Unit2 Operational Ratios

Unit 2Understanding Accounts

Operating Efficiency

A summarised balance sheet

A typical UK balance sheet

Fixed assets 1,000 Share capital500

Debtors (receivables) 500 Retained profits

Stocks (inventories) 300 (earnings) 325

Cash 25

Other assets 100

Creditors (payables) (350)

Borrowings (750)

Net assets 825 Equity 825


HOWEVER A BETTER WAY TO SHOW THE BALANCE SHEET – MOVE THE BORROWINGS TO THE “OTHER” SIDE

Fixed assets 1,000 Share capital500



Cash 25

Other assets 100

Creditors (payables) (350)

Borrowings (750)

Net assets 825 Equity 825


Fixed assets 1,000 Share capital 500



Cash 25

Other assets 100

Creditors (payables) (350) Borrowings 750

Capital employed 1,5751,575 Note the

change of title



Debtors (receivables) 500 Retained profits Equity


Cash 25

Other assets 100

Creditors (payables) (350) Borrowings 750 Debt

Capital employed 1,5751,575

This side of the balance sheet is the funding side = debt + equity





Cash 25

Other assets 100




As the balance sheet must “balance” so every £ on the funding side must be represented by a £ on the other side





Cash 25

Other assets 100




So this side represents what is done with the funding – the “operating” side of the balance sheet


OPERATING FUNDING




Cash 25

Other assets 100



This side comes at a cost – the weighted average cost of capital (WACC – unit 4)


OPERATING FUNDING




Cash 25

Other assets 100



This side comes at a cost – the weighted average cost of capital (WACC – unit 4)

This is the side that needs to pay the cost of finance – the operating side produces “operating profit”

Return on capital employed

So,

OPERATING = FINANCING

This side comes at a cost – WACC, say 10%. So each £1 invested costs 10p


So,

OPERATING = FINANCING

This side produces operating profit. For each £1 invested it must yield at least 10p to cover the cost of capital. This yield is: operating profit/capital employed%

This is called the return on capital employed - ROCE


ROCE = operating profit x 100

capital employed (= debt+equity)



capital employed (= debt+equity)

= operating profit % sales

sales x capital employed

Return on sales or asset turnover

operating margin



capital employed (=borrowings+equity)

= operating profit % sales

sales x capital employed

Return on sales/margin asset turnover

profitability asset efficiency

ROCE

This framework allows us to drill into the operating aspect of the business to investigate what is happening.

For example return on sales can be further broken down into :

operating profit

Sales

Cost of sales Operating costs

sales sales

Which in turn can be drilled into more detailed costs where available.

ROCE

This framework allows us to drill into the operating aspect of the business to investigate what is happening.

For example return on sales can be further broken down into :

operating profit

Sales

LabourHR

Cost of sales raw materials Operating costs Training

sales Utilities sales Salaries

Which in turn can be drilled into more detailed costs where available.

Asset turnover

Asset turnover = sales/capital employed

This is a measure of how efficiently a business uses its assets

Eg a company needs to be make 20 deliveries a day. It can use 5 vans making 4 drops each or 4 vans making 5 drops each .

Asset turnover


This is a measure of how efficiently a business uses its assets

Eg a company needs to be make 20 deliveries a day. It can use 5 vans making 4 drops each or 4 vans making 5 drops each .

If a delivery is worth £100 and a van costs £1,000 the asset turnovers are: 2000/5000 = 0.4 or 2000/4000 = 0.5

The latter case is more efficient. So the higher the asset turnover the more efficiently assets are being used. Note: it is not normally expressed as a percentage.

Asset turnover


Capital employed = the financing OR the operating assets

This can be drilled into its operating component parts

For example, Sales/fixed assets, Sales/debtors, Sales/stocks Sales/creditors

Asset turnover


Though the latter are more usually shown as “days”

Debtor days = debtors x 365/sales = average collection time

Eg if annual sales are £365,000 and debtors are £36,500 then it takes 10% of a year on average to collect the payments from customers.

(1 day’s sales = £1,000, so £36,500 = 36.5 days’ sales. Or

Debtor days = 36500 x 365/365000 = 36.5 days)

Asset turnover


Though the latter are more usually shown as “days”

Debtor days = debtors x 365/sales = average collection time

Creditor days = creditors x 365 / cost of sales

Stock days = stocks x 365/cost of sales

These use cost of sales in order to strip out the profit element

Example

Given the following 2010 data about a company:

1 Calculate the ROCE for 2010

2 Identify which is the main element of the business causing the movement.

Profit and loss/£ Balance sheet

Revenue 10,000 Fixed assets 20,000

Cost of sales 2,500 Debtors 2,200

Operating costs 1,500 Stocks 1,100

Creditors (800)

Operating profit 6,000 Capital employed 22,500

Last year’s key figures: ROCE = 32%. Return on sales = 58%, Asset turnover = 0.8

Cost of sales/sales = 23%, operating costs/sales = 17%, Sales/fixed assets = 0.52, debtor days = 50 days, stock days = 158 days, creditor days = 120 days

[Note: for this exercise, due to time constraint, we will just use the year end capital employed figure – strictly we should use an average of the start and end figures]

Example

ROCE = 6000/22500 = 27% [32%]

Return on sales = 6000/10000 = 60% [58%] Asset turnover = 10000/22500 = 0.44 [0.8]

So issue is around asset turnover. So only need to look at those items:





Creditors (800)


Example

ROCE = 6000/22500 = 27% [32%]



Sales/fixed assets = 10000/20000 = 0.5 [0.52]

Debtor days = 2200/10000 x 365 = 80 days [50 days]

Creditor days = 800/2500 x 365 = 117 days [120 days]

Stock days = 1100/2500 x 365 = 161 days [158 days]





Creditors (800)


Example

ROCE = 6000/22500 = 27% [32%]



Sales/fixed assets = 10000/20000 = 0.5 [0.52]

Debtor days = 2200/10000 x 365 = 80 days [50 days]

Creditor days = 800/2500 x 365 = 117 days [120 days]

Stock days = 1100/2500 x 365 = 161 days [158 days]





Creditors (800)


So increase in debtors appears to be main cause in drop in ROCE

ROCE in real lifeRecall we started this analysis with a simple balance sheet:

Fixed assets Share capital

Debtors Retained profits

Stocks Borrowings

Cash

Creditors

But in real life there are a number of other items that might appear on a balance sheet, for example De La Rue (p108 unit 2)

De La Rue – Summary balance sheet

Cash 86 Share capital 48

Receivables 89 Other reserves (82)

Inventory 73 Retained profits 194

Other current assets 17

Tangible fixed assets 240

Intangible fixed assets 3

S/T debt 26

Payables 34

Other current liabs 165

L/T debt 58

Other L/T liabs 2

L/T provisions 60

Minority interests 3

160 160








S/T debt 26

Payables 34


L/T debt 58

Other L/T liabs 2

L/T provisions 60


160 160

Need to move “financing” to the right hand side.








S/T debt 26

Payables 34


L/T debt 58

Other L/T liabs 2

L/T provisions 60


160 160


Obviously debt. But what else?








S/T debt 26

Payables 34


L/T debt 58

Other L/T liabs 2

L/T provisions 60


160 160


Obviously debt. But what else?

Anything else that might result in interest (or equivalent) being paid eg pension deficits





Other current assets 17 S/T debt 26

Tangible fixed assets 240 L/T debt 58

Intangible fixed assets 3 L/T provisions 60

Payables 34


Other L/T liabs 2


304 304

In calculating “capital employed” it is usually easier to decide what is “financing” and add that up (everything else = operating side as the balance sheet “balances”)

Next TimeWe shall look at more ratios concerning financing,

liquidity and investment markets

Unit2 Operational Ratios

Education

Transcript of Unit2 Operational Ratios