Interpreting Published Accountants

Interpreting Published Accountants

1. Evaluating ROCE

   • Operating profit / capital employed x100
     • higher % is better
     • watch for trend over time
     • watch out for low quality profit which boosts ROCE
     • leased equipment will not be included in capital employed

2. Evaluating liquidity ratios

   • Current ratio
     • interpreting the results
       • ratio of 1.5+ suggests efficient management of working capital
       • Low ratio (e.g. below 1) indicates cash problems
       • high ratio: too much capital?
     • Look out for
       • Industry norms (e.g. supermarkets operate with low current ratio because they low debtors
       • Trend (change in ratio) is perhaps most important
   • Acid test ratio
     • Current ratio adjusted for stocks
     • considered a better measure of liquidity, particularly for businesses which carry a lot of stock
     • Focuses on the assets that a business can quickly turn into cash
     • Important to look out for a change (e.g. a significant fall in the ratio indicates a problem

3. Profit Quality

   • looks at whether the reported profit can be sustained
   • Low quality profit
     • Difficult to repeated or sustained
     • Includes one-off profits (e.g. from the sale of surplus assets or businesses
     • Shareholders need to adjust reported profit to assess what the likely profit is for next year
   • High quality profit
     • profit which can be repeated or sustained
     • not reliant on one-off profits
     • Shareholders can have some confidence in the profit trend

4. Gearing

   • Interpreting the result
     • focuses on long-term financial stability of business
     • High gearing (>50%) = problems financially
     • not necessarily bad
   • Look out for
     • increased gearing & deterioration in other liquidity and/or financial efficiency ratios
   • How to reduce gearing
     • profit improving
     • long-term loans/issue more shares
     • retain profits
   • How to increase gearing
     • focus on growth
     • pay increased dividends
     • convert short-term debt into long-term debt

5. Limitations

   • ratios deal mainly in numbers - don't adress issues like product quality, customer service
   • ratios largely look at the past, not the future
   • Ratios are most useful when they are used to compare performance over a long period or against comparable businesses and an industry
   • financial information can be "massaged" to make the figures used for ratios more attractive