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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 evaluate business performance

Ratio Analysis
the study of relationships in a companys finances in order to understand and improve financial performance

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 its profits. Myth that the financial statements are an accurate reflection of the companys trading performance for the year. Accounts are little more than an indication of the 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 within the company financial ratios for other companies within the same sector

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.

Awareness of underlying trends

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 ZMK 100,000 150,000 225,000 Capital employed ZMK 1,000,000 1,500,000 2,250,000 ROCE 10% 10% 10%
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20X1 20X2 20X3

Common Accounting Ratios

Profitability ratios Liquidity ratios Efficiency ratios Financial Leverage Market Performance ratios

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Profitability Ratios
Ratios are used to track bottom-line performance.
Useful for comparison with competitors A tool to asses performance relative to other possible 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

Profitability Ratios

This ratio evaluates the efficiency of the assets of the company.

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Profitability Ratios

Liquidity Ratios
An important measure of a companys health is its ability to pay debts on time.
Need to have a favorable liquid position !

Liquidity Ratios

The current ratio shows how well the company is prepared to pay current liabilities.
Due within a year

A ratio of 2:1 represents a strong position in most industries.

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Liquidity Ratios

Inventory is a particular problem in some industries. A ratio of 1:1 is acceptable in many industries.

Identify the company norm?

The following is an extract from the 2003 Annual Report of Barloworld: 2003 2002 2001 2000 1999 1998 0.8 0.7 0.8 0.9 1.1 0.7 1997 0.8

Quick ratio

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Efficiency Ratios
Efficiency or Asset Management ratios compare the value of key assets to sales performance.
How efficient are we in operating our business? How successful are we in the way we use of assets?

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Efficiency Ratios

A company doesnt earn money until its inventory is sold. If a business has a low inventory ratio:
Inventory should be reviewed to determine if it is obsolete

Efficiency Ratios

Used to determine if a company has a reasonable amount of assets for the sales being 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

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Efficiency Ratios

Higher ratios mean that accounts receivable 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 x 365 / Credit Sales Creditor Settlement = Accounts payable / Cost of Sales x 365

Financial Leverage Ratios

Financial Leverage
Using debt financing to increase the rate of return on assets Critical Thinking: Is it more advisable to use your own funds exclusively in starting a business.or borrowing from a bank..or a mixture of the two sources? Why?

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Financial Leverage Ratios

The appropriate ratio is guided by The industry in which the company operates The financial stability of the company

Financial Leverage Ratios

Debt to Equity :Measures how much of the assets are owned by creditors in comparison to how much is owned by the owners Debt to Equity = Total Debt Total Equity

Financial Leverage Ratios

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

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Market Performance Ratios

Market performance ratios serve a variety of functions
Examine the overall financial performance of a business in contributing to shareholder value A metric of the effectiveness of executive leadership Helps compare multiple companies

Market Performance Ratios

If preferred stock is issued the dividends paid to preferred stockholders are subtracted from net income before dividing by the number of shares of common stock issued

Market Performance Ratios

Anticipated earnings on investments

Helps investors decide what price to pay for a companys stock

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PE a measure of market confidence

Market price also takes into account anticipated changes in the earnings arising from their assessment of macro events such as
Political factors, e.g. imposition of trade embargoes and sanctions Economic factors, e.g. the downturn in manufacturing activity Company-related events, e.g. possibility of organic or acquired growth and the implication of financial indicators for future cash flow estimates
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PE ratio implication of financial 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 repayment terms adequacy of working capital low acid test (quick) ratio in relation to prior periods indicating liquidity 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 of financial 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 of costs incurred Inventory is the weighted average of costs incurred Cost of Sales = Opening Stock + Purchases Closing Stock

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