3.7.2 Financial Ratios

Gross profit

Sales revenue - cost of sales

operating profit

gross profit - operating expenses

profit for year

Operating profit - interest and taxes

Capital employed

All capital invested into business (eg share capitaL, reserves)

Total equity + non current liabilities

ROCE

Operating profit / capital employed x 100

Return on capital employed

Operating profit / capital employed x 100

🟀 measures how efficiently a bs is using capital employed to generate profits

TYPICAL RANGE 20-30%

needs to be compared w

- prev yr OR

- competitor or

- benchmark

evaluate ROCE

🟀 higher % = better - bs able to compare w other investments or interest rates

🟀 improved by PAYING OFF non current liabilities OR improving operating profit -> bs more efficient

🟀 Leased equipment not included in capital employed

🟀 WATCH OUT for exceptional/extraordinary items

Current Ratio

current assets ÷ current liabilities

Liquidity/ current ratio

current assets ÷ current liabilities

🙘 ease of converting asset (or security) into cash

🙘 measure's bs survival ability short term

🙘 cant meet current liabilities from current assets = risk of failure

Evaluate current ratios

🙘 1.5:2 - suggest efficient management of working capital

🙘 JIT/lean production --> 1.6:1

🙘 LOW ration (below 1) = cash problems

🙘 HIGH ratio - TOO MUCH working capital (opportunity cost)

take these into acc:

- Industry norms

- Trend = most important (change in ratios)

how can a business improve their current ratio?

⋆ increase current assets &/or reduce current liabilities

⋆ sell non current assets that arent being used

⋆ switch to long term sources of finance (ncl)

⋆ Credit control- monitor receivables to avoid bad debt

gearing

Non-current liabilities ÷ capital employed x 100

Gearing (%)

Non-current liabilities ÷ capital employed x 100

🟆 measures long term liquidity of bs

🟆 proportion of bs capital funded thro long term loans (ncl)

🟆 Norm range 25 - 50%

🟆 Highly geared 50%+ = greater risk if interest rates increase

🟆 gearing high - harder to secure loans

🟆 low gearing - ez to secure finance low risk but opportunity cost

how to decrease gearing?

~ repay long term loans

~ retain profits (rather than pay dividends)

~ issue more shares

how to increase gearing?

acquire more long term loans to fund growth

convert short term debt into long term loans

efficiency

● assesses internal management of a bs

● looks at management of cash & inventory

Payable Days

(Payables ÷ cost of sales) x 365

measure in days

What are payable days?

▶ how long it takes bs to pay for supplies purchased on credit

▶ LONGER payable days ratio to ease cash flow problems

▶ SHORT payable days = DISCOUNTS from suppliers

Receivables days

(Receivables ÷ sales revenue) x 365

___ days

receivable days

▷ how long it takes for customers to pay bs for goods/services purchased on credit

▷TRY to have shorter receivable days to help cash flow

▷ low figure preferred = get money quicker

▷ HOWEVER - trade credit - help bs marketing strategy

▷ compare w payable days

Increase in receivable days cld be due to bs trying to ATTRACT new customers or POOR credit control

Inventory Turnover

cost of goods sold/average inventory

____ times

what is inventory turnover?

▪ measures the frequency of inventory replacement in a yr

▪ varys on nature of bs

benefits of using financial ratios to assess performance

(OVERALL)

✔ provides tool to interpret accounts

✔ provides structure for comparisons to be made overtime & w other bs

✔ aids decision making internally -> managers & externally -> investors

limitations of using financial ratios to assess performance

✘ historical - not always an indication of future

✘ NEED to consider reasons behind ratios

✘ ONLY considers financial aspects (quanitative)

NEEDS TO TAKE quantitative info into account

- market trading in

- pos of bs in market

- quality of workforce & mgt team

- economic env