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Unit 2
Understanding Accounts
Operating Efficiency
A summarised balance sheet
A typical UK balance sheet
Fixed assets 1,000 Share capital 500
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
A summarised balance sheet
HOWEVER A BETTER WAY TO SHOW THE BALANCE SHEET – MOVE THE
BORROWINGS TO THE “OTHER” SIDE
Fixed assets 1,000 Share capital 500
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
A summarised balance sheet
Fixed assets 1,000 Share capital 500
Debtors (receivables) 500 Retained profits
Stocks (inventories) 300 (earnings) 325
Cash 25
Other assets 100
Creditors (payables) (350) Borrowings 750
Capital employed 1,575 1,575
Note the
change of
title
A summarised balance sheet
Fixed assets 1,000 Share capital 500
Debtors (receivables) 500 Retained profits Equity
Stocks (inventories) 300 (earnings) 325
Cash 25
Other assets 100
Creditors (payables) (350) Borrowings 750 Debt
Capital employed 1,575 1,575
This side of the
balance sheet is the
funding side = debt +
equity
A summarised balance sheet
Fixed assets 1,000 Share capital 500
Debtors (receivables) 500 Retained profits
Stocks (inventories) 300 (earnings) 325
Cash 25
Other assets 100
Creditors (payables) (350) Borrowings 750
Capital employed 1,575 1,575
This side of the
balance sheet is the
funding side = debt +
equity
As the balance sheet must
“balance” so every £ on the
funding side must be
represented by a £ on the
other side
A summarised balance sheet
Fixed assets 1,000 Share capital 500
Debtors (receivables) 500 Retained profits
Stocks (inventories) 300 (earnings) 325
Cash 25
Other assets 100
Creditors (payables) (350) Borrowings 750
Capital employed 1,575 1,575
This side of the
balance sheet is the
funding side = debt +
equity
So this side represents
what is done with the
funding – the “operating”
side of the balance sheet
A summarised balance sheet
OPERATING FUNDING
Fixed assets 1,000 Share capital 500
Debtors (receivables) 500 Retained profits
Stocks (inventories) 300 (earnings) 325
Cash 25
Other assets 100
Creditors (payables) (350) Borrowings 750
Capital employed 1,575 1,575
This side comes at a
cost – the weighted
average cost of capital
(WACC – unit 4)
A summarised balance sheet
OPERATING FUNDING
Fixed assets 1,000 Share capital 500
Debtors (receivables) 500 Retained profits
Stocks (inventories) 300 (earnings) 325
Cash 25
Other assets 100
Creditors (payables) (350) Borrowings 750
Capital employed 1,575 1,575
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
Return on capital employed
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
Return on capital employed
ROCE = operating profit x 100
capital employed (= debt+equity)
Return on capital employed
ROCE = operating profit x 100
capital employed (= debt+equity)
= operating profit % sales
sales x capital employed
Return on sales or asset turnover
operating margin
Return on capital employed
ROCE = operating profit x 100
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
Labour HR
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
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 .
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
Asset turnover = sales/capital employed
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
For example, Sales/fixed assets, Sales/debtors, Sales/stocks
Sales/creditors
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
For example, Sales/fixed assets, Sales/debtors, Sales/stocks
Sales/creditors
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:
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
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:
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]
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
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:
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]
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
So increase in
debtors appears to
be main cause in
drop in ROCE
ROCE in real life
Recall 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
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
Need to move “financing” to
the right hand side.
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
Need to move “financing” to
the right hand side.
Obviously debt. But what
else?
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
Need to move “financing” to
the right hand side.
Obviously debt. But what
else?
Anything else that might
result in interest (or
equivalent) being paid eg
pension deficits
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 S/T debt 26
Tangible fixed assets 240 L/T debt 58
Intangible fixed assets 3 L/T provisions 60
Payables 34
Other current liabs 165
Other L/T liabs 2
Minority interests 3
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 Time
We shall look at more ratios concerning financing,
liquidity and investment markets

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Unit2 Operational Ratios

  • 2. A summarised balance sheet A typical UK balance sheet Fixed assets 1,000 Share capital 500 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
  • 3. A summarised balance sheet HOWEVER A BETTER WAY TO SHOW THE BALANCE SHEET – MOVE THE BORROWINGS TO THE “OTHER” SIDE Fixed assets 1,000 Share capital 500 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
  • 4. A summarised balance sheet Fixed assets 1,000 Share capital 500 Debtors (receivables) 500 Retained profits Stocks (inventories) 300 (earnings) 325 Cash 25 Other assets 100 Creditors (payables) (350) Borrowings 750 Capital employed 1,575 1,575 Note the change of title
  • 5. A summarised balance sheet Fixed assets 1,000 Share capital 500 Debtors (receivables) 500 Retained profits Equity Stocks (inventories) 300 (earnings) 325 Cash 25 Other assets 100 Creditors (payables) (350) Borrowings 750 Debt Capital employed 1,575 1,575 This side of the balance sheet is the funding side = debt + equity
  • 6. A summarised balance sheet Fixed assets 1,000 Share capital 500 Debtors (receivables) 500 Retained profits Stocks (inventories) 300 (earnings) 325 Cash 25 Other assets 100 Creditors (payables) (350) Borrowings 750 Capital employed 1,575 1,575 This side of the balance sheet is the funding side = debt + equity As the balance sheet must “balance” so every £ on the funding side must be represented by a £ on the other side
  • 7. A summarised balance sheet Fixed assets 1,000 Share capital 500 Debtors (receivables) 500 Retained profits Stocks (inventories) 300 (earnings) 325 Cash 25 Other assets 100 Creditors (payables) (350) Borrowings 750 Capital employed 1,575 1,575 This side of the balance sheet is the funding side = debt + equity So this side represents what is done with the funding – the “operating” side of the balance sheet
  • 8. A summarised balance sheet OPERATING FUNDING Fixed assets 1,000 Share capital 500 Debtors (receivables) 500 Retained profits Stocks (inventories) 300 (earnings) 325 Cash 25 Other assets 100 Creditors (payables) (350) Borrowings 750 Capital employed 1,575 1,575 This side comes at a cost – the weighted average cost of capital (WACC – unit 4)
  • 9. A summarised balance sheet OPERATING FUNDING Fixed assets 1,000 Share capital 500 Debtors (receivables) 500 Retained profits Stocks (inventories) 300 (earnings) 325 Cash 25 Other assets 100 Creditors (payables) (350) Borrowings 750 Capital employed 1,575 1,575 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”
  • 10. Return on capital employed So, OPERATING = FINANCING This side comes at a cost – WACC, say 10%. So each £1 invested costs 10p
  • 11. Return on capital employed 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
  • 12. Return on capital employed ROCE = operating profit x 100 capital employed (= debt+equity)
  • 13. Return on capital employed ROCE = operating profit x 100 capital employed (= debt+equity) = operating profit % sales sales x capital employed Return on sales or asset turnover operating margin
  • 14. Return on capital employed ROCE = operating profit x 100 capital employed (=borrowings+equity) = operating profit % sales sales x capital employed Return on sales/margin asset turnover profitability asset efficiency
  • 15. 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.
  • 16. 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 Labour HR Cost of sales raw materials Operating costs Training sales Utilities sales Salaries Which in turn can be drilled into more detailed costs where available.
  • 17. 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 .
  • 18. 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 . 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.
  • 19. Asset turnover Asset turnover = sales/capital employed 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
  • 20. Asset turnover For example, Sales/fixed assets, Sales/debtors, Sales/stocks Sales/creditors 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)
  • 21. Asset turnover For example, Sales/fixed assets, Sales/debtors, Sales/stocks Sales/creditors 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
  • 22. 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]
  • 23. 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: 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
  • 24. 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: 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] 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
  • 25. 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: 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] 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 So increase in debtors appears to be main cause in drop in ROCE
  • 26. ROCE in real life Recall 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)
  • 27. 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
  • 28. 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 Need to move “financing” to the right hand side.
  • 29. 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 Need to move “financing” to the right hand side. Obviously debt. But what else?
  • 30. 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 Need to move “financing” to the right hand side. Obviously debt. But what else? Anything else that might result in interest (or equivalent) being paid eg pension deficits
  • 31. 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 S/T debt 26 Tangible fixed assets 240 L/T debt 58 Intangible fixed assets 3 L/T provisions 60 Payables 34 Other current liabs 165 Other L/T liabs 2 Minority interests 3 304 304 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”)
  • 32. Next Time We shall look at more ratios concerning financing, liquidity and investment markets