Indicators Flashcards
Return in owners investment (ROI)
Profitability indicator
Net profit/ average capital x 100
Measures how effectively a business used the owners capital to earn profit.
Profit earned per dollar of capital invested by the owner.
—> profit decreased yet the ROI increases —> means average capital decreased—> this may mean the business is more reliant on debt, (risky) but from the point of view of the owner it results in improved profitability.
What does it mean if profit decreased but ROI increases?
—> profit decreased yet the ROI increases —> means average capital decreased—> this may mean the business is more reliant on debt, (risky) but from the point of view of the owner it results in improved profitability.
Debt ratio
Profitability
Stability indicator that Measures the percentage of a firms asset that are financed by liabilities
Total liabilities/ total assets x 100
- high debt ratio means greater reliance on borrowed funds than the owners capital, thus a lower reliance on funds contributed by the owner.
- a way to increase the ROI without actually increasing profit.
- higher debt ratio means higher risk that business will be unable to repay debts and meet interest payments. Interest effects profit and cash of business.
- the owner must judge carefully so that the debt ratio is high enough to maximise the return on owners investment, but not too high that it will create difficulties in relation to its debt burden.
Return on assets (ROA)
Net profit/ average total assets x100
A profitability indicator that measures how effectively a business has used its assets to earn profit
Assessed from the managers point of view. Specifically measures net profit per dollar of assets.
If assets increase, and net profit increases by smaller proportion then the return on assets will fall, indicating deteriorating profitability.
If net profit increases by more than assets,the ROA will rise ,indicating improved profitability.
-net profit figure is reliant on business’ ability t earn revenue and control expenses. THEREFORE the return on assets is depends heavily on firms ability to earn revenue and control expenses —> ASSUMING assets do not change.
ATO asset turnover
Sales/average total assets
- number of times in a period the value of assets is earned as sales revenue
- efficiency indicator that measures how productively a business has used its assets to earn revenue.
- asset turnover only relates to sales revenue, ROA related to net profit
What does it mean if ATO increases?
This confirms that the business has earned more revenue not only because it has more assets but because it has used those assets more productively.
- 2016
ATO. 1.2times. 1.35 times
ROA. 15%. 14%
The Asset turnover shows the business is more productive in terms of using its assets to earn revenue in 2016, however profitability (return on assets) has actually fallen. The difference between ATO and ROA is between sales revenue and net profit. THEREFORE when asset turnover and return on assets moves in different degrees, it indicates a change in expense control. In this example ATO has increased, and return on assets decreased which means worse expense control. (BECAUSE net profit depends on revenue earning ability and expense control, but increase in ATO shows revenue earning ability has improved as it increases from 1.2times to 1.35times so the only answer for a decreasing profit in (ROA) is the poor expense control.
If ROA increased and ATO decreased it may indicate the opposite, decreased ability to earn revenue.
NPM net profit margin
Net profit/ sales revenue x 100
A profitability indicator that measures the expense control by calculating the percentage of sales revenue that is retained as net profit.
How much of sales revenue remains as net profit after expenses are deducted.
💙Good indicator of expense control.
ATO x NPM = RETURN ON ASSETS (ROA)
GPM (Gross profit margin)
Gross profit/ sales revenue x 100
A profitability indicator that measures the average mark-up by calculating the percentage of sales revenue that is retained as gross profit.
Gross profit is difference between sales revenue and cost of goods sold—> THEREFORE assessed adequacy of the firm’s markup.
what does high GPM mean?
And how do we increase GPM?
Means higher average mark-up
- the could occur if selling prices increase and cost price is same
- cost price decreased, selling price same
- both increased but selling price more
- both decreased but cost price more
—>increasing selling price carries risk of lowering demand, to avoid risk find cheaper supplier, but it carries risk of its own, quality of stock is reduced. This could decrease sales or increase in sales return or stock loss(through damage)
Strategies to improve profitability:earning revenue
- selling price increase or decrease
- advertising
- stock mix. Adjust, slowing moving lines should be removed and replaced with those that sell
- non-current assets increased, or replaced by more efficient one
- customer service. Staff training, extra services
Strategies to improved profitability : expense control
- management of stock. Find cheaper supplier or better quality stock
- management of staff: different rostering systems
- management of NCAs, inefficient asses replaced or removed
Liquidity
The ability of a business to meet its short term debts as they fall due
WCR working capital ratio
A liquidity indicator that measures the ratio of current assets to non current liabilities to assets the firms ability to meet its short term debts
CA : CL
How many dollars of current assets are available to meet each dollar of current liabilities.
Less than 1:1 is bad
Much greater than 1:1 is bad
If WCR is less than 1:1 what does it mean and how to improve??
The business is not able to meet its debts as they fall due as it has insufficient current assets to meet current liabilities. Arising liquidity problems.
- make a capital contribution
- seek additional finance by entering into, or extending and overdraft facility
- take out loan to purchase non-current assets
Long term, borrowing may worsen, but in short term the survival of the business may depend on borrowed funds
What if WCR is much greater than 1:1
Although it’s beneficial to be above 1:1, owner should be wary of having a WCR that is too high as this may indicate business has excess CA that are idle and not being employed effectively
- Bank: bank earns very small interest. Thus there is little to gain from keeping more cash in the bank than is necessary to meet obligations
- stock control: large amounts of stock could incur additional storage costs, increase possibility of stock loss, damage—>lead to write down
- debtors control. Large debtors figure indicates high chance of bad debts
Debtors turnover
Average debtors/ credit sales x 365
Measures how quickly the business is collecting its debts
Debtors turnover of 35 days would mean that it takes the business an average of 35 days to collect amounts owing from its debtors
Lower DTO means improved efficiency and will help improve liquidity as cash is collected more quicky —>simplest benchmark is compare DTO to credit terms
How do u improve debtors turnover
Enforce terms more strictly— regular statements of account, reminders, prompt invoicing
Reduce terms on offer
Identify and target slow paying debtors
Offer discount—> unless they already offer discount/ then increase discount
Stock turnover
Average stock/ cost of goods sold x365
Measures how quickly the business is selling its stock
Lower days of STO indicates improved effiency and will help improve liquidity as selling stock is the first step to converting it to cash- if credit sales are significant the flow of cash wil then depend on debtors turnover
How to improve stock turnover?
Identify slow moving lines of stock and adjust.
Creditors turnover
Average creditors/ credit purchases x100
Measures how quickly the business is paying its creditors
If CTO is significantly over the terms offered — may help liquidity as we hold cash but this may cause problems with creditors (relationship may worsen)
If CTO is significantly under the terms offered- this may mean the business is benefiting from discounts for early payment but this may cause liquidity problems as cash is leaving the business earlier than it needs to and cash may not be available for other needs
Explain the different between profit and profitability
Profit is simply defined under accrual accounting as revenue is earned, less expenses incurred and is expressed as dollars amount.
Profitability however can be measured by a comparison of this profit figure against an investment base such as owners investment or total assets, and can therefore be used to examine how well a business has used its investment in assets
ROA. increased
ATO. Decreased
Return on assets has increased when the net profit margin has increased at a greater proportion than the decrease in asset turnover. This may have been achieved through better expense control or a better profit margin, which would lead to an increase in net profit margin.
Stability
The ability of the business to meet its debts and continue operations in the long term
how to improve WCR?
Improve cash flow from operating- linked to profitability advice, turnovers
Reduce drawings
Debt ratio -LOOKS AT STABILITY
Total liabilities: total assets x100
Indicates the extent to which the business is reliant on liabilities/ debt.
Lower debt ratio means increased stability- less risk
Not locked into repayments and interest
However the use of debt can allow the owner to invest less and can therefore lead to ROI.
INCREASED DEBT RATIO MEANS INCREASED ROI As business is more reliant on debt whilst less reliant on owners investments
Explain how WCR is favourable while the QAR trend is unfavourable
Stock and prepayments are both included in WCR but are excluded from QAR. An increase in stock levels may lead to a higher WCR without affecting QAR
State two strategies to improve stock turnover without affecting GPM.
Either sell more stock or reduce stock
- reduce average level of stock by discontinuing slow moving lines of stock
- introduce just in time ordering to ensure that excess stock is not carried.
- improve the stock mix by concentrating on fast moving lines
