7.2 Ratio Analysis Flashcards
Gross profit
Sales revenue-cost of sales
Net profit
Gross profit- total expenses
Internal factors
Owners- making profit, performance
Employees- making profit, job security bonuses
Managers- monitor performance set targets
External factors
Suppliers- can they pay back? Level of sales expected
Bank- should we lend? Can they pay back?
Competitors- benchmarking, ways to improve, comparisons.
Local community- income, ethical?
Potential investors- is it worth investing, what returns?
Income statements and law
Legislation demands production of financial statements specifies information to be included.
Exceptional items
Large (usually one off) financial transactions arising from ordinary trading activities. May be large enough to distort companies income statement.
Extraordinary items
Large transactions outside of normal trading activities. Not expected to reoccur.
Window dressing
Manipulation of financial accounts by a Buisness to improve appearance of its performance.
Methods of window dressing
-overstate brand value
-sales and leaseback
-presentation
-exceptional items
-hiding poor investments
Overstate brand value
Intangible asset therefore very subjective. A Buisness can set their own value for brand therefore boost it.
Sale and leaseback
Common trick for retail businesses who build a shop then sell it to a property group and then lease it back for a monthly rate. Provides huge cash injection (increasing current assets) improve cash flow and liquidity ratios.
Presentation
Financial info can be presented or displayed in different ways to emphasise success or mask failures. Simple tactics such as using distorted scales or not using previous years info can minimise look of failures.
Hiding poor investments/ costs
Downplaying poor investments in fixed assets by understanding the cost and overplaying the asset gained. Delay paying off large bill/ bonuses until account is published.
Balance sheet
Statement of firms financial position detailing its assets and liabilities at a specific point in time.
Purpose of balance sheet
-reporting purposes as part of limited company’s annual accounts
-to help you and other interested parties such as investors, shareholders to assess worth of Buisness at any time
- tool to help analyse and improve management of buisness
Why would shareholders use balance sheet?
To assess Buisness’ potential to generate good returns in the future.
Examine the extent and type of assets available high proportion signifys potential for profit
Why might suppliers use balance sheet
Investigate short-term position of company. May consider cash and other liquid assets to make judgment on whether it will be able to pay bills over time. Helps make decision whether to offer credit.
why might mangers use a balance sheet?
indication of performance of business. may extract info to help them reach a decision on how to raise further capital for future investment. amount of existing loans may be a factor influencing this decision.
non- current assets
assets a business it expects to retain for a year or more.
used regularly and not purchased for resale
e.g. land, property, vehicles
current assets
only retained for a relatively shorty period of time.
calculate: stock+debtors+cash
non-current liabilities
debts a business does not expect to repay within a year. e.g. mortgage
current liabilities
debts to be payed back in a year or less e.g. overdrafts or taxes
net assets
shows the overall value of the business, looks at what a business owns after you deduct all that they owe.
total assets- total liabilities
shareholders/capital fund
the money invested by the business into assets from sales or shares of retained profit.
share capital=reserves/ retained profit
depreciation
reduction of the value of an asset over a period of time.
why do assets depreciate?
-wear and tare
-availability of more modern equipment so desirability of older style equipment lessens.
-poor or inadequate maintenance of the equipment may mean expensive repairs are necessary.
why do firms depreciate assets?
-to spread cost of the asset over its useful life
-helps the business show accurate information of how much the business is worth.
-allows firms to calculate true costs of production.
working capital (%)
the finance needed in the business to pay for the day-day expenses.
working capital= current assets- current liabilities
benefits of healthy working capital
can cover liabilities no need for expensive short-term finance such as overdrafts.
what might cause negative working capital?
-poor credit control- not chasing receivables
-the business has high payables
-not being able to turn stock around quickly
- too few current assets to cover liabilities
factors that influence the amount of working capital a firm needs
-volume of sales (more materials+wages)
-amount of trade credits offered by business
-whether or not a firm is growing (need to avoid overtrading)
-the length of the operating cycle (longer=more)
-the rate of inflation
profitability ratios
-gross profit
-net profit margin
-return on capital employed
liquidity ratios
-current ratio
gross profit margin
gross profit/ sales revenue x 100
-higher results the better
how to improve gross profit margin?
- increase revenue and keep cost of sales the same
-lower cost of sales and keep revenue the same
net profit margin (%)
net profit/ sales revenue x 100
-higher the better
-COMPARE WITH GP%
how to improve net profit margin?
-increase revenue and keep expenses the same
-lower expenses keep revenue the same
return on capital (%)
net profit/ capital employed (shareholders funds+long-term liabilities) x 100
-higher the better
-considered most important ratio
how to improve ROCE
-reduce capital employed keep net profit the same
-increase return keep capital employed the same
current ratio
current assets/ current liabilities
-ideal should be approx 1.5: 1
e.g. for every £1 liabilities £1.50 of current assets to pay them
gearing (%)
long term liabilities/ shareholder funds and long term liabilities x 100
high= high risk
25-50% ideal
how dependent the business is on borrowed money.
problems with being highly geared (50% plus)
- high interest payment costs
- interest rate increases will increase cash outflow
-difficult to attract new investment
pros and cons of being lowly geared
pros
-interest rate increases aren’t a problem
-easier to attract new investment
cons
-low borrowing can be considered ‘safe’ therefore the business may not grow as fast as if it borrowed.
reducing or raising gearing
reduce
-use cash to play debts
-issue shares rather than take loans
increase
-increase long term loans
inventory turn over
inventory= cost of goods sold/ average inventories held
-low figure could be due to obsolete inventories
-high figure can indicate an efficient business but selling out can result in customer dissatisfaction.
How to improve inventory turnover ratio?
-sales and marketing
-improve supply chain
-better forecasting
-review pricing strategy
Receivable days
Receivable days= receivables/ revenue x365
-calculated time typically taken by a Buisness to collect the money it’s owed.
-lengthy may cause liquidity problems
Payable days
Payables /cost of sales x365
-time typically taken by a Buisness to pay the money it owes to suppliers and creditors
-delays = problems
-interest charged in delays adds costs +weakens liquidity position
What do liquidity ratios need to be compared to?
-results for the same Buisness over previous years.
-results of ratio analysis for firms in the same industry.
-results of ratios from firms in other industries.
Limitations of financial ratios.
-they use historic data (cannot predict the future)
-they are performance indicators (they don’t explain the causes)
-one-off transactions may distort true performance.
What else needs to be considered in financial ratios?
-the market the Buisness is in
-the position of the firm in the market (small won’t need same results as market leader)
-quality of workforce and management team
-the businesses goals and values (may be environmental)
-the economic environment (recession or boom)
