Week 7 - Tutorial 6 Flashcards
Question A: Why are financial ratios useful?
• They are useful for making comparisons. A comparison can be made to:
- Previous years’ figures
- Similar companies
- Budgeted and planned figures
- Industry averages
- Stock market averages
Question B: What are the main limitations of financial ratios?
Limitations posed by the use of financial ratios when measuring and comparing company performance:
• The effect of exceptional items
- E.g. losses incurred in closing down a production facility; profits from selling non-current assets
• Statement of financial position shows the position on a given date
- Not necessarily representative for the whole year. Companies may try to make their position look better at the end of the year because of this.
• Statement of financial position is based on historic cost
- The amounts shown for assets are not necessarily current values; some non-current assets are revalued from time to time
- When looking at the value of ‘equity’, the statements do not indicate the market value of the equity on the stock market.
• Information in financial statements is aggregated
- Most information reported in financial statements is for the business as a whole and so most ratios are an average.
- While companies do produce ‘disaggregated’ or ‘segmental’ information about different parts of the business, it is rather limited.
• Inflation not shown in financial statements
- A 3% increase in sales/profits is not an indication of success if the inflation rate was 4%
• Ratio analysis limited by the information companies disclose
• What basis of comparison should be used?
No two businesses are identical
Comparisons may be limited because companies
have different:
- Accounting policies: Capitalisation of development expenditure; depreciation methods; prudence
- Financing policies: Capital structure; leases; etc.
- Policies to achieve growth: Internal growth (investments in non-current assets); external growth (acquire other companies)
- Operating policies: Subcontracting manufacturing to overseas companies; standardisation
- Accounting dates: Seasonal business (e.g. a retailer with a fiscal year end before or after Christmas)
Question C:
Calculate ratios for Jackdan using the information on the following pages
Interpret whether the solvency, profitability, utilisation of assets, and dividend cover are improving for Jackdan.
You are required to comment on the financial
position and performance of the company,
making use of appropriate ratios
Financial Strength/Solvency: Current Ratio Quick Ratio Gearing Ratio Interest Cover
Overall Profitability: Return on Capital Employed Return on Shareholder’s Funds Profitability of Sales: Gross Profit % Net Profit %
Utilization of Assets: Sales/total assets Inventory (stock) Turnover Ratio Trade Receivables (debtors) Ratio Trade Payables (creditors) Ratio
Stock Market:
Earnings per share
Dividend per share
Dividend cover
Statement of Financial Position for Jackdan
Year 1 Year 2 Non-current assets £000 £000
Property, plant and equipment 300 330 Current assets
Inventories 70 90
Trade Receivables 50 70
Cash 30 40
150 200 Total assets 450 530 Liabilities and equity Current liabilities
Trade Payables 38 45
Taxation 32 40
Interest Payable 30 35
100 120 Non-current liabilities
8% debentures 100 150 Total liabilities 200 270 Equity
Ordinary 50p shares 200 200
Retained earnings 50 60 Total equity 250 260 Total liabilities and equity 450 530
Income Statement for Jackdan
Year 1 Year 2
£000 £000
Revenue 492 550
Cost of Sales (369) (410)
Gross profit 123 140
Distribution costs (12) (12)
Administration expenses (10) (9)
Operating Profit 101 119
Finance costs: interest (8) (12)
Profit before tax 93 107
Income tax expense (32) (40)
Profit for the period 61 67
Statement of Changes in Equity for Jackdan
Year 1 Year 2
£000 £000 Balance at the beginning of year 239 250 Profit for the year 61 67 Dividends paid (50) (57) Balance at end of year 250 260
Financial Strength/ Solvency Ratios
Current Ratio = Current Assets/ Current Liabilities
Year 1
150,000/100,000 = 1.5:1
Year 2
200,000/120,000 = 1.67:1
This is an improvement, although might be considered low – as always it depends on the industry
Quick Ratio = Quick assets (excluding inventories)/Current liabilities Year 1 (150,000-70,000)/100,000 = 0.8:1 Year 2 (200,000-90,000)/120,000 = 0.92:1 Same comments as for current ratio
Gearing Ratio = (Long-term Borrowings/(Long-term Borrowings +Equity))x100
Year 1
100,000/(100,000+250,000) = 28.57%
Year 2
150,000/(150,000+260,000) = 36.59%
The increased long-term loan has led to a higher gearing ratio
Interest cover = Profit before deducting interest/Interest
Year 1
101,000/8,000 = 12.6 times
Year 2
119,000/12,000 = 9.92 times
There is decline in cover due to the increased loan amount
Overall Profitability Ratios
Return on Capital Employed = (Operating Profit/Total equity plus long-term borrowings) x 100 Year 1 101,000/(100,000+250,000) = 28.86% Year 2 119,000/(150,000+260,000) = 29.02% Improvement due to a better net profit
Return on Shareholder’s Funds = (Profit for period/Total equity) x 100 Year 1 61,000/250,000 = 24.4% Year 2 67,000/260,000 = 25.8% Improvement due to a better overall profit
Profitability of Sales Ratios
Gross Profit % = (Gross Profit/Sales) x 100
Year 1
123,000/492,000 = 25%
Year 2
140,000/550,000 = 25.45%
Slight improvement due to increased prices, different product mix or negotiating better prices from suppliers
Net Profit % = (EBIT/Sales) x 100 Year 1 101,000/492,000 = 20.5% Year 2 119,000/550,000 = 21.6% Greater improvement than that for gross profit, indicating a good control of overheads
Utilisation of Assets Ratios
Asset turnover ratio = Sales/Total assets
Year 1
492,000/450,000 = 1.09:1
Year 2
550,000/530,000 = 1.04:1
A slight decrease of an already low ratio
Inventory Holding Days Ratio = (Inventories/Cost of Sales) x 365 Year 1 (70,000/369,000)*365 = 69.2 days Year 2 (90,000/410,000)*365 = 80.12 days Substantial slow down in stock movement
Trade Receivables Ratio = (Trade Receivables/ Sales)x365 Year 1 (50,000/492,000)*365 = 37.1 days Year 2 (70,000/550,000)*365 = 46.45 days This reveals a significantly worsening situation
Trade Payables Ratio = (Trade Payables/Cost of Sales)x365 Year 1 (38,000/369,000)*365 = 37.6 days Year 2 (45,000/410,000)* 365 = 40.1 days A slight increase, but now outside the working capital cycle
Stock Market Ratio
Earnings per share
Profit for the period/Number of shares in issue
Year 1
61,000/400,000 = £0.153p
Year 2
67,000/400,000 = £0.168p
There has been an increase in this amount, as profit has increased whilst the number of shares have remained the same.
On the Statement of Financial Position we can see that there are £200,000 worth of 50p shares –
meaning there are 400,000 shares in issue
Dividend per share Dividend paid/ Number of shares in issue Year 1 50,000/400,000 = £0.125p Year 2 57,000/400,000 = £0.143p The dividend per share has increased. We will need to check the dividend cover to see if they are paying out an equal proportion of profits as dividends
Dividend Cover Ratio = Earnings per share/ Dividends per share OR Profit for the period/ / Total Dividends Year 1 61,000/50,000 = 1.22 times Year 2 67,000/57,000 = 1.18 times There has been a decline in dividend cover, this is due to them paying out a higher percentage of its profits in dividends
• Profitability has increased during the period
• This has mainly been achieved through the containment of overheads
• Short-term solvency - currently its current ratio and
liquidity ratio are reasonable
• The gearing has increased and the interest cover
decreased, but neither are a cause for concern
• Movement in inventory has slowed down
• The company is also faced with increasing
receivables days, which will need to be managed
