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«Paul M. Collier Aston Business School, Aston University Accounting for Managers Accounting for Managers: Interpreting accounting information for ...»

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While in the above example the return on capital employed is a constant 20% (an operating profit of £20,000 on capital employed of £100,000), the return on shareholders’ funds increases as debt replaces equity. This improvement to the return to shareholders carries a risk, which increases as the proportion of profits taken by the interest charge increases (and is reflected in the interest cover ratio).

If profits turn down, there are substantially more risks carried by the highly geared business.

Activity/efficiency Asset turnover

–  –  –

This is a measure of how efficiently assets are utilized to generate sales. Investment in assets has as its principal purpose the generation of sales.

Three other efficiency ratios are those concerning debtors’ collections, stock turnover and creditors’ payments, which were covered in Chapter 6.

Shareholder return

For these ratios we need some additional information:

Number of shares issued 100,000 Market value of shares £2.50 Dividend per share

–  –  –

The shareholder ratios are measures of returns to shareholders on their investment in the business. The dividend and earnings ratios reflect the annual return to shareholders, while the P/E ratio measures the number of years over which the investment in shares will be recovered through earnings.


Interpreting financial information using ratios

The interpretation of any ratio depends on the industry. In particular, the ratio needs to be interpreted as a trend over time, or by comparison to industry averages of competitor ratios. These comparisons help determine whether performance is improving and where improvement may be necessary. Based on the understanding of the business context and competitive conditions, and the information provided by ratio analysis, users of financial statements can make judgements about the pattern of past performance and prospects for a company and its financial strength.

Broadly speaking, businesses seek:

ž increasing rates of profit on shareholders’ funds, capital employed and sales;

ž adequate liquidity (a ratio of current assets to liabilities of not less than 100%) to ensure that debts can be paid as they fall due, but not an excessive rate to suggest that funds are inefficiently used;

ž a level of debt commensurate with the business risk taken;

ž high efficiency as a result of maximizing sales from the business’s investments; and ž a satisfactory return on the investment made by shareholders.

When considering the movement in a ratio over two or more years, it is important to look at possible causes for the movement. These can be gained by understanding that either the numerator (top number in the ratio) or denominator (bottom number in the ratio) or both can influence the change.

Some of the possible explanations behind changes in ratios are described below.

Profitability Improvements in the returns on shareholders’ funds (ROI) and capital employed (ROCE) may either be because profits have increased and/or because the capital used to generate those profits has altered. When businesses are taken over by others, one way of improving ROI or ROCE is to increase profits by reducing costs (often as a result of economies of scale), but another is to maintain profits while reducing assets and repaying debt.

Improvements in operating profitability as a proportion of sales (PBIT or EBIT) are the result of profitability growing at a faster rate than sales growth, a result either of a higher gross margin or lower expenses. Note that sales growth may result in a higher profit but not necessarily in a higher rate of profit as a percentage of sales.

Improvement in the rate of gross profit may be the result of higher selling prices, lower cost of sales, or changes in the mix of product/services sold or different market segments in which they are sold, which may reflect differential profitability.

Naturally, the opposite explanations hold true for deterioration in profitability.


Liquidity Improvements in the working capital and acid test ratios are the result of changing the balance between current assets and current liabilities. As the working capital cycle in Figure 6.1 showed, money changes form between debtors, stock, bank and creditors. Borrowing over the long term in order to fund current assets will improve this ratio, as will profits that generate cash flow. By contrast, using liquid funds to repay long-term loans or incurring losses will reduce the working capital used to repay creditors.

Gearing The gearing ratio reflects the balance between long-term debt and shareholders’ equity. It changes as a result of changes in either shareholders’ funds (more shares may be issued), raising new borrowings or repayments of debt. As debt increases in proportion to shareholders’ funds, the gearing ratio will increase.

Interest cover may increase as a result of higher profits or lower borrowings (and reduce as a result of lower profits or higher borrowings), but even with constant borrowings changes in the interest rate paid will also influence this ratio.

Activity/efficiency Asset turnover improves either because sales increase or the total assets used reduce, a similar situation to that described above for ROCE. The efficiency with which debtors are collected, inventory is managed and creditors paid is also an important measure.

Shareholder return Decisions made by directors influence both the dividend per share and the dividend payout ratio. Dividends are a decision made by directors on the basis of the proportion of profits they want to distribute and the capital needed to be retained in the business to fund growth. Often, shareholder value considerations will dictate the level of dividends, which businesses do not like to reduce on a per share basis. This is sometimes at the cost of retaining fewer profits and then having to borrow additional funds to support growth strategies. However, the number of shares issued also affects this ratio, as share issues will result in a lower dividend per share unless the total dividend is increased.

As companies have little influence over their share price, which is a result of market expectations as much as past performance, dividend yield, while influenced by the dividend paid per share, is more readily influenced by changes in the market price of the shares.

Earnings per share is influenced, as for profitability, by the profit but also (like dividends) by the number of shares issued. As for the dividend yield, the price/earnings (P/E) ratio is often more a result of changes in the share price than in the profits reflected in the earnings per share.

Explanations for changes in ratios are illustrated in the following case study.


Case study: Ottakar’s – interpreting financial statements Ottakar’s has 74 bookshops and 900 employees. It is the second largest specialist bookseller in the UK after Waterstone’s. The information in Tables 7.2 and 7.3 has been extracted from the company’s annual report.

The number of shares issued was 20,121,000 in 2001 and 20,082,000 in 2000.

Ratios for profitability are shown in Table 7.4.

There was a strong sales growth between 2000 and 2001. Despite this growth, the gross margin remained constant and operating profit to sales increased. This is because the proportion of sales consumed by overheads (selling, distribution and administration costs) reduced from 36.6% [(22,707 + 3,986)/72,922] to 34.8% [(26,219 + 3,797)/86,287]. Operating profit more than doubled (from £1,678 to £3,516) and profit after tax increased from £463 to £1,792 (all figures are in £’000).

As shareholders’ funds increased by only 10% and capital employed by only 6%, the return on both measures of investment showed a strong improvement.

Ratios for liquidity are shown in Table 7.5. While the working capital ratio is healthy, indicating that the company has adequate funds to pay its debts, the acid test reveals that after deducting inventory, the company has only about 22% of assets to cover its current liabilities. This means that it is dependent on sales of books in stock to pay suppliers for those books. The efficiency measures (see below) support this.

–  –  –

Ratios for gearing are shown in Table 7.6. These ratios reflect the reduction in long-term debt and the increase in shareholders’ funds. Although there has been an increase in interest expense, the increase in operating profit has doubled the interest cover. Borrowings are one-third of capital employed, which is fairly conservative, while the interest cover provides good security for lenders.

The ratio for activity/efficiency is shown in Table 7.7. Despite a higher asset base, the 18.3% sales increase resulted in an improved efficiency ratio. As reflected in the acid test ratio (Table 7.5), working capital is affected significantly by the low stock turn (3.6 means that on average books are held for 101 days before they are sold). It is also reflected in the average time it takes to pay creditors (over


–  –  –

14,379 13,729 =22.0% =19.0% two months). However, the ratios show a slight improvement between 2000 and 2001 as current assets increased more than current liabilities, stock turn is higher and creditor payments quicker. Note that there are virtually no trade debtors as the bookshops are a retail business, consequently the debtor days measure is somewhat meaningless.

The shareholder return ratios are shown in Table 7.8. The increase in profits between 2000 and 2001 resulted in increased earnings per share and a higher dividend payout in cash terms, although the percentage of profits paid out in dividends reduced.

As was indicated earlier in this chapter, two years is too short a period to draw any meaningful conclusions and we would need to look at the ratios over five years


–  –  –

to identify any trends properly. Table 7.9 shows some of the information from the five-year summary of performance in Ottakar’s annual report. These figures show the sales growth over the five years much more clearly than do the two-year ratios, although the increase in profits has been much lower. It also shows that the


–  –  –

2000 year experienced a fall in profits that was outside the trend. By calculating the ratios in Table 7.10 we can see this more clearly.

Although sales continue to increase, the rate of sales growth is slowing. The rate of gross profit to sales is very steady (an indication of the margin allowed by book publishers), while operating profits fluctuated (probably a reflection of costs incurred in opening new bookshops, since location, in common with most retail businesses, is a key aspect of success). Ottakar’s annual report explains that the book market should experience an annual growth of 4–5%, but that the larger chains should gain market share at the expense of their weaker competitors.

It is important to remember that ratio analysis can be undertaken not only in relation to the manager’s own organization, but also in relation to the financial statements of competitors, customers and suppliers. This is an aspect of strategic management accounting that was discussed in Chapter 4.

Alternative theoretical perspectives on financial statements

Chapter 6 described the traditional theoretical perspective that has informed financial statements, that is agency theory. We now consider some alternative perspectives: social and environmental reporting, intellectual capital and institutional theory. We also introduce creative accounting and ethics.

Social and environmental reporting

The concern with stakeholders rather than shareholders (introduced in Chapter 2) began in the 1970s and is generally associated with the publication in 1975 of The Corporate Report, a publication by the Accounting Standards Steering Committee.

Accounting academics began to question profit as the sole measure of business


performance and suggested a wider social responsibility for business and social accounting. Concepts of corporate social accounting and socially responsible accounting – most recently corporate social and environmental reporting (CSR) – attempt to highlight the impact of organizations on society.

Jones (1995) suggested three reasons for this:

1 A moral imperative that business organizations were insufficiently aware of the social consequences of their activities.

2 External pressure from government and pressure groups and the demand by some institutional investors for ethical investments. This was linked to the role of accounting in demonstrating how well organizations were fulfilling their social contract, the implied contract between an organization and society.

3 Internal change taking place within organizations as a result of education etc.

However, there has been little support for broader social accounting because accountants and managers have generally seen themselves as the agents of owners.

Social reporting could be seen as undermining the power of shareholders and the foundation of the capitalist economic system. There are also technical difficulties associated with social reporting, and a dominant belief among business leaders that government and not business had the responsibility to determine what was reported.

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