step 5: 11. interpreting financial statements

return on capital employed (ROCE)

profit of the year/capital - non-current liabilities

OR

profit of the year/total assets - current liabilities

if ROCE is low:

• pursuing a higher margin, lower volume strategy

increase in ROCE

• higher ROCE is driven by net profit percentage

• will increase if a long term loan is paid

return on shareholder’s funds or return on equity

profit after tax / total equity

gross profit margin

gross profit / revenue

gross profit margin should be ____year to year.

e.g. incorrect inventory will affect gross profit twice

similar

exp/revenue percentage

specified expense / revenue

operating profit margin

operating profit / revenue

operating profit margin is profit before ___ ____ and ____

avoids distortion when comparisons when one company is heavily financed by loans, and the other by share capital

finance costs

tax

current ratio (working capital ratio)

current assets / current liabilities

current ratio:

too ___= they don’t have enough assets to cover debts

too ___= suggests that have too much inventory, receivables or cash

low

high

quick ratio or acid test ratio

current assets - inventories / current liabilities

quick ratio or acid test ratio omits _____bc they are the least liquid current asset

a ratio ____than 1:1 indicates a company would have difficulty paying debts

inventories

less

inventory turnover

cost of sales / inventories = X times

should be high

inventory holding period (days)

inventories / cost of sales x 365

should be low

trade receivables collection period (days)

trade receivables / revenue x 365

over time should reduce

trade payables payment period (days)

trade payables / cost of sales x 365

working capital cycle

inventory holding period + receivables collection period - trade payables payment period

OR
inventory days + receivable days - payable days

asset turnover (non-current assets)

revenue / non-current assets

asset turnover (net assets) ratio

revenue / total assets - current liabilities = X times

interest cover

operating profit / finance costs

gearing

total debt / total debt + total equity

total debt is all non-current liabilities

gearing is to do with the long term financial stability of the company

looks at how much the company is financed by debt

_____ gearing ratio = less secure financing and future of the company

higher

profitability measures the relationship between ___ and ___, also the profits or losses measured against ___

income

expenses

equity

_____focuses on the relationship between assets and liabilities and the ability of the company to pay its ____

liquidity

payables

use of resources analyses the profits or losses in relation to the ______ and ______of the company

assets

liabilities

____ _____ compares the relationship between the equity and the liabilities of the company

financial position

why in interest cover higher:

company: 6.7

industry standard: 4.1

• more profit is available to meet interest payments

• may be due to higher profits

• lower interest payments

why is trade payable payment period (days) better for cash flow

company: 45.8

industry standard: 32.7

• paying suppliers later

• may have cash flow issues

• bad for reputation with suppliers

• may have negotiated longer credit terms

why is current ratio better for cash flow

company: 3:1

industry standard: 2:1

• company is more solvent

• inefficient use of resources

• may have more current assets

• may have less current liabs

why is ROCE better for cash flow

company: 12.7

industry standard: 10.3

• may have lower equity

• less non-current assets

• could be due to higher profits

• capital employed is working more efficiently to generate profits.