Financial Statements Ratios Flashcards
Data required
-current or potential investors = ROI and stability and liquidation of their investor
-lenders = concerned with the security of their debt/loan
-creditors = primarily concerned with the security of their debt/repayment of credit
Profitability ratios
Gross profit margin
Operating/net profit margin
Return on capital employed
Gross profit margin
Gross profit/Sales revenue X 100%
-> shows how profitable a business is at producing and selling its products
Changes in ratio
1. Selling price
2. Product mix
3. Purchase mix
4. Production costs
5. Inventory valuations
6. Inventory valuations
7. Costs being allocated to COS
8. Stock write off
9. Expansion costs
10. New product launches
-> high margin = good performance
Operating/net profit margin
PBIT/Sales Revenue X100%
-> shows how effective the business has administered that process
Factors
1. Increased fuel cost
2. Wage + salary increase
3. Bad debts
4. Changes in depn policy
-areas that are subjective to judgement
-align policies before compare companies
Return on capital employed
Operating profit/Capital employed x100%
-> OP or PBIT
-> CE =assets-liabilities or equity+debt
-> how much the business has generate from capital invested. How much profit is generated for every £1 invested
Compare with
1. Prior year ROCE
2. Target ROCE
3. Accounting policy same= entity in same ROCE
-may be high investment for high margin, investors want same return for lower investment
LIQUIDITY + EFFICIENCY RATIOS
Current assets/Current liabilities, x:1
-> enough assets to meet short term liabilities
-> current ratio of 2:1 or higher regarded as appropriate for a business to be credit worthy, 1.5:1 is okay
High ratio could because of
-high stock levels (obsolete)
-high trade receivables (irrecoverable debts)
Factors worth considering
1. Ability to extend the bank overdraft if further finance was required
2. Seasonable nature of the business
3. Nature of inventory (fast or slow moving stock will impact the stock levels)
4. High levels of cash to put to better use
Quick ratio
Current assets - inventory/current liabilities, x:1
-> business ability to settle its liabilities with current resources
-> 1:1 to 0.7:1 is satisfactory
Inventory turnover period
Inventory/COS x 365 days
-> how effectively management uses its inventory to produce and sell goods
Increased days
1. Lack,of demand for product
2. Bulk buying to take advantage of bulk discounts
3. Anticipated increase in orders particularly if business seasonal
Receivables collection period/trade debtor days
Trade receivables/credit sales x 365 days
-> shows how long it takes for the business to collect cash from its credit customers
Compared to
1. Stated credit policy
2. Previous year figures
3. Industry average
High figures can be a bad sign suggesting lack of credit control and potential for bad debts. Distorted by
1.using year end figures which do not represent the average
2.invoice factoring which can result in very low trade recievables
3. Differing credit terms for different customers
Trade payables payment period/trade creditors days
Trade payables/credit purchase x365
-> shows credit period taken by the business from its suppliers
Ratio is compared to previous years
-long credit period is good as represents source of free finance
-could indicate inability to pay suppliers due to liquidity problems
Stretching supplier payment terms can have the following implications
-reputation as slow payer and may not be able to find new suppliers
-existing suppliers may decide not to continue supplying businesses
-could be losing out on worthwhile cash discounts
financial position ratios
Gearing
Interest cover
Gearing
Long term debt/equity
-> gearing is the measure of external debt compared to equity finance. Focus on stability and risk
Long term debt
-non current loans and redeemable pretence shares
Equity
-share capital, share premium, and resources (retained earnings and revaluation resources)
-> 50% is high gearing. Meaning a company is a greater financial risk in times of difficulty (high interest low profits. This makes company more susceptible to bankruptcy
Factors to consider
1. Risk
-external debt is considered riskier due to strict deadlines and failure to pay could lead to insolvency proceedings
-equity finance is less risky (obv above)
2. Finance cost
-cost of equity finance is considered high compared to debt because equity providers expect a greater return than they would get by offering a loan
Business has low gearing if has low debt compared to equity, they are less risky as they have the scope to increase debt if needed. The bank is more likely to lend a low geared business
Interest cover
PBIT/interest payable
-> shows ability of business to pay interest out of profits
-> less than 2 considered unsatisfactory
Low interest cover indicates to shareholders that their dividends are at risk because most profits eaten up with interest payments. May have difficulty financing its debts if its profit falls
What further info needed to conclude business performance
- Competitor info
- Industry norms
- Economic client
- Political climate
- Future plans
- Companies historic date
- Companies accounting policies
