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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

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Comparison of ratios

Historical Comparison, Inter-firm comparison

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Historical Comparison

Comparing the same ratio in 2 different time periods for the same business

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Inter-firm Comparison

Comparing the same ratios of 2 businesses in the same industry.

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Profitability Ratio

Examines profit in relation to other figures. More relevant to for-profit businesses than non-profit organizations. (%)

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Gross Profit Margin Formula

Gross Profit/Sales Revenue * 100%

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GPM Analysis

The higher the GPM, the better since more gross profit goes to paying expenses.

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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

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Profit Margin

Shows the percentage of sales turnover that turned into an overall profit (%)

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Profit Margin Formula

Profit before interest and tax/sales revenue * 100%

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Profit Margin Analysis

The higher the PM, the better since they will have more profit that goes towards dividends and retained profit

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Improving profit margin

Reduce business expenses: discuss preferential payment terms with trade creditors and suppliers, negotiate cheaper rent, reduce indirect costs

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Return on capital employed

Measures the financial performance of a firm based on the amount of capital invested (%)

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Return of Capital Employed Formula

Profit before interest and tax/capital employed * 100%

Capital employed = sum of owners equity + non current liabilities

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Analysis of ROCE

Shows profit as a percentage of the capital used to generate it. The higher, the better.

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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.

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Liquid Assets

Assets that can be turned into cash quickly (ex: cash, stocks, debtors)

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Current Ratio

Deals with liquid assets and short term liabilities. Reveal if the business can cover its short term debts.

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Current Ratio Formula

Current Assets/Current Liabilities

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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.

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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.

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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

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Acid Test Ratio (**Quick Ratio**)

Ignores value of stock

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Asset Test Ratio Formula

Current Assets-Stock/Current Liabilities

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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

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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

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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.

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Cash Flow

Transfer/movement of money into the business and out.

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Cash Flow Forecast

Shows expected movement of cash in a given period

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Working capital cycle

Time difference between the firm paying cash for its costs of production and receiving cash from sales

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Common causes of cash flow problems

overtrading

over borrowing

overstocking

poor credit control

unforeseen changes (recessions, machinery breaking)

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Solutions to cash flow problems

Better credit control, cutting down on costs, marketing to increase sales, tighter inflow, additional sources of finance

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Investment appraisal

Quantitative techniques used to calculate the financial costs and benefits of an investment decision

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Payback Period

The amount of time needed for an investment project to earn enough profits to repay the initial cost of investment

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Payback Period Formula

Initial Investment Cost ($)/Contribution per month

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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

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Average Rate of Return

Average profit of an investment project expressed as a percentage of the amount invested (%)

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Average Rate of Return Formula

((revenue-cost)/number of years)/Initial amount invested * 100%

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Cumulative Cash Flow

More accurate - takes into account fluctuation of profit for every year

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