Analysing Financial Accounts

Assessing Financial Accounts

Ratio Analysis

1. Profitability ratio: Analyse the profit made during the financial year.
2. Liquidity Ratio: Measures the ability to pay short-term debts
3. Gearing Ratio: Measure the proportion of the business's capital that has come from external sources.

USERS OF FINANCIAL INFORMATION

1. Employees and Managers: Their long-term job security depends on the business remaining profitable and solvent. May be rewarded for high profitability through wage increases or bonuses.
2. Shareholders: Concerned with profitability and the payment of dividends.
3. Lenders / Bank: Ability of business to repay its debts and gearing.
4. Suppliers: Liquidity, paying goods on credit.
5. Government: Tax on company profits and VAT, PRSI and PAYE.

• A business is solvent when the value of its total assets is greater than its external debt. This means the business can pay all its debts.

• External debt / liabilities refers to money that is owed to people outside the business, e.g. all creditors/

• Gearing measures the level of a business's debt compared to its equity capital such as shares and reserves.

1) Profitability

Gross margin = Gross Profit/Sales ×100/1 e.g. 172,000/350,000 × 100/1 = 49%

Means that the business makes 49c of gross profit from every €1 of sales revenue it receives from customers * compare with other years.

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Analysing Financial Accounts

Commentary and Evaluation

With the exception of a drop in profitability in 2013, this company has seen a gradual improvement in its gross profit margin. The 49% figure in 2016 represents a five year high and suggests sales (turnover) have improved and the cost of sales is under control. The result is also well above the industry average of 2016.

Net Margin = Net Profit / Sales × 100 / 1

e.g. 90,000 / 350,000 × 100 / 1 = 25.7%

This means that business makes 25.7c of net profit from every €1 of sales revenue that it receives from customers.

Commentary and Evaluation

This company has seen a year-on-year improvement in net margin between 2015 and 2016, figures rising from 17% to 25.7%. This is a positive trend since 2013, which has seen a steady increase since. This result is also above the industry average for 2016.

Return on Capital employed / return on investment

Net Profit / Capital Employed × 100 / 1

e.g. 90000 / 287000 × 100 / 1 = 31.36%

Useful when comparing profitability between companies – gives an indication of how well the business is using its capital to generate income.

By comparing the ROCE available on different investment options, potential investors can choose the best possible option.

Useful to compare the ROCE from a business investment with the return on a (risk-free) investment in a financial institution.

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Analysing Financial Accounts

Commentary and Evaluation

This business has seen a year-on-year improvement on capital employed, from 20% in 2012, to 31.36% in 2016. This figure is well above the "risk free" rate of return. It is also well above the industry average and is a positive result which is pleasing to managers and investors.

2) LIQUIDITY

Working capital / current ratio = current assets: creditors falling due within 1 year

e.g. 25,000 : 20,000 = 1.25 : 1

• Indicates the business should be able to generate enough short term cash to pay its short-term debts. The result, however, is well below the Recommended level of 2:1

Commentary and Evaluation: Generally improved. The 2016 figure of just 1.25:1 is below the recommended minimum of 2:1 and represents a major dis-improvement since last year.

ACID TEST RATIO = [Current assets – Closing Stock]: Creditors falling due within 1 year [ Ideal = 1:1 ]

e.g. (25,000 – 10,000) : 20,000 15,000 : 20,000 0.75 : 1

The acid test ratio is a sticker test of liquidity than the working capital ratio for the fact that some current assets, especially stock, can take time to convert to cash.

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Analysing Financial Accounts

Commentary and Evaluation

The ideal figure for the acid test ratio is 1:1. This business has achieved this target in each of the previous four years but its 2016 figure of just 0.75:1 is below both the required level and the industry average. This sharp decline in liquidity is a worrying sign and suggests the business may have a large portion of its available cash tied up in stock. This can create liquidity problems.

SOLVENCY: Measure of whether a business can pay its total debts.

A business that does not "pass" the solvency test is said to be insolvent. A business that is insolvent is likely to be declared bankrupt, unless it can find a solution to its debt problem.

Solvency Test = Total Assets > External Liabilities F.A. + C.A. > Current Liab + Long term Liab e.g.

Total Assets	External Liabilities
Fixed Assets = 282,000 Current Assets = 25,000 Total Assets = 307,000	Creditors falling due = 20,000 Long-term loan = 24,000 Total external liabs = 44,000

307,000 > 44,000

• Since total assets greatly exceed external debt, this business is solvent as at 31/12/2016.

4) GEARING

Gearing focuses on the capital structure of the business and compares the proportion of finance provided by debt to the proportion of finance provided by equity (shareholders)

Debt Capital includes all long-term loans (debentures mortgage). Equity capital includes issued share capital and reserves

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Analysing Financial Accounts

Debt capital > equity capital = business is highly geared Equity capital > debt capital = business is lowly geared

Highly geared

Associated with a greater level of risk, as the external debt must be repaid with interest. During periods of slow growth or economic downturn, a business may struggle to generate the levels of income required to meet these repayments.

Gearing = Debt Capital : Equity Capital

Lowly Geared Less risky since the business is under less pressure to meet fixed interest repayments.

Commentary and Evaluation: In 2016, this business is very lowly geared and the vast majority of its capital comes from equity. This means that the business will not be under any pressure to generate high levels of income to repay debt.