Analysing a balance sheet – an insolvency example
As you may know, we can use ratio analysis of financial statements to form a view of how a business is doing. One area worth looking at is liquidity and solvency, which we can for example assess using the current ratio or other working capital ratios.
I came across a great example of a “technically” insolvent organisation recently – none less than the professional body I am a member of, CIMA. Below is an extract from their financial statements of 2016 , but first let me briefly explain what insolvency means. Solvency means a business can pay its debts as they fall due, and technically, if current liabilities exceed current assets, a business is insolvent.
If we take a look at the current assets, the total value of current assets is £18,760,000, whereas current liabilities equals £22,564,000. Thus, technically CIMA is insolvent. What makes this example even more interesting is that if we look at the current liabilities, about £13m is deferred income, the subs in advance. These are already included within the cash balance, or the cash has been spent already, so they are not really a liability per se. However, if CIMA were to close tomorrow, it would have to repay these subs to members. So the cash in the bank more or less could cover this, but then if all receivables were paid they would not cover the payables.
Have a look at the full accounts at the link above if you want to see more.
What is wrong with this headline “Tesco delayed payments to suppliers and boosted profits”
Image from journal.ie
So what is wrong with above statement? Simply, it is the application of the accruals concept in accounting. Under this concept, revenues and expenses are matched, and when cash is received/paid is not relevant – at least in the calculation of profit.
Here is a simple example. Let’s assume a business sells goods for $1,000 cash but has not paid the supplier. The goods cost $600. The profit on this is $400. If the supplier is never paid, or is paid in 10 days, the profit will not change.
While the article is incorrect in terms of the title, it’s message is solid – that you can benefit by not paying people. In the simple example above, the business has $1000 in the bank.
The versatility of gross profit margin
You may know the gross profit margin ratio, which is:
Gross Profit x 100
Sales.
Gross profit is: Sales – Cost of Sales
and
Cost of Sales = Opening inventory + Purchases/cost of production – Closing Inventory.
In this short post I would just like to share some of my experiences on the versatility of this simple ratio. If we look at the elements of the ratio, it is easy to see that if each element remain stable, the answer should also be stable. So for example, if I buy something for €40, sell it for €100, then my GP margin is 60%. If my sales price or purchase price changes, then the GP margin changes. Then, if we think about inventory levels, if these fluctuate the GP margin changes too. Taking all this together, it’s easy enough to see how any business typically knows what its GP margin should be. Thus, if it varies considerably, there may be something wrong.
Here are two things I know the GP margin is used for. One, from my own experience, is in pubs/bars. Most pubs/bars are susceptible to fraud and controls typically put in place by owners. One such control is monthly stock-takes and monthly accounts. A fall in the GP margin could indicate “lost” stock or unrecorded cash receipts – which further controls may reveal. Another use is to spot inflated revenues. Businesses may want to make their profits look better and thus do things like invoice for goods early, before the end of a financial year. These good may not even be bought/made yet. Thus, the GP margin may be lower. Again further investigation is needed to find the issue.
There may of course be more simple reasons for changes in the GP margin – costs and sales prices may simply change and affect the ratio. But once these have been ruled out, it is a useful indicator.
Apple’s numbers
As you may know, profits at Apple for Q4, 2014 were some $18billion. This is reportedly the largest quarterly profit in history.
One of the things accountants often do is use ratios to compare businesses from one year to another and with other businesses. With such a large profit at Apple, I’d begin to think that any comparisons might not be of great value. So is there any way we could our such a number is perspective. Certainly Apple could probably clear all Irish sovereign debt with there cash pile, but here is an interesting presentation from the BBC
Comparing profits and other figures from accounts
One thing really annoys me about how the media reports company performance – they only ever give % increases or decreases in sales or profit typically.
If you have ever studied accounting you probably learned about ratios analysis, and how just looking at absolute numbers ( like sales or profit ) can give a false picture. Here’s a recent example from the Irish Times to illustrate what I mean.
According to the Irish Times (see here :
“Irish-owned book and stationery retailer Eason & Son has recorded a net profit after tax of €2.3 million in its financial year to January 2014, compared with €2.6 million the previous year. Eason Group revenues, however, were down 7.1 per cent to €227.4 million, in what the company called a “challenging year”.”
All the above is true, but if we do a quick calculation, profit as a % of sales ( profit margin ) is pretty much the same from one year to another. So despite a 7% drop in sales, costs must also have been well managed to maintain a stable profit margin. I appreciate the media try to keep these reports simple for the general public, but a little more depth would be very useful.
Facebook price earnings
I have written before about key financial ratios which can be used to analyse a business. Here is a great current example – the price earnings ratio for Facebook. The post is from a New York Times blog.
Martin's accounting blog 