Chapter 5 - Calculating Financial Ratios Flashcards
Definition | Financial Ratios
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- means of assessing financial health of business
- ratio relates one figure from financial statements to another figure there
- e.g. operating profit in relation to sales revenue or number of employees
- highlight financial strenghts and weaknesses of businesses (BUT rather starting point - no explanation and no standard method of calculating)
Financial Ratios are usedul for…
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- comparing financial health of different businesses (e.g. different scale of operations)
- elimination of problem of scale by use of ratios
Financial Ratios Classification
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- profitability
- financial gearing
- efficiency
- liquidity
Financial Ratios and Profitability
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- business primary purpose - creating wealth for owner
- indication of success
- normally, profit in relation to other key figures from financial statements
Financial Ratios and Efficiency
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- efficiency of use of particular resources (e.g. inventories or employees)
- aka activity ratios
Financial Ratios and Liquidity
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- vital of survival of business
- sufficicent liquid resources available to meet maturing obligations
- relationship between liquid resources and amounts due for payment in near future
Financial Ratios and Financial gearing
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- relationship between contribution to financing from owners and contribution made by others (loans)
- level of gearing -> level of risk associated wih a business
Financial Ratio and Investment
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- assessment of return and performance of shares in business
- from perspective of shareholders
- involved with business management
Bases that could be used to compare a ratio that you have calculated from the financial statements of your business for a particular period and their problems
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- looking at past-performance (same ratio, but different times | improvement or deterioriation?) - Problem: different trading conditions | operating inefficiencies not exposed
- planned performance (comparison with targets developed) problems: often times not appropiate target, no access to busienss plan for outsiders
- comparing to other businesses (benchmarking, businesses, industries, same period)
To ways of Evaluating the profitability of the business
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- operating profit margin | (operating profit / sales revenue) x 100
- gross profit margin | (gross profit / sales revenue) x 100
Operating Profit Margin
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- inclusion of operating profit, i.e. profit before interest and taxation
- no influence from way in which business is financed
- comparison of one output (operating profit) with another output (sales revenues)
High variation between types of businesses | Operating Profit Margin
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- low operating profit margins for supermarkets: tend to operate on low prices; try to stimulate sales -> increase total amount of operating profit (e.g. Aldi has higher profit margin than rewe and has more cost efficiency)
- high operating profit margins for jewellers: tend to operate on high prices; lower levels of sales volume
Factors Influencing the Operating Profit Margin
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- degree of competition (the higher -> the lower the profit margin because you want to stand out so you lower he price)
- type of customer
- economic climate
- industry characteristics (such as the level of risk)
Gross Profit Margin
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- (gross profit / sales revenue) x 100
- gross profit = sales revenue - cost of sales
- measure of profitability in buying or producing | selling goods or services | before ANY other expenses
What can you deduce from a comparison of the changes in the operating profit and gross profit margin ratios?
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- operating profit margin includes day-to-day expenses (e.g. goes from 10.5 to 2.8: day-to-day spend has exploded! bc of inflation or expansion -> can be both good and bad)
- gross profit margin -> deducting operating expenses -> operating profit margin
