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
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
- (Residual/ 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
Ignores time
Focuses on profit rather than cash flow
Nit adjust for time-money
Net present value calculations
- 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 or one product
- doesn’t include bulk buying discounts
- 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 lowered 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- variable costs
Contribution per unit calculation
selling price -variable costs per unit
Profit calculation using contribution
Profit= total contribution-fixed costs
Breakeven calculation
fixed costs/ contribution per unit
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
Payback
Time to an investment pays itself back
Payback benefits
Easy to calculate and understand the result
Payback drawbacks
Ignores cash flows after payback has been reached
May encourage short term thinking
Takes no account of the time value if money
Does not consider profitability in payback
Benefits of ARR
Simple understand and easy to calculate
Focuses on overall profitability of an investment
Easy to compare
Uses all returns generated by a project throughout
Net present value
Calculates the present value of future income from an investment , minus the cost
Purpose of budgets
Focus expenditures on company’s main objectives
No more is spent then the company expects
Measure of performance
Gives managers more responsibility - herzberg motivation
Types of budget
Historical budget - based on previous budgets with adjustments such as inflation
Zero-based budgets - based on justification of a manager (time consuming)
Variance analysis
Adverse - worse
Favourable - better
Variance analysis managers
They can spot areas of significant variance through software such as excel
Budget variances occur because…
Original budget was unrealistic
The target was not met due to factors beyond the budget-holders control
The target was not met due to to factors within the budget-holders control
Difficulties of budgeting
Setting budgets - unrealistic targets but also avoid budgets creeping up
Agreeing or imposing budgets - imposing budgets is far less motivating and effective than giving than gibbing budget-holders a genuine say in setting targets, in agreement with senior managements
Failing to understand the causes of a budget variance - blaming budget holder is demotivating
The costs of the system outweighing the benefits - smaller businesses, single manager can keep control of finance without needing to set up budgets
Ways to improve profit
Increase revenue/selling price
- increase profit margin but may decrease overall profit - PED + SALES VOLUME
Decrease costs
- using cheaper materials or less labour can damage reputation therefore revenue
- only when an obvious source of waste is produced that a straightforward cut in costs happens
What document does all PLC have to produce to companies house
Statement of comprehensive income (balance sheet)
Cash flow and profit
Sales revenue does not equal cash inflow
Costs do not equal cash outflows
Improving liquidity
Selling under-used fixed assets such as equipment or machinery
Raising more share capital
Increasing long-term borrowing through loans
Postponing planned investments
Managing working capital cycle
Ensuring there is enough cash in the cycle
Making sure it moves through the cycle as quickly as possible
If capital cycle requirements are met then the following actions are likely to be used….
Control cash used
Minimise spending on fixed assets
Plan ahead for the next few months
Under-utilisation of capacity utilisation
Lead to fears for job security among staff, damaging motivation
Poor morale among managers
Contribute to a poor reputation for the business - empty tables restaurants
Over-utilisation of capacity
Unable to accept new orders, Turing away new customers to rivals
No time for maintenance on machines or train staff
Improving capacity utilisation
Increase current output
Reduce maximum capacity
Swot analysis approaches
Top-down approach - external consultants
Consultative approach - boss analyses whole business
Top-down approach + -
+ a dispassionate approach
+ detachment from company culture may shed light on business
- managers may fail to share all necessary info about business
Consultative approach + -
+ greater insight from a wider range of contributors
+ the chance for boss to gain first hand understanding of the whole business
- staff less likely to point out problems as it may reflect badly on them
Key performance indicators
Staff turnover Like-for-like sales Market share Capacity utilisation Unit cost Brand recognition Staff turnover
Opportunities and threats
Demography - adaptation New laws and regulations Technological factors Competition - porters five forces Commodity prices - increase/decrease Economic factors - growth, inflation, tax, interest, unemployment and exchange rate
What do large businesses do (SWOT)
Lobbying - persuading MP’s to make decisions in bets interests of the business
PESTLE
Political Economical Social Technological Legal Environmental
Political factors
Following Brexit
- less access to EU market
- import cost increase
- devalued pound
- less FDI
Economic factors
Inflation Growth Unemployment Taxation Exchange rate Interest rate
Social factors
Trends
- eating healthy
- change attitude to smoking
- desire for convenience and service
- ageing population
Technological factors
New products
Lowered production costs
Changes can be a threat
Legal factors
New laws change structure and operations
Environmental factors
Pressure for ethical
Opportunity for USP
Adopting more efficient methods
What to do about external influences
Make the most of favourable factors
Minimise impact of unfavourable factors
Posters five forces
Threat of new entrants Threat of substitutes Supplier power Consumer power Rivalry between competition
Intensity of comp is low
High barriers to entry Few companies Booming market Branding high No direct comp from abroad Little spare capacity
Intensity of comp is high
equal size Undifferentiated products Slow market growth Low capacity utilisation Low barriers to entry Faces comp from overseas
Threat of new entrants
Depends on barriers to entry within market
- patents
- branding
- high costs to customers of switching supplier = gas and electricity
- substational network infrastructure
Changes in the buyer power of consumers
Sells it product to many individuals it is favourable
Sells its product to few large customers it is unfavourable - economies of scale
Merges unfavourable
More expensive products and complex more favourable to business
Changes in the selling power of suppliers
Number of alternative suppliers
Uniqueness of suppliers product or service
Reliance on the business on technical support from their supplier
Threat of substitutes
How convenient and close substitute is
Five forces shape strategy
Adapt to changes
Help business decisions - wiser and more effective
Quantitive sales forecasting helps
HR plan - no of employed
Cash flow forecasting - based on sales forecasting
Profit forecasts and budgets. - accurate sales forecast
Production planning - enough products and raw materials are available
Forecasting techniques used
Moving averages
Extrapolation - carry on the trend
Correlation - scatter graph
Limitations of quantitive force casting techniques
The future may not be the same as the past - external shocks/trends
The quality depends on the quality f the forecasters interpretations - pairing variables
Types of ratio
Profitability - relationship of profit and revenue with capital
Liquid - meet short term debts
Gearing - long term finance comes from loans
Reduce an unhealthily high gearing ratio
Issue more shares
Retain more profits
Repay some loans
Gross profit margin improve and too low
Price up
Unit variable costs down
May not be enough gross profit to cover overheads
Operating profits improve and too low
Boost gross profit margin
Cut overheads per £ of sales
Increase sales
May not be enough operating to reinvent into the business and so get growth
Net profit improve and too low
Boost operating profit margins
cut corporation tax bill legally
Too low to pay acceptable dividends
Boosting ROCE
Find a way to increase operating profit
Reduce capital e,played without damaging operating profit
Limitations of ratio analysis
Limitations of ability to whole business story
Lack of detail within h financial accounts - stocks and receivables aren’t shown
If receivables figure is on balance sheet, will be misleading in the ratios
If stock is about to go out of fashion becoming worthless, current ratio will mislead
On profit and loss account, net profit cash be affected by one off payments such as selling property
Boosting net profit, improve the net margin for this year, might be a blip, misleading those who do not investigate further than the ratio
