3. 3
Situation
Semmi has made lots of money during her singing
career. She is thinking of retiring one day from singing
and is looking hard at how she can invest her savings
wisely.
But she wants you to help her make good investment
decision. Semmi hears that investing in good
companies will earn her more money. She has been
recently invited to invest $100,000 in the firm XYZ,
which seems to be a promising and profitable firm.
4. 4
Can You Help Me?
XYZ’s most recent financial statements
are HERE.
I hear that you are an expert in
preparing clear and accurate P&L
Statement and Balance Sheet. Can
you recommend to me whether I
should invest in XYZ firm?”
6. 6
Financial Ratios
Ratios show important relationships
between financial figures.
Compare the business’ performance over
several financial periods.
Compare the business’ performance with
that of other business within the same
industry.
7. 7
Four Uses of Financial Ratios
Profitability of the business
Gives an indication of the level of returns that
the owner is getting:
Gross profit margin
Mark-up on cost
Net profit margin
Rate of return on capital
8. 8
Level of efficiency of business activity
Indicates the way the business uses its assets:
Rate of stockturn or Rate of stock turnover
Percentage of expenses to turnover
Four Uses of Financial Ratios
9. 9
Liquidity of the business
Indicates the business’ ability to pay its debt
and manage its working capital:
Working capital
Current ratio
Quick ratio
Four Uses of Financial Ratios
10. 10
Capital structure of the business
Show the composition of and relationship
between equity capital and other long-term
sources of finance eg long-term loan:
Owner’s equity
Capital employed
Four Uses of Financial Ratios
11. 11
Concept Map
Financial
Ratios
Four types
Profitability
Efficiency
Liquidity
Capital structure
Mark-up on cost
Gross profit margin
Net profit margin
Rate of return on capital
Rate of stockturn
Percentage of
expenses to turnover
Working capital
Current ratio
Quick ratio
Owner's equity
Capital employed
liabilities
Owner's
equity
Long term
Current
Beginning
Closing
Drawings
Net profit
Gross profit
Expenses
Turnover/
Net sales
COGS
Opening
stock
Closing
stock
Current
assets
Cash
Bank
Debtors
Prepayments
12. 12
Mark Up on Cost
Profit as a % of cost price
100
soldgoodsofCost
profitGross
upMark ×=
14. 14
Gross Profit Margin
Also known as:
Gross profit ratio
Gross margin
Margin
As a % of gross profit to turnover
100
Turnover
profitGross
marginprofitGross ×=
25. 25
Rate of Stockturn – another formula
100
pricesellingatstockAverage
Turnover
stockturnofRate ×=
Calculating rate of stockturn based on the
selling price of goods sold:
27. 27
Working Capital
Amount of capital used to meet the day-to-
day expenses of running a business.
sliabilitieCurrent-assetsCurrentcapitalWorking =
28. 28
Is working capital of $100,000 adequate or
$1,000,000 be adequate or too much?
How can we determine how many times
current assets are available to pay current
liabilities?
Think…
33. 33
Owner’s Equity
Also known as Owner’s capital
capitalAdditionalDrawing-profitNet
periodofbeginningatCapitalequitysOwner'
or
sLiabilitie-AssetsequitysOwner'
+
+=
=
What’s XYZ’s Owner’s equity?
34. 34
Capital Employed (Net Worth)
Is the effective amount of money actually
being used in a business, regardless to
whom it belongs
sliabilitieterm-LongequitysOwner'employedCapital +=
000,320,1$000,20$000,300,1$employedCapital
sXYZ'
=+=
35. 35
Rate of Return on Capital
Is the net profit as a % of capital at the
beginning of the period
100
Capital
profitNet
capitalonreturnofRate ×=
%26.8100
$1,210,000
$100,000
capitalonreturnofRate
sXYZ'
=×=
38. 38
Stock Valuation
Every business will carry out a physical
stock-take ie. count the units of goods NOT
sold
For some firms, physical stock-take is
important because:
Closing stock may be a main component of
current assets. Incorrect valuation will affect
the true and fair value of assets of the
business.
39. 39
Stock valuation (cont…)
Incorrect valuation will affect the cost of
goods sold, in turn affecting the gross profit
and net profit.
Since the closing stock of the current year is
the opening stock of the subsequent year,
incorrect valuation will not only affect the
current year profit and value of assets but also
the profit of the subsequent year.
40. 40
Basis of Stock Valuation
Cost or net realisable value (NRV), whichever is
LOWER
Cost = purchase price + ALL other expenses
incurred in bringing the goods to the present
location
Net realisable value = amount received from the
sale of the stock after deducting all expenses that
will be incurred in selling the goods
41. 41
Concept of Conservatism
Closing stock is valued at the LOWER of
cost or NRV
If closing stock at cost is $50,000 and at
NRV is $45,000, what is the appropriate
closing stock value which adheres to the
concept of conservatism?
42. 42
Stock-taking and Balance Sheet
Date
Stock-taking is time consuming and
usually takes a few days to complete
The work may be carried out before or
after Balance Sheet date
Meanwhile, business as usual
Need to make adjustments to arrive at the
value of stock on Balance Sheet date
43. 43
Before Balance Sheet Date
Date of Stock-take
28 December 2002
$12,345
Balance Sheet Date
31 December 2002
•add purchases
•less sales
•add returns inwards
•less returns outwards
Go to question
44. 44
After Balance Sheet Date
Balance Sheet Date
31 December 2002
Date of Stock-take
7 January 2003
$23,456
•less purchases
•add sales
•less returns inwards
•add returns outwards
Go to question
Introduction
Explain to class that up to this point, the class focus on the recording of financial transactions. In the next 4 lessons, they will be introduced to how they can analyse and interpret the final accounts which they learnt to prepare earlier.
Explain to class that financial ratios are computed to help users analyse relationships, make comparison over several periods, and with other businesses’ performance in the same industry.
Explain to class that users usually categorise four major uses of financial ratios; explain that a business exists to make profits, hence the importance of profitability ratios.
Tell class briefly the four profitability ratios they are to learn in this course.
Explain to class that besides knowing the profitability of the business, it is also important to know how efficient the business is run. Explain that they will learn two ratios in this course.
Explain that it is not enough to have a profitable business; the business must also be liquid enough to pay its debts and bills. Introduce the three liquidity ratios.
Explain that the fourth use helps the supplier of capital (eg. Banks) assess the level of credit risks of the business. Introduce that they will learn two ratios.
Explain to class the concept map, briefly mention what they are about to learn and how are these related to their prior knowledge.
Explain what is mark up on cost and show how the item is computed.
Show how the mark up for XYZ is computed. Illustrate with the model method (diagrams) how gross profit is a % of COGS.
Pose the following:
Worked example on board
Q: If instead, the mark up is given as 25% and gross profit is $305,000, what would be the cost of goods sold?
A: The mark up in dollar amount is equal the gross profit => 25% of COGS = $305,000, then 100% COGS = $1,220,000.
Pose the following and have three different students share their answers.
Thinking question
Q:What products do you see around you where mark up on cost are high?
A: cosmetics, perfume, audio & visual equipment, handphones.
Explain the different names of margin and its formula.
Show how the margin for XYZ is computed. Illustrate with the model method (diagrams) how gross profit is a % of turnover. Highlight how COGS is related to turnover.
Pose question and work out the answer on the board:
Worked Example
Q:If gross profit margin is 20%, and turnover is $1,000,000, calculate the COGS and mark up.
A: COGS = 80% of turnover = $800,000.
Mark up on cost = ($1,000,000 - $800,000)/$800,000 x 100% = 25%
Ask students to show another manner of solving the question:
A: Gross profit = 20% x $1,000,000 = $200,000. Then COGS = $1,000,000 - $200,000 = $800,000.
Mark up on cost = $200,000/800,000 x 100% = 25%.
Pose to students the following question and wait for response:
Thinking
Q: What are the ways to increase gross profit margin?
A: Increase selling price, reduce cost of goods sold without reducing the quantity sold.
Q: Does increasing turnover increase gross profit margin?
A: No, since margin is a ratio of gross profit to turnover. If turnover increase 20%, so does gross profit.
Explain another name for net profit ratio and the formula.
Show how the net profit margin for XYZ is computed. Illustrate with the model method (diagrams) how net profit, expenses, COGS, and turnover are related.
Pose these questions to students and obtain response:
Thinking
Q:What does a net profit margin of 10% mean in relation to every $1 of sales made?
A:Out of every $1 sales, the firm earns $0.10 in net profit.
Q:Interpret COGS 69.5% and expenses 20.5%.
A:Out of every $1 sales, the cost of goods sold take 69.5 cents and expenses take another 20.5 cents from that sales dollar.
Q: What does a firm do which would results in a drop in net profit margin?
A: Reduce mark up on cost, increase cost of good sold without increasing quantity sold, reduce quantity sold without proportional decrease in expenses, increase expenses like advertising without proportional increase in sales.
Explain what this ratio is and the formula.
Show how this ratio for XYZ is computed. Illustrate with the model method (diagrams) how expenses is related to turnover.
Pose question on board and work out answer on board:
Worked Example
Q:If gross profit is $250,000, gross margin is 20%, and expenses is $100,000, calculate the turnover, net profit margin, and % of expense to turnover ratio.
A: turnover = $250,000 x 100%/20% = $1,250,000.
Net profit margin = net profit/turnover = $(250,000-100,000)/1,250,000 x 100% = 12%
% of expense to turnover ratio = 100,000/1,250,000 x 100% = 8%
Have students pair up and work on worksheet_margin_markup.doc (20 min)
Have students shout out the answer as teacher work out the question on board.
Explain what is rate of stockturn.
Show how the rate of stockturn for XYZ is computed. Illustrate with the model method (diagrams) how this ratio is related to COGS.
Pose this question and get student response:
Thinking
Q:Is a higher stockturn better than a lower stockturn rate?
A:Depends. Too low means that stocks are not moving, which can lead to increase storage costs and obsolescence. Too high could mean that the firm may not have enough stocks to fulfill customers’ orders, which could lead to customers going elsewhere.
Explain that there is another formula for rate of stockturn; explain that the previous formula based on cost is more usually used.
Explain how these ratios can be calculated from the Trading and P&L account.
Explain to class what is working capital.
Pose the question on slide and ask 2 students for their response.
Explain how working capital ratio is calculated.
Show how the working capital ratio for XYZ is computed. Illustrate with the model method (diagrams) how current assets is related to current liabilities.
Explain what is quick ratio and its purpose - to provide a better indicator for liquidity.
Show how the quick ratio for XYZ is computed. Illustrate with the model method (diagrams) how current liability is related to the quick ratio.
Pose the thinking question in slide and get students’ response.
Briefly recap what is owners’ equity and get students to tell answer what’s XYZ’s owner’s equity.
Explain what is capital employed, and alert students that there are various definitions, but for the purpose of the syllabus, they need only learn this particular definition.
Pose following question:
Thinking
Q:Why would knowing the capital employed and the owner’s equity be helpful to (i) owner, and (ii) lending bank?
A:(i) how much he can “leverage” to take advantage of the lower cost of borrowing. (ii) for the bank to assess the risk of lending to the firm.
Explain how rate of return on capital is computed.
Pose following question and get students’ response.
Thinking
Q:What is the current bank fixed deposits rate? Would you recommend to Allan to invest in XYZ Dotcom?
A:1-2%. Depends. Although 8.26% is better than that earned from fixed deposits, XYZ is a riskier investment than fixed deposits. Allan may not even get back his capital invested if the future business is bad.
Q:When looking at these ratios, which is more important – those ratios that focus on the future or those ratios based on past financial data?
A:What is past is past. It is more helpful to Allan to have ratios that focus on the future. By computing ratios based on past data, we only have a gauge of how the firm performed. These information must be supplemented with other information about the future.
Explain that these ratios can be computed using the Balance Sheet.
Have students work in pairs on worksheet_balance sheet analysis.doc (20 min).
Have students shout out answers as teacher work out the question on board.
Explain to class that for some firms, stock is a major item of its current assets. Therefore, its valuation has implications on whether the accounts show a true and fair picture of the business.
Explain what is a stock take and its importance.
Explain the basis of stock valuation.
Pose question and get students’ response.
Thinking:
Q:What is the difference the expenses in determining cost and that in determining net realisable value?
A:The former refers to the cost incurred in preparing the goods to be sold, and the latter, refers to the selling price less out all expenses incurred in selling it.
Work question on slide on the board and have student answer the question.
Pose the following question and get students’ response.
Thinking
Q:What happens to the $5,000?
A:the loss is recognised before the goods are sold. => closing stock is $45,000, instead of $50,000, resulting in a higher COGS in the trading & P&L statement.
Explain that stock take takes several days and may be carried out before or after Balance Sheet date.
Refer to text book POA Loh/Ng pp 603
Work out on the board:
Computation of Stock as at 31 December 2002
Stock as at 28 Dec 200212,345
Add: Purchases1,300
Returns inwards 96 1,396
13,741
Less: Sales2,000
Returns outwards 200
Error – stock overstated 80 2,280
Stock as at 31 Dec 200211,461
Refer to text book POA Loh/Ng pp 603
Work out on the board:
Computation of Stock as at 31 December 2002
Stock as at 7 Jan 200323,456
Add: Sales3,104
Error – stock undercast 150 3,254
26,710
Less: Purchases1,875
Returns inwards 300_ 2,175
Stock as at 31 Dec 200224,535