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So far we have studied accounts and what they mean. Now we will devote a day to the active use of financial information. First we will take a look at ratios in the accounts, and then move on to investment decisions. Today is far from the easiest day but, provided that you have mastered the basics, it should be one of the most interesting and rewarding.
The programme for today covers:
ā¢ accounting ratios
ā¢ four key questions
ā¢ testing our understanding of accounting ratios
ā¢ investment decisions.
Accounting ratios
There are many useful ratios that can be taken from accounts. The following are among the most important but there are many others. It is a good idea to have a set of accounts with you as you work through this section. Pick out relevant figures, work out the ratios, and try to draw conclusions.
Profit to turnover
For example:
| Annual turnover | Ā£10,000,000 |
| Annual profit before tax | Ā£1,000,000 |
| Profit to turnover | 10% |
This uses Profit before Tax but it may be more useful to use Profit after Tax. Perhaps you want to define profit as excluding the charge for bank interest. You should select the definition most relevant to your circumstances. The ratio may be expressed in different ways (e.g. 1 to 10 instead of 10%).
Return on capital employed
For example:
| Capital employed | Ā£5,000,000 |
| Annual profit after tax | Ā£1,000,000 |
| Return on capital employed | 20% |
Again the profit may be expressed before or after tax.
Capital employed is the net amount invested in the business by the owners and is taken from the Balance Sheet. Many people consider this the most important ratio of all. It is useful to compare the result with a return that can be obtained outside the business. If a building society is paying a higher rate, perhaps the business should be closed down and the money put in the building society.
Note that there are two ways of improving the return. In the example, the return on capital employed would be 25% if the profit was increased to Ā£1,250,000. It would also be 25% if the capital employed was reduced to Ā£4,000,000.
Stock turn
For example:
| Annual turnover | Ā£10,000,000 |
| Annual cost of sales (60%) | Ā£6,000,000 |
| Stock value | Ā£1,500,000 |
| Stock turn | 4 |
As the name implies, this measures the number of times that total stock is used (turned over) in the course of a year. The higher the stock turn the more efficiently the business is be...
