3.6, 3.7, 3.8 - Finance and Accounts

What is ratio analysis?

Quantitative management tool that compares financial figures to examine the financial performance of a business

Liquidity Assets

Possessions of a business that can be turned into cash quickly without losing their value (ex. cash , stock, debtors)

Capital Employed

• Is the value of all long term sources of finance for a business, namely noncurrent liabilities plus equity

Purpose of financial ratio analysis?

• examine a firm’s financial position (short term or long term liquidity position, profitability)

• compare figures with projected or budgeted figures in order to improve financial managment

• aid decision making whether investors should take the financial risk

When conducting ratio analysis, why is it important to compare like-with-like?

Historical Compairosn: accurate assesment using same figures for comparison to be accurate

Inter-firm Comparison: Comparing ratios within the same industry helps to gauge how well a company is performing relative to its peers.

Profitability ratio examples

Examine profit in relation to other figures (GPM, PM, ROCE)

Gross Profit

Represents the revenue remaining after deducting the direct costs associated with producing or delivering goods and services.

Gross Profit = sales revenue - COGS (purchase + open - close)

Gross Profit Margin (GPM)

• Is a profitability ratio that shows the value of a firm’s gross profit expressed as a percentage of its sales revenue

Gross Profit/Sales Revenue x 100%

What does the GPM tell us about a firm’s profitability?

• shows the value of a firm’s gross profit expressed as a percentage of a firm’s profitability

• reflects the efficiency of production and pricing strategies

• a higher GPM indicates effective cost managment pricing

Profit Margin (PM)

Shows the percentage of sales turnover that is turned into overall profit after costs of sales (direct costs) and expenses (indirect costs)

= profit before interest and tax/sales revenue x 100%

What does the PM tell us about a firm’s profitability?

• Provides an overall view of a firm's profitability after considering all expenses.

• Higher PM signifies better overall financial health —> profits for investment in the company (retained profits) or dividends

Limitations of Ratio Analysis

• profit on final accounts is static, indication of financial health but does not tell its efficiency compared to size of business

• apply to profit orientated businesses only

• Changes in the external business environment can cause a change in the financial ratios without there being any underlying change in performance of a business (ex. Higher tax rates decrease profitability although sales revenue has increased)

• No universal way to report final accounts so this means that businesses may use slightly different account procedures. This makes inter-firm comparisons difficult.

• Qualitative factors that affect performance of a business are ignored (ex. Customer satisfaction, staff motivation)

Uses of Ratio Analysis

• Managers and directors can assess the likelihood of getting management bonuses for reaching profitability, liquidity and efficiency targets. Financial ratios identify areas for improvement

• Employees and trade unions can use financial ratios to assess the likelihood of pay rises and the level of job security (revealed by profitability and liquidity ratios)

• Trade creditors look at short term liquidity to ensure that their customers have sufficient working capital to repay them

• Shareholders use financial ratios to assess return on investment compared to other investments (ex. Saving in a commercial bank account instead)

• Financiers use ratios to consider if the business has sufficient funds and profitability to repay any loans that may be approved

Strategies to improve GPM

1. Raise Sales Revenue

   • Increasing the selling price for products with few substitutes

   • Decrease the selling price for products with many substitutes

   • Use marketing strategies to raise sales revenue

   • Seek alternative revnue streams

2. Reduce Direct Costs

   • reduce direct material costs by sourcing cheaper suppliers/raw materials

   • reduce direct labour costs (reduces gross profit deduction of expenses)

What is Return on Capital Employed (ROCE)?

Profitability ratio that measures the financial performance of a firm based on the amount of capital invested

• profit before tax/interest is used because it allows historical comparisons of fluctuations before interest/tax (that are beyond control of business)

• ROCE should exceed interest rates on loan capital = more beneficial investment in business

ROCE = net profit before interest and tax/ capital employed x 100

What are Liquidity Ratios?

Calculates how easily an organization can pay its short term financial obligations from its current assets

• shareholders (loan capital) assess the likelihood of getting back the money owed

Current Ratio

Reveals whether a firm is able to use its liquid assets to cover its short term debts within the next twelve months of the balance sheet date

• 1.5 - 2.0 is desirable

• Lower than 1 means low/negative working capital (more liabilities than current assets

• Higher than 2 can mean too much cash/stock which increases storage and insurance costs, could mean too many debtors which can increase likelihood of bad debts

  =Current Assets/Current Liabilities

Acid Test Ratio / Quick Ratio

Is a liquidity ratio that measures a firm’s ability to meet its short-term debts. It ignores stock because not all inventories can be easily turned into cash in a short time frame

• high quick ratio can suggest firm is holding on too much cash rather than use it to generate more trade

=Current Assets-Stock/Current Liabilities

Cash Flow vs Profit

Cash Flow: refers to the movement of money in and out of an organization

Profit: positive difference between firm’s total sales revenue and its total costs of production (Profit = total revenue - total cost)

Cash Flow Forecast

financial tool to show the expected movement of cash flow for a given time

Cash Inflows

refers to cash that enters business (sales revenue, debtors, loan capital)

Cash Outflows

refers to cash that leaves a business (rent, wages, taxes, interest payments, dividends)

Net Cash Flow

refers to the difference between cash inflows and cash outflows during a period of time

= cash outflow + cash inflow

Opening Balance

the amount of cash at the beginning of a trading period

Closing Balance

refers to the amount of cash left in a business at the end of each trading period, as shown in its cash flow statement/forecast.

CB = Opening Balance + Net Cash Flow

Reasons for Cash Flow Forecasts

• lenders require cash flow forecast to help assess financial health of a business

• help managers predict potential liquidity problems and plan accordingly (adjust cash flow to avoid cash deficiency)

• facilitate business planning to compare cash flows to improve future predictions

Cash Flow Problems

• Overtrading - situation occurs when a business attempts to expand to quickly without sufficient resources

Ex. excess orders add to production costs without a revenue until purchase, hence the purchase of fixed assets from expansion consumes cash = reduces cash flow

• Overborrowing - the larger the proportion of capital raised through external sources of finance

• Overstocking - a business holds too much inventory as a result of ineffective stock control, stocks cost money to buy/produce/store. Stocks are prone to damage and may expire before they are sold. Also can be a waste of scarce resources as money can be well spent elsewhere.

• Poor Credit Control - cash flow problems can arise when a firm offers customers a prolonged credit period leading the business to trade extended periods without cash inflows

Ex. too many customers are offered credit, increases chances of bad debts (debtors are unable to pay outstanding debts), which reduces cash inflow of business

• Unforeseen changes

Strategies to improve GPM

1. Raise Sales Revenue

   • Increasing the selling price for products with few substitutes

   • Decrease the selling price for products with many substitutes

   • Use marketing strategies to raise sales revenue

   • Seek alternative revnue streams

2. Reduce Direct Costs

   • reduce direct material costs by sourcing cheaper suppliers/raw materials

   • reduce direct labour costs (reduces gross profit deduction of expenses)

Gross Profit Margin (GPM)

• Is a profitability ratio that shows the value of a firm’s gross profit expressed as a percentage of its sales revenue

Gross Profit/Sales Revenue x 100%

What does the GPM tell us about a firm’s profitability?

• shows the value of a firm’s gross profit expressed as a percentage of a firm’s profitability

• reflects the efficiency of production and pricing strategies

• a higher GPM indicates effective cost managment pricing

Profit Margin (PM)

Shows the percentage of sales turnover that is turned into overall profit after costs of sales (direct costs) and expenses (indirect costs)

= profit before interest and tax/sales revenue x 100%

What does the PM tell us about a firm’s profitability?

• Provides an overall view of a firm's profitability after considering all expenses.

• Higher PM signifies better overall financial health —> profits for investment in the company (retained profits) or dividends

Limitations of Ratio Analysis

• profit on final accounts is static, indication of financial health but does not tell its efficiency compared to size of business

• apply to profit orientated businesses only

• Changes in the external business environment can cause a change in the financial ratios without there being any underlying change in performance of a business (ex. Higher tax rates decrease profitability although sales revenue has increased)

• No universal way to report final accounts so this means that businesses may use slightly different account procedures. This makes inter-firm comparisons difficult.

• Qualitative factors that affect performance of a business are ignored (ex. Customer satisfaction, staff motivation)

Uses of Ratio Analysis

• Managers and directors can assess the likelihood of getting management bonuses for reaching profitability, liquidity and efficiency targets. Financial ratios identify areas for improvement

• Employees and trade unions can use financial ratios to assess the likelihood of pay rises and the level of job security (revealed by profitability and liquidity ratios)

• Trade creditors look at short term liquidity to ensure that their customers have sufficient working capital to repay them

• Shareholders use financial ratios to assess return on investment compared to other investments (ex. Saving in a commercial bank account instead)

• Financiers use ratios to consider if the business has sufficient funds and profitability to repay any loans that may be approved

Investment Appraisal

Refers to capital expenditure or the purchase of assets with the potential to yield future financial benefits

Payback Period

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

Initial Investment Cost ($) / Contribution per month ($)

Pros and Cons of PBP

Advantages:

• Simplest and quick method of investment appraisal

• Can be useful for firms with cash flow problems as they can identify how long it would take for cash investment to be recouped

• The business can see whether it will break even on the purchase before it needs to be replaced especially due to fast paced business environment

• Can be used to compare different investment projects

• Help managers assess projects that will yield a quick return for shareholders

Disadvantages

• Encourages short term investment

• The contribution per month is likely to by fluctuating because demand is prone to seasonal change

• Payback focuses on time rather than on profits

Calculations of PBP can be inaccurate because it is difficult to predict future cash flow figures accurately

Average Rate of Return

The average rate of return calculates the average annual profit on an investment project as a percentage of the amount invested

total profit during project's lifespan ($)number of years of project initial amount investment ($) x 100

Pros and Cons ARR

Advantages:

• Easy to calculate and understand

• Enables easy comparisons (in percentage) between projects and decision making

Disadvantages

• Ignores timing of cash inflows, focuses on profit

• Prone to forecast errors when fluctuating seasonal changes

• Calculations are based on project’s useful lifespan which is an estimate