EM3100 - Examining Accounts: Business Ratios: Analysis of Trends
Not all of the above ratios will be relevant in every case. The more complex the case, the wider the picture that has to be built up. They should be looked at both in isolation and one with another to see whether a uniform picture is presented and to highlight any suspect areas. Some will only be of use if compared over a number of years to indicate the trend.
The indicators should supplement the traditional analysis of items in the balance sheet and profit and loss account. It is pointless slavishly putting down every item from the accounts - some like turnover and gross profit will always be relevant, but others should be selected according to their relevance to the particular business.
To determine trends both in relation to particular items, and when comparing different items, you should bear inflation in mind and use a common index figure. The first year of analysis can be used as a base year and subsequent years related to that base year. There are tools in the SEES Investigation package that can help. It enables trends to be discerned more easily, and a comparison with inflation can be seen at a glance. However, do not forget that inflation in this business sector may be greater or less than inflation in the economy as a whole as measured by the retail price index or some other index.
The technique is best illustrated by an example.
| 1995 | 1996 | 1997 | 1998 | 1999 | 2000 | 2001 | 2002 | |
|---|---|---|---|---|---|---|---|---|
| Turnover(£’000) | 750 | 811 | 801 | 905 | 1,086 | 1,531 | 1,868 | 2,010 |
| Gross profit (£’000) | 278 | 298 | 292 | 328 | 387 | 525 | 622 | 658 |
| Net profit (£) | 11,674 | 13,589 | 14,127 | 17,951 | 18,822 | 22,763 | 21,413 | 25,363 |
| Remuneration(£) | 22,000 | 22,000 | 28,000 | 28,500 | 33,000 | 37,000 | 36,000 | 40,000 |
| Cost of Plant(£’000) | 95 | 120 | 140 | 140 | 160 | 218 | 229 | 234 |
These are the ‘raw’ figures from the accounts. The trend within particular areas can be seen, but there is no adjustment for inflation. Moreover, some are in hundreds of thousands, some in tens of thousands and some in thousands and it is difficult to compare the relative movement. The same information can be presented in the following form.
| 1995 | 1996 | 1997 | 1998 | 1999 | 2000 | 2001 | |
|---|---|---|---|---|---|---|---|
| Inflation (say) | 100 | 114 | 134 | 150 | 162 | 170 | 179 |
| Turnover | 100 | 108 | 107 | 121 | 145 | 204 | 249 |
| Gross Profit | 100 | 107 | 105 | 118 | 139 | 189 | 224 |
| Net Profit | 100 | 116 | 121 | 154 | 161 | 195 | 183 |
| Remuneration | 100 | 100 | 127 | 129 | 150 | 168 | 164 |
| Cost of Plant | 100 | 126 | 147 | 147 | 168 | 229 | 241 |
For each item the figure in 1995 is turned into a base figure of 100 and the figures for subsequent years are related to that base figure. The trend for each entry compared to the original 100 can be seen, and can be compared to inflation (illustrated at the top) and the other items. Even this limited table shows that-
- gross profit has declined as a proportion of turnover
- net profit has not kept pace with gross profit
- directors’ remuneration has not kept pace with net profit, nor even held up with inflation
- cost of plant has largely kept up with turnover, with the substantial increase slightly preceding the increase in turnover, as might be expected.
Such features prove nothing in themselves. But they do throw new light on the results shown by the accounts. Analysis such as this and use of the preceding ratios can point to areas which on the limited amount of information available require some explanation. You are entitled to ask for that explanation.