Finance and Accounts 2 Analysing Accounts

Accounting and Finance Key Terms: Assets: the resources a business owns - Fixed Assets – those lasting more than one year and not used up in production – equipment, machinery, buildings, etc. Freehold assets – where the business has full ownership of the assets Leasehold assets – agreement permitting the leaseholder the right to use the asset for a fixed period in exchange for a regular payment Goodwill – the difference between the audited value and the market value of a business – the image, brand name, the existence of patents or trademarks, etc. Current Assets – assets used up during production and which will realise cash within a year – debtors, raw materials, stock, etc.

Key Terms:

Assets: the resources a business owns -

Fixed Assets – those lasting more than one year and not used up in production – equipment, machinery, buildings, etc.

Freehold assets – where the business has full ownership of the assets

Leasehold assets – agreement permitting the leaseholder the right to use the asset for a fixed period in exchange for a regular payment

Goodwill – the difference between the audited value and the market value of a business – the image, brand name, the existence of patents or trademarks, etc.

Current Assets – assets used up during production and which will realise cash within a year – debtors, raw materials, stock, etc.

Accounting and Finance Liabilities: The financial obligations of a business – what a business owes Loans, shareholders funds, creditors, tax liability, interest owing Current liabilities – those obligations the business has to meet within a year

Liabilities:

The financial obligations of a business – what a business owes

Loans, shareholders funds, creditors, tax liability, interest owing

Current liabilities – those obligations the business has to meet within a year

Accounting and Finance The Purpose of Accounts: To provide information for stakeholders Shareholders – progress of their investment Government – tax liability Suppliers – credit worthiness Customers – long term future of the business Prospective Investors – decision making Potential bidders in acquisition activity Trade Unions – negotiations with the company Management – monitor performance of the business Employees – their position in the business (they may well also be shareholders!)‏ In 2003, a trial took place in France where a total of 37 people, including Elf's former president, Loik Le Floch-Prigent, faced charges surrounding the ‘murky’ sale of the Leuna refinery in Germany to Elf in 1991. Allegations persisted throughout that bribes were paid by Elf to two former German ministers and to the Christian Democratic Union Title: Leuna Oil Refinery Scandal. Copyright: Getty Images, available from Education Image Gallery (http://edina.ac.uk/eig)‏

The Purpose of Accounts:

To provide information for stakeholders

Shareholders – progress of their investment

Government – tax liability

Suppliers – credit worthiness

Customers – long term future of the business

Prospective Investors – decision making

Potential bidders in acquisition activity

Trade Unions – negotiations with the company

Management – monitor performance of the business

Employees – their position in the business (they may well also be shareholders!)‏

Accounting and Finance Types of Information: Profit and Loss Account – the revenue and costs of a business over a time period Balance Sheet – the assets and liabilities of a business at a specific point in time Use these sources to give ratios – the relationship between different aspects of the business

Types of Information:

Profit and Loss Account – the revenue and costs of a business over a time period

Balance Sheet – the assets and liabilities of a business at a specific point in time

Use these sources to give ratios – the relationship between different aspects of the business

Ratio Analysis Key types: Profitability ratios - a measure of how much profit its activities generate Liquidity ratios – ability of a business to meet its debts Investment ratios – a measure of the performance of the business

Key types:

Profitability ratios - a measure of how much profit its activities generate

Liquidity ratios – ability of a business to meet its debts

Investment ratios – a measure of the performance of the business

Ratio Analysis Profitability Ratios Profit Margin – relates profit to turnover (sales revenue)‏ In general the higher the profit margin the better A profit margin of 10% means that the firm makes 10p profit for every £1 of goods sold Narrow margins – tend to be on products/services which are high volume, mass market products which are highly competitive Wide margins – tend to be on products/services that are low volume, high value with relatively high degree of monopoly power Stock markets rely on key financial data Title: Dow up on bullish brokerage calls. Copyright: Getty Images, available from Education Image Gallery (http://edina.ac.uk/eig)

Profitability Ratios

Profit Margin – relates profit to turnover (sales revenue)‏

In general the higher the profit margin the better

A profit margin of 10% means that the firm makes 10p profit for every £1 of goods sold

Narrow margins – tend to be on products/services which are high volume, mass market products which are highly competitive

Wide margins – tend to be on products/services that are low volume, high value with relatively high degree of monopoly power

Ratio Analysis Gross Profit: Total Revenue – Variable (Direct) Costs Gross Profit Gross Profit Margin = -------------- x 100 Turnover Net Profit: Total revenue – Total Costs (VC+FC)‏ Net Profit Net Profit Margin = -------------- x 100 Turnover

Gross Profit: Total Revenue – Variable (Direct) Costs

Gross Profit

Gross Profit Margin = -------------- x 100

Turnover

Net Profit: Total revenue – Total Costs (VC+FC)‏

Net Profit

Net Profit Margin = -------------- x 100

Turnover

Ratio Analysis Other profitability ratios Retained Profit Retained Profit Margin = ------------------- x100 Turnover Profit Profit Mark up = ----------- x100 Cost

Other profitability ratios

Retained Profit

Retained Profit Margin = ------------------- x100 Turnover

Profit

Profit Mark up = ----------- x100

Cost

Ratio Analysis Return on capital employed (ROCE)‏ A measure of the efficiency of the firm in using its capital to generate profit. A ROCE of 15% suggests that the firm uses every £1 of capital to generate profits of 15p

Return on capital employed (ROCE)‏

A measure of the efficiency of the firm in using its capital to generate profit.

A ROCE of 15% suggests that the firm uses every £1 of capital to generate profits of 15p

Ratio Analysis Example: Assume two firms produce identical products and have identical capital structures: Firm A – Capital Assets = £1,000,000 Profit = £250,000 Firm B – Capital Assets = £1,000,000 Profit = £100,000 Easy to see in this instance that firm A is the more efficient as every £1 of capital generates 25p in profit whereas for Firm B, every £1 of capital only generates 10p profit ROCE allows us to have a measure of efficiency for firms with different capital structures

Example:

Assume two firms produce identical products and have identical capital structures:

Firm A – Capital Assets = £1,000,000

Profit = £250,000

Firm B – Capital Assets = £1,000,000

Profit = £100,000

Easy to see in this instance that firm A is the more efficient as every £1 of capital generates 25p in profit whereas for Firm B, every £1 of capital only generates 10p profit

ROCE allows us to have a measure of efficiency for firms with different capital structures

Ratio Analysis Profit for the Year ROCE = ----------------------------------- x100 Equity Shareholders' Funds Generally – the higher the ratio, the more effective the firm is in using its capital assets

Profit for the Year

ROCE = ----------------------------------- x100

Equity Shareholders' Funds

Generally – the higher the ratio, the more effective the firm is in using its capital assets

Ratio Analysis Liquidity Ratios: Look at the ability of a firm to meet its expenditure and how much cash is tied up in the business available to pay for that expenditure Careful management of its income and expenditure is important to its cash flow and its ultimate long term survival More firms fail through cash flow problems than any other reason

Liquidity Ratios:

Look at the ability of a firm to meet its expenditure and how much cash is tied up in the business available to pay for that expenditure

Careful management of its income and expenditure is important to its cash flow and its ultimate long term survival

More firms fail through cash flow problems than any other reason

Liquidity Ratios Working Capital – having sufficient funds at the right time to be able to meet liabilities Working capital management is crucial to the success of a firm Working capital = the difference between current assets and current liabilities

Working Capital – having sufficient funds at the right time to be able to meet liabilities

Working capital management is crucial to the success of a firm

Working capital = the difference between current assets and current liabilities

Liquidity Ratios The Current Ratio – the proportion of assets to liabilities. A current ratio of 2:1 means the firm has sufficient liquidity to cover its liabilities twice over A current ratio of 0.75:1 would suggest that the firm is unable to meet its liabilities and could be in a weak financial position A ratio below 1 does not mean the firm will collapse but it will be in a vulnerable position

The Current Ratio – the proportion of assets to liabilities.

A current ratio of 2:1 means the firm has sufficient liquidity to cover its liabilities twice over

A current ratio of 0.75:1 would suggest that the firm is unable to meet its liabilities and could be in a weak financial position

A ratio below 1 does not mean the firm will collapse but it will be in a vulnerable position

Liquidity Ratios Acid Test Ratio = (Current Assets - Stocks) : Current Liabilities The Acid Test Ratio gives an indication whether a firm can meet its liabilities without having to dispose of its stocks. It gives a clear and quick indication of the state of the firm’s liquid assets. Comparing the Current ratio and the Acid Test ratio therefore gives an indication of the relative size of the stock holdings of a firm.

Acid Test Ratio =

(Current Assets - Stocks) : Current Liabilities

The Acid Test Ratio gives an indication whether a firm can meet its liabilities without having to dispose of its stocks. It gives a clear and quick indication of the state of the firm’s liquid assets.

Comparing the Current ratio and the Acid Test ratio therefore gives an indication of the relative size of the stock holdings of a firm.

Investment Ratios Measure the performance of the firm and are of interest to potential investors Gearing Ratio – measures the proportion of share capital to loan capital A high gearing ratio suggests high proportion of loans to share capital Gearing ratio important in looking at a firm’s capital structure and the impact of interest rate changes

Measure the performance of the firm and are of interest to potential investors

Gearing Ratio – measures the proportion of share capital to loan capital

A high gearing ratio suggests high proportion of loans to share capital

Gearing ratio important in looking at a firm’s capital structure and the impact of interest rate changes

Investment Ratios Other key investment ratios: Earnings per share = Profit available to equity shareholders Average number of issued equity shares The average profit earned per ordinary share Dividends per share = Dividends paid to equity shareholders Average number of issued equity shares The average dividend received per ordinary share

Other key investment ratios:

Earnings per share = Profit available to equity shareholders

Average number of issued equity shares

The average profit earned per ordinary share

Dividends per share = Dividends paid to equity shareholders

Average number of issued equity shares

The average dividend received per ordinary share

Investment Ratios Dividend yield = Latest annual dividends Current market share price A comparison of the dividend received with the current market value of the shares Dividend cover = Net profit available to equity shareholders Dividends paid to equity shareholders The ability of the firm to meet its dividend payments from its profits Price/earnings or p/e ratio = Current market share price Earnings per share The length of time for earnings to cover the cost of the initial investment – key investor ratio used to estimate degree of risk involved in the investment.

Dividend yield = Latest annual dividends

Current market share price

A comparison of the dividend received with the current market value of the shares

Dividend cover = Net profit available to equity shareholders

Dividends paid to equity shareholders

The ability of the firm to meet its dividend payments from its profits

Price/earnings or p/e ratio = Current market share price

Earnings per share

The length of time for earnings to cover the cost of the initial investment – key investor ratio used to estimate degree of risk involved in the investment.

Ratio Analysis Limitations of Ratio Analysis: Usefulness dependent on the accuracy of the figures – Enron, Parmalat? Only a part of the jig-saw – needs other information to make full judgement What has happened in the past is not necessarily a pointer to what will happen in the future! Statistics always have a limitation in that it depends when they are used and how they are used. No two businesses are fully comparable as the differences between them will always influence the performance of the business Ratios do not always reflect the degree of ‘intuition’/’genius’ that may influence the performance of a business The Crooked E – ironic logo of Enron. Statistics do have their limitations! Source: reubing, stock xchng

Limitations of Ratio Analysis:

Usefulness dependent on the accuracy of the figures – Enron, Parmalat?

Only a part of the jig-saw – needs other information to make full judgement

What has happened in the past is not necessarily a pointer to what will happen in the future!

Statistics always have a limitation in that it depends when they are used and how they are used.

No two businesses are fully comparable as the differences between them will always influence the performance of the business

Ratios do not always reflect the degree of ‘intuition’/’genius’ that may influence the performance of a business