7.2 Financial Ratio Analysis (Analysing internal position) Flashcards
2 key financial reports to assess financial performance:
Income statements
Balance sheets
Income statements
Formal financial documents that summarise business’ trading activities and expenses to show whether profit or loss made over specified period of time.
Profitability
measures financial performance by comparing profits to a 2nd variable (revenue)
-gross profit margin
-operating/net profit margin
-profit for year margin
Within an income statement:
-Sales revenue
-Cost of sales
-Gross profit
-Expenses
-Operating profit
-Interest
-Profit for year
Sales revenue
Money coming in from sales.
(qty sold x selling price)
Cost of sales
Costs directly linked to production of goods/services sold.
e.g raw materials.
Gross profit
Sales revenue - cost of sales
Expenses
All other costs associated with trading of business.
e.g salaries, marketing expenditure.
Operating profit
Gross profit - expenses
Interest
Interest paid on debt or received on positive balances.
Cost of borrowing, Reward for saving.
Profit for year
Operating profit - interest (tax is still to be deducted)
Income statements; Profit quality
Firms with high profit quality will have income statements that can show consistent increases in profit year on year due to business performance.
Inconsistent profit
Often a result of a one-off activity such as selling an expensive asset.
Group income statements
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.
Income statements and the law
Every business must complete income statements by law- the tax paid to government by business will be based on their operating profit.
Within the income statement, companies must disclose…
1) Exceptional items
2) Extraordinary items
Exceptional items
Large one-off financial transactions arising from “ordinary trading activities”.
e.g opening new stores.
Extraordinary items
Large financial transactions outside normal trading activities.
Unlikely to happen again.
Balance sheets
A financial statement produced on the final day of financial year, records a business’;
-Assets
-Liabilities
-Equity.
Non-current assets
Fixed assets, tangible items.
-Items owned by business, expect to own for year or more.
-Usually most valuable assets e.g land, equipment.
Current assets
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)
Current liabilities
Business is responsible for.
-Debts owed by business, expected to be paid within one year.
e.g overdraft, tax, trade payables (creditors)
Net current assets / working capital
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)
Non-current liabilities
Long term debts taken out for more than one year, often longer.
May be long term bank loan or mortgage.
Net assets
(What business owns - what business owes).
A figure that represents the value of the business on day balance sheet was drawn up.
Net assets formula
Total non-current assets + current net assets - non current liabilities
Equity
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.
Net assets =
Total Equity
-Equity and net assets will always balance (be same)
Window dressing
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.
Trade receivables (debtors)
People who owe money to the business.
Trade payables (creditors)
People the business owe money to.
Ratio analysis
Used to assess a business’ financial performance in the areas; profitability, liquidity, gearing and efficiency ratios.
Types of ratios
-Profitability ratios
-Liquidity ratios
-Gearing ratios
-Efficiency ratios
Return on capital employed (ROCE)
A measure of how efficiently a business is using capital employed to generate its profits.
Capital employed
All the money invested in the business from;
-share capital
-reserves
-long term loans
Capital employed formula
Total equity + Non current liabilities
ROCE formula
Operating profit
———————— x100
total equity + non current liabilities
Improving ROCE
Generating more operating profit without taking out any further long term loans improves ROCE.
Liquidity
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.
Liquidity is calculated using the current ratio
Current assets
——————— : 1
Current liabilities
Ideal current ratio
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.
Gearing
Gearing % measures what proportion of a business’ capital is funded through long term loans.
Formula for Gearing
non-current liabilities
——————————- x100
total equity + non current liabilities
High gearing
Anything over 50%, more than half the business is financed by debt.
Low gearing
Most the business is financed by equity but also gives business scope to borrow more money if required.
During times of low interest rates businesses might…
purposefully gear themselves highly, because they know they can afford the repayments.
Payables days
A measure of how long it takes on average for business to pay for supplies purchased on credit.
To ease cash flow problems
A business may try have longer payables days ratio.
Short payables days may result in
Discounts from suppliers.
Payables days formula
(Answer is in days)
Payables
————- x365
Cost of sales
Receivables days
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.
To ease cash flow problems
Business may try have shorter receivables days.
Receivables days formula
(answer is in days)
Receivables
—————– x365
Sales revenue
For good cash flow management…
Business should ensure receivables figure is LOWER than payables fire.
i.e customers are paying quicker than business is paying suppliers (on average).
Inventory turnover (stock)
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).
Inventory turnover formula
(answer is in ….’times’)
Average inventory held
Efficiency ratios
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.
