unit 7.2 - financial ratio analysis Flashcards
what is the balance sheet
-document describing the financial position of a company at a particular point in time
-historical data
- measures liquidity ( ability to pay bills on time)
- shows source of capital invested & in what form that capital is in
what is the income statement
- describes income or expenditure of a business over a period of time
- also known as the profit and loss account ( shows profit /loss business has made over a year)
- helps assess profitability ( how effectively the business coverts its sales revenue into profit & how well it controls costs)
non current assets
what the business owns with a lifespan of more than one year
- used repeatedly in the production process and allow a business to operate
- should not be sold
- machinery, land, vehicles, premises,
-lose their value through use ( depreciation)
current assets
- assets owned by a business that are likely to be turned into cash within a year
-constantly change form - used to pay for current liabilities
1. cash
2. receivables - money owed from customers from purchases on credit, may become bad debt if they are unlikely to be able to pay back and so it is written off. - can use debt factoring
3. inventories - stock, work in progress, finished goods. - value may reduce if it goes out of fashion or is damaged - stock control methods ( slowest to convert to cash)
non current liabilities
debts due for repayment after more than a year
-e.g. mortgages, loans w fixed interest + long repayment date
current liabilities
debts due for repayment within a year (short term debt)
- e.g. payables (owed to suppliers), overdrafts
- ideally business has £2 in CA to be able to pay every £1 in CL but this depends on whether they operate JIT & B2B
working capital
-also known as net current assets + / net current liabilities -
formula : Current Assets - Current Liabilities
- money left over to be used for day 2 day operations
- gives an idea of a businesses liquidity
net assets
- also known as net worth
- total assets ( NCA + CA) - total liabilities (NCL + CL)
- should be the same as the total equity
total equity
- also known as shareholder’s funds ( funds provided by shareholders to set up business, fund expansions etc)
- total equity = retained profits + share capital
- capital & reserves shows how the business has been financed
capital employed &
ROCE (profitability ratio)
CE = total equity + non current liabilities
- the amount of capital investment a business uses to operate & indicates how it is using its money
ROCE - operating profit/CE x 100
- shows how efficient business is at producing profit based on the capital invested
liquidity
the ability to pay short term debts on time e.g. operating costs
reserves + retained profit
- profit reinvested into the business that hasn’t been paid as dividends
purposes x users of company accounts
- stakeholders
- shows value x size of business
- indication of firms liquidity
- helps bank identify collateral for loan requests
- shows current borrowing levels
liquidity ratios
- measure whether a business can pay its short-term liabilities + how easily they can do this (how solvent they r)
1. current ratio
= CA / CL –> between 1.5 to 2:1 desirable ratio ~ between bcos firms can use JIT & suppliers to hold stock meaning they can operate at lower level
- Gearing ratio - shows how reliant a firm is on borrowing & what proportion of capital invested is borrowed ( firm’s long-term liquidity)
= NCL / ( TE + NCL) ~ aka capital employed –> above 50% highly geared & 25% lowly geared
profitability ratios
- compares profits made with the size of the business ( show a firms efficiency at producing profit)
1. gross profit margin, operating profit margin etc
2. return on capital employed ( ROCE)
efficiency ratios
inventory turnover - how quickly stock is converted into sales (number of times a year you sell off all your stock)
(cost of sales/ average inventory held)
receivables days - the number of days it takes to convert receivables into cash ( how long it takes to receive payment from customers)
(receivables/ revenue x 365) in days
payables days - the number of days it takes to pay any payables owed ( how long it takes to pay suppliers)
(payables/ cost of sales x 365) in days
current ratio
- dependant on size of firm x industry
- firms w higher ratio may not be investing enough cash in NCA to expand business to generate profit or may be holding too much stock
- sources of finance e.g. sale x leaseback & long term borrowing used to improve cash level and therefore C ratio
- experience poor liquidity when growing due to extra costs so need healthy C ratio before expansion
Gearing ratio
NCL/CE x 100
CE = NCL + total equity (shares + retained profit)
-gross profit margin
- operating profit margin
- profit for the year margin
- gross profit/ revenue x 100
- operating profit/ rev x 100
- profit for the year/ rev x 100
efficiency ratios
- payables days should be higher than receivables days to be solvent
- firms that offer credit may use overdrafts/ debt factoring to fund their business
issues with ratio analysis
- data may be window dressed ( made to look better) for various reasons e.g. attract investors
- economic factors + external factors may have impacted the results
- exceptional items may distort costs/profit e.g. one off costs like sold property
- firms may not always pursue profit maximisation but other objectives e.g. social enterprises ~ people, profit, planet
