Accounting Information and Users
Accounting information can be used by different users
for a variety of decisions, such as:
deciding when to buy, hold or sell an equity
investment
assessing the stewardship or accountability of
management
assessing the ability of the entity to pay and provide
other benefits to its employees
assessing the security for amounts lent to the entity.
Accounting Information and Users
Three general areas of interest in which users’ needs and
objectives may lie.
Financial status – can the business pay its way, is it in
fact liquid?
Performance – how successful is the business, is it
making a reasonable profit, is it utilizing its assets to
the fullest, is it in fact profitable and efficient?
Investment – is the business a suitable investment for
shareholders or would returns be greater if they
invested elsewhere, is it a good investment?
Bench marking
We use benchmarks against which we compare
current performance, financial status and investment.
Four possible benchmarks
past period achievements
budgeted achievements
other business achievements
averages of business achievements in the same area
Ratios
Ratio Analysis classified into 5 categories:
1. Liquidity ratio
2. Efficiency ratio
3. Profitability ratio
4. Investors ratio
5. Financing ratio
Liquidity ratio
Liquidity ratios are calculated using the Balance sheet
items. These ratios are important to measure the
ability of the company to meets its short-term and
long-term obligations.
Liquidity ratio
Two types
Current Ratio
Quick ratio (also known as acid test)
Current Ratio
Total Current Assets ٪ Total Current liability
Examples
Current assets: Current liability:
Inventory (stock) Bank overdraft
Bank (+) short-term loan
Cash Payables (creditors)
Receivables (debtors)
Current Ratio
Example:
Total current assets = 200
Total current liability = 100
Current Ratio = 2: 1
The Interpretation:
The company has £2.00 of Current Assets to meet £
1.00 of its Current Liability
Quick Ratio
Quick Ratio = Total Quick Assets/ Total Current
Liabilities
Total Quick Assets = Total Current Assets (minus)
Inventory
Quick Ratio
Example:
Total current assets = £200
Inventory = £50
Total current liability = £100
Quick ratio = (200 – 50) ٪ 100
e.g. Quick Ratio = 1.50 : 1
The Interpretation:
The company has £ 1.50 of Quick Assets to meet £ 1.00 of its
Current Liability
Efficiency Ratios
This ratio outlines how efficient the company is in
running the company
Efficiency ratio
Types:
Receivables days (debtors)
Payable days (creditors)
Inventory turnover days (stock)
Receivable days
(Trade receivables ٪ credit sales) x 365
Trade receivables = debtors (client OR customer)
Receivable days
Examples:
Credit Sales = £260
Trade Receivables = £200
Receivable days = (200/260) x 365 = 281
Interpretation:
It takes on average 281 days to receive money from
trade debtors.
Payable days
(Trade Payables ٪ credit purchases) x 365
Payables = creditors ( supplier)
Payable
Example
days
Trade Payables = £800
Credit purchase = £1500
Payable days = (800 / 1500) x 365 = 195 days
Interpretation:
It takes on average 195 days for the company to pay its
creditors
Inventory turnover days
Inventory/ Cost of Sales x 365
e.g. Inventory days = 30 days
Interpretation
It takes 30 days for the company to turn its inventory to
sales
Profitability ratio
Profitability Ratios show how successful a company is in
terms of generating profits on the Investment.
Generally , if a business is Liquid and Efficient it
should also be Profitable.
profitability ratios
Gross profit percentage
Net profit percentage
Return on Capital Employed
Gross profit percentage
Gross profit ٪ Sales revenue
Gross profit = Sales – Cost of sales
Cost of sales = opening inventory +
purchases – closing inventory
Gross profit percentage
£
Sales 100
Cost of sales (50)
Gross profit 50
Gross profit percentage = 50/100 = 50%
The Interpretation:
The company makes 50 pence gross profit on every
£1.00 of Sale
Net profit percentage
Net profit ٪ sales
Net profit = profit after tax, dividend and interest ( Profit
– ( tax + dividend + interest)
Net profit percentage
£
Sale 200
Cost of Sales (50)
Gross profit 150
Less:
Operating expenses (80)
Operating profit= 70
Interest (10)
Tax (5)
Net Profit 55
Net profit percentage
Net profit percentage
= 55 ٪ 200
= 27.5% (round it up)
The Interpretation:
The company makes about 28 pence net profit on every
£1.00 of Sale
Return on Capital Employed (ROCE)
Return = Operating profit
Capital Employed = Total Equity
Total Equity = share capital + retained profit
Widely use to measure with competitor or past
performance
Return on Capital Employed
Income Statement
£
Sale 200
Cost of Sales (50)
Gross profit 150
Less:
Operating expenses (80)
Operating profit= 70
Interest (10)
Tax (5)
Net Profit 55
Return on Capital Employed
Statement of Financial Position
£
Non-current asset 100
Current assets 100
Non-current liability 50
Current Liability 50
Net Asset 100
Equity 100
Return on Capital Employed
Operating profit = £70
Capital Employed = £100
= 70/100 = 70%
Interpretation
The capital had generated 70% of operating profit.
Investors Ratio
Outlines how the investors judge the company’s
performance
Listed companies in e.g LSE
Investors ratio
1. Earnings per share (EPS) – profit available per
ordinary share
2. Price Earnings Ratio (PER)– market value of share
compared to what individual willing to pay with EPS
3. Dividend cover – Return on investment
4. Dividend yield – compares dividend with market
price
Earnings per share
Profit after tax and dividend
Ordinary shares
Eg
Profit after tax and dividend = £200
Ordinary shares = 1,000 shares
Earnings per share = £200/1000 = £0.2
Interpretation
For every share the company had earned 20p.
How the market view this 20p EPS?
Price Earnings Ratio
Current share price
Earnings per share
Example
Market price £3.20 , EPS 20p
PER = £3.2/£0.2 = £16
Interpretation:
In the market the investors are willing to pay £16 for
every £1 of EPS. PER indicates the market confident.
The investors are confident that the company is
performing well.
Dividend cover
Earnings Per Share
Dividend per share
E.g. Dividend per share = 4p; EPS = 20p
Therefore dividend cover is 20/4 = 5 times
Interpretation
The EPS is 5 times the dividend paid. In other words, the
company paid one fifth of earnings per share as
dividend.
Divided yield
Dividend of the share for the year x 100%
Current market value of the share
Market value £1.81; Dividend per share = 4p
Dividend yield = (4/181) X 100 = 2.2%
e.g. Dividend yield = 2.2%
Interpretation
The rate of return of each share is 2.2%. For example if the
market price is £10 then the investor may receive = 10 x 2.2% =
22p as dividend
Financing Ratios
Gearing Ratio :- company’s commitments to its
long-term lenders ( e.g building, equipment etc.)
against the long-term capital ( value ) in the
company.
Interest cover:- ratio measures the amount of profit
available to cover the interest payable by the
company.
Gearing Ratio
Non-current liability x 100
Total Capital
Total Capital = Equity + Non-current liabilities
Equity = £70,000; NCL = £30,000
Gearing ratio = £30,000/(£70,000 + £30,000) x100%
E.g. Gearing ratio = 30%
Interpretation:
30% of the capital is debt i.e. long term liability.
Interest Cover
Profit before interest and tax
Interest due for the year
E.g.
Profit before interest and tax = £100
Interest (expense) = £20
Interest cover = 100/20 = 5 times
Interpretation:
The company has 5 times more than the interest due for the
year. Therefore, the company would not have any foreseeable
problem in paying its interest.
