7 A N A LY S I N G

THE Recap Year 1:

S T R AT E G I C
POSITION OF A What is the difference between profit and profitability?
BUSINESS
State 3 measures of profitability.

What is meant by return on investment?

What is meant by the proportion of long term funding that is

debt?

7.2 A NALYSING THE EXISTING INTERNAL

POSITION OF A BUSINESS TO ASSESS STRENGTHS
AND WEAKNESSES : FINANCIAL RATIO ANALYSIS
7.2 A NALYSING THE EXISTING INTERNAL POSITION OF
A BUSINESS TO ASSESS STRENGTHS AND WEAKNESSES :
FINANCIAL RATIO ANALYSIS

 In this topic you will learn about

 How to assess the financial performance of a business using

balance sheets, income statements and financial ratios
 Financial ratio analysis to include:
 profitability (return on capital employed)
 liquidity (current ratio)
 gearing
 efficiency ratios: payables days, receivables days,
inventory turnover

 The value of financial ratios when assessing performance

 Data may be analysed over time or in comparison with
other businesses
 A SSESSING FINANCIAL PERFORMANCE

• PLCs have a legal obligation to publish their annual

accounts

• The format is governed by International Financial

Reporting Standards (IFRS)

• This format has altered some of the terminology used by

UK businesses to comply with standard practices across
the world

• Financial data can be used to assess performance and

potential
 P UBLISHED ACCOUNTS

The financial performance of a business can be assessed

Recap Year 1: using two key financial reports:
Write down the
formula for
calculating each Balance sheet
type of profit.
• A formal financial document that summarises the net
worth of a business at a given point in time
• It balances net assets with total equity
Income statement
• A formal financial document that summarises a
business’ trading activities and expenses to show
whether the business has made a profit or a loss over a
specified period of time
 B ALANCE S HEET – T HE TERMINOLOGY

Assets: Items of value owned by a Liabilities: Money a business owes i.e.

business. debts.

Non – current assets Non – current liabilities

Likely to be kept by the business for more Debts that the business has more than
than one year e.g. one year to repay e.g.
• Vehicles • Bank loans
• Premises • Mortgages
• Machinery

Current assets Current liabilities

Likely to be turned into cash within a year Debts that the business may have to repay
e.g. within one year e.g.
• Inventories • Overdrafts
• Receivables • Payables
• Cash and cash equivalents
 B ALANCE SHEET

Non-current assets Long term or fixed assets

Current assets Short term assets
Inventories The value of stock held
Receivables Cash owing from credit sales
Cash and cash equivalents Cash in hand or at the bank
Total current assets All current assets added together
Current liabilities Money owed to be repaid in the short term
Net current assets Total current assets minus current liabilities
Non current liabilities Long term debts
Net assets The net worth of the business’ assets
Share capital Finance raised from the sale of shares
Retained profit and reserves Cumulative profits kept in the business
Total equity The value of shareholders’ funds
 B ALANCE S HEET

£ms £ms Calculations

Non-current assets 19 550
Current assets
Inventories 2 375
Receivables 1 170
Cash and cash equivalents 2 300
Total current assets 5 845 2 375 + 1 170 + 2 300
Current liabilities 8 160
Net current assets (2 315) 5 845 - 8 160
Non current liabilities (6 000)
Net assets 11 235 19 550 + (2 315) - 6 000
Share capital 6 000
Retained profit and reserves 5 235
Total equity 11 235 6 000 + 5 235
 I NCOME STATEMENT

Income statement Explanation

Sales revenue Money coming in from sales
Quantity sold x selling price
Cost of sales Costs directly linked to the production of the goods or services
sold e.g. raw materials
Gross profit Sales revenue – cost of sales

Expenses All other costs associated with the trading of the business e.g.
salaries and marketing expenditure
Operating profit Gross profit – expenses

Interest Interest paid on debt or received on positive balances

Profit for the year Operating profit – interest (tax is still to be deducted)
 I NCOME S TATEMENT

£ms £ms Calculations

Revenue 35 400
Cost of sales 30 100
Gross Profit 5 300 35 400 – 30 100 = 5 300
Expenses 720
Operating profit 4 580 5 300 – 720 = 4 580
Finance income 300
Finance cost (260)
Profit before tax 4 620 4 580 + 300 – 260 = 4 620
Interest 1 109
Profit for the year 3 511 4 620 – 1 109 = 3 511
 R ATIO A NALYSIS

 Allows for a more meaningful analysis of

What is meant by
the term published accounts
benchmark?

 Shows relationship between figures

 Used for comparisons over time
 Inter and intra business comparisons
 Intra means between businesses e.g. to
Why are numbers so compare performance to competitors or to
important when
understanding a
benchmark
business’
performance? View  Inter means within a business e.g. over time
M&S key facts.
within one organisation or between branches
 R ATIO A NALYSIS - P ROFITABILITY

Challenge:
Profitability
Capital employed can
also be calculated as  Return on Capital Employed (ROCE)
total assets minus
current liabilities. Can  A measure of how efficiently a business is using capital
you explain why?
employed to generate profits
 Capital employed = total equity + non-current liabilities i.e.
all the money invested in the business from:
 Share capital

 Reserves

 Long term loans

 Formula:
Operating profit x 100
Total equity + non-current liabilities
 R ETURN ON CAPITAL EMPLOYED

Balance Sheet £m
Non-current assets 19550
Income Statement £m
Inventories 2375
Revenue 35400
Receivables 1170
Cost of sales (30100)
Cash & cash equivalents 2300
Gross profit 5300
Total current assets 5845
Expenses (720)
Current liabilities (8160)
Operating profit 4580
Net current liabilities (2315)
Finance income 300
Non-current liabilities (6000)
Finance cost (260)
Net assets 11235
Profit before tax 4620
Taxation (1109)
Share capital 6000
Profit for the year 3511
Reserves & retained earnings 5235
Total equity 11235

Operating profit x 100 4580 x 100

Total equity + non-current liabilities 11235 + 6000

4580 x 100 = 27%

17235
 I NTERPRETATION OF ROCE

Why would it be Return on capital employed

meaningful to compare
this
to the current rate of Operating profit x 100
interest?
total equity + non-current liabilities
Why might a high
street retailer compare
ROCE between
4580 X 100 = 27%
individual stores? 17235

For every £1 of capital employed in the business 27 pence is

generated in operating profit.
 R ATIO A NALYSIS - L IQUIDITY

Define current
assets and current
liabilities.
 Liquidity

A second measure of  A measure of a businesses’ ability to survive in

liquidity is the acid the short term i.e. its ability to meet short term
test. It is useful to
understand this debts and day to day expenses
although it will not be
explicitly examined.
Research what is
 If a business can not meet current liabilities
meant by the acid from current assets then it is at risk of failure if
test.
creditors demand immediate payment of debts
 Liquidity is calculated using the current ratio
 Current assets
Current liabilities
Why might a business
be placed in
administration?
 C URRENT RATIO

Balance Sheet £m
Current assets : current liabilities
Non-current assets 19550
Inventories 2375
Receivables 1170 5845 : 8160
Cash & cash equivalents 2300 = 0.716 : 1
Total current assets 5845
Current liabilities (8160)
Net current liabilities (2315) For every £1 of CL the business owes it owns
Non-current liabilities (6000) £0.716 (72 pence) in CA.
Net assets 11235

Share capital 7000 Do you think this business has enough short
Reserves & retained earnings 4235 term assets to meet its short term debts?
Total equity 11235
 L IQUIDITY

What steps could a

business take to
 A business with low liquidity is in danger if short term creditors
improve cash flow? demand payment quickly e.g. the bank recalls an overdraft

What is the  Business may therefore seek to improve liquidity:

relationship
between cash flow
and liquidity?
 Increase current assets and/or reduce current liabilities
 Sell assets that are no longer being used i.e. turn them
from a non-current asset to a current asset (cash)
 Move cash balances from current accounts to high
interest bearing accounts so its value increases more
rapidly
 Switch to long term sources of finance
 Monitor debtors to avoid bad debts
 D ISCUSSION

Do you agree with these quotes?

“Sales for vanity, profit for sanity but cash is king”
“Profitable businesses can still go under if they run out of cash
at a critical moment. Forecasting is the most focused method of
avoiding that obstacle.”
Peter Jones

 List 5 reasons why businesses need cash on a regular

basis
 P RACTICE QUESTION

Using the extract

from SuperGroup
Plc’s balance sheet
calculate:
a) Current ratio
View full statement b) Acid test
of financial position.
(extension
activity)

Comment on the
liquidity of
SuperGroup Plc.
 R ATIO A NALYSIS - G EARING

Explain where
 Gearing (%)
interest rates would
appear on an income  Measures what proportion of a business’
statement capital is funded through long term loans
and which profit
figure(s) would be
affected.  Loans are “compulsory interest bearing” i.e.
you have to pay interest on them even if profits
are low or non-existent
 A highly geared business is of greater risk if
interest rates are likely to increase
 Non-current liabilities x 100
Total equity + non-current liabilities
 R ATIO A NALYSIS - G EARING

Balance Sheet £m
Non-current liabilities x 100
Non-current assets 19550 Total equity + non-current liabilities
Inventories 2375
Receivables 1170
Cash & cash equivalents 2300 6000 x 100
Total current assets 5845 11235 + 6000
Current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000) 6000 x 100 = 35%
Net assets 11235
17235
Share capital 6000
Reserves & retained earnings 5235 For every £1000 invested in this business how
Total equity 11235
much of it is from long term loans?

Why might a high gearing ratio be more of a concern to a business with small profit margins?
 E FFICIENCY RATIOS

 Efficiency ratios assess the internal management

of a business i.e. how efficient are managers in
controlling the current assets
 Efficiency ratios look at the management of cash
and inventory
 Payables days
 Receivables days
 Inventory turnover
 PAYABLES DAYS

 Payables days
 A measure of how long it takes, on average, for
the business to pay for supplies it has
purchased on credit
 A business may try to have a longer payables
days ratio to ease cash flow problems
 A short payables days may result in discounts
from suppliers

 Payables x 365
Cost of sales
 PAYABLES DAYS

Balance Sheet £m
Income Statement £m
Non-current assets 19550
Revenue 35400
Inventories 2375
Cost of sales (30100)
Receivables 1170
Gross profit 5300
Cash & cash equivalents 2300
Expenses (720)
Total current assets 5845
Operating profit 4580
Payables (4160)
Finance income 300
Short term loans (4000)
Finance cost (260)
Total current liabilities (8160)
Profit before tax 4620
Net current liabilities (2315)
Taxation (1109)
Non-current liabilities (6000)
Profit for the year 3511
Net assets 11235
Share capital 6000
Reserves & retained earnings 5235
Total equity 11235

Payables x 365 4160 x 365 = 50 days

Cost of sales 30100

Why might a business be willing to have

a payables days of 60 – 90 days?
 E FFICIENCY RATIOS

 Receivables days
 A measure of how long it takes, on average,
for customers to pay the business for goods
or services it has purchased on credit
 The customer is a debtor of the business
 A business may try to have a shorter
receivables days to ease cash flow problems

 Receivables x 365
Sales revenue
 R ECEIVABLES DAYS

Income Statement £m
Revenue 35400 Balance Sheet £m
Cost of sales (30100) Non-current assets 19550
Gross profit 5300 Inventories 2375
Expenses (720) Receivables 1170
Operating profit 4580 Cash & cash equivalents 2300
Finance income 300 Total current assets 5845
Finance cost (260) Payables (4160)
Profit before tax 4620 Short term loans (4000)
Taxation (1109) Total current liabilities (8160)
Profit for the year 3511 Net current liabilities (2315)
Non-current liabilities (6000)
Net assets 11235
Share capital 6000
Reserves & retained earnings 5235
Receivables x 365 1170 x 365 = 12 days Total equity 11235
Sales revenue 35400

This shows that on average it takes 12 days to receive payment for goods and services sold on credit.
 Show your understanding

1) Payables days was 50 days and receivables days 12 days. Should this
business be concerned? Justify your answer.

2) Payables are compared to cost of sales and receivables to revenue. Use

business terminology to explain the relationship between these variables.

3) What might be the expected receivables days of

a) A high street coffee chain
b) A commercial print company
Justify your answers.
 I NVENTORY TURNOVER

 Inventory turnover

 Average inventory held can be calculated by finding the average

of inventory at the start and end of the year
 You therefore also need the previous year’s balance sheet
 Alternatively you can just divide cost of sales by inventory

 Measures how frequently a business turns over its inventory in a

year
 Will vary depending upon the nature of the firm
 Hot dog stand (hopefully daily!)
 Fashion retailer (at least each season)
 New car showroom (maybe twice a year)

 Cost of sales
Average inventory held
 I NVENTORY TURNOVER

Income Statement £m Balance Sheet £m

Revenue 35400 Non-current assets 19550
Cost of sales (30100) Inventories 2375
Gross profit 5300 Receivables 1170
Expenses (720) Cash & cash equivalents 2300
Operating profit 4580 Total current assets 5845
Finance income 300 Current liabilities (8160)
Finance cost (260) Net current liabilities (2315)
Profit before tax 4620 Non-current liabilities (6000)
Taxation (1109) Net assets 11235
Profit for the year 3511
Share capital 6000
Reserves & retained earnings 5235
Total equity 11235
Cost of sales 30100 = 12.67 times
Average inventory held 2375
On average for how long does this business hold stock?
What type of business might have this level of inventory turnover? Justify your answer.
Why might it be more accurate to divide by average inventory held rather than just inventory?
 VALUE OF FINANCIAL RATIOS WHEN ASSESSING
PERFORMANCE

 Value  Limitations
What other
quantitative
 Provides a tool for the  Possibility that accounts
information could be
used to assess the interpretation of accounts have been window
performance of a dressed
business?  Structure from which
What other qualitative
comparisons can be made  Need to consider
information could be reasons behind ratios
 Overtime
used to assess the
performance of a  e.g. is ROCE lower
 With other businesses
business?
than previous years
 Aids decision making because of an
 Internally investment
programme
 Externally by investors
 Quantitative information
only
 A CTIVITY – INTERPRETING PUBLISHED
ACCOUNTS

 In pairs choose 2 businesses who operate in the same

industry e.g. 2 supermarkets, 2 football clubs

 Go on the internet and print off the balance sheet

and income statement (Google company
name/investors)

 The layout will vary from company to company but

you should be able to identify the key information

 Prepare a presentation comparing the performance

of the two businesses over time and in comparison to
each other

 Present your findings to the rest of the class

 7.2 A NALYSING THE EXISTING INTERNAL
POSITION OF A BUSINESS TO ASSESS STRENGTHS
AND WEAKNESSES : FINANCIAL RATIO ANALYSIS

 In this topic you have learnt about

 How to assess the financial performance of a business using

balance sheets, income statements and financial ratios
 Financial ratio analysis to include:
 profitability (return on capital employed)
 liquidity (current ratio)
 gearing
 efficiency ratios: payables days, receivables days,
inventory turnover

 The value of financial ratios when assessing performance

 Data may be analysed over time or in comparison with
other businesses