CIMA - C2 Fundamentals of Financial Accounting
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370 25: Interpreting company accounts ⏐ Part D Interpretation of accounts
2.4 Relationship between ratios
You may already have realised that there is a mathematical connection between return on capital employed, profit margin
and asset turnover, since sales in the right-hand side of the equation below cancel out.
Profit
Capitalemployed
=
Profit
Sales
×
Sales
Capitalemployed
ROCE = Profit margin × Asset turnover
You
must
learn these formulae, as they will not be given in the assessment.
This is important. If we accept that ROCE is the most important single measure of business performance, comparing
profit with the amount of capital invested, we can go on to say that business performance is dependent on two separate
'
subsidiary
'
factors, each of which contributes to ROCE.
(a) Profit margin.
(b) Asset turnover.
For this reason, just as ROCE is sometimes called the
primary ratio
, the profit margin and asset turnover ratios are
sometimes called the
secondary ratios.
The implications of this relationship must be understood. Suppose that a return on capital employed of 20% is thought
to be a good level of business performance in the retail trade for electrical goods.
(a) Company A might decide to sell its products at a fairly high price and make a profit margin on sales of
10%. It would then need only an asset turnover of 2.0 times to achieve a ROCE of 20%:
20% = 10%
× 2
(b) Company B might decide to cut its prices so that its profit margin is only 2½%. Provided that it can
achieve an asset turnover of 8 times a year, attracting more customers with its lower prices, it will still
make the desired ROCE:
20% = 2½%
× 8
Company A might be a department store and company B a discount warehouse. Each will have a different selling price
policy, but each, in its own way, can be effective in achieving a target ROCE. In this example, if we supposed that both
companies had capital employed of $100,000 and a target return of 20% or $20,000.
(a) Company A would need annual sales of $200,000 to give a profit margin of 10% and an asset turnover of
2 times
2
000,200$
000,20$
000,100$
000,20$
×=
(b) Company B would need annual sales of $800,000 to give a profit margin of only 2½% but an asset
turnover of 8 times.
8
000,800$
000,20$
000,100$
000,20$
×=
The interpretation of financial statements requires a large measure of common sense.
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Part D Interpretation of accounts ⏐ 25: Interpreting company accounts 371
Clearly, a higher return on capital employed can be obtained by increasing the profit margin or the asset turnover ratio.
The profit margin can be increased by reducing costs or by raising selling prices.
However, if selling prices are raised, it is likely that sales demand will fall, with the possible consequence that the asset
turnover will also decline. If higher prices mean lower sales turnover, the increase in profit margin might be offset by the
fall in asset turnover, so that total return on capital employed might not improve.
2.5 Example: profit margin and asset turnover
Suppose that Swings and Roundabouts Ltd achieved the following results in 20X6.
Sales $100,000
Profit $5,000
Capital employed $20,000
The company
'
s management wish to decide whether to raise its selling prices. They think that if they do so, they can
raise the profit margin to 10% and by introducing extra capital of $55,000, sales turnover would be $150,000.
Evaluate the decision in terms of the effect on ROCE, profit margin and asset turnover.
Solution
Currently the ratios are
Profit margin (5/100) 5%
Asset turnover (100/20) 5 times
ROCE (5/20) 25%
With the proposed changes, the profit would be 10%
× $150,000 = $15,000, and the asset turnover would be:
)000,55000,20$(
000,150$
+
= 2 times, so that the ratios would be
Profit margin
× Asset turnover = ROCE
0%
× 2 times = 20%
⎟
⎠
⎞
⎜
⎝
⎛
$75,000
$15,000
In spite of increasing the profit margin and raising the total volume of sales, the extra assets required ($55,000) only
raise total profits by $(15,000 – 5,000) = $10,000.
The return on capital employed falls from 25% to 20% because of the sharp fall in asset turnover from 5 times to 2
times.
Question
Ratios
A trader has the following results.
$
Sales 200,000
Profit 36,000
Capital employed 120,000
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25: Interpreting company accounts ⏐ Part D Interpretation of accounts
Fill in the blanks.
Profit margin = _________________
Asset turnover = _________________
ROCE = _________________
Answer
Profit margin =
%18
000,200$
000,36$
=
Asset turnover =
000,120
000,200
= 1
2
/
3
times
ROCE =
%30
000,120
000,36
=
2.6 Different definitions of 'profit' and 'capital employed'
ROCE can be calculated in a number of ways. Unless told otherwise in the exam, use:
employed capital Average
interest andtax before profit Net
where capital employed includes long-term finance.
We have calculated Return on Capital Employed as a measure of how well a company is performing. What do we mean
by 'return' and by capital employed?
Return is a reward for investing in a business.
Capital employed means the funds that finance a business.
The providers of finance to a business expect some return on their investment.
(a) Trade payables and most other current liabilities merely expect to be paid what they are owed.
(b) A bank charges interest on overdrafts.
(c) Interest must be paid to the holders of loan stock.
(d) Preference shareholders expect a dividend at a fixed percentage rate of the nominal value of their shares.
(e) Ordinary shareholders also expect a dividend, and, any retained profits kept in the business also represent
funds
'owned' or 'provided' by them.
So, when calculating return on capital employed, what measure of 'return' and what measure of 'capital employed'
should be used?
Key terms
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Part D Interpretation of accounts ⏐ 25: Interpreting company accounts 373
For a company, ROCE =
Netprofitbeforeinterest andtax
Share capital reserves longtermdebt++
which is the same as, ROCE =
Netprofitbeforeinterestandtax
Non current assetsplusnet current assets
−
2.7 Example: ROCE
For example, suppose that Draught reports the following income statement and statement of financial position.
INCOME STATEMENT FOR 20X4 (EXTRACT)
$
Profit before interest and tax
120,000
Interest
(20,000
)
Profit before tax
100,000
Taxation
(40,000
)
Profit after tax (earnings)
60,000
Note. An ordinary dividend of $50,000 was paid during the period.
STATEMENT OF FINANCIAL POSITION AT 31 DECEMBER 20X4
$
Non-current assets: tangible assets
350,000
Current assets
400,000
750,000
Capital and reserves
Called up share capital (ordinary shares of $1)
100,000
Retained profits
300,000
400,000
Non-current liabilities
10% debenture loans
200,000
Current liabilities
150,000
750,000
Solution
ROCE =
sliabilitie current less assets Total
taxand interest before Profits
×
100%
Where, total assets less current liabilities is equal to share capital plus reserves plus long term finance (ie the 10%
debenture loan).
If assets financed by debt capital are included below the line, it is more appropriate to show profits before interest above
the line because interest is the return on debt capital.
$600,000
$120,000
×
100% = 20%
Average capital employed = (capital employed at beginning of the accounting period + capital employed at the end of
the accounting period)
÷
2
Formula to
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25: Interpreting company accounts ⏐ Part D Interpretation of accounts
Question
Return on capital employed
Using the information in the last example for Draught Co, calculate ROCE.
Relevant figures as at 31 December 20X3 are as follows.
$
10% loans
200,000
Ordinary share capital
100,000
Retained earnings
290,000
590,000
Answer
Average capital employed = (590 + 600)
÷
2 = $595,000
ROCE =
595,000
120,000
= 20.2%
3 Working capital
Working capital is the difference between current assets (mainly inventory, receivables and cash) and current liabilities
(such as trade payables and a bank overdraft).
3.1 Current assets and liabilities
Current assets are items which are either cash already, or which will soon lead to the receipt of cash. Inventories will be
sold to customers and create receivables; and receivables will soon pay in cash for their purchases.
Current liabilities are items which will soon have to be paid for with cash. Trade payables will have to be paid and bank
overdraft is usually regarded as a short-term borrowing which may need to be repaid fairly quickly (or on demand, ie
immediately).
In statements of financial position, the word
'current' is applied to inventories, receivables, short-term investments and
cash (current assets) and amounts due for payment within one year
's time (current liabilities).
3.2 Working capital and trading operations
Current assets and current liabilities are a necessary feature of a firm's trading operations. There is a repeated cycle of
buying and selling which is carried on all the time. For example, suppose that on 1 April a firm has the following items.
$
Inventories
3,000
Receivables
0
Cash
2,000
5,000
Payables
0
Working capital
5,000
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Part D Interpretation of accounts ⏐ 25: Interpreting company accounts 375
It might sell all the inventories for $4,500, and at the same time obtain more inventories from suppliers at a cost of
$3,500. The statement of financial position items would now be
$
Inventories
3,500
Receivables
4,500
Cash
2,000
10,000
Payables
(3,500
)
Working capital
6,500
(The increase in working capital to $6,500 from $5,000 is caused by the profit of $1,500 on the sale of the inventories.)
The receivables for $4,500 will eventually pay in cash and the payables for $3,500 must also be paid. This would give us
$
Inventories
3,500
Receivables
0
Cash (2,000 + 4,500 – 3,500)
3,000
6,500
Payables
0
Working capital
6,500
However, if the inventories are sold on credit for $5,500 and further purchases of inventories costing $6,000 are made,
the cycle of trading will continue as follows.
$
Inventories
6,000
Receivables
5,500
Cash
3,000
14,500
Payables
(6,000
)
Working capital (boosted by further profit of $2,000)
8,500
From this basic example you might be able to see that working capital items are part of a continuous flow of trading
operations. Purchases add to inventories and payables at the same time, payables must be paid and receivables will pay
for their goods. The cycle of operations always eventually comes back to cash receipts and cash payments.
3.3 The operating cycle or cash cycle
The operating cycle (or cash cycle) is a term used to describe the time taken from the purchase of raw materials to the
sale of finished goods.
A firm buys raw materials, probably on credit. The raw materials might be held for some time in stores before being
issued to the production department and turned into an item of finished goods. The finished goods might be kept in a
warehouse for some time before they are eventually sold to customers. By this time, the firm will probably have paid for
the raw materials purchased. If customers buy the goods on credit, it will be some time before the cash from the sales is
eventually received.
The cash cycle, or operating cycle, measures the period of time between the time cash is paid out for raw materials and
the time cash is received in from receivables.
This cycle of repeating events is shown diagrammatically below.
Key term
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25: Interpreting company accounts ⏐ Part D Interpretation of accounts
RAW
MATERIALS
WORK IN
PROGRESS
FINISHED
GOODS
PROFIT IN RECEIVABLES
PAYA BL ES
CASH
CASH CYCLE
OR
OPERATING
CYCLE
Suppose that a firm buys raw materials on 1½ months
'
credit, holds them in store for 1 month and then issues them to
the production department. The production cycle is very short, but finished goods are held for 1 month before they are
sold. Receivables take two months
'
credit. The cash cycle would be
Months
Raw material inventory turnover period
1.0
Less: credit taken from suppliers
(1.5)
Finished goods inventory turnover period
1.0
Receivable's payment period
2.0
Cash cycle
2.5
There would be a gap of 2½ months between paying cash for raw materials and receiving cash (including profits) from
receivables. A few dates might clarify this point. Suppose the firm purchases its raw materials on 1 January. The
sequence of events would then be as follows.
Date
Purchase of raw materials 1 Jan
Issue of materials to production (one month after purchase) 1 Feb
Payment made to suppliers (1½ months after purchase) 15 Feb
Sale of finished goods (one month after production begins) 1 Mar
Receipt of cash from receivables (two months after sale) 1 May
The cash cycle is the period of 2½ months from 15 February, when payment is made to suppliers, until 1 May, when
cash is received from customers.
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Part D Interpretation of accounts ⏐ 25: Interpreting company accounts 377
3.4 Turnover periods
A 'turnover' period is an (average) length of time.
(a) In the case of inventory turnover, it is the length of time an item of inventory is held in stores before it is
used.
(i) A raw materials inventory turnover period is the length of time raw materials are held before being
issued to the production department.
(ii) A work in progress turnover period is the length of time it takes to turn raw materials into finished
goods in the factory.
(iii) A finished goods inventory turnover period is the length of time that finished goods are held in a
warehouse before they are sold.
(iv) When a firm buys goods and re-sells them at a profit, the inventory turnover period is the time
between their purchase and their resale.
(b) The receivables
' turnover period, or debt collection period, is the length of the credit period taken by
customers
– it is the time between the sale of an item and the receipt of cash for the sale from the
customer.
(c) Similarly, the payables
' turnover period, or period of credit taken from suppliers, is the length of time
between the purchase of materials and the payment to suppliers.
Turnover periods can be calculated from information in a firm
's income statement and statement of financial position.
Inventory turnover periods are calculated as follows.
(a) Raw materials:
(Average)rawmaterialinventoriesheld
Totalrawmaterialconsumedinone year
×
12 months
(b) Work in progress (the length of the production period):
(Average)WIP
Totalcost ofproductioninthe year
×
12 months
(c) Finished goods:
(Average)inventories
Totalcost of goodssoldinone year
×
12 months
(d) Inventories of items bought for re-sale:
(Average)inventories
Total(materials)cost of goods
bought andsoldinone year
×
12 months
The word 'average' is put in brackets because although it is strictly correct to use average values, it is more common to
use the value of inventories shown in a single statement of financial position
– at one point in time – to estimate the
turnover periods. But if available use opening and closing balances divided by two.
3.5 Example
A company buys goods costing $620,000 in one year and uses goods costing $600,000 in production (in regular
monthly quantities) and the cost of material in inventory at 1 January is $100,000.
Key term
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25: Interpreting company accounts ⏐ Part D Interpretation of accounts
Solution
The inventory turnover period could be calculated as:
000,600$
000,100$
×
12 months = 2 months
In other words, inventories are bought two months before they are used or sold.
3.6 Trade receivables collection period
The debt collection period is calculated as:
Average receivables
Annual credit sales
×
12 months
3.7 Example
If a company sells goods for $1,200,000 per annum in regular monthly quantities, and if receivables are $150,000.
Solution
The trade receivables collection period is
000,200,1$
000,150$
×
12 months = 1.5 months
In other words, receivables will pay for goods 1
1
/2 months on average after the time of sale.
3.8 Trade payables payment period
The period of credit taken from suppliers is calculated as:
Average trade payables
Totalpurchasesinone year
×
12 months
Notice that the payables are compared with materials bought whereas for raw material inventory turnover, raw material
inventories are compared with materials used in production. This is a small, but very significant difference.
3.9 Example
For example, if a company sells goods for $600,000 and makes a gross profit of 40% on sales, and if the amount of
trade payables is $30,000.
Solution
The period of credit taken from the suppliers is:
)000,600£of%60(
000,30£
×
12 months = 1 month
In other words, suppliers are paid in the month following the purchase of goods.
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Formula to
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Part D Interpretation of accounts ⏐ 25: Interpreting company accounts 379
Question
Cash cycle
Legion's 20X4 accounts show the following.
$
Sales 360,000
Cost of goods sold 180,000
Inventories 30,000
Receivables 75,000
Trade payables 45,000
Calculate the length of the cash cycle.
Answer
Inventory turnover Debt collection period Credit taken from suppliers
12
180,000
30,000
× 12
360,000
75,000
× 12
180,000
45,000
×
= 2 months = 2
1
/2 months = 3 months
The cash cycle is
Months
Inventory turnover period
2.0
Credit taken from suppliers
(3.0)
Debt collection period
2.5
Cash cycle
1.5
In this example, Legion pays its suppliers one month after the inventories have been sold, since the inventory turnover is
two months but credit taken is three months.
3.10 Turnover periods and the total amount of working capital
If the inventory turnover period gets longer or if the debt collection period gets longer, the total amount of inventories or
of receivables will increase. Similarly, if the period of credit taken from the suppliers gets shorter, the amount of
payables will become smaller. The effect of these changes would be to increase the size of working capital (ignoring
bank balances or overdrafts).
3.11 Example
Suppose that a company has annual sales of $480,000 (in regular monthly quantities, all on credit) and a materials cost
of sales of $300,000. (
Note
. A
'
materials cost of sales
'
is the cost of materials in the cost of sales.)
(a) If the inventory turnover period is 2 months, the debt collection period 1 month and the period of credit taken
from suppliers is 2 months, the company
'
s working capital (ignoring cash) would be
$
Inventories (2/12
× $300,000)
50,000
Receivables (1/12
× $480,000)
40,000
90,000
Payables (2/12
× $300,000)
(50,000)
40,000
The cash cycle would be (2 + 1 – 2) = 1 month.
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