Objectives
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to understand the term ratio analysis
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to understand how shareholders use ratio analysis
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to understand the limitations of ratio analysis to shareholders
Analysing accounts
It is possible to analyse the performance of a company by using ratio analysis.
That is, comparing the relationships between costs and revenues for one year's
accounts with past years' accounts of the same company or with similar
businesses in the same industry.
Many companies have internal targets for ratios that all their operations are
expected to meet. This way they ensure that their overall operation meets
performance targets when the company reports to shareholders. The shareholders
will then be satisfied with the performance of the company.
In order to calculate ratios, first we need to examine our profit and loss
account. You will have to generate these for your chosen business case. The categories you will need will be:
Trading profit and loss account for Shinkendo Oi for first year
| Sales |
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| Direct cost of production
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| Other costs
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| Operating profit
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Although you might want to divide the other costs between general overhead and marketing costs.
What does the profit and loss statement look like for the next two years? Are things getting better or worse?
The following table shows the headings for a typical balance sheet. Examine the
balance sheet for a real company and create your own
imaginary balance sheet inserting figures that are proportionate. Ensure your
figures are properly balanced. Balance sheets would normally be prepared for a
company, or a subsidiary company, and not for a single product – although the
accounting principles can still be applied to our case study product. In the case of many companies now some of the categories of asset might be missing or for very small amounts. Typically some service businesses don’t have any stock.
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Estimated Balance sheet for Shinkendo Oi at the end of year 1
as at the end of year 1
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Fixed Assets
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Machinery at cost
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Current Assets
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Stock
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Debtors
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Cash at bank
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Current Liabilities
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Trade creditors
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Net Asset Value
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Shareholders' Funds
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Equity capital
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Retained profit
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Capital Employed
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Accounting and decision making – ratio analysis
Shareholders are dependent on analysing published company accounts to assess
their investments as they are not usually allowed access to confidential
internal accounts.
Shareholders are mainly interested in the following ratios:
1. Return on capital employed = profit /shareholders' funds x 100
2. Earnings per share = profit after tax/number of shares
3. Dividend cover = profit after tax/dividends
4. Dividends per share = dividends/number of shares
5. Price/earnings ratio = market price/earnings per share
6. Dividend yield = dividends per share/market price per share
Imagine you are a shareholder, and look through the accounts of a real company (see appendix)
and see if you can work out the above ratios, and their significance.
Limitations to ratio analysis
Shareholders use ratio analysis to evaluate their investments, but there are
limitations to the figures produced.
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Ratios are only meaningful when they are compared to similar accounts
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Companies may adjust the way they account over time, which makes it more
difficult to see trends over a series of years
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There may be variations between companies in their methods of accounting, which
makes inter-company comparisons difficult
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The management of the company may not want to make their accounts transparent
to shareholders
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Financial accounts are often published long after the end of the financial year
- the figures that investors are looking at may simply be out of date
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