Ratios analysis Flashcards
ROCE
ROCE shows the NET profit that is generated from every $1 of assets employed.
An increase in ROCE could be achieved by:
- Increasing net profit, e.g. through an increase in sales price or through better control of costs… actually also selling more at the same margin would do it also as long as the size of the co is the same (the denominator)
. - Reducing capital employed, e.g. through the repayment of long term debt.
GPM
This is the gross profit as a percentage of turnover.
OPM
This is the net profit (turnover less all expenses) as a percentage of turnover
Asset Turnover
The asset turnover shows the turnover that is generated from each $1 of assets employed.
An increase in the asset turnover could be achieved by:
- Increasing turnover, e.g. through the launch of new products or a successful advertising campaign.
- Reducing capital employed, e.g. through the repayment of long term debt.
Current Ratio
The ratio measures the company’s ability to meet its short term liabilities as they fall due.
A ratio in excess of 1 is desirable but the expected ratio varies between the type of industry.
A decrease in the ratio year on year or a figure that is below the industry average could indicate that the company has liquidity problems.
The company should take steps to improve liquidity, e.g. by paying creditors as they fall due or by better management of receivables in order to reduce the level of bad debts.
Quick Ratio (Acid test)
This is a similar to the current ratio but inventory is removed from the current assets due to its poor liquidity in the short term.
It’s a tougher test of liquidity
Inventory Holding Period
This indicates the average number of days that inventory items are held for.
INCREASE
An increase in the inventory holding period could indicate that the company is having problems selling its products.
*** Could also indicate that there is an increased level of obsolete stock.
The company should take steps to increase stock turnover, e.g. by removing any slow moving or unpopular items of stock and by getting rid of any obsolete stock.
DECREASE
A decrease in the inventory holding period could be desirable as the company’s ability to turn over inventory has improved and the company does not have excess cash tied up in inventory.
** There might have been a write off of obsolete stock
However, any reductions should be reviewed further as the company may be struggling to manage its liquidity and may not have the cash available to hold the optimum level of inventory.
Receivables Collection Period
Can’t really say if good or bad if yoy…might lose customers… but if comparing to industry is more ‘telling’
Could be deceptive if Eoy fig .. Use average if poss
An increase in the receivables collection period could indicate that the company is struggling to manage its debts. Possible steps to reduce the ratio include:
- Credit checks.
- Improved credit control, e.g. chasing up bad debts.
- Prompt payment discounts (but hits profit)
A decrease in the receivables collection period may indicate that the company’s has improved its management of receivables
Payables period
This is the average period it takes for a company to pay for its purchases.
Incr/Decr could be good or bad sign!!
- May be struggling / May have negotiated.
- May be better able / May have had terms curtailed.
Good to use free credit
Bad if it gets you put on stop!
An increase could indicate that the company is struggling to pay its debts as they fall due. However, it could simply indicate that the company is taking better advantage of any credit period offered to them.
A decrease in the company’s payables period could indicate that the company’s ability to pay for its purchases on time is improving.
However, the company should not pay for its purchases too early since supplier credit is a useful source of finance.
Gearing
Non-current liabilities
Non-current liabilities + Equity
This is the long term debt as a percentage of equity.
If it’s high then you have a lot of loans which means more interest so probably links to higher/lower interest cover ratio
A high level of gearing indicates that the company relies heavily on debt to finance its long term needs. This increases the level of risk for the business since interest and capital repayments must be made on debt, where as there is no obligation to make payments to equity.
The ratio could be improved by reducing the level of long term debt and raising long term finance using equity.
Osborne says highly geared is >50%
Interest cover
This is the operating profit (profit before finance charges and tax) divided by the finance cost
If it’s high then the co can weather a period of low profits
A decrease in the interest cover indicates that the company is facing an increased risk of not being able to meet its finance payments as they fall due.
The ratio could be improved by taking steps to increase the operating profit, e.g. through better management of costs, or by reducing finance costs through reducing the level of debt.
- Has it Improved, deteriorated (YoY)
Is it better, worse (comparison) - What does it measure/mean?
- Why did it happen?
- So what? (Implications for the company)
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Conclusion wording … think about what you are being asked for eg. profitability and use that as the initial wording followed by the ratios that support that ..
“X is the more profitable company … with a higher Return on shareholder funds & higher GP%”
“X has a more secure financial position… being lower geared with a much higher interest rate cover than Y.
“X is more liquid … working capital ratios?
Don’t forget simple stuff like
Sales Revenue increased (no ratio) … shows growth!
Has there been investment in NCAs?
Don’t try too hard … keep it simple … remember the FI lectures are making simple remarks and picking up points
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