First some basic profitability equations: Gross Profit Margin = Gross Profit * 100 Turnover Operating Profit * 100

Turnover

Operating Profit Margin =

Net Profit Margin =

Net Profit * 100 Turnover Retained Profit * 100 Turnover

Retained Profit Margin =

Profit Mark up =

Profit * 100 Cost

What are you going to do if someone asks you to tell them whether a business is profitable or not? Firstly, do you remember what profit is? Profit is the difference between turnover, or sales, and costs: that is, profit = turnover - costs One problem is that there are several ways of measuring profit: gross profit; net profit before and after taxation; and retained profit are just some of them. So, you didn't print out those Tesco accounts we showed you did you? Well, look back at them to remind yourself of all these names for profit A profit margin is one of the profit figures we just mentioned shown as a percentage of turnover. They always tell us how much profit, on average, our business has earned per 1 of turnover. We already know from the ratios table that there are several ratios we could use to calculate the profitability of a business. Next we'll discuss gross and net profit margins. First some basic Rate of Return equations: Return on Capital Employed (ROCE) = Profit for the Year * 100 Equity Shareholders' Funds

Return on Total Assets (ROTA) =

PBIT * 100 Total Assets

The rate of return ratios are thought to be the most important ratios by some accountants and analysts. One reason why the rate of return ratios are so important is that they are the ratios that we use to tell if the managing director is doing their job properly.

Current Assets: Current Liabilities (Current Assets-Stocks): Current Liabilities The two liquidity ratios, the current ratio and the acid test ratio, are the most important ratios in almost the whole of ratio analysis are also the simplest to use and to learn. The current ratio is also known as the working capital ratio and is normally presented as a real ratio. That is, the working capital ratio looks like this: Current Assets: Current Liabilities = x: y eg 1.75: 1 The Carphone Warehouse is our business of choice, so here is the information to help us work out its current ratio. Consolidated Balance Sheet 31 March 2001 '000 Total Current Assets Creditors: Amounts falling due within one year 315,528 222,348 25 March 2000 '000 171,160 173,820

As we saw in the brief review of accounts section with Tesco's financial statements, the phrase current liabilities is the same as Creditors: Amounts falling due within one year. Here's the table to fill in. OK, so we've done this one for you! Current Ratio For the Carphone Warehouse 31 March 2001 Current Assets: Current Liabilities 315,528: 222,348 1.42: 1 25 March 2000 Current Assets: Current Liabilities 171,160: 173,820 0.98: 1 Maths revision. How did we get 1.42: 1 for the year ended 31 March 2001? All we did was to divide the current assets by the current liabilities and that gives us: current assets 315,528 = = 1.42 current liabilities 222,348 so we automatically know that our ratio is 1.42: 1 The same with the year before: current assets 171,160 = = 0.98 current liabilities 173,820 so the ratio is 0.98: 1

It's time to say that whatever you've read about the ideal current ratio being 2:1 and the ideal acid test ratio being 1: 1 forget it! This is a golden rule ...there's no such thing as an ideal current ratio or acid test ratio ... or an ideal any other ratio for that matter. We still need to know whether 0.98: 1 and 1.42: 1 are good results, though. For the Carphone Warehouse, there has been a major turnaround between the two years as the ratio has increased from 0.98: 1 to 1.42:1. Look at the accounting information above and you can see that whilst the business has increased its sales by 59% over the two years, its stocks are almost unchanged; debtors have increased by 80%, investments by 316% and cash by 166%. As always, we have to point out that we only have two years' worth of data so any conclusions we can draw have to be done cautiously. The assessment of asset usage is important as it helps us to understand the overall level of efficiency at which a business is performing. The basic equations for this section are: Total Asset Turnover = Turnover Total Assets

Stock Turnover =

Average Stocks Credit Sales/365 Average Debtors Credit Sales/365 Average Creditors Credit Sales/365

Debtors' Turnover =

Creditors' Turnover =

The assessment of asset usage is important as it helps us to understand the overall level of efficiency at which a business is performing. Our basic ratios for this section are Total asset turnover - The overall efficiency of the business. We will look at total asset turnover and net asset turnover; then we will investigate the fixed and current asset turnover ratios. Stock turnover, Debtors' turnover and Creditors' turnover help us to assess the liquidity position as well as giving us detailed information about stock control and credit control. We'll look at total asset turnover first and then we'll look at the other three together, under the general heading of working capital management II.

What we are about to study - stock, debtors and creditors control - are all part of working capital management in the same way that a discussion of liquidity was part of working capital management. We know that working capital is concerned with the ability of a business to be able to pay its way. The three ratios we are concerned with now are concerned with spending and saving money in the right places. Too much stock and we waste money on buying it and keeping it. Too much money loaned to our debtors and it's money we can't use for something else, such as buying machinery, paying our creditors or even investing it. Too much money in the form of creditors and we might have a problem that no one else will give us credit for anything else because they think we can't afford it, and, if we suddenly have a cash problem, we might not be able to pay our creditors. Working capital management is concerned with the control aspects of the issues we have just mentioned. In principle, the lower the investment in stocks the better. Apart from buffer stocks that businesses sometimes need in case of shortages of supply and strategic stocks in case of war, sudden changes in demand and so on, modern stock control theory tells us to minimise our investment in stocks. Let's see how the Carphone Warehouse behaves in this respect. The formula for this ratio is: Stock Turnover = Average Stocks (Cost of Sales/365) 31 March 2001 '000 Cost of sales Stock 830,126 52,437 25 March 2000 '000 505,738 51,842

Carphone Warehouse Consolidated Profit and Loss Account

Stock Turnover Ratio for the Carphone Warehouse 31 March 2001 25 March 2000 52,437 830,126 / 365 51,842 505,738 / 365 23.06 days 37.42 days

If you use alternative formulae and are happy with them, that's fine. If you think you need help because of that, see your teacher/lecturer for guidance.

Firstly, the result of this calculation is that the answer is instantly in terms of the number of days, on average, that the stocks are held in the business.

Secondly, we use the cost of sales figure because stocks are bought and shown in the profit and loss account and the balance sheet at cost; so we need to compare like with like. Thirdly, we only have two years' worth of stock information, so we can't use the average stock for both years as we should do according to the formula. Never mind, even though the answer won't be 100% spot on, it will give us a very good estimate of how stock control is going.

How can we interpret this ratio? With a result of 23.06 days, we can imagine that we bought our 52,437,000 worth stocks of raw materials or whatever they were on 1st January 2002. We then know that we ran out of those raw materials on 1 + 23.06 days = just into 25th January. Similarly with the result of 37.42 days, if we bought our 51,738,000 worth of raw materials on 1st January, we would run out and have to buy some more on 7th February. This ratio has fallen from 37 days to 23 days over the two years and that is probably a good thing. If there's less stock to worry about, lower investment in stocks meaning that the money they used to have tied up in the stock room is now free to spend somewhere else. In fact, stocks have remained at around 52 million as we mentioned before, but the cost of sales has increased by 64% over the two years. Put these two facts together and that explains the improvement in this ratio. Well done the Carphone Warehouse! Remember that we talked about the liquidity of stocks when we discussed the acid test ratio. Now we can see that the Carphone Warehouse's stocks are fairly liquid, since a turnover ratio of 23 days isn't too bad! In the same way that stock control is a vital aspect of working capital management, so too is debtors' control. Many businesses need to sell their goods on credit, otherwise they might find it difficult to survive if their competitors provide such credit facilities; this could mean losing customers to the opposition. Nevertheless, since we do provide credit, we must do so as optimally as possible. We've used the word 'optimal' before and let me confirm that it doesn't necessarily mean the best possible, but the best possible under the circumstances. Why is credit control so important? For the Carphone Warehouse, the total amount owing by debtors was 149 million at the end of 31 March 2001, which as a percentage of total assets, is 14.09%. That's a lot of money in absolute terms and relatively, and it's 80% more than it was the year before. So, they've given an additional 69 million worth of credit to their customers over the year. What we need to know, though, is whether they are controlling these debtors. We can do that by looking at their debtors' turnover ratios for the two years, firstly. Carphone Warehouse 31 Mar 2001 25 Mar 2000

000 Turnover Debtors due within one year The formula for debtors' turnover is: Debtors' Turnover = Average Debtors Credit Sales/365 1,110,678 149,200

000 697,720 82,826

We have to assume, by the way, that all sales are credit sales unless we know which sales are for cash. The calculations: Debtors Turnover Ratio for the Carphone Warehouse 31 March 2002 25 March 2001 149,200 1,110,678 365 82,826 697,720 365 49.03 days 43.33 days

Well, what do you think of that? Firstly, the ratio seems to have worsened by going from 43 to 49 days over the two years; and it means that, on average, the Carphone Warehouse's debtors are taking one and a half months to pay their accounts. Does this sound as if it's a good policy? How do we know? One of the ways we can tell, in fact, whether this ratio is good or not is to go to a Carphone Warehouse shop or go to their Web site and find out their terms of business. If we sign up with them, will they give us around 49 days to pay our bills? At the time of writing, the page http://www.carphonewarehouse.com/commerce/servlet/gbenstore-Mobile shows that there are a number of ways we can choose to get a phone from the Carphone Warehouse:

Pay monthly Handset only Pay for calls ... no line rental Pay as you go

Try and work out how it's possible to have a debtors' turnover figure of 49 days from these deals ... it's not! So what's the problem? Well, do they have corporate customers who are allowed to pay after, say, 55 days or 60 days? Do some research and find the answer if you can. Creditors are the businesses or people who provide goods and services in credit terms. That is, they allow us time to pay rather than paying in cash.

There are good reasons why we allow people to pay on credit even though literally it doesn't make sense! If we allow people time to pay their bills, they are more likely to buy from your business than from another business that doesn't give credit. The length of credit period allowed is also a factor that can help a potential customer decide whether to buy from your business or not: the longer the better, of course. In spite of what we have just said, creditors will need to optimise their credit control policies in exactly the same way that we did when we were assessing our debtors' turnover ratio after all, if you are my debtor I am your creditor! We give credit but we need to control how much we give, how often and for how long. Let's do some calculations for the Carphone Warehouse. The formula for this ratio is: Creditors' Turnover = Average Creditors (Cost of Sales/365)

As with the stock turnover ratio, creditor values relate to the costs of raw materials, goods and services, which is why we use the cost of sales figure in the denominator (Remember the numerator? Well, this is the opposite. The denominator is the bottom part of a fraction!) Carphone Warehouse 31 March 2001 '000 Cost of sales Creditors: Amounts falling due within one year 830,126 222,348 25 March 2000 '000 505,738 173,820

Creditors Turnover Ratio for the Carphone Warehouse 31 March 2001 25 March 2000 222,348 830,126 365 173,820 505,738 365 97.76 days 125.45 days

We interpret this ratio in exactly the same way as the debtors' turnover ratio. That is, in 2001 if we had bought some supplies for 222,348 on 1st January, we would have paid for them 97.76 days later on 6th April. You can work out the payment date for 2000 if we imagine buying some supplies for 173,820 on 1st January of that year. Having found that debtors are taking somewhere between 30 and 50 days to pay their accounts, notice that the business is taking over three months credit for itself in 2001 and about four months' credit in 2000. These results are worrying: especially when we know that small businesses in the UK are suffering because large businesses take too long to pay their accounts; and if the Carphone Warehouse has many small suppliers that is worrying. Gearing = Long Term Liabilities

Equity Shareholders' Funds

Gearing is concerned with the relationship between the long terms liabilities that a business has and its capital employed. The idea is that this relationship ought to be in balance, with the shareholders' funds being significantly larger than the long term liabilities. Shareholders ought to have the upper hand because if they don't that could cause them problems as follows:

Shares earn dividends but in poor years dividends may be zero: that is, businesses don't always need to pay any! Long term liabilities are usually in the form of loans and they have to be paid interest; even in bad years the interest has to be paid Equity shareholders have the voting rights at general meetings and can made significant decisions Long term liability holders don't have any voting rights at general meetings but they have the power to override the wishes of the shareholders if there are severe problems over their interest or capital repayments

So, shareholders like to see the gearing ratio, the relationship between long term liabilities and capital employed, being in their favour! Let's look at the Carphone Warehouse's gearing ratio. The formula: Gearing = Long Term Liabilities Equity Shareholders' Funds

The data: Carphone Warehouse Creditors: Amounts falling due after more than one year Equity shareholders' funds Gearing Ratio for the Carphone Warehouse 31 March 2001 25 March 2000 14,107: 436,758 21,033: 44,190 0.032: 1 0.476: 1 31 March 2001 '000 14,107 436,758 25 March 2000 '000 21,033 44,190

A shareholder of the Carphone Warehouse will be happy with these results. Even in 2000 when the ratio was relatively high at 0.476 or 47.6% they probably were not too worried because their other ratios were fine too.

In 2001 the gearing ratio fell to almost zero indicating that the business much prefers equity funding to debt funding. This minimises the interest payment problems and the control problems of having a dangerously high level of long-term debt on the balance sheet. There is an alternative gearing ratio, we can call it the Gearing Ratio II. The formula for this ratio is: Gearing 2 = Long Term Liabilities Long Term Liabilities + Equity Shareholders' Funds

Let's just get on with this one. Gather the necessary data from both of our businesses, Carphone Warehouse and Vodafone and calculate this ratio for them. The calculations: Gearing II Ratio for the Carphone Warehouse 31 March 2001 14,107: 436,758 + 14,107 0.031: 1 25 March 2000 21,033: 44,190 + 21,033 Gearing II Ratio for Vodafone 31 March 2002 13,118: 130,573 + 13,118 0.091: 1 31 March 2001 11,235: 145,007 + 11,235 0.072: 1 In the case of both the Carphone Warehouse and Vodafone, these ratios are, as we should expect, smaller than Gearing 1 and they are still, therefore, insignificant by the end of the two years we are analysing here. Basic equations you'll need: Earnings per share = Profit available to equity shareholders Average number of issued equity shares Dividends paid to equity shareholders Average number of issued equity shares 0.322: 1

Dividends per share =

Dividend yield =

Latest annual dividends Current market share price Net profit available to equity shareholders Dividends paid to equity shareholders Current market share price Earnings per share

Dividend cover =

Price/earnings or p/e ratio =