Accounting L3: Horizontal Trend and Ratio Analysis (profitability efficiency and liquidity)

Marveg Case Study

• Context: Produced and sold vegetable smoothie drinks in the UK starting January 2016.

• Technology: Innovatively pasteurized drinks with 8-week shelf life.

• Initial Investment: £50,000 by two directors.

• Funding Structure:

  • Long-term secured borrowings over 4 years (from January 2017).

  • Short-term bank overdraft facility of £40,000 (to be reviewed April 2018).

Financial Performance Overview in 2016

• Sales Performance: Sold to 3 large supermarkets; secured additional contract for an own-brand product.

• Expansion Potential: Domestic and overseas markets with significant investments needed in PP&E.

• Administrative Expenses:

  • Professional fees: £30,000

  • Marketing: £40,000

  • Staff training: £20,000

• Investment Consideration: Questions on investing in Marveg.

Financial Data - Income Statement Comparison (2016 vs 2017)

Financial Position as at 31 December 2016

Horizontal Analysis

• Purpose: Compare figures to assess differences.

• Sales Revenue Growth: Sales were expected to rise by £220 (27.5%) from 2016 to 2017.

• Context Importance: Determine if increase is advantageous based on broader context.

Problems with Horizontal Analysis

• Comparability Issues:

  • Changes in business operations and practices.

  • New accounting standards.

  • Ignoring inflation effects.

Vertical Analysis and Common Size Analysis

• Purpose: Express figures as percentages of key figures (e.g., total sales).

• Common Size Analysis: Compares over multiple periods.

• Income Statement Example (2017 Forecast vs. 2016 Actual): |Metric|2017 Forecast (£'000)|%|2016 Actual (£'000)|%| |---|---|---|---|---| |Revenue|1,020|100%|800|100%| |Cost of Sales|620|61%|520|65%| |Gross Profit|400|39%|280|35%| |Operating Expenses|190|19%|210|26%| |Operating Profit|210|21%|70|9%| |Finance Costs|25|2%|20|3%| |Profit Before Tax|185|18%|50|6%| |Taxation|30|3%|20|3%| |Profit for the Year|155|15%|30|4%|

Comments on Vertical Analysis

• Expectation of Profit Margin Changes:

  • Gross profit percentage to rise from 2016 to 2017.

  • Anticipated decrease in all expenses.

  • Tax percentage expected constant.

• Need for Comparative Analysis: To truly understand financial health.

Comparing Businesses with Each Other - Considerations

• Accounting Policies Variability: Impacts comparability.

• Business Activities Differences: Affects results.

• Industry Averages Misleading: Context is crucial.

Profitability Analysis - Return on Capital Employed (ROCE)

• Formula: ROCE = Operating Profit / (Equity + Non-current Liabilities)

• 2016 Calculation: ROCE = 70 / (130 + 350) = 14.6%

Components of ROCE

• Key Drivers:

  • Profitability: Gross and operating margins.

  • Efficiency: Net asset turnover.

Gross Profit Margin Example

• 2016 Definition: Gross Profit = £280; Revenue = £800 → 35%

• 2017 Forecast: Gross Profit = £400; Revenue = £1,020 → 39.2%

Operating Profit Margin Example

• 2016 Margin: Operating Profit = £70; Revenue = £800 → 8.8%

• 2017 Forecast: Operating Profit = £210; Revenue = £1,020 → 20.6%

  • Analysis of changes in expenses critical.

Net Asset Turnover

• Calculation: Revenue / (Equity + Non-current Liabilities)

• 2016 Calculation: Net Asset Turnover = 800 / (130 + 350) = 1.67 times.

Comparable ROCE Calculation

• Efficacy Breakdown: ROCE = Operating Profit Margin × Net Asset Turnover;

  • 14.6% = 8.8% × 1.67.

Efficiency Analysis

Inventory Holding Period

• Calculation: Closing Inventory × 365 / Cost of Sales

  • 2016: 40 × 365 / 520 = 28 days

  • 2017 Projection: 30 × 365 / 620 = 18 days.

Collection Period Calculation

• For 2016: Trade Receivable = 140 × 365 / 800 = 64 days

• For 2017 Forecast: 290 × 365 / 1,020 = 104 days.

Payment Period Calculation

• For 2016: Trade Payables = 50 × 365 / 520 = 35 days.

Liquidity Analysis

• Current Ratio: Current Assets / Current Liabilities;

  • 180 / 102 = 1.76; indicates debts manageable when due.

• Acid Test Ratio: Current Assets - Inventory / Current Liabilities;

  • (180 - 40) / 102 = 1.37.

• Rationale behind Inventory Removal: Highlights time lag of cash conversion.

Concerns in Liquidity

• Observation: Low inventory due to perishability.

• Potential Risks: Possibility of liquidity issues with expansion plans.

Solvency Analysis - Gearing Ratio

• Formula: Gearing = (Non-current Liabilities + Overdraft) / (Ordinary Share Capital + Retained Earnings);

  • Debt = 390; Equity = 130; Gearing = 3x.

Interest Coverage Ratio

• Formula: Interest Cover = Operating Profit / Interest Payable;

  • 2016: 70 / 20 = 3.5x;

  • Forecast: 210 / 25 = 8.4x.

Investment Considerations for Marveg

• Strengths: Profitable, well-managed business.

• Concerns:

  • Dependency on new technology and intellectual property.

  • Reliance on major supermarkets as customers;

  • Future debt levels and dividend distribution are major considerations.

Key Performance Indicators Usage

• Ratios provide insight into operational efficiency and environmental impacts.

• Usefulness: Comparison over time and across organizations.

Further Reading

• Gowthorpe:

  • Chapter 8: Understanding Financial Reports: Trend Analysis, pp. 164 – 174.

  • Chapter 9: Understanding Financial Reports: Using Accounting Ratios, pp. 181 – 190 and pp. 193-194.