Have you ever wondered what all those headings and figures mean when your accountant returns your Balance Sheet and afraid to ask? Or maybe someone asks you about your gearing and you think they are talking about your car?
Perhaps you are looking at buying a business and you’ve been given their last 3 years of accounts and have no idea what you should be looking at?
Let’s look at what some of the financial ratios you are most likely to come across mean and how you can understand company accounts.
Most business owners want to know the answer to 3 basic questions:
- How much profit has the business made and is it up or down?
- How much does the business owe?
- How much is owed to the business?
The balance sheet only provides a snapshot of the day it was produced – generally the last day of your accounting year. The profit & loss account only provides an estimate of the business’ profitability, while the balance sheet is a mishmash of different costs and values.
If you were looking at a company’s accounts with a view to purchase or even checking how you have done yourself over 3 or more years, there are 4 main analysis techniques you can use:
- Horizontal analysis
- Trend analysis
- Vertical analysis
- Ratio analysis
Horizontal analysis involves looking at the same line of the accounts, for example sales income, for each year.
From the table above you could see that sales had increased by 10% in the first year and 25% in the second year from our baseline in 2015.
Trend analysis is similar to horizontal analysis, except instead of using cash figures they are given a weighting of 100 as the baseline figure.
Taking the example above the 2015 sales figures would be 100, the 2016 figures 110 and the 2017 figures 137.5. You would normally only relate this for the most significant items.
This technique requires all the profit and loss account and all the balance sheet items to be expressed as a percentage. For example, if trade debtors were £20,000 in 2017 and the balance sheet total was £50,000 then trade debtors would be 40% of the total of the final balance.
This technique attempts to relate one item to another item and then express that relationship as a percentage. For example 20 to 40 is (20/40) x 100 = 50%.
Techniques for interpreting accounts
The four main business ratios are:
- Profitability ratios
- Liquidity ratios
- Efficiency ratios
- Investment ratios
Let's look at these in more detail.
Do you want to know if the money you invested has given you a return on that original investment?
- Return on Capital Employed (ROCE)
This is probably the best way of assessing the business profitability. However, both ‘profit’ in the accounting sense and ‘capital’, (capital assets) can be defined in several different ways. It is often calculated using the capital as at the year end.
If you are looking at profit from the point of view of the business as a whole this may be the best ROCE ratio.
Often business owners are asked what their profit margin is or their mark up and get confused over the difference. Understanding what these ratios are used to measure will help you to calculate them.
- Gross Profit
This ratio can be used to assess how successful the business has been at trading, measuring how much profit has been made in relation to sales.
- Mark up
This ratio measures the amount of profit added to the cost of goods sold.
- Net Profit
This ratio may be best used to make internal comparisons as it is difficult to compare net profit between different businesses.
Do you need to know if you can afford to make that large cash investment in the business within your next 12 months of trading?
Liquidity ratios assess how much cash the business has available within the next 12 months.
- Current assets
Usually expressed as a factor. It is expected that most businesses have current assets in excess of current liabilities e.g. 1:1 or a more favourable ratio of 2:1. If you have less than 1:1 as a ratio then now may not be the best time to use that valuable cash asset.
- Acid Test (Quick Test)
If cash is needed for the business but it is not easy to dispose of stocks in the short term the acid test ratio is used.
Do you think you have a lot of old stock in that rear stockroom? Are you a seasonal business, especially in the fashion industry? If so, you need to be moving that stock through quickly.
Maybe you have just bought a business along with all its stock. Moving this through may make your business more efficient – even if you have to have that “sale” to do so.
- Stock Turnover
The greater the turnover of stock the more efficient the business appears to be in purchasing and selling goods. Expressed as a number, a stock with a turnover of 2 would suggest the business has about 6 months of sales in stock and a turnover of 12 only a month’s normal sales in stock.
Average stock is usually calculated as follows:
- Fixed assets turnover
Justifying why you have to have all that lovely, new, shiny equipment?
Fixed assets (plant and machinery) enable the business to function efficiently therefore a high level of fixed assets ought to generate more sales. It can be measured as a percentage or a number.
This ratio is only really useful if it is compared with previous periods, or with other businesses.
- Trade debtors collection period
Cashflow a problem and your customers not paying on time? Maybe its time to look at your terms & conditions on your invoices.
If your debtors are slow at paying the business could fall into cashflow problems. Cash sales should be excluded from the calculation.
This calculation could allow a business to decide its invoice payment period and where the crisis point would be in a 30, 60 or 90 day invoice repayment period.
- Trade creditor payment period
Are you thinking of investing in a company? These ratios could help in assessing any returns.
Investment ratios are primarily of interest to prospective investors.
Companies are usually financed from a mixture of share capital, retained profits and borrowings. These borrowings may be long term, such as debentures, or short term, such as credit given by trade creditors.
Companies may also have funds set aside for items like taxations which are payable in the future. If a company finances itself from a high level of borrowings there may be a higher risk of investing in it.
- Dividends Yield
The dividend yield measures the rate of return an investor gets by comparing the cost of shares with the dividend paid.
- Dividends Cover
Can you afford to pay a Dividend and how often can you draw it?
This ratio will show the number of times that an ordinary dividend could be paid out of current earnings.
If the dividend is covered twice, the company would be paying out half its earnings as an ordinary dividend.
- Earnings per share
This puts the profit into context and enables a fair comparison to be made between one year’s earnings and another.
- Price / Earnings Ratio
When looking at share prices, the P/E ratio is shown but what does this really mean? It should demonstrate the value of the company, measuring the current share price relative to its earnings per share.
This ratio shows the market price in relation to the earnings and how many years it would take before recovering the market price paid for the shares out of the earnings.
On 21 December 2016 The Telegraph reported that the FTSW 100’s p/e ratio was 33, the historical average is 15. Therefore on that date shares were assumed to be hugely overvalued.
- Capital Gearing
Want to buy shares in a company? Before investing in a company you should check that it is profitable enough to pay you any dividends at all.
A company with a low level of borrowing is regarded as being low geared. A high geared company is potentially a higher risk investment, as it has to earn sufficient profit to cover the interest payments, and the preference dividend before it can pay out any ordinary dividend.
This ratio will calculate the proportion of the company financed out of borrowings.
You don’t need to be a mathematician to run a successful business. Pick and choose those ratios that are most relevant to what you want to know.
Are you looking at trends for your own net profitability? Do you want to invest in an existing business? Do you want to demonstrate the figures for your business in the best light for your investors?
Whether you have a simple accounting template or audited accounts you should have your monthly or annual turnover figures, the cost of any goods directly associated with making your product and the cost of running the business each month. From this you can work out your Gross and Net Profit and Mark up covering the profitability ratios.
Having a list of your assets and how much you owe will give you the figures for your liquidity ratio. Are you solvent?
Efficiency and investment can come later but knowing what they mean and why they are important is a step forward in being able to analyse all your working data.
Knowing and improving on both of these may help you in identifying and reducing costs and thereby increasing your profitability.
Dyson, J. R. (1997). Accounting for Non-Accounting Students. Pitman Publishing, London. ISBN0-273-62575-6.
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