Unit2 Operational Ratios

Unit 2
Understanding Accounts
Operating Efficiency

A summarised balance sheet
A typical UK balance sheet
Fixed assets 1,000 Share capital 500
Debtors (receivables) 500 Retained profits
Stocks (inventories) 300 (earnings) 325
Cash 25
Other assets 100
Creditors (payables) (350)
Borrowings (750)
Net assets 825 Equity 825

HOWEVER A BETTER WAY TO SHOW THE BALANCE SHEET – MOVE THE
BORROWINGS TO THE “OTHER” SIDE
Cash 25
Other assets 100
Creditors (payables) (350)
Borrowings (750)
Net assets 825 Equity 825

Cash 25
Other assets 100
Creditors (payables) (350) Borrowings 750
Capital employed 1,575 1,575
Note the
change of
title

Debtors (receivables) 500 Retained profits Equity
Cash 25
Other assets 100
Creditors (payables) (350) Borrowings 750 Debt
This side of the
balance sheet is the
funding side = debt +
equity

Cash 25
Other assets 100
This side of the
equity
As the balance sheet must
“balance” so every £ on the
funding side must be
represented by a £ on the
other side

Cash 25
Other assets 100
This side of the
equity
So this side represents
what is done with the
funding – the “operating”
side of the balance sheet

OPERATING FUNDING
Cash 25
Other assets 100
This side comes at a
cost – the weighted
average cost of capital
(WACC – unit 4)

OPERATING FUNDING
Cash 25
Other assets 100
This side comes at a
cost – the weighted
average cost of capital
(WACC – unit 4)
This is the side that needs to pay
the cost of finance – the operating
side produces “operating profit”

Return on capital employed
So,
OPERATING = FINANCING
This side comes at a cost –
WACC, say 10%. So each £1
invested costs 10p

So,
OPERATING = FINANCING
This side produces operating profit. For each
£1 invested it must yield at least 10p to cover
the cost of capital. This yield is:
operating profit/capital employed%
This is called the return on capital employed -
ROCE

ROCE = operating profit x 100
capital employed (= debt+equity)

capital employed (= debt+equity)
= operating profit % sales
sales x capital employed
Return on sales or asset turnover
operating margin

capital employed (=borrowings+equity)
= operating profit % sales
sales x capital employed
Return on sales/margin asset turnover
profitability asset efficiency

ROCE
This framework allows us to drill into the operating aspect of the
business to investigate what is happening.
For example return on sales can be further broken down into :
operating profit
Sales
Cost of sales Operating costs
sales sales
Which in turn can be drilled into more detailed costs where available.

ROCE
This framework allows us to drill into the operating aspect of the
business to investigate what is happening.
For example return on sales can be further broken down into :
operating profit
Sales
Labour HR
Cost of sales raw materials Operating costs Training
sales Utilities sales Salaries
Which in turn can be drilled into more detailed costs where available.

Asset turnover
Asset turnover = sales/capital employed
This is a measure of how efficiently a business uses its assets
Eg a company needs to be make 20 deliveries a day. It can use 5 vans
making 4 drops each or 4 vans making 5 drops each .

Asset turnover
This is a measure of how efficiently a business uses its assets
Eg a company needs to be make 20 deliveries a day. It can use 5 vans
making 4 drops each or 4 vans making 5 drops each .
If a delivery is worth £100 and a van costs £1,000 the asset turnovers
are: 2000/5000 = 0.4 or 2000/4000 = 0.5
The latter case is more efficient. So the higher the asset turnover the
more efficiently assets are being used. Note: it is not normally
expressed as a percentage.

Asset turnover
Capital employed = the financing OR the operating assets
This can be drilled into its operating component parts
For example, Sales/fixed assets, Sales/debtors, Sales/stocks
Sales/creditors

Asset turnover
Sales/creditors
Though the latter are more usually shown as “days”
Debtor days = debtors x 365/sales = average collection time
Eg if annual sales are £365,000 and debtors are £36,500 then it takes
10% of a year on average to collect the payments from customers.
(1 day’s sales = £1,000, so £36,500 = 36.5 days’ sales. Or
Debtor days = 36500 x 365/365000 = 36.5 days)

Asset turnover
Sales/creditors
Though the latter are more usually shown as “days”
Debtor days = debtors x 365/sales = average collection time
Creditor days = creditors x 365 / cost of sales
Stock days = stocks x 365/cost of sales
These use cost
of sales in order
to strip out the
profit element

Example
Given the following 2010 data about a company:
1 Calculate the ROCE for 2010
2 Identify which is the main element of the business causing the movement.
Profit and loss/£ Balance sheet
Revenue 10,000 Fixed assets 20,000
Cost of sales 2,500 Debtors 2,200
Operating costs 1,500 Stocks 1,100
Creditors (800)
Operating profit 6,000 Capital employed 22,500
Last year’s key figures: ROCE = 32%. Return on sales = 58%, Asset turnover = 0.8
Cost of sales/sales = 23%, operating costs/sales = 17%, Sales/fixed assets = 0.52, debtor
days = 50 days, stock days = 158 days, creditor days = 120 days
[Note: for this exercise, due to time constraint, we will just use the year end capital
employed figure – strictly we should use an average of the start and end figures]

Example
ROCE = 6000/22500 = 27% [32%]
Return on sales = 6000/10000 = 60% [58%] Asset turnover = 10000/22500 = 0.44 [0.8]
So issue is around asset turnover. So only need to look at those items:
Creditors (800)

Example
ROCE = 6000/22500 = 27% [32%]
Sales/fixed assets = 10000/20000 = 0.5 [0.52]
Debtor days = 2200/10000 x 365 = 80 days [50 days]
Creditor days = 800/2500 x 365 = 117 days [120 days]
Stock days = 1100/2500 x 365 = 161 days [158 days]
Creditors (800)

Example
ROCE = 6000/22500 = 27% [32%]
Sales/fixed assets = 10000/20000 = 0.5 [0.52]
Debtor days = 2200/10000 x 365 = 80 days [50 days]
Creditor days = 800/2500 x 365 = 117 days [120 days]
Stock days = 1100/2500 x 365 = 161 days [158 days]
Creditors (800)
So increase in
debtors appears to
be main cause in
drop in ROCE

ROCE in real life
Recall we started this analysis with a simple balance sheet:
Fixed assets Share capital
Debtors Retained profits
Stocks Borrowings
Cash
Creditors
But in real life there are a number of other items that might appear on a balance
sheet, for example De La Rue (p108 unit 2)

De La Rue – Summary balance sheet
Cash 86 Share capital 48
Receivables 89 Other reserves (82)
Inventory 73 Retained profits 194
Other current assets 17
Tangible fixed assets 240
Intangible fixed assets 3
S/T debt 26
Payables 34
Other current liabs 165
L/T debt 58
Other L/T liabs 2
L/T provisions 60
Minority interests 3
160 160

S/T debt 26
Payables 34
L/T debt 58
Other L/T liabs 2
L/T provisions 60
160 160
Need to move “financing” to
the right hand side.

S/T debt 26
Payables 34
L/T debt 58
Other L/T liabs 2
L/T provisions 60
160 160
Obviously debt. But what
else?

S/T debt 26
Payables 34
L/T debt 58
Other L/T liabs 2
L/T provisions 60
160 160
Obviously debt. But what
else?
Anything else that might
result in interest (or
equivalent) being paid eg
pension deficits

Other current assets 17 S/T debt 26
Tangible fixed assets 240 L/T debt 58
Intangible fixed assets 3 L/T provisions 60
Payables 34
Other L/T liabs 2
304 304
In calculating “capital
employed” it is usually easier
to decide what is “financing”
and add that up (everything
else = operating side as the
balance sheet “balances”)

Next Time
We shall look at more ratios concerning financing,
liquidity and investment markets

Unit2 Operational Ratios

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Unit2 Operational Ratios