Lecture 9 (concluding ratio analysis) Flashcards
What are the 3 equations of break even point?
Why use ratios?
Ratio is one of the most useful means of comparing one figure with another as it expresses the relationship between lots of amounts easily and simply
Financial ratios is where the decision making occurs
Liquidity ratio = measure of a company’s ability to meet its
Liquidity ratio = measure of a company’s ability to meet its short-term obligations with its short term assets
Current Ratio - Is a liquidity ratio, it compares current assets with …
Current Ratio - Is a liquidity ratio, it compares current assets with current liabilities and debts NEED to be paid when due.
What is the Current ratio formula and what output is ideal?
total current assets/total current liabilities = cash
As suggested a organisation should have a ratio of at least 1:1 meaning that it has £1 of resource to cover £1 of liability
Therefore the answer would be X:1
What output do we want?
We want current asset to exceed current liabilities
Cash is a necessity to pay liabilities
If someone has no cash the would need to sell some assets to generate cash
When not having the ideal current ratio, is it a raise for concern?
Be careful before you assume that a ratio of 0.75:1 suggests that the company will be going into immediate liquidation.
It is important we remember what accumulates to an asset and accumulates to a liability
A clothing store may have opened more shops and therefore need to have more goods in those shops, or have they closed shops and need less stock? Or maybe the amount of people they owe has escalated
A company may have received cash from its debtors, and it may be able to balance these against what it has to pay to its creditors?
The current ratio is just one piece of the financial puzzle!
It is important to consider it alongside other financial metrics
Define and explain Defensive position
Long term solvency relationship between capital and long term debt
These ratios are used specifically for sport especially football
Investors can use defensive position ratios to assess the level of financial risk to identify if they are likely to get their money back
Ratios identifies the measure of risk taken with regard to the amount of money it has borrowed
Lower level of borrowing = Healthier position to be in
What is debt ratio and when high what does this indicate?
The extent of which creditors have power over an organisation
Identifies how much of the companies asset are financed by debt
A high ratio indicate that the creditors are funding a firms assets.
if a creditor decide that they want repaying the company may need to sell assets in order to raise the cash needed
What a good debt ratio percentage?
50% ratio is a safe limit however 75% is high cause for concern!!
What is Debt ratio formula?
Debt ratio = Total Debt/Total Assets x 100
What is Return On Capital Employed (ROCE)
A measure of how efficiently a company is using its capital to generate profits
Provides percentage that reflects that return a company is making on the total capital employed in its business
Explain the use of ROCE
Higher the rate = the more efficient use of capital
A measure of profitability
Provide target return for individuals project
Benchmark performance with competitors
What is the ROCE formula?
ROCE(%) = operating profit (net profit) / Total Equity + Non-current liabilities
Funding, known as capital employed, is the sum …
Funding, known as capital employed, is the sum of equity and debt funding e.g. how much have the owners put in and how much have the investors put in (long term liabilities such as a loan)
Strengths and shortcomings of ratio analysis
Ratios are an excellent way to interpret the results of companies and understand the story behind the numbers but they do have certain limitations.
They have the potential to significantly change the numbers reported by companies
Ratios are based on past historical information contained in the financial statements and as such refer to past performance.
Past performance is not necessarily an indication of future performance
Sometimes the numbers in the financial statements are wrong even if audited – accounting scandals often discredit the numbers in the accounts of even the largest of companies
Companies have different year ends and may be subject to different accounting rules; US companies, for example follow
Different accounting rules to companies in the United Kingdom. This makes comparison between different companies difficult.
You should only really compare like with like
We also saw that there are many options when calculating ratios – do we use gross profit, operating profit or profit after tax
When computing profit margin or ROCE? Unless you understand which formula has been used to calculate a ratio and which lines from the financial statement were used, it would be impossible to interpret the result.
While ratio analysis is very useful it should be used in combination with other information when making decisions about investing in or lending to a company
