Operating Ratios

Then comes the question of how efficiently the company is being run. Many indicators are available for this purpose and the following represent only the main ones used by most analysts. First we must define some new terms.

Shareholders' funds refers to the total nominal value of the issued ordinary shares, plus the reserves.

Capital employed refers to the total capital being used in the business, irrespective of who owns it. It therefore includes not only the total of ordinary shareholders' funds plus issued preference shares and debentures, if any, but also capital borrowed from any source, including money by way of loan or overdraft from the bank. Capital employed is virtually the total assets in the balance sheet less the current trade creditors and any other (non-financing) outside creditors (e.g. Inland Revenue).

Current assets are those which, by their nature, are continuously changing from cash to stock to debtors and back to stock.

Current liabilities are those that will have to be paid off soon. Working capital is the term used to described the excess of current assets over current liabilities (excluding liability to the bank, if any). Now we come to the indicators. The figures in brackets again refer to the example.

Current assets turnover:

sales current assets

(580,000) (209,500) (= 2.8)

This indicates that the current assets, whose nature it is to change form, are revolving nearly three times a year, which is rapid. Stock turnover:

cost of stock sold : stock held

(477,300) (88,000) (= 5.4)

This indicates a rapid movement. Stock is being turned over nearly six times a year, the average time any item is held in stock being just over two months. Compare this with the stock of the jeweller in Chapter 13. An analyst, however, would seek to find out why the stock held at 31 December is £17,300 lower than at the start of the year. This does call for an explanation (see 'working capital ratio' below).

Working capital turnover:

working capital sales

(139,090) (580,000) (= 24%)

This indicates that, provided no capital is lying idle, each £100 of sales is requiring working capital finance of £24 (but query: working capital figure includes 128,000 cash on short-term deposit - in other words this is not used for financing sales. Is this cash intended to be spent on purchasing larger stocks to meet expanding turnover in the next few months? If so, this might explain the reservation expressed above regarding low stock values at 31 December.)

Solvency Ratios

One can learn a great deal about a company from a study of the final accounts. The features one would select for particular attention will depend on whether the results are being analysed by an investor in the company (in which case see Chapter 6), a potential supplier of goods on credit to the company, a prospective employee of the company, or a lending banker.

An important factor concerning the performance and stability of the company, not normally revealed in a balance sheet, is the accuracy of the valuation of fixed assets and of stock. The basis of valuation is usually shown (e.g.... see: Solvency Ratios

Personal And Business Finance 2018

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