Understanding & Managing Finance

Seminar 7

Seminar Seven - Activities

Preparation: readChapter 7 (M & A 2nd Edition)

Exercises: Ratio Activity Spreadsheet M & A Exercise 7.3 (pages 239-240) M & A Exercise 7.5 (pages 241-242)

Starting Points

Describe what is meant by Financial Ratio Analysis, and outline the key steps in performing such an analysis.

State some of the categories we need to consider when we are examining accounts, and describe some of the factors which might affect our analysis.

Describe some of the Key Ratios within each category, and what they mean.

Select and calculate

appropriate ratios

Identify the question and the

informationrequired

Interpret and

evaluate the results

The key steps of financial ratio analysis

Some Financial Issues to Consider

Categories

Profitability

Efficiency

Liquidity

Profitability

Return on ordinary shareholders’ funds

Return on capital employed

Net profit margin

Gross profit margin

Formula

Net profit after taxation and preference dividend (if any) x 100 Ordinary share capital + Reserves

Net profit before interest and taxation x 100 Share capital + Reserves + Long-term loans

Net profit before interest and taxation x 100 Sales

Gross profit x 100 Sales Sales

Efficiency

Average stock turnover period

Average settlement period for debtors

Average settlement period for creditors

Sales to capital employed

Formula

Average stock held x 365 Cost of sales

Sales per employee

Trade debtors x 365 Credit sales

Trade creditors x 365 Credit purchases

_______Sales_______ Number of employees

_______ Sales__________ Long-term capital employed

Liquidity

Current ratio

Acid test ratio

Formula

Current assets_______________ Current liabilities (creditors due within one year)

Current assets (excluding stock) Current liabilities

The main elements comprising the ROCE ratio

Sales______ Long-term

capital employed

Return on capital employed

multiplied by

equals

Net profit before interest and taxation

sales

P & Q Hypermarkets: CASE STUDYP & Q Hypermarkets are a small retail chain concentrating on evening and weekend trade. The company has been relatively profitable for the past few years, and has grown steadily. At the beginning of 2002, P & Q took out a Bank Loan of £100,000 to finance an expansion of business (fitting a new store). The new store was opened in January 2003. At that time there was an issue of shares which provided the capital to enable the Bank loan to be repaid.

P & Q Hypermarkets

Balance Sheet Summary 2001 2002 2003

Fixed Assets £536,000 £702,290 £739,190

Current AssetsTrade Debtors £8,150 £10,800 £12,100Bank Account £9,600 £33,500 £31,000

Stock £81,000 £73,000 £109,060

Current LiabilitiesTrade Creditors £81,500 £79,400 £98,800

Dividends owing £5,300 £20,100 £10,000Corporation tax owing £2,500 £12,760 £10,580

Long-Term LiabilitiesLT Loans £50,000 £150,000 £50,000

£495,450 £557,330 £721,970

Capital & ReservesShare Capital £400,000 £400,000 £500,000

Profit & Reserves £95,450 £157,330 £221,970

£495,450 £557,330 £721,970

P & Q Hypermarket

s

Profit & Loss Summary 2002 2003

Sales (Turnover) £1,040,000 £981,200Cost of Sales £845,400 £832,000Gross Profit £194,600 £149,200

Overheads £52,000 £38,400Net Profit £142,600 £110,800

Interest £15,000 £5,000Profit before Tax £127,600 £105,800

Tax £25,520 £21,160Profit after Tax £102,080 £84,640

Dividends £40,200 £20,000Profit After Tax & Dividends £61,880 £64,640

Earned Surplus £61,880 £64,640

P & Q Hypermarket

s

Profitability Analysis 2002 2003

Relevant Data From the P & L Accounts

Sales £1,040,000 £981,200Cost of Sales £845,400 £832,000Gross Profit £194,600 £149,200

Overheads £52,000 £38,400Net Profit £142,600 £110,800

Interest £15,000 £5,000Profit before Tax £127,600 £105,800

Tax £25,520 £21,160Profit after Tax £102,080 £84,640

Dividends £40,200 £20,000Profit after tax and dividends £61,880 £64,640

Relevant Data From the Balance Sheets

Share Capital £400,000 £500,000Reserves £157,330 £221,970LT Loans £150,000 £50,000

Profitability Ratios 2002 2003

Gross Margin% 18.7% 15.2%Net Margin% 13.7% 11.3%

ROCE 20.2% 14.4%

P & Q Hypermarket

s

Commentary on the Profitability Ratios

It is quite clear that the new store has reduced profitability. With every new venture, this is to be expected, however, in this case there are some concerns. Firstly, it would have been expected that with a new store, there would have been an increase in Turnover. This does not seem to have happened. Both the Gross Margin and the Net margin are lower in 2003 than 2002, and the ROCE seems to have dropped considerably. It is possible that given the expansion, the senior management has 'taken their eye off the ball' in other stores and this has led to the reduction in profitability.

P & Q Hypermarket

s

Liquidity Analysis

2,002 2,003Relevant Data From the Balance Sheets

Trade Debtors £10,800 £12,100Bank Account £33,500 £31,000

Opening Stock Value £81,000 £73,000Closing Stock Value £73,000 £109,060

Trade Creditors £79,400 £98,800Dividends owing £20,100 £10,000

Corporation tax owing £12,760 £10,580

Liquidity Ratios 2002 2003

Current Assets £117,300 £152,160Current Liabilities £112,260 £119,380

Current Ratio 1.0 1.3Acid Test 0.4 0.4

Commentary on the Liquidity Ratios

Current Ratio has increased, but Acid test Ratio has stayed the same. (This is very low, but P & Q is a retail store therefore has low levels of trade debtors). The Current Ratio signals an increase in stock levels. This is to be expected with a new store. There does not seem to be a threat to cash flow.

P & Q Hypermarket

s

Relevant Data From the P & L Accounts

Sales £1,040,000 £981,200Cost of Sales £845,400 £832,000Gross Profit £194,600 £149,200

Overheads £52,000 £38,400Net Profit £142,600 £110,800

Relevant Data From the Balance Sheets

Trade Debtors £10,800 £12,100Bank Account £33,500 £31,000

Opening Stock Value £81,000 £73,000Closing Stock Value £73,000 £109,060

Trade Creditors £79,400 £98,800Dividends owing £20,100 £10,000

Corporation tax owing £12,760 £10,580

Additional Data

Credit purchases £804,400 £942,800

Efficiency Ratios 2002 2003

Stock Turnover (Days) 33.2 39.9Creditors (Days) 36.0 38.2

Debtors (Days) 3.8 4.5Sales/Capital Employed 1.5 1.3

P & Q Hypermarket

s

Commentary on the Efficiency Ratios

Turnover Time has increased; this means that it is is not just that stock levels have increased, but that the stock is not moving as quickly as it did previously. It may be that in the new store, sales have not followed the normal pattern, and that a new strategy is required. Debtor payment time has increased somewhat but this is not really significant; similarly, Creditors have increased by 2 days, but this is only marginally higher than in

P & Q Hypermarket

s

Calculating and Using the Ratios (1)

To what extent should a business extend credit to its customers?

McLaney & Atrill Exercise 7.3

Conday & Co.

Solutions available after the seminar.

Calculating and Using the Ratios (2)

What should a supplier look for when deciding whether to supply a business customer?

McLaney & Atrill Exercise 7.5

Threads Ltd.

Solutions available after the seminar.

Additional Material:Using the Ratios

1. What sort of Liquidity Ratio is acceptable?

2. What early-warning signs can be detected that a company may be heading towards insolvency and failure?

Average current ratio and average acid test ratio for 1996 for UK listed companies in various industrial sectors

Mineralextraction

0.0Generalindustrie

s

Consumergoods

Services

0.2

0.4

0.6

0.8

1.0

1.6

1.2

1.4

Utilities

Current ratio

Acid test ratio

Current ratio

Time

19X1 19X419X319X2 19X5

XYZ Ltd

Industry average

Graph plotting current ratio against time

Mean ratios of failed and non-failed businesses

+0.35

+0.45

+0.25

+0.15

+0.05

-0.15

-0.05

+0.1

-0.1

-0.2

0.78

0.79

0.65

0.58

0.51

0.37

0.44

0.0

1 2 3 4 5 2 3 4 51 1 2 3 4 5

Cash flow Total debt

Net income Total assets

Total debt Total assets

Non-failed firms Failed firms

Mean ratios of failed and non-failed businesses

0.36

0.42

0.30

0.24

0.18

0.06

0.12

3.5

2.5

2.0

+0.15

+0.05

-0.05

-0.15

3.0

1 2 3 4 5 2 3 4 51 1 2 3 4 5

Working capital Total assets

Current ratio

No credit interval

Non-failed firms Failed firms

Scatter diagram showing the distribution of failed and non-failed businesses

Current ratio

ROCE ratio

Failed businessesNon-failed businesses