Ratio calculations and investment Flashcards
profitability (%)
type of profit/revenue X100
(gross profit)
(Operating profit)
(net profit)
What is return on capital employed (ROCE)
measures profit generated by the business from assets owned by the business
(the larger the better)
How to calculate return on capital employed (ROCE)
(operating profit/capital employed) X100
Capital employed
total assets- current liabilities
What are the two liquidity measures
current ratio
acid test ratio
CURRENT ratio
current assets/current liability
Acid test ratio
(current assets-stock)/current liability
Acid erodes stock
Liquidity
the amount of cash a business has to cover its short term liability
Gearing ratio definition
percentage of business assets bought using borrowed finance
The you need to buy gears using borrowed finance
Gearing ratio calculation
(Non current liabilites/ capital employed) X100
What is investment
spending on capital equipment used to make products
Pay back calculation
- minus annual returns from investment to work out how many years it will take
- (what is still owedl/ remaining payback) X12
define payback
the amount of time it takes for an investment to repay its cost.
disadvantages of payback
- based on future predictions.
2. is a short term calculation and doesn’t consider money made after payback period
Average rate of return calculation
- add positive cashflows
- takeaway initial cost of investment
- divide by the lifespan
- calculate as a percentage of investment
ARR definition
calculates the rate of return as a percentage of the investment
negatives ARR
- doesn’t consider the future value of cash
How to calculate net present value.
- multiply each return by discount factor
- add all values up
- minus the cost of investment
evaluation of investment appraisals
- the validity of the predictions (without past experience it may be biased)
- doesn’t account for external shocks
what does theory suggest if the NPV is positive
the theory suggests that a business should go through with the project
how to calculate contribution per unit
selling price- variable cost per unit
break even calculation
fixed cost/ contribution per unit
what is break even
the level of output needed for a firm to cover its costs
limitations of breakeven
- assumes all stock is sold at the same price
- doesn’t take into account the future value of money
- variable costs are likely to change (COVID)
how to calculate variance
actual- budgeted
what is a favourable variance
when the differences in figures results in a positive outcome for the business.
EG when there are high revenues/lower costs than expected
What the ideal for a current ratio
1.5:1
or 2:1
Whats the ideal for acid test ratio
1:1
what’s the suggested gearing ratio when interest is low
25%. Firms can afford to have higher gearing ratios as borrowing is cheaper
what does the current ratio and acid test ratio actually calculate
whether a firm has sufficient short-term assets to cover its immediate liabilities.
how to calculate capacity utilisation
(actual output/potential output) X100
what’s the ideal capacity utilisation rate
theory suggests its 85%
Contribution calculation
revenue- total variable costs
Contribution per unit calculation
selling price -variable costs per unit
Profit calculation using contribution
Profit= total contribution-fixed costs
3 Breakeven advantage
- can help decide if the business is viable
- calculations are quick and easy
- can support loans and application
- may be motivational
Margin of safety
difference in business actual output and its breakeven output
what is an adverse variance
when the differences in figures results in negative outcome for the business.
EG when there are lower revenues/higher costs than expected
why does a business do variance analysis
to make budgets more accurate in the future.
Gross profit
Revenue-cost of sales
Operations profit
Gross profit- operating costs
Profit before tax
operations profit- interest
evauluation of using a calculation
- it is only useful if compared with another thing such as competitors/ past years
- depends on how reliable the data is
what is contribution
It focuses on the returns (contribution) a business makes from each unit of product sold and whether that return is enough to allow the business to make money overall after taking account of its fixed costs.
what is a high gearing ratio
theory suggests 50% or above an organisation is highly geared
what is a low gearing ratio
theory suggests 24% or below an organisation is lowly geared
what is a mid gearing ratio
theory suggests 25-50% an organisation is moderately geared
negatives of operations that are highly geared
- vulnerable to changes in interest (which is particularly likely as interest rates are rising in the UK to prevent inflation)
however this assumes that the business is on variable interest rates
benefits of operations that are highly geared
- can access greater sources of finance
- they are less reliant on retained profit for growth and as a result may be able to award greater dividends to shareholders and investment may increase in the long term as a result
negatives to being lowly geared
- the business may have to use retained profits to finance growth.
this may mean shareholders get less dividends and short term investors may see this as less profitable and stop investing as a result
what may negatively impact the validity of the ROCE
- eg if a business sells a factory their ROCE may be higher than normal and it may give the business a false indication of performance
- if a firm leases a product there capital employed may be lower as it is cheaper and it may give a false indication of performance
problems with having high liquidity ratios
- less money used to invest
2. less money to give to shareholders
ways to improve liquidity
- reduce credit period offered to consumers
- delay payments to suppliers
- increase long term borrowing (however banks may be unwilling to offer loans to cover short term liabilities as it is risky)
