3.5.2 Ratio Analysis Flashcards
Working capital formula
Current assets-current liabilities
Ratio analysis definition
the calculation and interpretation of key financial performance indicators to provide useful insights into business performance
Liquidity definition
This shows the ability of a firm to meet its short-term debts with cash or near cash assets. Assess whether a business has sufficient cash or equivalent current assets to be able to pay its debts as and when they fall due. The ratios are current and acid test.
Current ratio formula
Current ratio= current assets/ current liabilities.
What is the ideal current ratio
The ideal value would be 1.5, meaning that a business would have £1.50 of current assets for every £1 of short-term debt which is enough to cover debts comfortably without holding too many resources in unproductive forms, where they could be better invested elsewhere. Low ratio indicates possible liquidity problems and high ratio shows there is too much working capital tied up in inventories or debts.
Acid test ratio
(current assets-inventory)/current liabilities
Why is acid test better than current
Better indicator and more realistic picture of liquidity problems because it discounts inventories as something that can be quickly converted to cash.
What does it mean if acid test below 1
Significantly less than one is often bad news because suggests may struggle to cover short term debts.
What is it called when acid ratio went from 1.5:1 to 0.8:1
A deteriorating liquidity position
What should a firm do if liquidity too high
the firm may have too much money tied up in stock, debtors or cash. This money could generate a far greater return if invested in non-current assets.
Gearing definition
How dependent a business is on loans and external finance. Measures the long-term financial health of a business. Expresses long-term liabilities (debt) as a percentage of the total amount of long-term capital in the business.
Gearing
non-current) liabilities/ capital employed x 100 OR
non-current liabilities/ equity + non-current liabilities x100. Expressed as a %.
Less than 50% gearing means
a business is ‘low geered’.
High geering implications
reliant on external sources of finance) suggests potential problems in financing. With interest payments to make, as well as loan repayments, high levels of debt can suck the lifeblood from a business rapidly
However point for high geering
this is not necessarily bad because debt is often cheaper than equity
To reduce an unhealthily high gearing ratio:
issue more shares, retain more profits, repay some loans.
Why is is had to be highly geered
Banks less likely to loan if highly geered and low liquidity.
Highly geared bad as vulnerable to increases in interest rates.
How to improve gross profit margin
price up, unit variable costs down
How to improve operating profit margin
boost gross margin, cut overheads per £ of sales, increase sales
Problem if gross profit margin is too low
may not be able to cover overhead expenses
Problem if operating profit margin is too low
limited growth because may not be enough operating profit to reinvest into the business.
Problem if net profit margin is too low
shareholders might not get acceptable annual dividends.
Return on capital employed ROCE
Expresses operating profit as a percentage of the capita that has been invested in the business. Therefore can see if it would be more profitable to leave in bank to earn interest
ROCE Formula
ROCE= Operating profit/ capital employed x 100 (CA is equity + non-current liabilities)
Implications of high and low roce
Higher is better for this RATIO because it means the money invested in the business is generating a higher return on that investment. Where ROCE falls below current interest rates, a business may question whether it would be better off closing, liquidating its assets and putting all money in the risk-free bank for a higher return than the risky option of running a business.
In order to boost ROCE:
- Find a way to increase operating profit
2. Reduce capital employed without damaging operating profit e.g. buy back shares from shareholders.
Gearing and liquidity rations help to identify whether
a business can afford to invest money in new projects.
ROCE can help to assess
The attractiveness of a new investment (alongside ARR), or identify underperforming parts of a business.
Examples- Can we afford a £50 million spend on launching in China with an acid test ratio of 0.95 and gearing of 24.5%?
Yes- finance can come from extra borrowing (to a 50% gearing maximum) plus some use of working capital (to an acid test minimum of 0.6).
Limitations of ratio analysis- receivables figure
It doesn’t tell us the whole story. If money owed by customer is mainly owed by reliable, regular customers, this should turn into cash received on time. However, if much of the receivables figure on the balance sheet consists of bad debts from failing customers, acid test and current ratio results will paint a misleadingly healthy picture.
Limitations of ratio analysis- obselete
If stock is about to go out of fashion and become worthless, current ratio will present a misleadingly healthy picture.
Limitations of ratio analysis- non-qualitative factors
Does not take into account qualitative issues such as comp advantages like brand image or customer service performance, quality, ethical reputation, future prospects (they are backwards looking), changes in external environment.
Limitations- short-term
Does not take into account the impact of long-term decisions, such as investments today that may lower profitability in the short term but boost it in the long term.
Limitations- economic
Economic climate- ratios do not take into account economic conditions or the performance of other businesses.
Limitations- 1 data set
One data set is not enough- need to compare with competitors and analyse over time for trends. Circumstances change over time, markets and industries change and different economic and market conditions.
Limitations- reliability
How reliable? Based on historical financial accounts. Financial information involves making subjective judgements, potential for manipulation of accounting information (window-dressing, making balance sheet look more advantageous than it really was).
Identify issues but don’t solve problems
Key term to remember surrounding limitations
window-dressing, making balance sheet look more advantageous than it really was
