Analysis and Interpretation Flashcards
Profitability Definition:
Refers to the earning capacity of the business during the accounting period.
What are the profitability ratios?
- Profit
- Gross Profit
- Expense Ratio
- Rate of return on assets
Profit ratio:
Shows the percentage of profit that is contained in each dollar of sales.
Profit/Net sales
What do the profit ratio results indicate?
- The higher the better.
- The ideal is any positive amount, as a negative amount indicates that a loss has been made.
Increasing Trend for profit ratio:
- Selling a greater proportion of high-profit items
- Cost of sales may have decreases
- Expenses may have decreased
Decreasing Trend for profit ratio:
- Selling a higher proportion of low-profit items.
- Cost of sales may have increased
- Expenses may have increased.
Gross profit ratio:
It is a measure of the level of profit available, after subtracting the cost of sales expense, to cover the remaining expenses of a business.
Gross Profit/Net sales
What do the Gross profit results tell us?
- The higher the better
- The ideal is any positive amount, as a negative amount indicates that a gross loss has been made
Increasing trend for gross profit ratio:
- An increase in the inventory’s selling price is higher than any increase in the purchase price.
- Business has purchased inventory at a lower price
Decreasing Trend for gross profit ratio:
- An increase in the purchase price of inventory Is higher than any increase in selling price
- A decrease in the selling price of inventory is possibly caused by a new competitor entering the market, a price war with competitors, or a desire to increase market share by selling inventory at a lower price.
Expense ratio:
Compares the sales to the total operating expenses. From this ratio, the owner of a business can see the extent to which the operating expenses have affected the profit.
Expenses ( Other than COGS)/Net Sales
What do the results of the expense ratio tell us?
- The lower the better.
Increasing Trend in Expense Ratio:
- Expenses have increased
- Net sales have decreased
Decreasing Trend in Expense Ratio:
- Expenses have decreased
- Net sales have increased
Rate of return on Assets:
Ratio shows the overall earning power of total assets before any payments to equity or debt providers.
Profit/Average Assets
What do the results of the rate of return on assets tell us?
- The higher the better
- Ideal is a positive amount, as a negative result indicates that a loss has been made.
Increasing Trend of Rate of return on asset:
- Money invested is being used more efficiently.
- Greater return earned from the same quantity of assets
Decreasing Trend of rate of return on asset:
- Businesses are using assets less efficiently
- Businesses might need to consider reducing the amount invested in assets
How to improve profitability?
- Locating cheaper supplies
- Increasing prices
- Cutting operating costs
Liquidity Definition:
Ratios assist in assessing the business’s ability to meet its financial commitments in the short term.
What are the liquidity ratios?
- Working capital/Current Ratio
- Quick Asset/Acid test ratio
Working capital/Current Ratio
Shows short-term debt-paying ability. It answers the question of whether the business can meet its debts as they fall due in the normal course of business.
Current Assets/Current Liabilities
What do the results for the working capital/current ratio indicate?
- The higher the ratio the better = Strong liquidity
- Ideal level = 2:1, indicates that for every $1 of current liabilities, the business has $2 in current assets to meet that obligation
- If ratio > 2:1 the business may be missing investment opportunities.
Increasing trend for working capital/current ratio:
- Inventory might be sold more slowly
- Debtors may be taking longer to pay
- Idle cash
Decreasing trend for working capital/current ratio:
- Inventory being sold more quickly
- Debtors may be paying more promptly
Quick Asset/Acid test Ratio:
Is a measure of the ability of a business to pay its short-term debts using only its more liquid current assets.
Current Assets (Excluding inventory and prepayments)/Current Liabilities (Excluding bank overdraft)
What do the results for the Quick asset/Acid test ratio tell us?
- Higher the better = Strong liquidity
- The ideal level is 1:1 or more, which means the business can pay its immediate debts
- If the ratio is less than 1:1 then it means that a business cant pay off immediate debts.
Increasing Trend Quick Asset/Acid Test Ratio:
- Debtors short-term investments or cash might have increased
- Creditors have decreased.
Decreasing Trend Quick Asset/Acid Test Ratio:
- Debtors, short-term investments, or cash might have decreased
- Creditors might have increased.
How to improve Liquidity:
- Additional Capital
- Using Credit Terms for debtors
- Increasing collections from debtors
- Using Cheaper supplies.
Gearing/Leverage Definition:
Describes the extent to which a business has funded its operations from borrowed funds rather than equity.
Gearing/Leverage Ratios:
- Debt to Equity Ratio
Debt to equity Ratio:
Measures how the business has funded its assets comparing the total liabilities to the amount of contributed equity.
Total Liabilities/Equity(End)
What do the results for debt to equity tell us?
- The lower it is, the safer - financially
- The ideal result is a ratio below 1:1 as this indicates that the business is less reliant on external financing pressures.
Increasing trend for debt to equity ratio:
- Higher level of borrowed funds
- Liabilities increased
- Interest rate pressures might cause problems for the business.
Decreasing Trend for debt to equity ratio:
- Lower level of borrowed funds
- Equity Increased
- Interest rates are less of concern
How to improve leverage?
- Paying off Debt
- Contributing additional capital
- Cutbacks on inventory purchases
- Delaying a major capital investment
Business analysis report format:
D - Define the type of ratio
R - Results (Compare business results)
U - Use ratio analysis (What do results tell us)
M - Make a recommendation/judgment (Which business is better in this area?)
