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Current and future developments
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14 Presentation of published financial statements (2)
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- Example: calculating ratios To illustrate the calculation of ratios, the following draft
- Notes to the financial statements
- FAST FORWARD > Profitability and return on capital
- Profit before interest and tax
- Return on capital employed (R0CE)
- ROCE = -— - 7 ГТ7 x 1 Total assets less current liabilities Capital =
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Current and future developments in the company's markets, at home and overseas, recent acquisitions or disposals of a subsidiary by the company
Unusual items separately disclosed in the financial statements Any other noticeable features of the report and accounts, such as events after the end of the reporting period, contingent liabilities, a qualified auditors' report, the company's taxation position, and so on
To illustrate the calculation of ratios, the following draft statement of financial position and statement of profit or loss figures will be used. We are using a separate statement of profit or loss for this example as
Notes to the financial statements
The following information is also available:
Return on capital employed (ROCE) may be used by the shareholders or the Board to assess the performance of management. In our example, the company made a profit in both 20X8 and 20X7, and there was an increase in profit between one year and the next:
Profit before taxation is generally thought to be a better figure to use than profit after taxation, because there might be unusual variations in the tax charge from year to year which would not affect the underlying profitability of the company's operations. Purchases of capital equipment may attract significant tax depreciation, so an increase in profit may not necessarily result in an equivalent increase in the tax charge. Equally, if the tax charge has increased significantly year on year, the previous year may have benefited from lower tax rates, better capital allowances or even there has been issues with underpaid tax in previous years. The information in the question will assist in providing plausible reasons for unusual changes. If not, then suggest potential logical ones which may work in the given circumstances. For Furlong Co, the tax charge year on year (based on profit for the period) has increased from 16% to 31%, however, information in the question has highlighted the purchase of an expensive piece of machinery, so the 20X7 tax charge is likely to have been reduced by generous tax depreciation, artificially reducing the tax charge for the year. Another profit figure that should be calculated is PBIT, profit before interest and tax. This is the amount of profit which the company earned before having to pay interest to the providers of loan capital, such as loan notes and medium-term bank loans, which will be shown in the statement of financial position as non-current liabilities. Profit before interest and tax is therefore:
Published accounts do not always give sufficient detail on interest payable to determine how much is interest on long-term finance. We will assume in our example that the whole of the interest payable ($18,115, Note 2) relates to long-term finance. PBIT in our example is therefore:
This shows a 46% growth between 20X7 and 20X8.
It is impossible to assess profits or profit growth properly without relating them to the amount of funds (capital) that were employed in making the profits. The most important profitability ratio is therefore return on capital employed (ROCE), which states the profit as a percentage of the amount of capital employed. Profit before interest and taxation ROCE = -— - 7 ГТ7 x 1 Total assets less current liabilities Capital = Shareholders' equity plus non-current liabilities employed (or total assets less current liabilities) Formula to learn The underlying principle is that we must compare like with like, and so if capital means share capital and reserves plus non-current liabilities and debt capital, profit must mean the profit earned by all this capital together. This is PBIT, since interest is the return for loan capital. In our example, capital employed = 20X8 $1,870,630 - $860,731 = $1,009,899 20X7 $1,664,425 - $895,656 = $768,769 These total figures are the total assets less current liabilities figures for 20X8 and 20X7 in the statement of financial position. ROCE $360,245 $1,009,899 $247,011 $768,769 = 32.1% What does a company's ROCE tell us? What should we be looking for? There are three comparisons that can be made.
In this example, if we suppose that current market interest rates, say, for medium-term borrowing from banks, are around 10%, then the company's actual ROCE of 36% in 20X8 would not seem low. On the contrary, it might seem high. However, it is easier to spot a low ROCE than a high one, because there is always a chance that the company's non-current assets, especially property, are undervalued in its statement of financial position, perhaps because they are carried at historic cost rather than valuation, and so the capital employed figure might be unrealistically low. If the company had earned a ROCE, not of 36%, but of, say only 6%, then its return would have been below current borrowing rates and so disappointingly low. When considering changes in ROCE consider looking at the numerator (PBT) and denominator (capital employed) separately. If there has been significant investments in assets close to the year end financed by a non-current loan or through a leasing arrangement, this may have little impact on profit for the period, but may have a more significant increase in capital employed. Look at the information given and consider the interactions between increases and decreases in the light of the business's performance for the year. Taking ROCE as a standalone figure does not give the user of the financial statements the whole picture.
Return on equity gives a more restricted view of capital than ROCE, but it is based on the same principles. Download 0,93 Mb. Do'stlaringiz bilan baham: 
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