Studied by 3 people
Ratio Analysis Purpose
Examines a firm’s financial position (profitability, short/long term liquidity position)
Assess a firm’s financial performance (controlling expenses)
Compare actual figures to projected figures in order to improve financial management
To aid decision-making
Comparison of ratios
Historical Comparison, Inter-firm comparison
Historical Comparison
Comparing the same ratio in 2 different time periods for the same business
Inter-firm Comparison
Comparing the same ratios of 2 businesses in the same industry.
Profitability Ratio
Examines profit in relation to other figures. More relevant to for-profit businesses than non-profit organizations. (%)
Gross Profit Margin Formula
Gross Profit/Sales Revenue * 100%
GPM Analysis
The higher the GPM, the better since more gross profit goes to paying expenses.
To improve GPM:
Raising revenue: increase selling price with products with few substitutes, marketing strategies, seek alternative revenues
Reduce cost of sales (direct costs): reduce direct material cost, reduce direct labour cost
Profit Margin
Shows the percentage of sales turnover that turned into an overall profit (%)
Profit Margin Formula
Profit before interest and tax/sales revenue * 100%
Profit Margin Analysis
The higher the PM, the better since they will have more profit that goes towards dividends and retained profit
Improving profit margin
Reduce business expenses: discuss preferential payment terms with trade creditors and suppliers, negotiate cheaper rent, reduce indirect costs
Return on capital employed
Measures the financial performance of a firm based on the amount of capital invested (%)
Return of Capital Employed Formula
Profit before interest and tax/capital employed * 100%
Capital employed = sum of owners equity + non current liabilities
Analysis of ROCE
Shows profit as a percentage of the capital used to generate it. The higher, the better.
Liquidity Ratios
Look at the ability of a firm to pay its short-term liabilities. Reveal the level of working capital with which firms can meet their everyday financial obligations.
Liquid Assets
Assets that can be turned into cash quickly (ex: cash, stocks, debtors)
Current Ratio
Deals with liquid assets and short term liabilities. Reveal if the business can cover its short term debts.
Current Ratio Formula
Current Assets/Current Liabilities
Current Ratio Analysis
should be between 1.5 and 2.0
For every $1 of current liabilities, the firm has $1.50 to $2 of current assets to pay it.
Working Capital
The difference between current assets and current liabilities.
Positive - business has potential to invest and grow.
Negative - (current assets lower than current liabilities) the business with have problem paying back trade creditors and suppliers.
A current ratio that is too high means:
Too much cash, could be spent better
Too many debtors, increases likelihood of bad debts or customers
Too much stock, increases storage and insurance cost
Acid Test Ratio (Quick Ratio)
Ignores value of stock
Asset Test Ratio Formula
Current Assets-Stock/Current Liabilities
Limitations of Ratio Analysis
do not indicate current/future financial situation, changes in the external business environment, no universal format, qualitative factors ignored, different organizational objectives that affect performances
Liquidity crisis
A situation where a firm is unable to pay its short term debts. Insufficient cash in the working capital cycle.
Due to more cash outflow. Solutions: Cut expenses, negotiate pay plans with suppliers
Cash vs Profit
Cash: A current asset that is received from sale of goods and services. Needed to pay for daily costs.
Profit: positive difference between total sales revenue and total cost of production. Contributes toward paying costs.
Cash Flow
Transfer/movement of money into the business and out.
Cash Flow Forecast
Shows expected movement of cash in a given period
Working capital cycle
Time difference between the firm paying cash for its costs of production and receiving cash from sales
Common causes of cash flow problems
overtrading
over borrowing
overstocking
poor credit control
unforeseen changes (recessions, machinery breaking)
Solutions to cash flow problems
Better credit control, cutting down on costs, marketing to increase sales, tighter inflow, additional sources of finance
Investment appraisal
Quantitative techniques used to calculate the financial costs and benefits of an investment decision
Payback Period
The amount of time needed for an investment project to earn enough profits to repay the initial cost of investment
Payback Period Formula
Initial Investment Cost ($)/Contribution per month
Advantage/Disadvantages of PBP
Advantages: simple and quick, useful for liquidity problems, used to compare different investment projects
Disadvantages: fluctuations, focuses of criteria for investments rather than profit, short term approach to investment, not suitable for everything, short term for cash flow
Average Rate of Return
Average profit of an investment project expressed as a percentage of the amount invested (%)
Average Rate of Return Formula
((revenue-cost)/number of years)/Initial amount invested * 100%
Cumulative Cash Flow
More accurate - takes into account fluctuation of profit for every year
Note
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