Evaluating Business Performance - Profitability

Question 1

Debt Ratio

Answer 1

a stability indicator that measures the percentage of a firm’s assets that are financed by liabilities (external sources of finance)

Question 2

Return on Owner’s Investment

Answer 2

A profitability indicator that indicates how efficiently a business has used the owner’s capital to earn profit.

Question 3

Return on Assets

Answer 3

A profitability indicator that indicates how effectively a business has used its assets to earn / generate profit.
Assessment of profitability from the manager’s perspective.

Question 4

Profitability

Answer 4

the ability of the business to earn a profit, measured by comparing its profit against a base, such as sales, assets or owner’s equity.

Question 5

Liquidity

Answer 5

the ability of the business to meet its short term debts as they fall due.

Question 6

Stability

Answer 6

the ability of the business to meet its debts and continue operations in the long term.

Question 7

Profit

Answer 7

under accrual basis accounting, revenues earned minus expenses incurred within a Period, expressed in dollar terms.

Question 8

Asset Turnover

Answer 8

An efficiency indicator which measures how productively a business has used its assets in the generation of sales revenue.

• It measures the number of times in the period the value of assets is earned as sales revenue: the faster the ATO, the more capable the firm is of using its assets to earn revenue.

Question 9

Gross Profit Margin

Answer 9

A profitability indicator that measures the average mark-up by calculating the percentage of sales revenue that is retained as gross profit.

Question 10

Net Profit Margin

Answer 10

A profitability indicator that measures expense control by calculating the percentage of sales revenue that is retained as net profit.

Question 11

Strategies to increase gross profit margin

Answer 11

• Increase selling price, but must maintain same sales volume at a minimum
• Reduce cost price of Inventory:
  
  • Negotiate better deal with existing supplier
  • Buy in bulk to take advantage of lower pricing
  • Seek a new supplier
  • Decrease quality of Inventory however this can lead to problems with increased sales returns and complaints

Should always consider the ethical impact of any decisions made.

Question 12

Strategies to increase revenue

Can be used to improve ROA, ATO and NPM

Answer 12

Note: If using for ROA and NPM, Revenue needs to grow faster than expenses

Question 13

Strategies to reduce average total assets

Can improve Asset Turnover and Return on Assets

Answer 13

• If can’t increase sales, reduce assets → particular unproductive / idle / obsolete assets.
• Sell assets, and then lease back

Question 14

Strategies to control expenses

Can be used to improve NPM and ROA

Answer 14

Question 15

Strategies to improve generation of revenue

Answer 15

Question 16

Strategies to improve expense control

Answer 16

Question 17

Non-financial indicators

Answer 17

Non-financial indicators relate to any information that cannot be found in the financial statements, and is not expressed in dollars and cents, or reliant on dollars and cents for its calculation.

Question 18

The firm’s relationship with its customers (non-financial indicators):

Answer 18

• Customer satisfaction
• Number of repeat sales
• Number of sales returns
• Number of customer complaints
• Number of sales enquiries / catalogue requests
• Degree of brand recognition, based on market research

Question 19

The suitability of inventory (non-financial indicators)

Answer 19

• Number of sales returns
• Number of purchase returns
• Number of customer complaints

Question 20

The firm’s relationship with its employees (non-financial indicators)

Answer 20

• Performance appraisals
• Days lost due to sick leave or industrial action
• Staff turnover
• Average length of employment

Question 21

Implications of a high debt ratio

Answer 21

Positive:

• Funds can be used to expand / grow the business
• Funds used to replace old and inefficient assets

Negative:

• Increases risk in the business as external sources of finance must be paid back in line with contractual arrangements negatively impacting on stability.
• Cash required to service debt, taking it away from other areas of the business.
• Makes sourcing additional funds more difficult as financial institutions will not lend if the debt ratio is high.