Balance sheets as at 31 December

Fixed assets Current assets Stocks Debtors Bank and cash Current liabilities Working capital Net assets employed Share capital: Ordinary shares		60 2 38 100 40	2000 140 60 $200 20		80 4 36 120 70		2001 250 50 $300 20
	Reserves:
	Profit and loss account			100 120		120 140
	10% Debentures			80		160
	Net capital employed			$200		$300

Number of employees: 20 (2000); 25 (2001). There is no market price for the shares - use the normal value of $1.

1. The first step in the analysis is to calculate the ratios. (A calculator is a great help in this type of exercise!)

2. What can we now deduce from these ratios, the accounts and the knowledge that this business is a chain of general stores?

Task 6. Read the passage summarising the use of ratios and answer the following questions.

1. Why do you need internal comparisons?

2. What are external comparisons required for?

3. What are the limitations of these ratios?

Desirable ratios will differ depending on the nature of the business being assessed. For example, newsagents will have a much higher rate of stock turnover than an aeroplane manufacturer. Consequently an internal comparison which monitors ratios in the same business on a regular basis is one of the best ways of understanding the performance of that business. Any changes in the trend of results can be spotted and corrective action taken if required.

Some firms may also use ratios as targets. For example, a business may want to increase its stock turnover rate and might therefore introduce control over buying in order to reduce stock levels. The actual ratio will then be compared with the target to see if it has been achieved through that course of action.

A weakness of internal comparisons is that they do not show what it is possible for a particular type of business to achieve. A comparison with similar

firms or competitors can show that, as well as highlighting where specific improvements might be made.

A number of industry-based schemes provide this type of information. The most significant schemes are run by the Centre for Interfirm Comparison which provides data for over 100 sectors. It is possible though this system to provide confidential information about the detailed operation of your business and to be able so compare it with very detailed ratios from similar firms. The data is collected in a standard manner and the analysis can contain 60-100 ratios for each business. All this work is computerised.

Whilst they are valuable in assessing a company's performance, they do have limitations which should be recognised:

• They will help to identify strengths and weaknesses in a business but will not necessarily provide answers. For example, a low rate of stock turnover may be identified but the reasons for it will not.

• They must be related to the particular activities and circumstances of the business. This is why internal analysis of accounts using 'inside' knowledge is very valuable.

• Comparisons must be used as much as possible to help in the correct interpretation of them.

• The source from which the ratios were calculated must be considered. If you have used an old balance sheet then the results will obviously be outdated.

Case study 6 A. Briefly explain why

1. a trade creditor might be interested in examining a company's accounts, what ratios he would use to assess the information relevant to him;

2. ratios are needed to help understand a company's accounts.

B. Calculate the relevant ratio(s) and comment on the chairman's claim.

The chairman of Honeymoon Stores Ltd. claimed in his report on the company's latest accounts 'a greatly improved current ratio'. The balance sheets at 31 ecember 2000 and 2001 showed the following:

Current assets 2000 2001

Stocks 32,000 75,000

Debtors 41,000 106,000

Bank -------- 54,000

Current liabilities

Creditors 29,000 45,000

Bank overdraft 4,000 -------

Case study 7. From the information below identify the main features of the company's performance over the period given with particular reference to 1999.

Computer Services Ltd. was formed in 1995 to manufacture and sell a small business computer. Until 1999 the company expanded rather rapidly and was very successful. However in 1999 the combined impact of technical change and very heavy competition from the market leaders resulted in a slowdown in the company's rate of growth and severe financial problems. The company's main ratios from 1995 to 1999 were as follows.

	1995	1996	1997	1998	1999
ROCE (%)	55.5	50	53	58	5
Cross profit margin (%)	50	50	50	40	30
Net profit margin (%)	10	9	8	7	0.3
Stock turnover (times)	20	20	20	20	18
Debtor collection period (days)	37	36	36	36	40
Current ratio (:1)	5.1	4.8	2.6	2.7	1.4
Acid test ratio (:1)	3.9	3.5	1.7	1.9	0.9