SL Business Unit 4

Ratio Analysis Purpose

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