CHAPTERS 18-19 Flashcards
Profitability
The ability of the business to earn profit, as compared against a base, such as Sales, assets or owners equity.
Liquidity
The ability of the business to meet its short-term debts as they fall due.
Efficiency
The ability of the business to manage its assets and liabilities.
Stability
The ability of the business to meet its debts and continue its Operations in the long term.
Analysing
examining the financial reports in detail to identify changes or differences in performance
Interpreting
examining the relationships between the items in the financial reports in order to explain the cause and effect of changes or differences in performance
What does business survival depend on
Business survival depends on having both satisfactory profitability and satisfactory liquidity. A profitable business will still fail if it cannot pay its debts.
Firms ability to earn profit is dependent on
earning revenue and controlling expenses.
Per dollar vs total
A firm with more assets is likely to generate a much larger profit than a firm with much less assets. Comparing these firms on the basis of profit alone will only tell us that one firm had more assets to use. However, if the profit was expressed per dollar of assets, a comparison of the ability of each firm to earn profit if it had the same asset base would be possible, showing which was more profitable.
4 tools for assessing profitability
- trends
- variances
- benchmarks
- profitability indicators.
Trends
the pattern formed by changes in an item over a number of periods
Benchmarks
In terms of profit and profitability, it is impossible to say whether a result is satisfactory without reference to a of some sort. A benchmark is an acceptable standard against which the firm’s actual performance can be assessed.
3 benchmarks
Previous periods
Budgeted performance
Other firms
Previous period benchmark
This allows for the preparation of a horizontal analysis and identification of trends. Using this benchmark enables an assessment of whether profitability has improved or worsened from one period to the next.
Budgeted performance benchmark
Budgeted performance for the current year. This allows for the preparation of a variance report, and enables an assessment of whether profitability was satisfactory or unsatisfactory in terms of meeting the firm goals/expectations.
Other firms benchmark
This is sometimes expressed as an’industry average. It allows the firm performance to be compared against other firms operating under similar conditions. This is sometimes known as an ‘inter-firm comparison.
Profitability indicators
These indicators express an element of profit in re/ation to some other aspect of business performance. As a result, differences in profitability between years and also between businesses can be assessed, as the indicator expresses profitability according to a common base.
5 profitability indicators
ROI ROA ATO NPM GPM
ROI
From an investor’s point of view, the main measure of profitability is rerun on owners investment, which measures the profit (return) earned per dollar of capital invested by the owner. As a result, it indicates how effectively the business has used the owner’s funds to earn profit, which is useful in helping the owner to decide between alternative investments.
ROI formula
Net profit/average capital *100
DR
A stability indicator. The debt ratio measures the percentage of a firm’s assets that are financed by liabilities, and thus indicates the extent to which the business is reliant on liabilities/ debt (rather than owner’s capital) to purchase its assets.
Debt ratio formula
Total liabilities/total assets *100
High debt ratio
Debt ratio and risk
A high Debt Ratio means a greater reliance on borrowed funds (liabilities) to purchase assets and, consequently, a lower reliance on funds contributed by the owner. This will have implications for the firm’s profitability, and its Return on Owner’s Investment. However, the Debt Ratio is also a measure of the firm’s long-term stability, and can be used to evaluate the level of risk.
Asset the debt ratio in isolation?
However, the Debt Ratio cannot be assessed in isolation: it should be assessed in conjunction with the Return on Owner’s Investment.
Discuss a Higher debt ratio
A higher Debt Ratio means the firm is more heavily reliant on borrowed funds than it is on the owners capital, and this is one way of increasing the Return on Owner’s Investment without actually increasing profit. With a higher Debt Ratio, the business is using someone else’s funds to buy the assets to earn profit, but the owner still receives all that profit.
However, a higher Debt Ratio means there is a higher risk that the business will be unable to repay its debts and meet the interest payments. Further, interest rate rises could have a significant impact on profit and cash as the business is carrying so much debt.
Lower debt ratio
On the other hand, a low Debt Ratio means the firm is not very reliant on borrowed funds, and is therefore at relatively low risk of being unable to repay its debts. However, it also means that most of the finance used to purchase assets has come from the funds of the owner, and as the owner has had to contribute more personal funds, a lower Return on Owner’s Investment will ensue.
Ideal debt ratio
The owner must judge carefully so that the Debt Ratio is high enough to maximise the Return on Owner’s Investment, but not too high that it will create difficulties for the business in relation to its debt burden.
ROA
Whereas Return on Owner’s Investment assesses profitability from an investor’s point of view, assesses profitability from a manager’s point of view. Specifically, it measures Net Profit per dollar of assets controlled by the business. As a result, it indicates how effectively the firm has used its assets to earn profit.
ROA formula
Net profit/average total assets *100
ROI AND ROA
As many small business owners are both investors and managers, they will need to look at both the Return on Owner’s Investment and the Return on Assets when assessing profitability. One thing they will notice is that the Return on Owner’s Investment will always be higher than the Return on Assets. This is because owner’s equity will always be lower (or the same) than total assets
Cnages in roa if assets change
If assets increase, and Net Profit increases
by a smaller proportion, then the Return on Assets will fall, indicating deteriorating profitability. On the other hand, if Net Profit increases by more than assets, the Return on Assets will rise, indicating improved profitability.
Changes to roa if assets don’t change
Therefore, assuming assets do not change, an improvement in the Return on Assets may be the result of an improved ability to earn revenue or better expense control, or both. A deterioration in the Return on Assets would, of course, be caused by the opposite. Either way, the Return on Assets will depend heavily on the firm’s ability to earn revenue and control its expenses,
AT
Asset Turnover indicates how efficiently the firm has used it assets to generate revenue. As earning revenue is key to earning profit therefore, AT will have a significant effect on profitability. This indicator measures the number of times in a period the value of assets is earned as Sales revenue: the higher the Asset Turnover, the more capable the firm is of using its assets to earn revenue.
At formula
Sales/average total assets
AT AND ROA
The similarity between AT and the ROA reflects the fact that they both assess the firm’s ability to use its assets; the only difference being that ROA relates to profit, whereas AT relates only to revenue. Theoretically, an increase in AT (meaning an increased ability to earn Sales revenue) should mean an increase in the ROA, and increased Net Profit. However, this is not always the case.
Expense control
The firm’s ability to manage its expenses so that they either decrease or in the case of variable expenses increase no faster than Sales revenue. 2 indicators used to evaluate expense control are NPM and GPM.
NPM
The net profit margin measures the percentage of Sales revenue that is retained as Net Profit. Put another way it measures how much of each dollar of Sales revenue remains as Net Profit after expenses are deducted. As a result it is a good indicator of expense control.
NPM formula
Net profit/sales revenue*100
NPM, AT AND ROA
The ability of a firm to use its assets to earn profit depends on its ability both to earn revenue and to control its expenses. AT measures the ability of the firm to use its assets to earn revenue. NPM measures the ability of the firm to control its expenses and retain Sales revenue as Net Profit. Thus ROA depends on both the Asset Turnover and the Net Profit Margin.
What does roa and profitability depend on
Return on Assets, and therefore profitability depends on the ability of the firm to use its assets to earn revenue (as measured by Asset Turnover) and to control its expenses (as measured by the Net Profit Margin).
GPM
Gross profit margin measures the percentage of Sales revenue that is retained as Gross Profit. Gross Profit is the difference between Sales revenue and Cost of Goods Sold and is used to assess the adequacy of the firm’s mark-up: the difference between the selling price and the cost price of its stock. The GPM can be used to assess the average mark-up on all goods sold during a particular period.
4 limitations of financial indicators
. the reports use HISTORICAL DATA - they do not guarantee what will happen in the future
. many indicators rely on AVERAGES, and this may conceal details about individual items
. firms use different accounting methods, which can undermine the COMPARABILITY of the reports, and profitability indicators
. the reports contain LIMITED INFORMATION: there are many items of information simply not reported in an Income Statement.
Non financial information
Any information that is not expressed in dollars and cents, or reliant on dollars and cents for its calculation. It refers to information that cannot be found in the financial statements. The types of non-financial information that could be useful to the owner of a small business are impossible to quantify, but in assessing the firm’s performance, the owner may want this information.
Firms relationship with customers
Given the difficulties they face in attracting customers, it is vital that small businesses retain those customers they already have. It is therefore essential to have feedback from current customers on their degree of satisfaction (or dissatisfaction) with current products and services offered by the firm.
4 measures used for customer satisfaction
Surveys
Number of repeat sales
Number of complaints
Number of sales returns
Suitability of stock
Must be assessed to ensure that they are meeting the demands of consumers. level of Sales gives little feedback on whether customers were satisfied with stock. The number of sales returns will provide a guide to the suitability of stock, with the firm keeping detailed records on the reasons for those returns. Number of purchase returns and complaints will provide a guide as to the quality of stock.
Firms relationship with employees
Staff may be responsible for tasks, such as generating Sales or managing stock, so appraising their performance is an important part of assessing performance. This could be done by structured performance appraisals. The degree of employee satisfaction could be assessed by the number of days on sick leave/industrial action, or the staff turnover/ average length of employment.
State of the economy
Even the most profitable business will struggle to survive in a shrinking economy. The owner may wish to consider interest rates, the unemployment rate, and the number of competitors it faces, all of which will affect the firm’s ability to generate Sales. The level of inflation will also be relevant when assessing the firm’s ability to control its expenses.
Strategies to improve revenue earning ability
Selling price Advertising Stock mix NCAs Customer service
Selling price strategy
Selling prices could be decreased to generate more Sales volume, or increased to generate greater revenue per sale.
Advertising strategy
Advertising could be increased, or targeted more accurately at prospective customers.
Stock mix strategy
Stock held for sale could be changed so that only those products that are in demand are kept on hand: slow-moving lines should be removed, and replaced with those that sell.
NCAs strategy
Non-current assets could be increased, or replaced by more efficient versions, to enable the firm to increase Sales (or lower operating and maintenance expenses). This may be better equipment, display fittings, delivery vehicles or, in extreme cases, a new location.
Customer service strategy
Internal procedures (such as paperwork) could be made more customer friendly; staff training could improve employees service/product know- ledge; extra services (such as deliveries, wrapping, Internet/phone access and product advice) could be offered.
3 expense control strategies
Stock
Staff
NCAs
Stock expense strategy
An alternative supplier may be able to provide cheaper and/
or better quality stock, while different ordering procedures could reduce storage costs and Stock Losses, or generate price discounts.
Staff expense strategy
Different rostering systems, appropriate incentives and extra training may improve staff productivity and performance.
NCAs expense strategy
Assets that are inefficient, under-.utilised or unReliable are ultimately expensive, and should be replaced or removed.
3 liquidity indicators
WCR
QAR
CFC
3 efficiency indicators
STO
CTO
DTO
WCR
Working capital ratio assesses liquidity by comparing current assets and current liabilities. Specifically, the Working Capital Ratio measures how many dollars of current assets are available to meet each dollar of current liabilities. As a result, it indicates whether the business will be able to meet its short-term debts (its current liabilities) using cash generated from its current assets.
WCR formula
Current assets/current liabilities
Satisfactory WCR
satisfactory liquidity exists if the Working Capital Ratio is at /east 1:1, as this would indicate that there is at least $1 of current assets available to meet every $1 of current liabilities, and the firm would be able to meet all its short-term debts as they fall due.
Unsatisfactory WCR
A Working Capital Ratio of less than 1:1 indicates unsatisfactory liquidity; the business may not be able to meet its debts as they fall due as it has insufficient current assets to meet its current liabilities. If the situation is not addressed, and creditors and others are unable to be paid, the business may be forced into liquidation, with its assets sold to raise funds to pay off its debt.
Strategies to improve WCR
- make a cash capital contribution
- seek additional finance by entering into, or extending, an overdraft facility
- take out a loan to purchase non-current assets. In the long term, borrowing may worsen the cash situation, as the servicing of the debt would require cash to repay both the principal and interest. However, in the short term, the survival of the business may depend on the extra finance provided by a loan.
Excessive WCR
Although it is beneficial for the WCR to be above 1:1, a business owner should also be wary of having a WCR that is too high, as this may indicate that the business has excess current assets that are idle, and not being employed effectively. Excess cash should be invested. High stock increased storage and stock write down. Higher debtors could mean ageing debtors who are unlikely to pay.
Problems with WCR
Underlying the use of the WCR to assess the level of liquidity is the assumption that all current assets can be liquidated immediately if cash is needed to meet short-term debts. However, there are some practical difficulties with this assumption. Stock and prepaid expenses cannot be quickly converted into cash. Additionally a bank overdraft is unlikely to quickly require repayment.
How to overcome WCR problems
In order to overcome these deficiencies, the quick asset ratio can be used as an alternative indicator of the level of liquidity. It assesses the firm ability to meet its immediate debts using its immediate assets.
QAR formula
Current assets (excluding Stock and Prepaid Expenses)/Current liabilities (excluding Bank Overdraft).
Limitations of WCR AND QAR
One of the key problems with using both the Working Capital Ratio and the Quick Asset Ratio is that they rely on static items to measure future cash flows. That is, the information used in both ratios comes from the Balance Sheet, so it provides no real
indication of the cash flows of the business.
Overcoming limitations of WCR and QAR
The cash flow cover assesses liquidity by identifying the cash that the business generates from its Operating activities to meet its financial obligations. It measures the number of times avg current liabilities can be met using Cash Flows from Operations. If a business cannot generate sufficient cash from operations, regular capital contributions/external finance will be required.
CFC formula
Net Cash Flows from Operations/Average Current Liabilities
Speed of liquidity
Business can survive in spite of bad liquidity, if the speed of its trading cycle is fast enough. If a business can sell its stock and collect the cash before its required, it will be able to survive even with a low WCR. Businesses such as this may never have a high level of cash but can survive because their turnover is so fast. Assessment of liquidity must also consider the speed of the firms turnovers.
Does efficiency effect liquidity
In common with Asset Turnover (from Chapter 18), these indicators actually assess ef:i:iciency: the ability of the firm to manage its stock, debtors and creditors. However, because they have a direct and significant effect on cash flows (namely, Cash Sales, Receipts from Debtors and Payments to Creditors), they also have a significant effect on liquidity.
STO
As the main source of revenue, stock is also the main source of cash inflows. But before cash can be collected from cash sales or debtors, the stock must first be sold. Stock turnover assesses how effectively the firm has managed its stock holdings, by calculating the average number of days taken to convert stock into sales.
STO formula
Average stock*365/cost of goods sold
Fast STO
Fast Stock Turnover, as measured by low days, means that, on average, stock is sold quickly. This will enhance the firm’s ability to generate cash from the sale of stock, and assist its liquidity.
Stock turnover too slow
If Stock Turnover is too slow, the firm will be less able to generate sales and, therefore, less able to generate cash inflows (from Cash Sales and Receipts from Debtors) in time to meet debts as they fall due. This could be caused by a decrease in the level of sales or an increase in the level of stock on hand (due to ordering more stock than is required).
Strategies to speed up stock turnover
- employ strategies to increase sales, such as advertising, changing selling prices or changing the stock mix (see Chapter 18 for strategies to increase sales)
- decrease the level of stock on hand by ordering less, ordering smaller amounts more frequently (just-in-time ordering) or replacing slow-moving stock lines.
Stock turnover too fast
Stock Turnover can be too fast. Although the business would be generating high sales, it may be because the selling price is too low, and this would be a loss of potential revenue, and profit. It may also be because the firm is holding too little stock. If this is the case, delivery costs may be higher (frequent deliveries) and the business could lose the possibility of earning discounts for bulk buying.
There are certain strategies a business owner can employ to ensure that stock is managed wisely to maximise the potential for sales. 6
Review sales Complimentary goods Up to date stock Rotate stock Appropriate stock level Strong marketing
Review sales to maintain an appropriate stock mix
What is ‘appropriate’ may change from season to season or as tastes and preferences change so the owner must pay close attention to which stock is selling. Stock lines that are selling well should be expanded while those that are not should be reduced or even discontinued.
Promote the sale of complementary goods
Complementary goods are add-on sales that are generated to support the original item sold. As part of its assessment of its stock mix the business should consider what ‘extra sales’ it can generate from stock that is related in some way. For example a business selling tents may also sell sleeping bags inflatable mattresses and gas lights to encourage more sales.
Ensure stock is up to date
Sales of some stock lines will be heavily affected by changes in fashion or technology. In order to maintain sales stock of these items must be the most current version available: older and out-of-date versions should be discounted for quick sale.
Rotate stock
The positioning of stock in the store can have a significant impact on whether it sells or simply sits on the shelf. Particularly for perishable items older products should be moved to the front so they are taken first: this will minimise stock loss or write-down issues. At other times moving an entire stock line to another location within the store may boost its sales.
Determine an appropriate level of stock on hand
Stock levels should be sufficient to meet demand but not so high that additional storage costs or stock write-down issues (such as damage or technical obsolescence) ensue. Setting a target level for stock also assists in identifying when to reorder.
Strong marketing
Strategies like advertising will hopefullylead to increased sales and faster Stock Turnover for alI lines of stock or for a particular line (which may then attract customers and entice them to buy other items too).
DTO
Debtors turnover is a factor influencing a firm’s ability to generate cash to meet its short-term debts. It assesses how effectively the firm has managed its debtors, by calculating the average number of days it takes a firm to collect cash from its debtors. Fast DTO means it takes (on average) a few days to collect cash; if cash is collected quickly, it can then be used to meet other debts.
DTO formula
Average debtors*365/credit sales
Assessing DTO
Debtors Turnover can be assessed against a previous per!od to identify increases or decreases, but it is the credit terms of:fered to customers (and perhaps the budgeted Debtors Turnover) that should be used to determine whether Debtors Turnover is satisfactory.
Problems with slow DTO
If Debtors Turnover is too slow (that is, greater than the credit terms offered to customers), the firm will have to wait too long for cash from debtors and thus will be less able to meet its short-term debts as they fall due.
6 strategies to improve DTO
Discounts Prompt invoicing Credit checks Reminders Threats Debt collector
Discounts
Offering settlement discounts can encourage debtors to pay well within the credit terms. (Discounts should not be offered on overdue clebts!)
Prompt invoicing
Invoices should be sent with the goods so that the customer is immediately aware of the amount owing and the repayment date. Until the invoice is received, the debtor will not begin to even think about paying.
Credit checks
Only offering credit to customers who have a proven record will increase the chances that cash will be received on time.
Reminders
Notices should be sent immediately to remind debtors that their payment is overdue progressing from friendly reminders to threatening legal action. Reminders may take the form of a copy of the invoice, or a statement of account that has the outstanding amount clearly shown as overdue.
Threats
The threat of court action can sometimes prompt payment, but legal action can be a long and costly process. (It also signals the end of the relationship with the debtor, but perhaps debtors who pay this late are undeserving of further Credit Sales!) Debtors who have not paid their current debts should be refused further credit until the amount outstanding is received
Debt collectors
Debt collection agencies can employ practices ranging from annoying a late payer by persistent telephone contact to embarrassment at their place of work.
CTO
Creditors Turnover (CTO) measures the average number of days taken to pay creditors, indicating the effectiveness of the firm in managing its creditors.
STO DTO and CTO
Ability to pay creditors will rely on ability to generate cash from stock. Therefore CTO relies on STO and, if the business deals mainly on credit, DTO. The days between purchase and sale of stock,are measured by the STO; the days between the sale of stock and receipt from the debtor are measured by the DTO; and the days between the purchase of the stock and the payment to the creditor are measured by the CTO.
Assessing CTO
If discounts are offered, and the cash is available, then paying early may be beneficial. However, if discounts are not available there is no incentive to pay early, Creditors,Turnover should be as close as possible to the credit terms. This will mean the business retains cash longer, and can use it to meet other payments as they fall due.
Dangers of high CTO
EXCEEDING TERMS
Interest charges (late fees)
Removal of credit facilities
Reduction in credit rating
Optimal STO DTO AND CTO
In most cases, a firm will want its cash inflow (from STO and DTO) to be as fast as possible, whereas it will want to pay its creditors as slowly as possible. The best circumstance for a trading business is to sell stock for cash and to buy stock on credit. This approach provides time for the business to sell its stock, collect the cash and repay its creditors.
Explain the implications for Aime traders of having a debt ratio that is significantly higher than the industry average.
A significantly higher Debt Ratio can have a number of implications for a business. Higher debt will usually mean higher loan repayments, which may put additional pressure on the liquidity of the business and create cash management issues. If the business is running low on cash this may also have an adverse effect on the relationships with other suppliers. Bills may not be met on time and this could threaten future credit facilities being available and may in fact threaten supply from some creditors. Also, with higher debt levels the interest expense incurred by a business may also increase. The implication of this is a negative impact on the profit earned by the business. These implications should be weighed up against the benefits of having a higher ROI through using borrowed funds to fund the assets required by the business.
What can changes to ROI involve when net profit margin decreases
Contributions and drawings
