The report will mainly dwell upon the financial ratios in order to assess the performance of Marks and Spencer (M&S 2011). Thereafter, the report will also highlight the weaknesses of the financial ratios when analyzing the financial performance of the business. Finally, the report will also provide an explanation of the major accounting principles that are used in the preparation of the financial statements.
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Financial ratios are very valuable tools that can be used in evaluating the performance of a business entity. In this assignment, we are going to compute the financial ratios of Marks and Spencer for 2010 and 2011 (M&S 2011).
In this assignment, we are going to start with the profitability ratios as follows:
Operating Profit Margin
2010 852 x 100 = 8.9%
2011 836.9 x 100 = 8.6%
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According to Peterson (2012), the operating profit margin indicates how much each dollar to the income before interest and taxes. A high operating profit margin indicates that the company is making more per every dollar that it invests in the company. Looking at the operating profit margin of the company in 2010 and 2011, it can be seen that the ratio has decreased marginally from 8.9% to 8.6%. Furthermore, it can be seen that the ratios are still low showing that the cost or the overheads are increasing at a faster rate than sales.
Gross Profit Margin
2010 3618.5 x 100 = 37.9%
2011 3724.7 x 100 = 38.2%
A high level of gross profit margin indicates that the company has a high potential to make a profit A low gross profit margin is indicative of the fact that the company has failed to control its production cost. From the calculations, it can be seen that the gross profit margin has increased marginally from 37.9% to 38.2%.
In addition, we can carry out an analysis of the company’s liquidity ratios as follows:
2010 1520.2 x 100 = 0.8: 1 times
2011 1641.7 x 100 = 0.7: 1 times
The current ratio shows how well the company is prepared to pay its current liabilities. It follows that the higher the current ratio, the higher the ability of the company to honour its short term financial obligations. A current ratio which is lower than 1, indicates that the company may be unable to pay its short term obligations. In addition, the current ratio can be used to show the company operates efficiently. In as much as a high current ratio may be used to show that the company is liquid, it may also be indicative of the fact that the company may not be converting receivables into cash efficiently.
The current computed ratios for the company indicate that the current ratio for the company in 2011 declined marginally from 0.8 to 0.7. This is indicative of the fact that the company’s ability to pay its short term financial obligations is declining, albeit marginally.
Acid Test Ratio
2010 1520.2 – 613.2 = 0.5 times or 0.5:1
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2011 1641.7 – 685.3 = 0.4 times or 0.4:1
Acid test ratio is a reflection of the ability of the company to pay its short term obligations using its immediate assets. The immediate assets include cash, cash equivalents, and marketable securities. It is postulated that an acid test ratio of 0.75:1 or more is preferable. It is a better measure than the current ratio in that it deducts all the unknown receivables. Looking at the acid test ratio for this company, it can be seen that it was changed slightly from 0.5 in 2010 to 0.4 in 2011. While this should not worry about the management so much, it nonetheless shows that the ability of the company to honour its short term obligations might be on the decline.
Return on equity
523/526.3 = 0.99
598.6/612 = 0.99
The return on equity ratio is used to show the profit that is attributable to the investment made by the equity holders. Looking at the return on equity for the two periods, it can be seen that it has remained constant. This indicates that the efficiency in utilizing the funds derived from equity has not been enhanced.
Return on assets
523/7153.2 = 0.073
598.6/7344.1 = 0.082 albeit
The return on assets ratio is used to indicate how efficient the company is using its assets. A higher return on assets ratio indicates that the company is very efficient in the manner that it makes use of the assets. It can be seen that the return on assets ratio improved slightly. This indicates a slight improvement in the manner in which the assets are utilized.
The other ratios that we are going to look at are the gearing ratios.
2010 3076.8 x 100 = 58.5%
2185.9 + 3076.8
2011 2456.5 x 100 = 47.8%
2677.4 + 2456.5
The gearing ratio is used to indicate the extent to which the company has been funded using equity rather than loan capital. This implies that if the company is reflecting a high gearing ratio, it has been funded with loan capital to a great extent,.
A high gearing ratio is indicative of the fact that the company may have to incur very high cost in terms of increased interest that is payable on the debts; this may consequently reduce the profitability of the business. However, it must be noted that high gearing ratio may also be indicative of the fact that the business is very aggressive in its expansion plans, which is the contrary opinion that is implied by a low gearing ratio.
The gearing ratio for this company indicates that the gearing ratio declined from 58.5% to 47.8%. This shows that the company reduced its loan capital.
Interest Cover Ratio
2010 852 = 5.2 times
2011 836.9 = 5.7 times
The interest cover ratio is used to show the extent to which the company is prepared to pay interest on its outstanding debts. A low-interest cover ratio shows that the company is shouldering a heavy burden in terms of interest expenses. In fact, if the company’s interest cover ratio is below 1.5, the ability of the company to honour the interest payment on a debt is severely undermined. Additionally, it is postulated that if the interest cover ratio is less than 1, it shows that the company is not getting enough revenue to enable it to meet its interest expenses.
From our calculations, it can be seen that the interest cover ratio for the company has increased from 5.2 times to 5.7 times. This shows that the company is getting enough revenue, which enables the company to pay its interest expenses.
Dividend Cover Ratio
2010 523 = 2.2 times
2011 598.6 = 2.4 times
This ratio indicates the ability of the company to pay dividends from profits. For this reason, it can be seen that a high dividend cover ratio indicates that the company is in a very good position to pay dividends from its profits. Looking at our calculated figures, it can be seen that the company dividend cover ratio had increased from 2.2 in 2010 to 2.4 in 2011. This increase might be as a result of the increase in the profitability of the company.
Earnings per share
The formula for the computation of the earnings per share is earnings available to ordinary shareholders divided by the number of the ordinary shares issued. However, in this case, the earnings per share ratios for Mark and Spencer have already been computed, and they are indicated as follows:
The earnings per share ratio are used to indicate the portion of the company’s profit that is apportioned to the outstanding shares of the common stock. The earnings per share ratio are a very strong determinant of the price of the stock. Looking at the earnings per share ratio for Marks and Spencer, it shows an increase from 33.5p in 2010 to 38.8p. This could be indicative of the enhanced profitability of the company. This could serve as a signal to the market for the share price for this company to rise accordingly.
Payout ratio= dividends per share/ earnings per share
15/33.5 = 0.45
15.7/38.8 = 0.41
It shows the portion of the income that is shared out amongst the shareholders of the company. Looking at the computed figures, it can be seen that the company reduced its payout ratio. This indicates that the portion of income that is given to the shareholders in the form of dividends declined accordingly.
Total liabilities/ total assets
4967.3/7153.2 = 0.69
4666.7/7344.1 = 0.64
The debt ratio is used to show the extent of the total debt in relation to its assets. A high ratio indicates that the company has more liabilities than assets. However, when the debt ratio is low, it shows that the owners of the company have ownership of most of the company’s assets. It can be seen that the debt ratio of the company declined from 0.69 to 0.64. This shows that the company’s assets are higher than the debts owed to other parties.
Debt equity ratio
Total liabilities /shareholders equity
4967.3/2168.6 = 2.29
4666.7/2673.5 = 1.75
This ratio indicates the relationship between the debt and the equity capital in the company. A high debt-equity ratio indicates that the company prefers a lot of debt to equity capital. This can have a negative effect on the profitability of the company because of the increased interest expense needed to service the debts. However, for this company, it is declining, indicating that the company is reducing its debt relative to equity.
Interest coverage ratio
702.7/163.4 = 4.3
780.6/146.4 = 5.3
The ratio indicates the ability of the company to pay its interest expense from the profit before interest and tax. A higher rate indicates that the company is in a much better position to pay up the interest expense. For the computed figures, the interest coverage ratio indicates that the company has enhanced its ability to service its debt.
Average Inventory Period
2010 613.2 x 365 = 37.8 days
2011 685.3 x 365 = 41.6 days
This ratio shows how soon the company utilizes its stock or inventory to give forth usable goods or services. However, the company’s inventory period should be compared to that of its competitors. Looking at the average inventory period of the company, it can be seen that it increased from 37.8 days in 2010 to 41.6 days. This indicates that the company is not turning overstock as fast as it should.
Average Receivables Period
2010 281.4 x 365 = 10.8 days
2011 250.3 x 365 =9.4 days
This ratio is used to indicate the average number of days that the company takes to change its receivables into cash. This ratio is only used to consider the sales that are done in credit. This is because if the sales that are made in cash are used, the ratio may lose its relevance. When the value of this ration is very low, the company’s operations will be at stake. This is because the company may not have cash enough to fund daily operations. The firms should try as much as possible to convert their receivables into cash so that the company’s liquidity is maintained at a sound level. The more refined liquidity ratios like cash and acid test ratios will be very low when the receivables remain unsettled for a long time.
The computed average receivables period indicates that the company reduced the period for the conversion of the receivable from 10.8 days to 9.4 days. This indicates that the company is in a much better position to convert its receivables to cash using a shorter period than was the case previously.
According to Baker and Powell (2005), one of the apparent drawbacks of the financial ratios is that they are computed on the basis of the balance sheet figures. These balance sheet figures are as at the date indicated on the balance sheet, and may not be indicative of the year-round financial position of the company. These figures may also not be comparable with those of the competitors due to differences in accounting policies and the accounting periods.
The financial ratios are only used to show the past and the current trends in the business. As such, they cannot be used to indicate the trend of the company in the future, as the performance could be affected by a lot of other factors prevailing in the industry. The financial ratios do not factor in the effect of inflation since the figures that are used in computing them are historical numbers, which have no bearing on the current inflation levels. It has also been postulated that there are different approaches that are used by the financial analysts to interpret those ratios. As such, they may be subject to varying interpretations that may be confusing.
In addition, the financial ratios are tools of quantitative analysis, which do not factor in the qualitative information. Examples of the qualitative information that is not taken into account by the financial ratios include the rate of change in the market, customer service, and product quality. Moreover, it has been adduced that the financial ratios are as good as the accounting data that are used in their computation. As such, if the wrong figures are used, they are likely to give the wrong ratios, whose interpretation could be misleading.
The main accounting principles
Juan (2007) contends that the accounting principles set out the manner in which the financial statements should be prepared. One of the financial principles that are used in the preparation of the financial statements is the going concern basis. This sets out that the business will continue in its operations in the foreseeable future.
The other accounting convention that is used during the preparation of the financial statement is the historical concept. This sets out that the assets should be recorded using the cost that was incurred in their acquisition. This cost can be supported by documentary evidence, for example, the invoice. The other concept that is used is the accruals concept. This concept means that expenses are tracked in the books of accounts on the dates they are incurred but not when the company receives cash for them. In addition, revenues are realized when they are earned and not when they are received by the company in cash. The other principle that is used is the materiality concept. This concept states that the financial statements should consist of all the material facts that pertain to the business.
The other accounting principle used is the monetary measurement. This principle states that only those transactions which can be expressed in monetary terms are recorded in the financial statements. Additionally, there is the prudence principle that states that revenue should only be accounted for when the sales have been made. In addition, the principle states that the business entity should be very quick to take into account expenses, but be very slow when recording the revenues.
Some of the financial ratios indicate that the company is performing well while some other ratios indicate otherwise. However, overall the company is performing well, buoyed by enhanced profitability in the current year. This leads to enhanced earnings per share ratio, which is likely to influence the price of its stock positively. According to the auditors’ report, the company follows the major accounting principles in the preparation of the financial statements.
Baker, H and Powell, G 2005, Understanding Financial Management: A Practical Guide, Blackwell Publishing, Malden.
Juan, D 2007, Fundamentals of Accounting: Basic Accounting Principles Simplified For accounting students, AuthorHouse Publishing, Bloomington.
M&S. Financial highlights 2011, Web.
Peterson, P 2012, Analysis of Financial Statements, John Wiley and Sons, Hoboken.