Chapter 1: The accounting Function - Ratio explanations (Task 1) Flashcards
Financial performance indicators
There are lots of financial performance indicators that we can use to appraise the performance of a business.
These are sometimes referred to as “ratios”
Ratio analysis is a very important part of how to understand how well a business is doing
These can be set as targets to help manage the performance of the business through decisions made by management
Gross profit margin
Explanation
How is it expressed?
Difference year on year?
Changes in GP margin?
Reasons for falling margins?
An ideal gross profit margin?
This expresses, as a percentage, the gross profit in relation to revenue.
The gross profit percentage should be similar from year to year for the same company.
A significant change from one year to the next, particularly a fall in the percentage, needs to be investigated, focusing mainly on the buying and selling price.
A falling margin may be due to increasing costs or reduced selling prices
Gross profit, both as an amount and a percentage, needs to be enough to cover the overheads of the company and give an acceptable return on investment.
Operating profit margin
Explanation
What is operating profit?
Difference year on year?
Changes in OP Margin?
Diff between GP margin and OP margin?
This uses the profit before finance costs and tax (sometimes referred to as the net profit)
This percentage should be similar from year to year for the same company.
It should, ideally, increase from year to year which indicates that the overhead costs are being kept under control.
Any significant fall should be investigated to see if it has been caused by a fall in gross profit percentage or an increase in one particular expense.
Differences between the gross profit margin and the net profit margin allows us to establish whether changes in profitability are due to changes in cost of sales or caused by other operating costs.
Return on capital employed ROCE
How is it expressed?
What does it measure?
What does it indicate?
The only ratio to do what?
what is the % return best thought of?
This expresses the profit of a company in relation to the capital employed (investment).
It measures how much profit is generated for every £ of assets employed
It indicates how efficiently the company uses its assets to generate profit
This is the only ratio which compares profits to the overall size of the business
It is sometimes viewed as the most important ratio for analysing company performance
The percentage return is best thought of in relation to other investments. For example, a bank may offer a return of 5%.
A person setting up a company is investing a sum of money in that company and the profit is their return on that investment.
Current Ratio
What figures are used?
Acceptable ratio?
What is important to a business that is highlighted by the current ratio?
Ratio of less than 1:1?
Too high current ratio?
The current ratio uses figures from the statement of financial position and looks at the relationship between current assets and current liabilities.
Although there is no ideal current ratio, an acceptable ratio is about 2:1. This means that there are twice as many current assets than current liabilities.
It is important the company can cover its debts at any time.
A ratio of less than 1:1 means we will have difficulty paying our creditors when they demand payment.
A current ratio can also be too high. A ratio of 3:1 might indicate that the company has too many inventories, too many trade receivables or too few trade payables.
Quick ratio or acid test ratio
Indication of what?
What figures are used?
Why is inventory removed?
Ideal ratio and what it means?
Figure below 1:1?
This gives a clear indication of the health of a company’s finance.
It uses the current assets and current liabilities from the statement of financial position, but removes the inventories.
This is because the inventories are the lease liquid current asset. They have to be sold, turned into trade receivables, and then the cash has to be collected.
Therefore, the acid test ratio provides a direct comparison between trade receivables / cash and short term liabilities.
The balance between these should ideally be 1:1. At this ratio, a company is expected to be able to pay its current liabilities from its current assets (less inventories).
A figure below 1:1 would indicate that the company may have difficulty in paying its current liabilities.
Average receivables collection period (Debtor days)
What does it show?
What should it be compared to?
Ideal situation?
This shows how many days trade receivables take to pay for goods sold to them by the company.
The collection time should be compared to that of the previous year.
This comparison is a measure of the company’s efficiency at collecting money.
Ideally, year on year, the company is looking to reduce the time receivables take to pay them.
Ideally, trade receivables days should be shorter than trade payables days.
This would indicate the money is being received from trade receivables before it is paid out to trade payables.
If we make more sales to larger customers, this ratio may increase as these larger customers may be able to negotiate longer credit terms
If we make mainly cash sales (supermarket), we will have a very low or even zero receivables days
Trade payables payment days (Creditor days)
What does it measure?
It can’t be used by what type of companies?
Ideal situation?
This measures how quickly it takes to make a payment to trade payables.
The ratio is most appropriate for companies that buy and sell goods.
It can’t be used for companies that sell a service.
Ideally, trade payables payment days will be greater than trade receivables payment days.
Also, the figure for trade payable payment days should be similar year on year.
This would indicate a stable company.
Inventory holding period (stock days)
What is it?
Companies improving in efficiency?
This is the number of days’ inventories held on average.
It can only be calculated for companies that sell goods, not provide a service.
The figure will depend on the type of goods sold by the company.
For example, a market trader selling fresh flowers who finishes every day when sold out, will have an inventory holding period of one day.
Alternatively, a jewellery shop will have a much longer inventory holding period.
It is important to keep its inventory holding period as short as possible.
A company which is improving in efficiency will have a shorter inventory holding period compared to the previous year.
Gearing
What does it measure?
What does high gearing mean? 2 things
This measures the percentage of debt to total financing.
In other words, how much of the company is supported by borrowing.
High gearing means there is less profit available to distribute to shareholders because the profit will be eaten up by interest charges on borrowings.
High gearing also means lenders are less likely to lend the company more money.
A high gearing figure is bad.
