3.7.2 Financial Ratio Analysis

Balance sheet

A financial statement recording the assets and liabilities of a business on a particular day at the end of an accounting period

Income Statement

This measure the business’ performance (income and costs) over a given time period

What’s on a firm’s balance sheet?

1. Assets

2. Liabilities

3. Capital

Working Capital

The money a business has available to run it day-to-day operations

Working Capital equation

Working capital = current assets - current liabilities

Importance of working capital

1. To pay for their day-to-day bills

2. When there are significant time lags

Usefulness of a balance sheet

1. Compare different firms of the same size in the same industry

2. Trend analysis

3. Shows firm what they are able to afford

Factors influencing a firm’s financial performance

1. Economic climate

2. New/strong competition

3. Supplier/production/quality issue

4. A change in the firm’s objectives

5. Withdrawal from a market

Window dressing

The manipulation of financial accounts by a business to improve the appearance of its performance

Goodwill

Intangible assets that accounts for the excess purchase price of another company. E.g. brand loyalty and brand name

Income statement

A historical record of a firms income and expenditure of a business over a period of time

Gross profit

The profit made after costs of sales have been deducted from revenue

Gross profit equation

Gross Profit = Sales Revenue - Cost of goods sold

Operating profit

The profit made after admin and distribution costs have been deducted from gross profit

Operating profit equation

OP = Gross Profit - Expenses

Net profit before tax

The profit left after all expenses have been paid

Net profit before tax equation

NPBT = OP - financial expenses

Profit for the year

The profit the firm has left after tax has been deducted

PFTY equation

PFTY = Profit before tax - tax

Different types of ratio

1. Liquidity ratios

2. Efficiency ratios

3. Profitability ratios

Liquidity ratios

Refers to how easy the firm could pay all of its short term debts

Current Ratio

Assesses whether a business has sufficient cash to be able to pay its short term debts

Current Ratio equation

Current Ratio = Current Assets / Current Liabilities

Improving Current Ratio

1. Increase current assets

2. Reducing trade credit terms

3. Be ensuring that receivables are received quickly

Acid test ratio

More severe test of firms capability to meet short term debts

Acid test ratio equation

Acid test = (current assets - stock) / Current liabilities

Inventory turnover

How many times in a trading year a firm sells the value of their stock

Inventory turnover equation

IT = Cost of goods sold / closing stock

Improving inventory turnover

1. Sell off obsolete stock

2. Introducing lean production

3. Rationalise the product range to reduce stock-holding requirements

Receivable days

How long it takes receivables to pay

Receivables days equation

Receivables / sales revenue x 365

Payable days

How long it takes the firm to pay creditors

payable days equation

payables / cost of sales x 365

Gearing ratio

It indicates the proportion of a company's capital that is financed by debt. it looks at the relationship between debt and equity financing.

gearing ratio equation

non-current liabilities / (equity+NCL) x 100

Return on Capital Employed (ROCE)

Shows the operating profit as a percentage of capital employedto assess financial efficiency and profitability.

ROCE equation

operating profit / Capital employed x 100

Limitations of using ratios

1. only shows a fixed position

2. doesn’t consider external factors

3. can be misleading

4. doesn’t take into account inflation

5. doesn’t take account of any internal change

6. and is based on historical data.

weakness of using financial data

1. they cannot be used in isolation

2. only considers the financial aspect