without his tractor but with a bag of cash!! Additional Question 1 Study the following table of D. BAA and suggest what has happened to his business in the two-year period. 20112012Gross Profit %7565Net Profit %4548 Suggested Answer1 Baa’s Gross Profit% has fallen from 75% to 65%. If we assume that he is selling items for £ 1 then his cost of sourcing them has increased from 25p to 35p. However although this has made it harder for him he has managed to cost his other costs much better. They have fallen from 30p (75-45) to just 17p ( 65-48). He may have been able to have done this by introducing annualised hours /renegogiated the terms of his lease/moved to cheaper premises/switched power suppliers. The following are extracts of financial information relating to Brisbane Ltd and Adelaide Ltd, as at 30 November 2011, and 30 November 2010. Brisbane Ltd £000Brisbane Ltd £000Adelaide Ltd £000Adelaide Ltd £000 2011201020112010Turnover1,8001,9201,7302,070Cost of sales1,0801,1259601,010Gross Profit7207957701,060Net Profit before interest and tax4045360600Inventory200250250240Trade receivables375480160260Cash424040Trade payables195225380370 Calculate the following ratios, and answer the questions below: Brisbane LtdBrisbane LtdAdelaide LtdAdelaide Ltd 2011201020112010Current Ratio= Current assets Current Liabilities 379/195=1.95601/225= 2.68450/380=1.18540/370=1.46 Acid Test ratio= Current assets-inventory Current liabilities 379-200/195 = .9602-250/225 = 1.56450-250/380 = .52540-240/370 = .81Gross profit margin= Gross profit Sales revenue 720/1800= .4795/1920= .4770/1730= .441060/2070 = .51Net Profit margin= Net profit Sales revenue 40/1800= .0245/1920 = .02360/1730= .2600/2070 = .29Stock Turnover period= Inventory *365 Cost of sales 200*365/1080 = 67 days250*365/1125=81 days250*365/960= 95 days240*365/ 1010= 86 daysTrade receivables period= Trade receivables*365 Sales 175*365/1800 = 35 days350*365/1920 = 66 days160*365/1730 = 33 days260*365/2070 = 45 daysTrade payables period = Trade payables*365 Cost of sales 195*365/1080= 66 days225*365/1125= 73 days380*365/ 960= 144 days370* 365/ 1010 = 133 days From the limited information, and ratios calculated, answer the following to the best of your knowledge. Which company : Question 1 Q Was taking the longest to pay its debts at November 2010? A Adelaide Q Appeared to be in the best situation to pay off its current liabilities in November 2011? Why do you say this? A Brisbane, current ratio/acid test/trade payables Q Held stock for the longest amount of time from November2011 figures? A Adelaide Q Had the highest gross margin in 2011? A Brisbane Q Had the highest gross margin in 2010? A Brisbane 2. What might be possible reasons for the change in trade receivables period for both Brisbane and Adelaide Ltd between 2010 and 2011? A Tighter credit controls, chasing debts more effectively, being more carefully who credit is offered to 3. Comment on the trade payables period for Adelaide Ltd between 2010 and 2011? What are potential issues the company may face as a consequence? A Increasing, possibly alarming, goodwill with suppliers likely to be harmed, will they want to trade with Adelaide in future, potential court action if against terms of trade etc 4. Brisbane Ltd has improved the inventory turnover period from 2010 to 2011. What might have caused this improvement ? A Improved stock management/reordering procedures, offering discounts on slow moving stock etc Comment on the differences between gross and net profit for Brisbane Ltd. Give a possible reason for this. A Possible misallocation of costs, high overhead costs, poor management of costs etc What are the limitations of using the above ratio analysis as the only tool to evaluate the performance of a company? A Using point of time figures which may not be fair reflection of years figures, for example need more detail of stock movements overall in the year . (ICE Cream/Fireworks) We do not know if the companies are in the same industry and therefore limited comparison possible between the two, Ratio gives us numbers but does not help in analysis, for example we do not know the industries the companies are in and therefore whether they are fairing well or poorly.
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