Term 3 - Analysis of Ratios Flashcards
Title
Evaluation of the Financial Position of ____________ as at 30 June 2017
Summary
_______ is/is not operating at an acceptable level. The business compares favourably with other business in the industry. However, in other areas the business’ performance is unfavorable and improvements need to be made. These areas will be addressed in this report
Introduction
Financial reports are one means of communicating information. The use of ratio financial stability, earning capacity and effectiveness of management policies ratios, greatly assist in the analysis and interpretation of financial reports. Each type of ratio will be addressed independently in this report.
Define Financial Stability
The Financial Stability ratios give an indication of the short term liquidity and the long term solvency of an enterprise
Current Ratio Define
The current ratio indicates the ability of an enterprise to meet its short term financial obligations
Current Ratio Acceptable
2:1
However, above 1:1 indicates it is able to meet its short term obligations
Current Ratio Analysis
Assets decreasing
Liabilities Increasing
Horizontal Analysis
Current Ratio Strategies
- monitor and bring back to 2:1
- decrease current liabilities
- if appropriate renegotiate short term loans into long term.
- increase current assets
Current Ratio Recommendation
Why Concern? Below the acceptable ratio and industry average
The current ratio should be monitored and steps taken to increase the ratio back to 2:1.
- reducing the liabilities
- renegotiate short term loans to long term
- increasing the current assets
This will ensure the business can meet its short term financial obligations.
Quick Ratio Define
The quick ratio measures the ability of a business to meet its immediate financial obligations
Low Quick Ratio
The business is unable to meet its immediate financial obligations and is dependent on inventory turnover to pay its current liabilities
Quick Ratio Analysis
Current Assets decreasing
Current Liabilities Increasing
Horizontal Analysis
Quick Ratio Strategies
- decrease current liabilities
- increase current assets
Quick Ratio Reccomendation
Why Concern? Unable to meet its immediate financial obligations
- Decrease Accounts Payable
- be mindful of the amount of credit purchase, buying
goods when possible.
- be mindful of the amount of credit purchase, buying
- Increase current assets.
This will provide a high degree of assurances that the current liabilities can be paid out of current assets, allowing the business to meet its immediate financial obligations
Equity Ratio Define
The Equity Ratio indicates the extent to which the owner has financed the business’ assets, as opposed to using alternative sources of financing - borrowings.
Equity Ratio Analysis
Net Profit decreasing
Drawing Increasing
Vertical and Horizontal Analysis
Equity Ratio Strategies
- decrease debt, _____ , through repayments
- minimize the need to hold large assets
- minimize the need to borrow beyond 50:50 balance of equity and debt
Equity Ratio Recommendation
Issue? The business is highly dependent on borrowings for financing
- increase the amount invested/decrease drawings
- decrease debt through repayments
This will mean that business is financed in the most effective manner
Debt Ratio Define
The Debt Ratio indicates the way in which the business is financed and the extent of the business’ borrowings in relation to assets.
Debt Ratio Analysis
- Liabilities increasing
- Assets decreasing
- Verticle and Horizontal Analysis
Debt Ratio Strategies
- Decrease debt, __________, through regular repayments, reducing the interest on debt
- Minimize the need to hold large assets, meaning the business will not need to borrow to finance these purchases.
- Do not borrow beyond 50% debt equity
Debt Ratio Recommendation
Why issue? Highly dependent on external sources for financing
- decrease their debt ______ through repayments
This will mean that business is financed in the most effective manner
Define profitability
Profitability is the ability to earn income within the current financial structure of an enterprise
Gross Profit Define
The gross profit ratio indicates the ability of a trading enterprise to generate gross profit from sales
Gross Profit Analysis
Increase in Cost of Goods Sold
Decrease in Net Sales
Vertical and Horizontal Analysis
Gross Profit Strategies
- Reduce Cost of Goods Sold
- Find a cheaper supplier - spend less on goods
and retain the same revenue on sales - Increase Net Sales
- Increase selling price
Gross Profit Recommendation
Why?- Below industry average
- reduce cost of goods sold
- increase net sales
This will allow the business to increase their gross profit and easily cover all of their expenses and have the capacity to earn an acceptable net profit and return on investment
Net Profit Define
The purpose of Net Profit is to show the ability of the business to generate a return on the owner’s investment.
Net Profit Analysis
Gross Profit High or Low
Increase in Expenses - Too high when compared to sales
Decrease in Revenues - low selling margin
Vertical and Horizontal Analysis
Net Profit Strategies
Reduce Expenses
Increase Revenues
Net Profit Recommendation
Issue? Below industry average
- monitor expenses and implement strategies to decrease
- Increase revenues
A higher operating revenue and low operating expenses will result in a high net profit. This will mean that the owner will receive a higher return on equity
Rate of Return on Equity Define
The rate of return on Owners Equity indicates the return on the owner’s investment in the business
This is good/bad compared to the return the owner would have recieved if invested in other financial institutions
Rate of Return OE Analysis
Decrease in Net Profit
Increase in /Too Much Capital
Horizontal Analysis
Rate of Return OE Strategies
Decrease Capital or use it more effectively
Increase Net Profit by increasing revenue or decreasing expenses
Rate of Return on OE Recommendation
Issue? - Below industry Average, may suggest it would be more beneficial for the owner to invest elsewhere
- increase net profit
- Decrease capital
This will mean that the Owner’s return on equity will increase.
Rate of Return on Total Asset Define
The rate of return on total assets ratio indicates the ability of the enterprise to generate profit using their assets.
Rate of Return TA Analysis
Increase in Total Assets
Decrease in Net Profit
Horizontal Analysis
Rate of Return TA Strategies
- Increase Net Profit
- Decrease Average total Assets
- Ensure assets are used effectively to generate profit
Rate of Return on TA Recommendations
Why Issue? Poor performance of assets in generating profit
- increase net profit
- consider selling assets such as _____ which are proving ineffective in generating profit
- ensure assets are being used to their full capacity
The implementation of these recommendation will ensure the effective use of assets to generate profit
Management Effectiveness Define
Effectiveness of management policies is the measurement of how proficient managers have been in directing and maintaining set policies
Rate of Turnover of Inventories Define
The rate of turnover of inventories ratio measures how efficiently the inventory of the business is being managed
Rate of Turnover of Inventories Analysis
The business has a large holding of slow moving inventory indicated by the high inventory control when compared to the cost of goods sold
Rate of Turnover of Inventories Strategies
- sell more inventory
- target customers through advertising and reassessment of business' pricing policy - phase out stock that is not moving quickly and ensure a steady supply of popular inventory
Rate of Turnover of Inventories Recommendations
Why Issue? Poor compared to industry
- Targeted advertising
- reassessment of pricing policy
- phasing out stock that doesn’t move quickly and have a steady supply of stock that does
Implementing these recommendations will ensure that the business be selling more stock and therefore has a greater chance of generating profit.
Rate of Turnover of Accounts Receivable Define
The rate of turnover of accounts receivable measures the efficiency of the business in managing its accounts receivable
A variation with 10-15 days of company policy is acceptable
Rate of Turnover of Accounts Receivable Analysis
The poor turnover of accounts receivable can be attributed to a loose credit policy. This has resulted in a low amount of accounts receivable when compared to net credit sales and a significant amount of bad debts.
Rate of Turnover of Accounts Receivable Strategies
Tighten Credit Policy
- following up on late payers via phone, email or letter
- offering discount for early cash payments
- effective screening of customers prior to providing
credit
Rate of Turnover of Accounts Receivable Recommendation
Concern? High number of bad debts.
Immediate attention should be given to debt collection.
Tighten credit policy
- Follow up on late payers
- offer discounts for early cash payments
- effective screening of customers prior to providing them with credit
The adoption of these recommendations will decrease the rate of turnover of accounts receivable, improving the average payment time and reducing the amount of bad debts. This will result in a greater profit for the business.
