Accounting for Business

Ratio Analysis 1: Profitability, Efficiency and

Performance

Chapter 6

© Peter Scott, 2019. All rights reserved.

 Financial Statements: Analysis and Interpretation
Enables users to draw conclusions about:
• How profitable an entity is
• How strong an entity’s financial position is
• How efficiently its assets are being used
• How well an entity is performing to meet the
expectations of its investors
• How secure its future cash flows and financial stability
are

© Peter Scott, 2019. All rights reserved.

 Financial Statement Analysis Categories
• Profitability

• Efficiency

• Performance

• Short-term liquidity and working capital (Chapter 7)

• Long-term financial stability (Chapter 7)

© Peter Scott, 2019. All rights reserved.

 Ratio Analysis
How do users evaluate and assess financial statements?
• Ratios are used as a tool to evaluate, interpret and assess
financial information
• A ratio expresses the relationship between two different figures
• Users calculate the same ratio for several different time periods
• To enable them to make comparisons to see if ratios are rising,
falling or staying the same
• This is called trend analysis (or horizontal analysis)

© Peter Scott, 2019. All rights reserved.

 The Usefulness of Ratio Analysis (1)
Example of Company A:
• £15m revenue and £3m profit in the year to 31 March 2019
• Profitability = £3m ÷ £15m x 100% = 20%
• £25m revenue and £4.5m profit in the year to 31 March 2020
• Profitability: £4.5m ÷ £25m x 100% = 18%
• More profit in 2020 but 2019 is a more profitable year, more
pence of profit per £1 of sales
• Ratios are a relative measure

© Peter Scott, 2019. All rights reserved.

 The Usefulness of Ratio Analysis (1.a)
30 21%

20% 25 20%
25

20%
20

19%
15
15

19%

10
18% 18%

5 4,5
3 18%

0 17%
March 2019 March 2020

Revenue Profit Profitability (%)

© Peter Scott, 2019. All rights reserved.

 The Usefulness of Ratio Analysis (2)
• Ratios highlight variances across time that are not
apparent from the figures in the financial statements
• Highlighting these variances enables users to ask
questions to find out why the changes have occurred
• Calculating ratios provides information about which
relationships have changed
• Explanations for these changes assist users in
understanding a business and how it operates

© Peter Scott, 2019. All rights reserved.

 The Usefulness of Ratio Analysis (3)
• You might ask yourself:
– Has Company A reduced selling prices to increase market
share?
– Has there been a rise in the employees’ wages that
cannot be passed to the customers?
– Has the Company A offered discounted prices?
– Has a rival company business opened in the area forcing
selling prices down through increased competition?

© Peter Scott, 2019. All rights reserved.

 Financial Statement Figures and Ratios
Given that ratios are so useful in interpreting an
organization’s results, should we just ignore the financial
statement figures? → NO!!
• Users should look at both the figures and the ratios
based upon them
• Looking at just the ratios ignores the size of the figures
• Looking at just the figures ignores the changing
relationships between the figures

© Peter Scott, 2019. All rights reserved.

 Financial Statement Figures and Ratios (2)
• Entity A: profitability of 20%.

• Entity B: profitability of 10%.

– Which one do you prefer?

• Entity A: Profit £ 50.000 and Sales of £250.000.

• Entity B: Profit £ 10.000.000 and Sales of £100.000.000.

– Now, which one do you prefer?

© Peter Scott, 2019. All rights reserved.

 Ratios: Advantages
• Easy to calculate and understand
• Simplify data into key indicators to highlight trends and variances
• Express relationships between different figures in the financial
statements
• Assist in trend analysis
• A proportion calculated on a consistent basis overcomes the
problem of changing figures
• Provide a solid basis for further investigations to determine the
reasons for changes in ratios

© Peter Scott, 2019. All rights reserved.

 Profitability Ratios
• A key indicator used in financial statement analysis

• Profit is a very important figure for stock market

analysts and share valuations

• Is an entity’s profit rising or falling?

• Is an entity more or less profitable than last year?

• Ratios consider whether an entity is making more or

less profit per £1 of sales

© Peter Scott, 2019. All rights reserved.

 Profitability Ratios

Gross
Profit%

Profit
Profitability Operating
after ratios Profit%
Tax%

Profit
before
Tax%

© Peter Scott, 2019. All rights reserved.

 Profitability Ratios: Gross Profit %
• The profitability % after deducting the direct costs of
production of goods sold or the direct costs of goods
bought for resale
• Assesses how effectively entities are controlling their
production costs/costs of buying in goods for resale

• Calculation: Gross Profit x 100%

Revenue (Sales)

© Peter Scott, 2019. All rights reserved.

 Gross Profit %: Explaining Changes
Possible reasons for the changes in gross profit %:
• Selling prices rising faster/more slowly than direct costs of goods
sold
• A changing sales mix from higher to lower margin goods or vice
versa
• Rising/falling prices of materials/goods bought in
• Increased/decreased productivity of the workforce
• Supplier bulk discounts reducing input costs
• Bulk discounts offered to customers reducing revenue, bulk
discounts from suppliers reducing costs

© Peter Scott, 2019. All rights reserved.

 Profitability Ratios: Operating Profit %
• Profitability % of revenue after deducting all operating costs
• But before considering the effects of net finance costs and
income tax
• Evaluate changes in distribution and selling costs and
administration expenses and their effect on profitability year
on year

• Calculation: Operating Profit x 100%

Revenue (Sales)

© Peter Scott, 2019. All rights reserved.

 Profitability Ratios: Profit Before Tax %
• Ratio calculation based on profit before tax
• Thereby eliminating the distorting effect of changes in
tax rates
• The profitability % after deducting all costs incurred and
adding all income earned

• Calculation: Profit Before Tax x 100

Revenue (Sales)

© Peter Scott, 2019. All rights reserved.

 Profitability Ratios: Profit After Tax %
• Profitability % after adding all income and deducting
all expenses and charges for the period under
review

• Calculation: Profit for the Year x 100%

Revenue (Sales)

© Peter Scott, 2019. All rights reserved.

 Profitability Ratios: Example
• Antigoneia Plc: Statements of Profit or Loss for the Years Ended 30 April 2019
and 30 April 2018

© Peter Scott, 2019. All rights reserved.

 Profitability Ratios: Example
• Gross profit % 2019: £10,625 x 100% = 34.00%
£31,250
• Gross profit % 2018: £9,482 x 100% = 33.00%
28,732
Comments:
• Sales are more profitable and generating more gross profit per £
of sales
• Conduct investigations to find out why e.g. lower product costs,
bulk discounts, economies of scale as a result of expansion and
growth

© Peter Scott, 2019. All rights reserved.

 Profitability Ratios: Example
• Operating profit % 2019: £4,482 x 100% = 14.34%
£31,250

• Operating profit % 2018: £4,630 x 100% = 16.11%

£28,732
Comments:
• Fall in operating profit % this year
• Large rise in administration expenses and
• Distribution costs represent 8.45% of sales v 7.66% in 2018: investigate
these changes in costs to determine why they have risen

© Peter Scott, 2019. All rights reserved.

 Profitability Ratios: Example
• Profit before tax % 2019: £3,732 x 100% = 11.94%
£31,250

• Profit before tax % 2018: £4,170 x 100% = 14.51%

£28,732
Comments:
• Lower % in 2019 due to lower operating profit
• Higher finance cost on higher borrowings used to finance
expansion will also have contributed to the reduced PBT and
PBT%

© Peter Scott, 2019. All rights reserved.

 Profitability Ratios: Example
• Profit after tax % 2019: £2,799 x 100% = 8.96%
£31,250

• Profit after tax % 2018: £3,125 x 100% = 10.88%

£28,732

Comments:

• Lower % in 2019 due to higher distribution and selling

costs, administration and finance expenses

© Peter Scott, 2019. All rights reserved.

 Efficiency Ratios
• Measure how effectively and productively the resources
of the organization are being used in the generation of
revenue and profit
• Resources fall into two categories:
– Non-current assets used in the production of goods and
generation of sales
– The employees engaged within the business

• More efficient and productive use of entity resources will

result in higher profits and higher profitability

© Peter Scott, 2019. All rights reserved.

 Efficiency Ratios

Non-current
asset turnover

Efficiency
ratios

Profit per Sales per

employee employee

© Peter Scott, 2019. All rights reserved.

 Efficiency Ratios: Non-Current Asset Turnover
• Compares sales to non-current assets used in the
organization

• Measures £s of sales per £ of non-current assets

• The higher the ratio, the more efficiently and

productively the non-current assets are being used
to generate sales

• Calculation: Revenue ÷ Non-Current Assets

© Peter Scott, 2019. All rights reserved.

 Efficiency Ratios: Revenue and Profit Per Employee
• Employee performance determines the success or otherwise of
organizations

• Not recognized in the financial statements… why?

• Increasing productivity = greater sales, more profit

• If employees are paid a fixed salary, the more they produce/sell for that
fixed amount, the more profit their employer will make and vice versa

• Revenue per employee = Revenue ÷ number of employees

• Profit per employee = Operating profit ÷ number of employees

© Peter Scott, 2019. All rights reserved.

 Efficiency Ratios : Example
Antigoneia Plc: Statements of Financial Position at 30 April 2019 and 30 April 2018

© Peter Scott, 2019. All rights reserved.

 Efficiency Ratios : Example
Antigoneia Plc: Statements of Financial Position at 30 April 2019 and 30 April 2018

© Peter Scott, 2019. All rights reserved.

 Efficiency Ratios : Example

Non-current asset turnover: 2019: £31,250 = £1.05

£29,889

Non-current asset turnover: 2018: £28,732 = £1.13

£25,370
Comments:
• Lower £s of sales per £ of non-current assets in 2019
• Probably due to new capacity coming on stream and not yet
performing to its full potential

© Peter Scott, 2019. All rights reserved.

 Efficiency Ratios : Example
Revenue per employee:
2019: £31,250,000 ÷ 400 employees = £78,125
2018: £28,732,000 ÷ 355 employees = £80,935

Operating profit per employee:

2019: £4,482,000 ÷ 400 employees = £11,205
2018: £4,630,000 ÷ 355 employees = £13,042

• Reduced employee efficiency this year as new capacity is

built up; potential overstaffing of shops

© Peter Scott, 2019. All rights reserved.

 Performance Ratios: EPS

Earnings per
share

Dividend Price
cover earnings ratio

Performance
ratios

Dividend per Dividend

share Yield

© Peter Scott, 2019. All rights reserved.

 Performance Ratios: EPS
• EPS = Earnings Per Share

• A measure of the pence of profit earned during an

accounting period by each ordinary share

• Theoretically, the dividend that would be paid if all profits

for the financial period were paid out to shareholders

• (Profit after taxation and after preference dividends) ÷

Number of ordinary shares in issue x 100 pence

© Peter Scott, 2019. All rights reserved.
 The Importance of EPS
• EPS is a key figure for the stock market

• Where EPS are expected to rise, share prices rise

ahead of a profits announcement

• Where EPS are expected to fall or stay the same, share

prices tend to fall ahead of a profits announcement

• Falling EPS suggest reduced dividends

• Rising EPS suggest increased dividends

© Peter Scott, 2019. All rights reserved.

 Performance Ratios: DPS
• DPS = Dividends Per Share

• The dividend in pence paid out on each ordinary share

• Rising DPS indicates confidence in a company’s ability to

generate rising profits each year

• Higher dividends lead to higher share prices

• DPS = Total Ordinary Dividends ÷ Number of Ordinary Shares in

Issue

• DPS/EPS x 100% = the pay-out ratio, the % of EPS distributed as

dividend each year

© Peter Scott, 2019. All rights reserved.

 Performance Ratios: Dividend Yield
• The DPS as a % of the current market price of one
ordinary share

• Serves the same purpose as an interest rate on a

bank deposit account, the interest earned on the
amount invested

• Dividend yield = ordinary dividend per share ÷

current market price of one ordinary share
© Peter Scott, 2019. All rights reserved.
 Return on Capital Employed (ROCE)
Profit before interest and tax x 100%

Equity + Long-Term Borrowings

• Compares different profits of different entities with

different capital structures

• To determine which entities produce the highest returns

from their capital structures

• To guide investors towards the highest available returns

© Peter Scott, 2019. All rights reserved.

 Ratios: Consistency
• Ratios must be calculated and presented consistently

• To give a fair comparison year on year

• Otherwise comparisons are distorted and figures given

are misleading

• Consistent calculation and presentation gives an

accurate picture of an entity’s financial position and
performance compared to other years

© Peter Scott, 2019. All rights reserved.

 How Well Are We Doing?
Compare company results to:
• Competitors in the same industry
• Of similar size
• In similar locations
• Over the same accounting period
• In order to eliminate random variances arising from different activities,
size, industry, geographical location and economic factors

Comparative data should be consistently prepared to avoid distortions and

bias in the figures

© Peter Scott, 2019. All rights reserved.

 Other Comparisons
Compare for the same accounting period:

• Budgeted/planned performance data

• Industry data

• Industry averages

© Peter Scott, 2019. All rights reserved.