International Accounting and Finance

Chapter 6: Analysis of Financial Statements: Ratios

Christopher Nobes

This chapter was prepared for the University of London by: Christopher Nobes, School of Management, Royal Holloway, University of London It is part of a series of chapters developed for the module on International Accounting and Finance by the same author, and published by the University of London. This chapter contains some material from an earlier version prepared by Bill Ryan. We regret that the author is unable to enter into any correspondence relating to, or arising from, this chapter. Correspondence should be addressed to the module leader, via the WWLC.

Publications Office The External Programme University of London Stewart House 32 Russell Square London WC1B 5DN United Kingdom www.londonexternal.ac.uk Published by the University of London Press Royal Holloway, University of London 2011 Printed by Central Printing Service, University of London

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Chapter 6: Analysis of Financial Statements: Ratios

Introduction Overview
In this chapter we are going to look at the analysis of financial statements. One method of analysis is to use ratios, that is to put one number in the context of another number. Business ratios of one form or another are what guide the management of business enterprises. They are beneficial to managers as they strive to develop and direct the long-term strategies of the organisation. Outsiders (such as shareholders, financial analysts and the bank manager) also use ratios. The sort of data and ratios of interest inside the organisation may be different from those of interest to, for example, the investment community who are interested on behalf of their shareholders. Some investment analysts make a substantial amount of money analysing the financial statements of companies in order to provide advice to current and potential investors on whether they should buy or sell shares in certain companies. These analysts may construct very complex and sophisticated spreadsheets in order to analyse company financial statements to derive their conclusions. However, no matter how sophisticated the spreadsheet, the aim of the analysis will be the same as that which we undertake in this chapter. It is all about assessing the companys long-term performance and short-term stability. The aim of analysing the financial statements is to build up a picture of how the company has been performing and how it is likely to perform in future in order to take decisions. There is a lot of information in financial statements. The financial analysis should help the user to distil the information into a more manageable form. With financial analysis often called ratio analysis we calculate ratios based on financial statements which can help to simplify our analysis. Different users of financial statements will be looking for different information from their analysis and you should always consider what the aim of your analysis is, as that will help you decide exactly what analysis you should undertake. Suppliers to the company are going to want to know if the company has enough liquidity to pay them in the short-term future. Investors are going to want to know whether they should invest in the company. Investors will probably look at all aspects of the company, but may concentrate on profitability and any aspects that particularly affect their share-holdings and the growth potential of their investment. Managers of a company are going to be interested in all aspects of their company, but mainly in the operational aspects. The main perspective taken in this chapter will be that of the investor. We will start by giving you some background analysis as a context for your financial analysis. Subsequently, we will put financial analysis in an international context and highlight some of the problems of undertaking comparative financial analysis in an international context. We will also provide you with a self-test question to reinforce your understanding of financial analysis.

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Learning Outcomes
After studying this chapter, you will be able to: Understand the contextual environment in which we apply financial ratios Identify the differing needs with various operational contexts for ratio analysis Explain the calculation and application of ratios in the areas of profitability, efficiencies, liquidity, etc. and apply them to a set of financial statements Calculate different ratios from supplied company details and interpret these ratios Explain the different classifications of financial ratios Explain the limitations of ratio analysis Explore the results of ratio analysis in terms of what it tell us about the organisation

Chapter 6:

Analysis of Financial Statements: Ratios

Contents
Introduction Overview Learning Outcomes 6.1 Introduction to analysis The decision to invest Activity 6.1.1 Making meaningful comparisons 6.2 Profitability ratios Activity 6.2.1 Activity 6.2.2 6.3 Efficiency ratios Activity 6.3.1 Industry and country impacts on ratios Activity 6.3.2 6.4 Liquidity and gearing ratios Activity 6.4.1 6.5 Investment ratios 6.6 Methods of financial analysis Limitations of ratio analysis: creative accounting 6.7 An approach which puts financial analysis into context Self-assessment activity Feedback on activities 1 1 2 4 4 4 4 5 6 6 6 7 7 8 8 9 11 11 12 12 15 17

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6.1

Introduction to analysis

Companies need funding and the primary source for public companies is the shareholding community. In this section we are concerned with how analysis of the company's financial statements might affect decisions about investing and also, importantly, about operational performance. The big issues for the interested parties are assets, profits, growth and cash flow, all of which are interconnected.

The decision to invest

Let us begin by taking a simple example and an exercise. Try to answer the question below from your own knowledge and experience.

Activity 6.1.1
You are faced with a company in which you could invest. It has a net profit of 34 million. Should you invest in this company, based on this net profit figure? Obviously, you would want to see whether 34 million was a good profit figure or a bad pr ofit figure compared to something. Comparison is of the essence here. You need to compare the 34 million with something to see whether the company has done well or not. Against what could you compare the 34 million net profit to decide whether the company had done well? See Feedback on Activities.

Making meaningful comparisons

In order to make any meaningful financial analysis, some comparison is necessary, as is some understanding of the business context in which the company is operating. A company may have made large net profits and be seen as an attractive investment, but if all other companies in the same sector have also made large net profits, as it is a growing market in that sector, then looking at the company on its own as a good performer may be misleading without looking at how it performed in comparison with other similar companies.

Types of ratio
Financial analysis is undertaken by calculating many different ratios and these can be classified into five main groups, as summarised in Table 6.1. Table 6.1: The different types of ratios Type Reflects Profitability Performance of the company and its managers Efficiency Efficiency with which certain resources have been used in the company Liquidity Reflects the ability of a firm to meet its short term obligations Gearing Main issue is the degree to which the business is financed by borrowing as against finance provided by the owners of the firm

Examples Return on capital employed, and gross profit %. Average debtors, creditors and stock days. Sales per employee. Current ratio. Acid ratio. % of business funded by long term loans. Interest cover ratio.

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Analysis of Financial Statements: Ratios

Investment

Reflects the desirability of rewards to investors as they assess the returns on their investments

Earnings per share. Price/Earnings ratio. Dividend yield. Dividend cover.

6.2 Profitability ratios

Financial ratios include profitability, efficiency and liquidity ratios along with some illustrative examples. This section examines profitability. You will find the approach to calculating these key profitability ratios well explained in your textbook (Chapter 7) and other readings for this chapter. Here we provide summaries and we add some comments to highlight certain aspects of the calculations.

Net profit margin

This ratio is calculated as: Net profit margin = net profit before tax sales

You could calculate a gross margin as: Gross profit margin = gross profit sales

You can also calculate narrower versions of ratios, such as: Expenses-to-sales = expenses sales

Inter-company comparisons of net profit margins can be very useful and it is especially important to look at businesses within the same sector. For example, food retailing is able to support low margins because of the high volume of sales. A manufacturing or knowledge company would expect higher margins.

Return on capital employed (ROCE)

This ratio is calculated as: ROCE = net profit before interest on long-term borrowings owners equity plus long-term borrowings

It is also possible to calculate a narrower ratio: the return for the shareholders. This is called return on equity and can be calculated as: net profit

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ROE = owners equity (= share capital + reserves)

The ratio shows how efficiently a business is using the resources at its disposal. If the return is very low, the business may be better off selling all its assets and investing the proceeds in a high interest bank deposit account. This might be an extreme view but at least the point is made that the ratio needs improvement and/or explanation. Once calculated, ROCE should be compared, inter alia, with the cost of borrowings. If the cost of borrowing is 15% and the ROCE is 10%, then, if the company needs to borrow funds, it may soon run into financial trouble. ROCE should also be compared with other companies in the same industry. Different industries will tend to have different ROCEs so you should not generally compare ROCEs across industries. However, even within an industry, care is required with such a comparison because there may be different accounting policies (e.g. on deprecation and stock valuation) and different ages of fixed assets. Where plant and equipment are written down to low net book values, the ROCE will appear high. Now is a good time to test your understanding so far. Try to use your current work experience or knowledge to answer the following question.

Activity 6.2.1
Identify for your company what are the standard net profit margins and return on capital employed figures for the industry in which it operates. Your company accountant should be able to give you this information. No feedback available for this activity.

Activity 6.2.2
In the Financial Accounting textbook, try exercise 7.1 at the end of Chapter 7. Then, you can check your answer by looking at Appendix D to the book.

6.3

Efficiency ratios

Your reading for this chapter (especially Chapter 7 of the Financial Accounting textbook) will inform you on how to undertake the calculations of these ratios. Here is a summary and some extra points.

Efficiency, working capital and the cash operating cycle

Chapter 6:

Analysis of Financial Statements: Ratios

In a company, the efficiency with which it manages its cash operating cycle can be crucial to the amount of cash that it needs for its operation. The investment made in working capital by a company is largely a function of sales and, therefore, it is useful to consider the problem in terms of a firm's cash operating cycle. The firms cash operating cycle reflects the amount of cash tied up in the business due to the length of time for which inventory (finished goods, work-in-progress and raw materials) and receivables (debtors) are held, less the length of time taken to pay trade creditors. The longer this cash operating cycle, the longer the business will need to fund the cycle.

To put it another way, if a retail company holds inventory for 30 days before selling it; the companys debtors take a further 40 days to pay; and trade creditors for the invento ry are paid within 20 days, the company has to fund the cash operating cycle in some way for 30+4020 days = 50 days. In that 50 days, no money from debtors will be received. Therefore, to be efficient, a company wants to minimise this cash operating cycle. Ideally, the company wants to have a negative cash operating cycle by receiving money from debtors before it has to pay its creditors. The faster a company can 'push' items around the operating cycle, the lower its investment in working capital will be. However, too little investment in working capital can lose sales for the company since customers will probably prefer to buy from suppliers who are prepared to extend trade credit and if items are not held in stock when required by customers, sales may be lost. It is always worth calculating a companys cash operating cycle if there is sufficient information, as this will give an indication as to how much investment the company needs for its working capital. Efficiency ratios can also be called funds management ratios. The obvious ones are: - Debtors collection - Creditors payment - Inventory holding period You will remember that debtors and creditors are often shown in balance sheets as receivables and payables. It is particularly the amounts related to customers and suppliers that are relevant here. These might be called trade receivables and so on. The ratios can be defined as follows: Debtors collection in days = Trade payables x 365 sales trade receivables x 365 cost of goods sold inventory x 365 cost of sales

Creditors payment in days =

Inventory holding period in days =

Activity 6.3.1
Try out your calculations on Question 7.3 at the end of Chapter 7 in the Financial Accounting textbook. Feedback on this can be found in Appendix D at the end of that book.

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Industry and country impacts on ratios

All the standard efficiency ratios will vary between different industry sectors. For example, inventory turnover ratios vary enormously with the nature of the business. A butcher might have an inventory turnover period of 1-2 days, whereas a building contractor may have a stock turnover period of 200 days. Manufacturing companies may have an inventory turnover ratio somewhere between the two. These ratios will also vary between countries. For example, debtor and creditor days may vary depending on particular payment practices within a country.

Company efficiency analysis

In each company there are often key efficiency indicators, or key drivers of profitability, for example: "sales per square metre". This might be a very important efficiency indicator for a retail outlet as a key constraint on the company is the amount of retail space that it has. The more sales the retail outlet can generate per square metre the more efficient the company will be. In many industries the key driver is also used as a basis for simple measures of company valuation. For example, supermarkets may be valued on the basis of some multiple of their square metres of sales space. In the mobile phone industry, a key driver of profitability is the number of mobile phone contracts. Therefore a valuation of a mobile phone company may be undertaken based on a multiple of the number of contracts. Company costs per mobile phone contract may also be a key efficiency indicator. As a contrasting example, let us look at a key efficiency indicator in a very different type of industry. A good way of learning about this indicator is to undertake an exercise based on it. Try the following activity, going back to your reading or your online tutor if you have any problems.

Activity 6.3.2
In the asset management companies, the companies manage portfolios of assets on behalf of their customers. The asset management companies earn commission from their customers in relation to the amount of assets, or funds, the company has under management. This commission is usually charged to customers as a percentage of the funds under management. Based on this description, what do you think would be a key driver of profitability for an asset management company? How could efficiency ratios be linked to this key driver? See Feedback on Activities.

6.4 Liquidity and gearing ratios

The essential point here is whether the company will have enough cash to cover the immediate future and its short-term liabilities. Unless the answer is positive, the company is in financial crisis irrespective of its profit position.

Chapter 6:

Analysis of Financial Statements: Ratios

You will find that liquidity ratios are described in detail in your reading. A summary is given here. The two most common liquidity ratios are: Current (or working capital) ratio = current assets current liabilities current assets - inventory current liabilities

Acid test (or quick ratio) =

The current ratio gives an impression of whether the short-term assets are sufficient to pay the short-term liabilities. The acid test is more careful, by excluding the inventory, which might take some time to turn into cash. Gearing (or leverage) is connected to the measurement of liquidity. Gearing can be defined in several different ways. Here are two common versions: Gearing1 = debt equity debt equity + debt

Gearing2 =

As usual, it is important to stick to the same definition from year to year or from company to company. Either way, increased gearing means increased risk of not being able to pay interest or loans falling due. These gearing ratios also tell you something about likely future profitability. High gearing means that the shareholders will gain more if the company is profitable. Consequently, gearing ratios can be included under the heading of measuring profitability. A connected ratio that is more clearly to do with liquidity is: Interest cover = net profit before interest and tax interest

A high cover shows some safety.

Activity 6.4.1
Try out Questions 7.2 and 7.4 at the end of Chapter 7 of the Financial Accounting textbook. The feedback for these is in Appendix D at the end of that book.

A number of points are worth emphasising here. A company's gearing ratio is considered very important by outside analysts. This is because the more highly geared a company is, the more risky any investment in that company is. On the other hand, a company with very little gearing, i.e. loans, may not be using the most cost effective forms of finance. Here we will just give you a simple arithmetical example to show why a company with higher gearing is considered more risky, and the impact on costs of finance.

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The implications of high or low gearing

The importance of gearing for company cost of finance (through tax deduction) and risk can be illustrated by an example as follows in box 6.A. Once you have thought through the contents of this exercise, you should complete your reading for topic.

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Box 6.A An example of the implications of gearing

Two companies, Alpha and Beta both have capital of 10,000. All of Alpha s capital is equity shares of 1 each. Beta has 5,000 1 equity shares and 5,000 10% debentures. Both companies earn profits of 5,000 in year 1 and 3,000 in year 2. The corporate tax rate is 30% and the dividend paid is 10p per share. The position over the two years will be as follows:

Balance sheets

Alpha

Beta 5,000 5,000 10,000 Beta Yr 2 3,000 3,000 900 2,100 1,000 Yr 1 5,000 500 4,500 1,350 3,150 500 Yr 2 3,000 500 2,500 750 1,750 500

Shares Debentures

10,000 10,000

Income statements Yr 1 Profit before tax and interest Interest

Alpha

5,000 5,000

Taxation (30%) Profit after tax Dividend (10p per share)

1,500 3,500 1,000

Retained profits Earnings per share*

2,500 35p

1,100 21p

2,650 63p

1,250 35p

* This is the amount of profit after tax divided by the number of shares. You can see the effect of Betas gearing as follows: (a) The debenture interest is an allowable deduction for tax, but dividends are paid out of profits after taxation. Therefore, though both companies have paid out 1,000 to their finance providers (debt and share holders), Beta plc has consistently higher retained profits than Alpha. (b) The earnings of a highly geared company are more sensitive to profit changes. Thus, shareholders in Beta have seen a wider swing in their earnings per share held over the two years (from 63 pence per share to 35 pence per share). Thus a highly geared company is seen as more financially risky.

Manipulating the gearing ratio

As gearing is such an important ratio for companies and investors, it is also a ratio that companies may try to manipulate. A common way of manipulating gearing to give a false impression is to keep loans off the balance sheet in some way. One way of doing this is to

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have a large number of leases that are treated as operating leases. Another is to try to transfer liabilities to companies that are not consolidated. This was one of the tricks used by Enron before its collapse in 2001.

6.5

Investment ratios

In this section we will review the basic investment ratios that are well covered in your reading for this chapter, in particular Sections 7.8 and 17.2 of the Financial Accounting textbook. Two of the ratios are considered as crucial in any company analysis: Earnings per share and The P/E ratio

Earnings per share is defined as follows: EPS = earnings for the ordinary shareholders number of ordinary shares

The reference to ordinary shares reminds you that some shares are preference shares (see Chapter 2 of this course). So, the earnings is after deducting any dividends for the preference shareholders. You will remember (from Chapter 4 of this course) that there are two sorts of income statement. The earnings is before addition of other comprehensive income. The price/earnings ratio is defined as: P/E = market price of one share EPS Using todays market price and the latest available EPS, the ratio is a measure of how much an investor would have to pay for a given amount of annual earnings. A high ratio suggests that the market expects good future growth.

6.6 Methods of financial analysis

There are many suggested methods of undertaking a financial ratio analysis of a company. We suggest you adopt something along the following lines. 1. Undertake a survey of the general business environment along the lines that we discussed above. 2. Obtain as much information on the company as is possible. 3. Proceed to undertake as detailed an analysis as is possible of the company results. 4. Work out what has happened in the company by comparing for example, different time periods and different elements within those time periods. 5. Write up your results. This approach imposes a formality on your conclusions that make them worthy of presentation to, for example, the board, or your management. In any question involving ratio analysis, after you have calculated a ratio, you will need to discuss your analysis. In your discussion, the following points may serve as a useful structure for your analysis:

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(a) Why might the change in the ratio have occurred? E.g. if the current ratio has increased, is this because the company is holding more stock? (b) What is the norm for this ratio? E.g., you could compare the ratio with the industry average or with the companys stated policy for that ratio. (c) What are the limitations of the ratio? E.g. how is the ratio affected by certain accounting policies?

Limitations of ratio analysis: Creative accounting

This is a phrase which has been used to describe the attempt by companies to improve the presentation of their financial accounts so as to mislead users. It is not that it is (usually) fraudulent, but as there is always some latitude in the preparation of financial accounts, companies may make full use of this latitude. This topic is well covered in your reading and you should make sure you have read this before proceeding.

6.7 An approach which puts financial analysis into context

The other point to understand is that financial analysis of financial statements is only a starting point for a further analysis of a company. For example, a decline in the gross profit to sales ratio for a business could arise for several reasons: The company could be offering trade discounts to its customers. The company could have more inventory obsolescence that usual. There could be a change in the mix of products offered. The company may have reduced its selling price.

All these could be valid reasons for the change. Ratios point you in the direction where you should undertake further analysis. In themselves, ratios do not give answers to why a business performs as it does. That is why it is essential to look behind the numbers for answers. For example, if a company had to reduce its selling price and this resulted in a drop in profitability, it may be due to its product range becoming mature, out of date and could also explain an amount of obsolescence. All of these indicators might steer us in the direction that the company needs a new product. Note that the performance of an individual company must be judged against the performance of the whole sector. So, for an investor in a company, it is important to understand the business context in which the company is operating. Then the investor can make more sense of the financial analysis. Over thirty years ago, Michael Porter outlined a model to help companies formulate a strategy by understanding the competitive situation in their industries. The basis of his model was that potential profitability in an industrial sector is determined by five factors: 1. Ease with which new entrants can join the industry 2. Bargaining power of the industry's suppliers 3. Bargaining power of the industry's customers 4. Availability of alternative products and services which could meet the needs currently met by the industry 5. Behaviour of existing players in the sector The potential profit for the industry will depend, for example, on how easily other competitors could join the industry. This approach of looking at the competitive nature of the industry can provide a rich context to our financial analysis. Below is a checklist of the factors Porter suggested are important in determining the importance of each of the 1 above aspects of industry structure . These characteristics apply to an 1 The list is drawn from M. Porter
(1980), Competitive Strategy, Free Press.

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industry or sector, rather than a firm, but they are very useful as a way of setting the scene for any analysis of the firm's performance.

Threat of new entrants - barriers to entry

Economies of scale Product differentiation Capital requirements Switching costs Cost disadvantages independent of size (e.g. learning curve; government subsidies) Access to distribution channels Government policy (e.g. re-licensing)

Bargaining power of customers (the following factors will limit profits that can be
achieved in an industry) If there is a concentration of customers (e.g. only a few) It faces few switching costs Standard or undifferentiated products Product represents a significant proportion of customer's costs Buyer is in a low-profit industry Product is unimportant to the quality of the buyer's product or service Buyer poses a credible threat of backward integration

Bargaining power of suppliers (the following factors will also limit the profit that can be
achieved in an industry Supplier's industry is dominated by a few companies or is more concentrated than the industry it is selling to Input is unique, differentiated or has switching costs Input cannot be easily substituted by a similar product Supplier poses a credible threat of forward integration Industry is not an important customer of the supplier

Threat of substitute products or services

The availability of any substitutes will limit the price and therefore potential profit in the industry.

Intensity of rivalry among current contestants (intense rivalry, limiting the total profit achieved by all players in an industry) will increase with the following factors:
Many players of roughly equal size Slow rate of growth in the industry (life cycle) Lack of differentiation or switching costs Fixed costs represent a high proportion of total costs Capacity that can only be increased in large increments High exit barriers Rivals diverse in strategy, origin and personality

This type of industry analysis provides a background to financial analysis in so far as it helps to identify what sort of financial analysis profile you would expect to find. For example, in a

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very competitive industry you would expect to see low net profit to sales ratios. You would want to analyse your company to see how it is coping with the competition and whether it has any particular competitive advantage: e.g. is it the lowest cost provider in its industry?

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Self-assessment activity
We will finish this chapter with a self-test question, for you to use as revision of the ratios

Zanzo Co.
Zanzo Co. is a retail company that sells toys from its four shops. It obtains the toys from a few, very large, suppliers. There are few other toy shops in its localities, but it is beginning to find that there is competition from Internet-based suppliers. In the last year, Zanzo has diversified into computer games. Zanzo Co: Balance sheets as at 31 December 20X5 '000 '000 Non-current assets Land & buildings Fixtures and fittings Current assets Inventory Receivables Cash Current liabilities Trade payables Other Company tax due Net current assets Non-current assets + net current assets Long-term liabilities 10% Debentures Capital and reserves 0.50 Ordinary shares Other reserves Retained profits 940 125 1,065 740 420 80 1,240 230 147 152 529 711 1,776 500 1,276 671 80 525 1,276 600 490 57 1,147 440 80 130 650 497 1,387 400 987 609 131 247 987 20X4 '000 '000 762 128 890

Income statements Zanzo Co. for years ended 31st December 20X5 '000 '000 Sales 5,459 Less Cost of sales Opening inventory 600 Purchases 4,284 4,884 Less closing inventory 740 4,144 Gross profit 1,315 Wages and salaries 512 Interest payable 52 Other costs 174

20X4 '000

'000 4,481

482 3,608 4,090 600 460 48 132

3,490 991

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Net profit before tax Company tax Net profit after tax Add retained profits b/forward Dividends paid Retained profit c/forward All sales and purchases are made on credit.

738 577 152 425 247 672 147 525

640 351 130 221 106 327 80 247

The market value of the shares of the company was 7 at 31st December 20X5 and 5 at 31st December 20X4. The issues of equity shares during 20X5 was at the beginning of the year. Dividends of 6.6 pence per share were paid in 20X4, and of 11 pence per share in 20X5. Calculate the following ratios for 20X4 and 20X5 and comment on the companys performance: Profitability Return on Capital Employed Gross profit margin Net profit margin Efficiency Liquidity Gearing Investment Inventory days (using the year end balances) Debtors and creditors days (using the year end balances) Current and acid test ratios Gearing ratio Interest cover ratio Earnings per share Price/Earnings ratio Dividend yield What other "key driver" ratios would be a useful calculation for this company? Do you think Zanzo Co. operates in a competitive industry?

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Feedback on activities
Activity 6.1.1
Against what could you compare the 34 million net profit - fairly - to decide whether the company had done well? Here are some suggestions: Compare against a similar-sized company in the same industry Compare against what the company intended to do. Compare against what the company has done in the past. Compare the net profit to the sales of the company as a percentage to see what net profit it generated from each sale Compare the net profit to the net assets of the company as a percentage to see return the company has generated from the net assets ( a little like calculating the interest rate on a deposit account)

Activity 6.3.2
Based on this description, what do you think would be a key driver of profitability for an asset management company? A key driver would be the size of funds under management. The larger the funds under management, the larger the potential profits. Thus any key efficiency indicators are likely to be linked to the funds under management, e.g. % of admin costs to funds under management.

Self-assessment activity
Zanzo Co. Return on capital employed
Profit before interest and tax x 100% Non-current assets + net current assets 20X5 577+52 x 100% = 35.4% 1,776 20X4 351+48 x 100% = 28.8% 1,387

We do not know if this is a good or bad ratio in itself, but we can say that it has improved over the year. There are two fundamental reasons why this could have changed due to changes in profitability and changes in utilisation of assets.

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Gross profit margin Gross profit Sales x 100%

20X5 1,315 x 100 = 24.1% 5,459

20X4 991 x100% = 22.1% 4,481

One normally expects this % to remain reasonably constant. Here we can see that it has improved. This may flow from the move to computer games which may have a higher gross margin. Net profit margin Net profit Sales 20X5 577+52 x 100 = 11.5% 5,459 20X4 351+48 x100%= 8.9% 4,481 x100%

This has increased. You could look into further detail to see which decrease in costs has led to this change by calculating the % cost of each of the cost lines (wages and salaries, and other costs) as a percentage of sales. Then, you would want to look behind the figure (e.g., other costs) to see what has happened to decrease these costs, relative to sales. Efficiency ratios Inventory days Inventory Cost of sales 20X5 740 x 365 = 65.2days 4,144 20X4 600 x 365 = 62.8days 3,490 x 365

This ratio has shown a slight increase. It may mean that the some new products are not selling so well. Another consideration is that in the UK toy industry, one of the busiest times of year is in the two months before Christmas. One would expect a very low inventory turnover as stock comes in and is quickly sold. To have a stock holding ratio of 65 days at the end of December i.e. just after Christmas, would seem to be very inefficient.

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Debtors days Trade receivables Sales 20X5 420 x 365 = 28.1 5,459 20X4 490 x 365 = 39.9 4,481 x 365 days

This ratio has shown a marked improvement over the year. Cash from debtors/receivables is being received a lot quicker. There would need to be some further analysis to see why this is the case (has Zanzo set stricter credit limits? Have there been changes in the industry?) However, even 28 days would seem to be a high ratio for a retailer where most sales would be for cash, or near cash. Creditors days Trade payables x 365 days Purchases 230 4,284 x 365 = 19.6 440 3,608 x 365 = 44.5days

Unfortunately, this has also seen a decrease over the year, which means that creditors/payables are being paid faster. This could cause future cash flow problems if Zanzo had not also improved debtor collection. It may be that the new computer games supplier has demanded shorter payment periods. It could also be that the few large suppliers are extracting quick payments from Zanzo. Liquidity Ratios Current ratio Current assets Current liabilities 20X5 1,240 = 2.3 times 529 Acid test or quick assets ratio Current assets - inventory Current liabilities 20X4 1,147 = 1.8 times 650

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20X5 1,240- 740 = 0.95 times 529

20X4 1,147- 600 = 0.84 times 650

Both ratios have seen an increase over the year. This may be good news (less chance of liquidity problems), but it may also reflect inefficient management of working capital e.g. stock holdings. To understand whether this is a problem for Zanzo, one would have to know more about the industry. The two ratios seem somewhat high for a retail company. Current ratios could be less than one in the retail sector. Gearing Loans x 100% Ordinary share capital + reserves + loans 20X5 500 x 100 = 28.2% 1,276+500 20X4 400 x 100 = 28.8% 987+400

This has remained constant over the year, even though more long term loans have been taken out. 20X5 Interest cover ratio Profit before interest and tax Interest payable 577+52 =12.1 52 351+48 = 8.3 48 20X4

The large increase in interest cover shows that the company has plenty of interest cover. Maybe it could safely take on more debt? Earnings per share (EPS) Earnings available to ordinary shareholders Number of ordinary shares in issue 20X5 425 1,342 = 0.32 20X4 221 1,218 = 0.18

The dramatic increase in EPS reflects the increase in profit after tax, with only a small increase in the number of shares over the year.

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P/E =

Market value per share Earnings per share

20X5 7.00 = 21.9 0.32

20X4 5.00 = 27.8 0.18

The fall in the P/E ratio could reflect the fact that the stock market does not believe that the increase in earnings will continue. Alternatively, it could mean that here is a bargain share with potential where its growth prospects have not been recognised by the stock market. What other "key driver" ratios would be a useful calculation for this company? As this is a retail company selling through stores, any measure of sales per square metre or per employee would be very useful. To decide whether Zanzo operates in a competitive market, you need to obtain a lot more information about the market. However, given the way in which Zanzo only has a few large suppliers, the way in which it is easy to enter Zanzos market (e.g. via the Internet) and the nature of the product customers can easily switch it is probably fair to state that the market is competitive.

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