Chapter 34 - Analysis of

published accounts
This chapter covers syllabus section A Level 10.2

LEARNING intentions
In this chapter you will learn how to:
• calculate liquidity ratios and evaluate methods of improving liquidity
• calculate profitability ratios and evaluate methods of improving profitability
• calculate financial efficiency ratios and evaluate methods of improving
financial efficiency
• calculate gearing ratios and evaluate methods of improving gearing
calculate investor ratios and evaluate methods of improving returns to investors.

KEY TERMS
Acid test ratio Dividend yield ratio Price/earnings ratio

Capital employed Earnings per share Rate of inventory turnover

Current ratio Gearing ratio Return on capital employed (RoCE)

Dividend Gross profit margin ratio Share price

Dividend cover ratio Liquidity Trade payables turnover (days)

Dividend per share Operating profit margin Trade receivables turnover (days)

KEY SKILLS EXERCISES

To answer the questions in this chapter, you need to know and understand:
● current and acid test ratios
● gross profit margin, operating profit margin and return on capital employed ratios
● trade receivables turnover, trade payables turnover, rate of inventory turnover ratios
● gearing ratio
● price/earnings, dividend yield and dividend cover ratios.
Introduction
One accounting figure, on its own, is a poor measure of business performance or
efficiency. It needs to be compared with another figure to give a ratio result.
Accountants make meaningful assessments by relating two accounting results to
each other in the form of a ratio. Accounting ratios are grouped into five main
categories. We start by considering liquidity ratios.

34.1 Liquidity ratios

The meaning and importance of liquidity

Liquidity refers to the ease with which a company can pay its short-term debts.
Liquidity ratios, such as the current ratio and the acid test ratio, measure a
company's working capital and its ability to meet its financial obligations.

Current ratio
The current ratio is measured by the formula:

Look at the accounting data from two sports clothing manufacturers, Port Louis
Sports (PLS) and Bengaluru Sports Kit (BSK), shown in Table 34.2.

Table 34.2: PLS and BSK: current ratios

Points to note:
• There is no specific result that is considered universally reliable, as it depends
on the industry and the recent trend of the ratio in the company. A result of
around 1.5:1 to 2:1 is recommended.

• A current ratio above 1.5 indicates that the company has sufficient liquidity to
pay its current debts.
 • In the case of a low ratio, management may take steps to increase the
company's current assets.

• A ratio above 2 may indicate that there is too much money tied up in
unproductive assets.

Acid test ratio

The acid test ratio is measured by:

Liquid assets are calculated by:

liquid assets = current assets - inventories

By eliminating the value of inventories when calculating the acid test ratio, a clearer
picture is given of the ability of the business to pay short-term debts.

Table 34.3: PLS and BSK: acid test ratios

Points to note:
• Results below 1:1 are cautiously considered, indicating that the company has
fewer liquid assets to pay each short-term debt.

• Businesses with high inventory levels will record very different current and
acid test ratios.

• Selling inventory for cash will not improve the current ratio, but it will improve
the acid test ratio, since cash is considered a liquid asset.

Methods of improving liquidity

See Table 34.4 for an evaluation of methods to improve liquidity.

Method to increase liquidity Examples Evaluation of method

Sell off fixed assets for cash. Land and property could be If assets are sold quickly, they
They could be leased back if sold to a leasing company. might not achieve their true
still needed by the business value.
If assets are still needed, then
leasing charges will add to
overheads and reduce the
operating profit margin.

Sell off inventories for cash Inventories of finished goods This will reduce the gross profit
(this will improve the acid test could be sold off at a discount margin if inventories are sold at
ratio, but not the current ratio). to raise cash. a discount.
Brand image may be damaged
if inventories are sold off at low
prices.

Use JIT inventory JIT inventory management will Inventories might be needed to
management. cut inventories held. meet changing customer
demand levels. JIT might be
difficult to adopt in some
industries.

Increase loans to inject cash Bank (long-term) loans could These will increase the gearing
into the business and increase be taken out if the bank is ratio (see Section 34.4).
working capital. confident of the company's
Increased interest costs will
prospects.
reduce profit for the year.

Table 34.4: Evaluation of methods to improve liquidity

34.2 Profitability ratios

The meaning and importance of profitability

Corporate profitability is a key indicator for assessing a company's performance. It is
not enough to have high profit levels, as profitability also depends on sales and
invested capital. The higher the profitability, the higher the returns for investors.

Gross profit margin ratio

The gross profit margin ratio evaluates a company's ability to convert revenue into
gross profit.
 The gross profit margin ratio is measured by the formula:

Gross profit margin Revenue $000 Gross profit $000

PLS 125 250 125/ 250 × 100 = 50%

BSK 800 3 200 800/ 3200 x 100 =

25%

Table 34.8: PLS and BSK: gross profit margins, 2021

Points to note:
• It is widely used to measure a company's performance and efficiency.

• Higher profit does not always mean higher profitability.

• A lower gross profit margin may be due to lower pricing strategies or higher
production costs.

• It is misleading to compare profitability ratios between companies in different

industries.

Operating profit margin ratio

Operating profit margin is a ratio used to measure a company's ability to convert
sales into operating profit. It is calculated by subtracting overhead from gross profit.

Operating profit Revenue $000 Operating profit

$000 margin

PLS 50 250 50/250 × 100 = 20%

BSK 500 3200 500/ 3200 x100 =

 15.6%

Table 34.9: PLS and BSK: operating profit margins, 2021

Points to note:
• A company could increase operating profit margin by reducing overhead while
maintaining revenue, or by increasing revenue without increasing overhead.
• It is important to analyse the results in comparison with previous years to get
a more complete picture of the company's performance and profitability.

TIP
Many learners state that, 'To increase profit margins the business should increase
sales'. This is a poor answer unless revenue can be increased at a greater rate
than the costs of the business.

Return on capital employed ratio

The return on capital employed (RoCE) is the most widely used ratio to measure a
company's profitability by comparing operating profit to invested capital.

Capital employed is measured by:

non-current liabilities + shareholders' equity (where shareholders' equity
= issued shares + reserves)

Operating profit Sm Capital employed Return on capital

$m employed

PLS 50 400 50/ 400 × 100 =

12.5%

BSK 500 5 000 500/ 5000 × 100 =

10%
Table 34.10: PLS and BSK: return on capital employed, 2021

Points to note:
• The higher the value of this ratio, the greater the return on the capital invested
in the business.

• It can be evaluated with respect to other companies, the previous year and
bank interest.

• Indebtedness can be negatively affected if the RoCE is lower than the interest
rate.

• Increasing the efficient use of assets can increase RoCE.

KEY CONCEPT LINK

The profitability ratios are a very important way for management and shareholders
to assess business performance.
Comparisons should be made with companies in the same industry as the context
in which they operate will be similar.
Comparing profitability ratios with businesses in other industries can be
misleading.

Methods of improving profitability

Methods to increase profit Examples Evaluation of method
margins

Reduce direct costs Use lower-cost materials. Quality image may be

damaged, which could hit the
product's reputation.

Cut labour costs (for example, Quality may be at risk - there

offshoring production to low- may be communication
cost countries). problems with distant factories.

Cut labour costs by increasing Purchasing machinery will

productivity through increase overhead costs,
automation. workers will need retraining
and short-term profits may be
cut.
 Cut wage costs by reducing Motivation levels might fall,
workers' pay. which could reduce productivity
and quality.

Increase prices This will increase profit on Total profit could fall if too
each item sold. many consumers switch to
competitors. This links to price
elasticity of demand.¡

Increase profit margin by Relocate to low-cost site. Lower rental costs could mean
reducing overhead costs / moving to a less attractive
cutting interest costs area, which could damage
image.

Reduce promotion costs. Cutting promotion costs could

lead to sales falling by more
than fixed costs.

Delayer the organisation. Having fewer managers could

reduce the efficient operation
of the business.

Reduce long-term borrowing, The success of a new issue of

perhaps by raising finance shares will depend on the
from a new issue of shares. prospects for the business and
investor confidence.

Table 34.11: Evaluating methods to improve profit margins

Methods to increase RoCE Evaluation of method

Increase operating profit without increasing • Demand could be price elastic.

capital employed. • Cheaper materials could cut back on
For example: quality.
• This may not be effective in increasing
• raise prices
profit in the short run and may have
• reduce direct costs per unit
drawbacks (for example, less promotion
• reduce overheads, such as delayering
could reduce sales).
or reducing promotion costs.

Reduce capital employed. For example: • The assets may be needed in the future
• sell assets that contribute nothing or (for example, for expansion of the
little to sales/profit, and use the capital business).
raised to reduce debts.

Table 34.13: Evaluating methods for improving RoCE

TIP
Many questions will ask for methods to increase the profitability of a business. If
the question needs an evaluative answer, it is very important that you consider at
least one reason why your suggestion might not be effective.
 TIP
When commenting on ratio results, it is often advisable to question the accuracy of
the data used. In addition, try to explain the limitations of using just a limited
number of ratio results or results from just one year in your analysis.

34.3 Financial efficiency ratios

The meaning and importance of financial efficiency

Financial efficiency refers to the way a company uses its financial resources. It is
important for reducing financing costs and using assets effectively.

The three most commonly used financial efficiency ratios are: rate of inventory
turnover, trade receivables turnover and trade payables turnover.

Inventory turnover
In principle, the lower the amount of capital used in holding inventories, the better.
The rate of inventory turnover records the number of times the inventory of a
business is bought in and resold in a period of time. If this ratio increases over time,
then the business is reducing the finance used to hold inventories.

The rate of inventory turnover is measured by the formula:

Average inventory is calculated by the formula:

Cost of sales Sm (2021) Average inventory Sm Rate of inventory

(2021) turnover

PLS 125 40 125/ 40 = 3.125

BSK 2 400 200 2400 / 200 = 12

Table 34.16: PLS and BSK: rate of inventory turnover, 2021

Points to note:
• The result is not a percentage, but the number of times inventory turns over in
the time period, usually one year.

• The higher the number, the more efficient the managers are in selling
inventory rapidly. Very efficient management, by using JIT, will give a high
rate of inventory turnover.

• The normal result for a business depends very much on the industry it
operates in. Comparison with businesses in other industries is therefore
difficult.

Trade receivables turnover (days)

The trade receivables turnover (days) measures how long, on average, it takes a
business to recover payment from customers who have bought goods on credit (the
trade receivables). The shorter this time period is, the better the management is at
controlling its working capital.

The trade receivables turnover is measured by the following formula:

Table 34.17: PLS and BSK: trade receivables turnover. 2021

Points to note:
• There is no right or wrong result: it will vary from business to business and
industry to industry.

• A business that is able to put pressure on its credit customers may have a
very low trade receivables turnover.
 • A high result for trade receivables turnover may be a deliberate management
strategy. Customers will be attracted to businesses that give extended credit.

• The value of this ratio could be reduced by giving shorter credit terms.
Improved credit control could involve refusing to offer credit terms to frequent
late payers.

Trade payables turnover (days)

The trade payables turnover (days) measures the average length of time the
business takes to pay its suppliers. The longer this period is, the lower the working
capital needs of the business will be. The formula can use either credit purchases
or cost of goods sold.

The trade payables turnover is measured by the following formula:

Table 34.18: PLS and BSK: trade payables turnover, 2021

Points to note:
• Both companies pay their suppliers more quickly than they receive payment
from trade receivables. This creates a cash flow problem.

• It must find additional finance to cover the very long period before it receives
payment from its customers.

Methods of improving financial efficiency

Financial efficiency can be improved in several ways. These would all reduce the
need for high levels of working capital.

Method Evaluation

Increase inventory turnover by adopting JIT See evaluation of this concept in Section 24.2
inventory management. (for example, the risk of zero-inventory problems
 if supplies are delayed).

Reduce the credit period offered to customers. Customers may switch demand to another
This will reduce the debt collection period. business that offers a longer credit period.

Delay payment to suppliers. This will increase Discounts from suppliers for quick payment
the creditor payment period. might be reduced.
Suppliers may refuse to supply unless quick
payment is made.

Table 34.19: Methods to improve financial efficiency

34.4 Gearing ratio

The meaning and importance of gearing

The gearing ratio measures the degree to which the capital of a business is
financed from debts.

Calculation and interpretation of gearing ratios

The gearing ratio is measured by the formula:

Non Current liabilities Capital employment Grating ratio

PLS 40 400 40/400 x 100 x 10%

BSK 2000 5000 2000/5000 x 100 = 40%

Table 34.21: PLS and BSK: gearing ratios, 2021

Points to note:
• The ratio shows the extent to which a company's capital is financed by long-
term borrowing, and a company is considered to be highly indebted if this ratio
exceeds 50%.

• The higher the leverage, the greater the risk for shareholders, as the company
will have more interest to pay and its liquidity may be affected.
 • On the other hand, low leverage indicates a safe business strategy, but can
be disappointing for shareholders looking for a rapid increase in the return on
their investment.

Methods of improving gearing

A highly geared business may want to reduce its dependence on debt when
economic conditions are difficult or interest rates are high. Table 34.22 evaluates
methods to improve gearing.

Method Evaluation

Sell more shares and use the This dilutes the control of existing shareholders. Dividend
capital raised to pay back loans. payments will have to increase to maintain dividend yield (see
Section 34.5). Poor economic conditions might mean that
additional shares are sold at a low price.

Reduce dividends, retain more Profit may be very low and some of this is used to pay
profit and use this finance to dividends. If dividends are reduced, returns to shareholders
repay loans. will fall.

Sell assets to raise finance which If assets have to be sold quickly, a high price might not be
is then used to repay loans. achieved. This reduces the value of the business, and limits its
ability to expand unless the assets sold are no longer required
(for example, an empty office building).

Table 34.22: Evaluating methods of improving gearing

34.5 Investment ratios

The meaning and importance of return to investors

A company's performance is of great interest to current and potential investors. This
return can be obtained in two ways: through capital gains from share price
increases and through the dividends that companies pay annually to shareholders.

Dividend yield ratio

The dividend yield ratio measures the percentage rate of return a shareholder
receives from the dividend per share at the current share price. The dividend yield
ratio is measured by the formula:
The dividend per share is calculated by the formula:

Dividends, Number of Dividend per Market share Dividend yield

2021 (S issued shares share ($) price (end of %
millions) ($ millions) 2021 financial
year) ($)

PLS 21 140 0.15 $1.50 $ 0.15 × 100 / 1.5

= 10%

BSK 140 200 0.70 $10.00 $ 0.70 × 100 /10

= 7%

Table 34.23: PLS and BSK: dividend yield ratios

Points to note:
• If the share price rises, the dividend yield will decrease.

• If the managers propose a dividend increase and the share price remains
unchanged, the dividend yield will increase.

• Shareholders compare this rate of return with other investments and the
dividend yield of other companies. It is also important to consider
benchmarking with previous years and with other companies in the same
industry.

• Management may decide to pay a dividend out of reserves to keep

shareholders happy, or to reduce the annual dividend to increase retained
earnings and have more funding to expand and reduce debt.

• A high dividend yield does not always indicate a good investment if the share
price has fallen recently.

Dividend cover ratio

The dividend cover ratio is the number of times the ordinary share dividend could be
paid out of current profits after tax and interest: the profit for the year. The higher this
ratio, the more able the company is to pay the proposed dividends. A high ratio
leaves a considerable margin for reinvesting profits back into the business.

The dividend cover ratio is measured by:

Dividends, 2021 Profit for the year, Dividend cover

(Sm) 2021 (Sm)

PLS 21 30 30 / 21 = 1.3

BSK 140 400 400 / 140 = 2.9

Table 34.24: PLS and BSK: dividend cover ratios

Points to note:
• If directors decided to increase dividends to shareholders, with no increase in
profits, then the dividend cover ratio would fall.

• A low result means the directors are retaining low profits for future investment
and this could raise doubts about the company's future expansion.

Price/earnings ratio
The price/earnings ratio (P/E ratio) is a vital ratio for shareholders and potential
shareholders. It reflects the confidence that investors have in the future prospects of
the business.

The price/earnings ratio is measured by:

The earnings per share is calculated by the formula:

Current share price ($) Earnings per share ($) Price/earnings ratio
 PLS 1.50 0.21 7.1

BSK 10.00 2.00 5.0

Table 34.25: PLS and BSK: earnings per share and price/earnings ratios

Points to note:
• The results measure how much investors are currently willing to pay for each
$1 of earnings. PLS currently has a P/E of 7.1. This means investors are
willing to pay $7.10 for $1 of current earnings.

• The ratio should only be compared with other companies in the same
industry.

Methods of improving investor returns

The most effective way to improve returns to investors is to increase profits. Higher
profit levels allow for increased dividends, which raise the dividend yield.

There might be a short-term trade-off, however:

• To increase profit might require investment in the business to buy more
assets.
• If the company directors decided to reduce dividends to increase retained
profit, this will increase internal finance for the company. This will obviously
reduce returns to shareholders in the short term.
• If the new investment in expanding the business is successful, then profit
should rise in the long term.