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Unit 34 (P7, M3): Financial State

Illustrate the financial state of a given business (P7)
Interpret the contents of a trading and profit and loss account and balance sheet for a selected company explaining how accounting ratios can be used to monitor the financial performance of the organisation (M3)

Ratio analysis is used to analyse the working capital of a business. Financial ratios can be used to look at a wider range of performance of a business. There are several ratios that a business would use.

Note: All numbers shown below are in millions excluding the result.

To Determine Solvency Current Ratio

Current Ratio = Current Assets / Current Liabilities

0.77 = 15572 / 20206

Current ratio is to do with debts, it is also known as a liquidity and efficiency ratio. The current ratio is where if Tesco was to sell all the current assets they had, then does it cover the cost to what they owe. This shows how many times Tesco can sell the business over to pay the liabilities, to be able to sell the business, Tesco needs to score 1 or more. Current assets like cash, cash equivalents, and marketable securities can easily be converted into cash in the short term. This means that businesses with larger amounts of current assets will more likely be able to pay off their current liabilities when they become due without having to sell off long-term, revenue generating assets.

This would be beneficial for Tesco as it would indicate how much debt they have and how many times they would be able to sell the business. This would mean that they would know how much debt they have and how much revenue they had made as it would indicate by the amount of times they can sell and pay the debt. However, Tesco would not be able to sell their business over because their current ratio is 0.77. This makes it so that Tesco cannot sell their business over, not even once, as the ratio does not equal 1 or more. This would be a negative thing for Tesco as they need to sell the long-term investments to pay for the liabilities.

Acid Test

Acid Test Ratio = (Current Assets - Inventory) / Current Liabilities

0.59 = (15572 - 3576) / 20206

Acid test ratio is a liquidity ratio which determines whether a business has enough money to pay its current liabilities when they come due with only quick assets. Quick assets are current assets that can be converted to cash within 90 days or in the short-term. So, if the result is less than 1, then Tesco cannot pay their liabilities. Since Tesco has a result of 0.59, this means that they cannot pay their current liabilities with their quick assets. If, however, a business passes the acid test which is shown if the ratio has a value more than 1, then that business can pay their liabilities with their quick assets and is a stable business.

This would be an advantage to any business as they can see whether they would be able to pay back their debts. This will also show how stable they are as a business in the current year and possibly for the next year too. However, the disadvantage would be that they would not be able to pay back the liabilities if they had a value below 1. This would mean that they would have to sell their non-current assets to pay it back. Just like Tesco, they have gotten a value lower than 1 which means that Tesco would need to use other means to pay back the liabilities such as using their long-term investments to pay it back. This will affect next year as Tesco will need to make more long-term investments as they used most of it in the previous years.

To Determine Profitability Gross Profit Percentage

Gross Profit Percentage = ((Revenue - Cost of Sales) / Revenue) x 100

6.31% = ((63557 - 58547) / 63557) x 100

The gross profit percentage is a profitability ratio which compares the gross profit of a business to the revenue. High ratios can typically be achieved by two ways. One way is to buy inventory very cheap. If retailers can get a big purchase discount when they buy their inventory from the manufacturer or wholesaler, their gross margin will be higher because their costs are down. The second way retailers can achieve a high ratio is by marking their goods up higher. This obviously has to be done competitively otherwise goods will be too expensive and customers will shop elsewhere.

This is important to Tesco as it allows them to monitor the amount of profit that is made on the revenue. This will mean that they would be able to keep track on how much inventory is selling and how much money is being made. Tesco has a low gross profit percentage which means the revenue of stock is slower, as they have a 6.31% revenue of their sales. This indicates to Tesco that they have a bad gross profit and they will only have 6.31% to pay for their operating expenses like salaries and rent. As it is a very low percentage, it will most likely mean that Tesco would need to use money from another income to cover the cost of the operating profit.

Net Profit Percentage

Net Profit Percentage = (Net Profit before Tax and Interest / Revenue) x 100

3.55% = (2259 / 63557) x 100

The net profit margin helps Tesco to control its overheads. The net profit percentage measures how much out of every pound of sales a business keeps in earnings. A higher profit margin indicates a more profitable company that has better control over its costs. Tesco, on the other hand, does not have good control over its costs as the net profit percentage is a very low 3.55%. This shows that Tesco is not an effective business and their net profit margin is very weak. Having said this, Tesco could see if they have improved over previous years. Therefore, they would be able to measure the effective of the business.

I did a quick sum to see what the net profit percentage was for Tesco in 2013:

3.24% = (2057 / 63406) x 100

This shows that Tesco has improved in 2014, however, it is not a big improvement and the net profit percentage is still very low.

Without this ratio, then Tesco would not be able to measure how well the business is doing. It is important for Tesco that they use this ratio otherwise if they did not then they would not be able to assess the businesses performance.

Return of Capital Employed

Return of Capital Employed = (Revenue - Operating Profit) / (Total Assets - Current Liabilities)

2.03 = (63557 - 2631) / ((34592 + 15572) - 20206)

Return on capital employed is a profitability ratio that measures how efficiently a business can generate profits from its capital employed by comparing net operating profit (revenue subtract operating profit) to capital employed. It shows how many pounds in profits each pound of capital employed generates. The advantage of this is that it relates the profit to the size of the business.

This allows Tesco to monitor their performance as they can see how their profit compares to their business. This would mean that they would be able to see how well they are doing and how much profit they are making before tax. So, this would be an advantage as they would be able to see how much they are making compared to their business. The return on capital employed for Tesco is 2.03, this means that for every pound that Tesco invests into their business, Tesco generates £2.03. This ratio shows that they are slightly above doubling their money for every pound they invest.

To Determine Performance Inventory Turnover

Inventory Turnover = Cost of Sales / Average Inventory

16.27 = 59547 / ((3576 + 3744) / 2)

The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is managed by a business cost of goods sold with average inventory (inventory start and end of the year divided by 2) for a certain period. The higher the turnover is, the better the business has done. A lower turnover indicates that they have been over stocking the business and holding costs. It is important that Tesco have a high turnover as they would have had good stock turnover. This allows Tesco to monitor their stock turnover and as they can keep track on how much they have spent and whether they have more stock then they need. It also allows Tesco to look at how much stock they have over many days. Tesco’s inventory turnover is 16.27. This is very high which is good for Tesco. This means that Tesco has sold 16 times more of its inventory during the year.

Debtors’ Collection Period

Debtors’ Collection Period = (Account Receivables / Credit Sales) x 365

12.58 = (2190 / 63557) x 365

This indicates how a business is improving their debt and how it has fallen. This means that a business knows how long it will take for their credit sales to convert into cash. This is how many days they would pay it. So, for Tesco, they would have to wait 12.58 days for the debt to be paid. Tesco can reduce the amount of days that the debtors’ collect by offering early payments to reduce the amount of days. Therefore, they would pay their debt off less than 12.58 days.

Asset Turnover

Asset Turnover = Revenue / Net Assets

4.32 = 63557 / 14722

The asset turnover ratio is an efficiency ratio that measures a business’s ability to generate sales from its assets by comparing net sales with average total assets. This shows that the assets have risen by £4.32 in the year for Tesco. This is a positive for Tesco as they have increased their assets. So, this means that they are using their assets to produce revenue which they have sold. However, it does not look at net profits. Therefore, they can monitor revenue but not the net profits. This means that they are not looking at the profits, they are looking at how effective the assets are to produce revenue.

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