7. Unit 7 Handouts - Accounting Ratios

7/27/2019 7. Unit 7 Handouts - Accounting Ratios

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ACCOUNTING PERFORMANCE

STUDY UNIT 3

ACCOUNTING RATIOS AND PERFORMANCE

SUNJAY LUTCHMAN

Understanding Financial Ratios

Financial Ratios

comparisons of financial data used to evaluatebusiness performance

Ratio Analysis

the study of relationships in a companysfinances in order to understand and improvefinancial performance

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Ratio Analysis main strength

Ratios:

direct the users focus of attention

identify and highlight areas of good and bad

performance

identify areas of significant change.


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Caveat

Beware creative accounting

View that:

Every company in the country is fiddling itsprofits.

Myth that the financial statements are anaccurate reflection of the companys tradingperformance for the year.

Accounts are little more than an indication ofthe broad trend

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Compare like with like

Comparing current financial ratios with:

financial ratios for a preceding period

budgeted financial ratios for the current period

financial ratios for other profit centres withinthe company

financial ratios for other companies within thesame sector

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Importance of uniformity

Comparison is possible only if there is

Uniformity in the preparation of accounts and

An awareness of any differences in international

accounting policies


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How are ratios are defined?

Implications of any given ratio requires a clear

definition of its constituent parts.

Definitions of ratios may vary from source to

source e.g. concepts and terminology are not

universally defined.

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Awareness of underlyingtrends

ROCE remains a constant 10% over the years 20X120X3

Net profit increased by 50% in both 20X2 and 20X3

This trend is not ascertainable in the ROCE ratio.

Return on

Net profit Capital employed ROCE

ZMK ZMK

20X1 100,000 1,000,000 10%

20X2 150,000 1,500,000 10%

20X3 225,000 2,250,000 10%

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Common Accounting Ratios

Profitability ratios

Liquidity ratios

Efficiency ratios Financial Leverage

Market Performance ratios


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Ratios are used to track bottom-lineperformance.

Useful for comparison with competitors

A tool to asses performance relative to otherpossible investments

Profitability Ratios

Gross Profit margin ratio (gross profit) (net sales)

Operating Profit margin ratio (operating income) (net sales)

Operating Income

earnings before interest and taxes


This ratio evaluates the efficiency of the assets ofthe company.



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An important measure of a companyshealth is its ability to pay debts on time.

Need to have a favorable liquid position !

Liquidity Ratios

The current ratio shows how well thecompany is prepared to pay current liabilities.

Due within a year

A ratio of 2:1 represents a strong position in

most industries.

Liquidity Ratios


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Inventory is a particular problem in some

industries.

A ratio of 1:1 is acceptable in many industries.

Liquidity Ratios

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Identify the company norm?

The following is an extract from the 2003 Annual Reportof Barloworld:

2003 2002 2001 2000 1999 1998 1997

Quick ratio 0.8 0.7 0.8 0.9 1.1 0.7 0.8

Efficiency or Asset Management ratioscompare the value of key assets to salesperformance.

How efficient are we in operating our business?

How successful are we in the way we use ofassets?

Efficiency Ratios


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A company doesnt earn money until itsinventory is sold.

If a business has a low inventory ratio:

Inventory should be reviewed to determine if it isobsolete

Efficiency Ratios

Used to determine if a company has a

reasonable amount of assets for the salesbeing produced.

A low value suggests assets are not being

used efficiently.

Efficiency Ratios

Fixed Asset Turnover Ratio = Sales

Fixed Assets

Examines the efficiency of land, buildings,and major equipment

Efficiency Ratios


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Higher ratios mean that accountsreceivable are collected quickly.

Lower ratios might indicate losses.

when older accounts are not paid

Efficiency Ratios

Number of Days Inventory = Stock / Cost

of Sales x 365

Debtors Collection = Accounts receivable x365 / Credit Sales

Creditor Settlement = Accounts payable /

Cost of Sales x 365

Efficiency Ratios

Financial Leverage

Using debt financing to increase the rate of

return on assets

Financial Leverage Ratios

Critical Thinking: Is it more advisable to useyour own funds exclusively in starting abusiness.or borrowing from a bank..or a

mixture of the two sources? Why?


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The appropriate ratio is guided by

The industry in which the company operates

The financial stability of the company


Debt to Equity :Measures how much of the assetsare owned by creditors in comparison to how muchis owned by the owners

Debt to Equity = Total Debt

Total Equity


A high ratio means the company has a highmargin of safety in being able to pay creditors.



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Market performance ratios serve a variety offunctions

Examine the overall financial performance of abusiness in contributing to shareholder value

A metric of the effectiveness of executiveleadership

Helps compare multiple companies

Market Performance Ratios

If preferred stock is issued

the dividends paid to preferred stockholdersare subtracted from net income beforedividing by the number of shares of commonstock issued


Anticipated earnings on investments

Helps investors decide what price to payfor a companys stock



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PE a measure of marketconfidence

Market price also takes into account anticipated

changes in the earnings arising from theirassessment of macro events such as

Political factors, e.g. imposition of trade embargoes andsanctions

Economic factors, e.g. the downturn in manufacturingactivity

Company-related events, e.g. possibility of organic oracquired growth and the implication of financialindicators for future cash flow estimates

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PE ratio implication offinancial indicators

Balance sheet:

change in debt/equity ratio in relation to prior periods

new borrowings to finance expansion

debt restructuring following inability to meet current repaymentterms

adequacy of working capital

low acid test (quick) ratio in relation to prior periods indicatingliquidity difficulties

change in current ratio in relation to prior periods, i.e. higher

indicating a build-up of slow-moving inventory and lower possible

inventory-outs

contingent liabilities that could be damaging if they crystallise non-current assets being increased or not being replaced

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PE ratio implication offinancial indicators

Income statement:

change in sales trend

limited product range, products moving out of patent protection

period

expanding product range changes in technology beneficial or otherwise to company

high or low capital expenditure/depreciation ratio indicating that

productive capacity is not being maintained

loss of key suppliers/customers, e.g. loss of longstanding Marks &Spencer contracts

change in ratio of R&D to sales


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Inventory Treatment

First-In, First-Out

Earliest goods assumed to be first units sold

Inventory made up of latest goods acquired

Last-In, First-Out

Newest goods assumed to be first units sold

Inventory made up of earliest goods acquired

Inventory Treatment

Average cost

Cost of items sold is the weighted average ofcosts incurred

Inventory is the weighted average of costsincurred

Cost of Sales = Opening Stock + Purchases Closing Stock

7. Unit 7 Handouts - Accounting Ratios

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