anaysing financial performance Flashcards
sources of information for financial performance
past financial performance
industry benchmarks
economic environment
published accounts
profitability ratios
measure the amount of profit made by a firm in relation to the capital that has been invested
a low value could harm confidence of management and result in falling share value- vulnerable to takeover
return on capital employed ( ROCE)
measures how effectively the capital invested in the business is being used to create profits
formula
net profit before tax/ shareholders fund+ long term liabilities. OR capital employed X100
how to improve ROCE
- improve operating profit e.g. cheaper suppliers, advertisment, expand to new markets, introduce new products , cut unncessiary expenses, negotiate better supplier deals, impliment automation, train employees- \increase productivity
-reduce capital employed, e.g. may back long term liabilities such as bank loan , sell or lease underperforming assets, reduce inventory levels, speed up reciveables collections, extend supplier payments, reduce need for capital investment- outsource instead
redinance loans at lower IR , reduce excessive borrrowing
offer better customer service, unique benefits, steong branding and innovation- charge premium prices
reduce shareholders fund/; equity
why is ROCE useful
evaluate overall perfomenace -ROCE indicates how well a company generates profit from its total capital (both equity and debt).
A higher ROCE means the company is using its resources effectively to generate returns.
provide benchmark/tarhet for projects
benchmark performance with competitors especially in capital-intensive industries like manufacturing.
-It provides a better comparison than just net profit, as it considers the capital used to achieve those profits.
if higher than IR investors happy receiving higher return than in bank
A declining ROCE may signal that a company is becoming inefficient, investing in low-return projects, or misusing capital.
Companies can use ROCE to improve operational efficiency by reducing costs or reallocating capital.
reasons for low ROCE
Low Operating Profit
Declining Sales Revenue – Weak demand, poor marketing, or strong competition can reduce sales and, in turn, profits.
High Operating Costs – Rising expenses
Inefficient Pricing Strategy
Poor Productivity
High Capital Employed
Too Many Fixed Assets isn’t generating enough returns
High Inventory Levels – Excess stock ties up capital and increases storage costs, reducing efficiency.
Inefficient Working Capital Management – If a company takes too long to collect payments pays suppliers too quickly
- External Factors
Economic Downturns –
High Competition – Intense competition can force a company to reduce prices and accept lower profit margins. - High Debt Levels
Expensive Borrowing – High interest payments on loans can reduce net profits, impacting ROCE.
Overexpansion with Borrowed Capital – If a company funds growth through excessive borrowing without generating enough profit, ROCE declines.
advertising campaign not kicked in yet to see rising sales
GPM and NPM expand
The Gross Profit Margin (GPM) is an indicator of how efficient the business is at making and selling its product.
The Net Profit Margin (NPM) is a measure of how efficient the business is overall, and how well it manages its expenses
what is liquidity
ability of a business to pay back its short term debts and the availability of working capital
why is liquidity important
important to have a good level of liquidity if unable to pay creditors or suppliers may not be able to trade stop raw materials , stop allowing borrowing
therefore businesses must have sufficient levels of assets to cover their liabilities, liquid assets that can be easily turned into cash - cash, bank account balences,debtors- customers,
inventories and stock, machinery, highly illiquid as can become obsolete or perished( removed from acid test ratio)
why is liquidity important
must be analysed in context to be meaningful and can’t be used singly as can have good liquidity but not be profitable
current ratio
measure of the size of a firms current assets compared to Current liabilities
ideally 1.5-2 times more current assets than current liabilities
must put figure into context : compare to previous years, competitors, industry average
ratio above 2:1 = bad, not reinvesting, not using assets efficiently
formula current ratio
current assets/ current liabilities :1
reasons for high current assets
- too much cash kept in bank, only earn low interest may be better reinvested
-a firm allows debtors more time to reapy- risky as may not repay
- stock levels rise perhaps recession and decrease in demand high cost for storage and security may perish or become obsolete
acid ratio
exudes stock from current ratio as a way of measuring firms ability to meet short term demands for cash more reliably- stock highly illiquid as it can perish/ go obsolete
ideal= 1:1
depends on company
supermarket stock highly liquid our into cash quickly/ easily-low acid ratio- low acid ratio can mean The company may struggle to cover its short-term liabilities (e.g., supplier payments, wages, short-term loans) without selling inventory.
high ratio- The company has sufficient cash, receivables, and short-term investments to pay off its immediate debts without relying on inventory sales.
This reduces the risk of financial distress or insolvency.
If the ratio is too high (e.g., 3 or more), it could indicate that the company is holding too much cash instead of investing in growth opportunities.
what is gearing
measure of a firms total capital that has been financed through long term borrowing
if highly geared means they have barred heavily making them vulnerable to changes in the interest rate repay more back
low geared less than 30%
av gearing 30-50%
high gearing more than 50%
low geared, much of capital from shareholders- equity finance
although shareholders may want to take control of how businesses is managed
formula
long term liabilities / capital employed X100
capital employed= long term liabilities + shareholders fund ( equity gearing ratio calculates the proportion of capital employed that is financed by long term liabilities
high gearing
high gearing may to be an issue if they are able to repay their debts
if have low gearing may risk missing out on opportunities for future expansion and profits
reasons for debt finance
low interest rates
quicker to get bank loan especially if need to quick respond to opportunities/ threats
already have low gearing
don’t want to loose control
what is a budget
financial plan for the future
reasons for favourable / adverse sales variances
favourable
- sucessful marketing
- demise of competitors
-effective bonus scheme salesman
adverse
- success competitor
ineffective advertising campaign
- logistics issue stock didn’t arrive on time
reasons fir favourable/ adverse cost variances
-improved profuctivity of labour
-reduced cost imported goods strengthening £
- reduced supplier costs raw materials
adverse- strikes, bad weather farmers crops, unexpected rise price suppliers
advantages and disadvantages variance analysis
Advantages of using budgets:
* Improved financial control. Part of the budgeting process is the monitoring of expenditure and revenues. Any variances need to be explained and reacted to; for example sales revenue is adverse therefore strategies can be introduced to increase sales. (credit any other use of figures) * Budgeting ensures, or should ensure, that limited resources are used effectively. The budgeting process allocates resources to where they are most likely to help achieve the restaurants objectives. * Budgeting can motivate managers. When managers at all levels are involved in the budgeting process they will have a commitment to ensuring that budgets are met. * Budgeting can improve communication systems within the organisation. The budgeting process itself will involve communication both up and down the hierarchy. This will help to establish formal methods of communication, which can be used for purposes other than setting and administering budgets. Used by investors to assess potential investment/return on investment. Disadvantages of using budgets: * The restaurant manager is excluded from the budgeting process therefore s/he may not be committed to the budgets and may feel demotivated. This could be the reason why the sales revenue variance is adverse. * The budget may be inflexible, therefore the restaurant manager may not be able to react to changes in the market or other conditions may not be met by appropriate changes in the budget. For example, new competitors have entered the market and the marketing budget may not allow for a response to this. Therefore, sales are likely to be lost. * An effective budget can only be based on good quality information.
