7.2 Financial Ratio Analysis (Analysing internal position)

Question 1

2 key financial reports to assess financial performance:

Answer 1

Income statements
Balance sheets

Question 2

Income statements

Answer 2

Formal financial documents that summarise business’ trading activities and expenses to show whether profit or loss made over specified period of time.

Question 3

Profitability

Answer 3

measures financial performance by comparing profits to a 2nd variable (revenue)
-gross profit margin
-operating/net profit margin
-profit for year margin

Question 4

Within an income statement:

Answer 4

-Sales revenue
-Cost of sales
-Gross profit
-Expenses
-Operating profit
-Interest
-Profit for year

Question 5

Sales revenue

Answer 5

Money coming in from sales.
(qty sold x selling price)

Question 6

Cost of sales

Answer 6

Costs directly linked to production of goods/services sold.
e.g raw materials.

Question 7

Gross profit

Answer 7

Sales revenue - cost of sales

Question 8

Expenses

Answer 8

All other costs associated with trading of business.
e.g salaries, marketing expenditure.

Question 9

Operating profit

Answer 9

Gross profit - expenses

Question 10

Interest

Answer 10

Interest paid on debt or received on positive balances.
Cost of borrowing, Reward for saving.

Question 11

Profit for year

Answer 11

Operating profit - interest (tax is still to be deducted)

Question 12

Income statements; Profit quality

Answer 12

Firms with high profit quality will have income statements that can show consistent increases in profit year on year due to business performance.

Question 13

Inconsistent profit

Answer 13

Often a result of a one-off activity such as selling an expensive asset.

Question 14

Group income statements

Answer 14

Companies have been taken over by other companies to form GROUPS.
-Each company within group retains separate legal identity, so are obliged to produce own income statement by law.

Question 15

Income statements and the law

Answer 15

Every business must complete income statements by law- the tax paid to government by business will be based on their operating profit.

Question 16

Within the income statement, companies must disclose…

Answer 16

1) Exceptional items
2) Extraordinary items

Question 17

Exceptional items

Answer 17

Large one-off financial transactions arising from “ordinary trading activities”.
e.g opening new stores.

Question 18

Extraordinary items

Answer 18

Large financial transactions outside normal trading activities.
Unlikely to happen again.

Question 19

Balance sheets

Answer 19

A financial statement produced on the final day of financial year, records a business’;
-Assets
-Liabilities
-Equity.

Question 20

Non-current assets

Answer 20

Fixed assets, tangible items.
-Items owned by business, expect to own for year or more.
-Usually most valuable assets e.g land, equipment.

Question 21

Current assets

Answer 21

These change all the time.
-Items owned by business that change on daily basis.
-Converted to cash at some point.
e.g inventories (stock) trade receivables (debtors)

Question 22

Current liabilities

Answer 22

Business is responsible for.
-Debts owed by business, expected to be paid within one year.
e.g overdraft, tax, trade payables (creditors)

Question 23

Net current assets / working capital

Answer 23

Used to help business operate on daily basis and pay short term debts, overall keep business going.
-Deduct current liabilities from current assets.
( CURRENT ASSETS - CURRENT LIABILITIES)

Question 24

Non-current liabilities

Answer 24

Long term debts taken out for more than one year, often longer.
May be long term bank loan or mortgage.

Question 25

Net assets

Answer 25

(What business owns - what business owes).
A figure that represents the value of the business on day balance sheet was drawn up.

Question 26

Net assets formula

Answer 26

Total non-current assets + current net assets - non current liabilities

Question 27

Equity

Answer 27

Refers to money invested in the business from either;
1) Shareholders in form of share capital (finance raised through selling shares to shareholders)
2) Retained earnings and reserves kept back over number of years.

Question 28

Net assets =

Answer 28

Total Equity
-Equity and net assets will always balance (be same)

Question 29

Window dressing

Answer 29

Try to attract investors.
Making balance sheet look as good as possible.
1. Business may have agreed to sell valuable assets AFTER date of balance sheet.
2. Business may have agreed a large short term loan to improve look of cash position.

Question 30

Trade receivables (debtors)

Answer 30

People who owe money to the business.

Question 31

Trade payables (creditors)

Answer 31

People the business owe money to.

Question 32

Ratio analysis

Answer 32

Used to assess a business’ financial performance in the areas; profitability, liquidity, gearing and efficiency ratios.

Question 33

Types of ratios

Answer 33

-Profitability ratios
-Liquidity ratios
-Gearing ratios
-Efficiency ratios

Question 34

Return on capital employed (ROCE)

Answer 34

A measure of how efficiently a business is using capital employed to generate its profits.

Question 35

Capital employed

Answer 35

All the money invested in the business from;
-share capital
-reserves
-long term loans

Question 36

Capital employed formula

Answer 36

Total equity + Non current liabilities

Question 37

ROCE formula

Answer 37

Operating profit
———————— x100
total equity + non current liabilities

Question 38

Improving ROCE

Answer 38

Generating more operating profit without taking out any further long term loans improves ROCE.

Question 39

Liquidity

Answer 39

A measure of a business’ ability to survive in short term.
i.e its ability to meet short term debts and day to day expenses.
-If business cannot meet current liabilities from current assets, then its is at risk of failure if creditors demand immediate payment of debts.

Question 40

Liquidity is calculated using the current ratio

Answer 40

Current assets
——————— : 1
Current liabilities

Question 41

Ideal current ratio

Answer 41

An ideal current ratio is between 1.5 and 2 : 1
-Anything over this suggests business should be using excess cash to reinvest in assets for future or developing staff.

Question 42

Gearing

Answer 42

Gearing % measures what proportion of a business’ capital is funded through long term loans.

Question 43

Formula for Gearing

Answer 43

non-current liabilities
——————————- x100
total equity + non current liabilities

Question 44

High gearing

Answer 44

Anything over 50%, more than half the business is financed by debt.

Question 45

Low gearing

Answer 45

Most the business is financed by equity but also gives business scope to borrow more money if required.

Question 46

During times of low interest rates businesses might…

Answer 46

purposefully gear themselves highly, because they know they can afford the repayments.

Question 47

Payables days

Answer 47

A measure of how long it takes on average for business to pay for supplies purchased on credit.

Question 48

To ease cash flow problems

Answer 48

A business may try have longer payables days ratio.

Question 49

Short payables days may result in

Answer 49

Discounts from suppliers.

Question 50

Payables days formula
(Answer is in days)

Answer 50

Payables
————- x365
Cost of sales

Question 51

Receivables days

Answer 51

A measure of how long it takes on average for customers to pay business for goods/services purchased on credit.
-Customer is debtor to the business.

Question 52

To ease cash flow problems

Answer 52

Business may try have shorter receivables days.

Question 53

Receivables days formula
(answer is in days)

Answer 53

Receivables
—————– x365
Sales revenue

Question 54

For good cash flow management…

Answer 54

Business should ensure receivables figure is LOWER than payables fire.
i.e customers are paying quicker than business is paying suppliers (on average).

Question 55

Inventory turnover (stock)

Answer 55

Measures how frequently a business turns over its inventory in a year.
-Varies depending on nature of the firm (what type of firm it is).

Question 56

Inventory turnover formula
(answer is in ….’times’)

Answer 56

Average inventory held

Question 57

Efficiency ratios

Answer 57

Assess internal management of a business.
i.e how efficient are managers in controlling current assets.
-Look at management of CASH and INVENTORY:
Payables & Receivables days, and Inventory turnover.