ratios

liquidity— current ratio

current assets/current liabilities

Shows the extent to which a business can meet financial commitment in the short-term (liquidity)

• rough measure of how easily a business can meet its current liabilities

• suggested level of 2:1 ($2 assets to $1 liabilities)

• Improvement strategy:

  • reduce current liabilities through sale of inventory

  • overdraft and credit card

Gearing— debt to equity ratio

total liabilities/total equity

shows the ability to meet longer term financial commitments

• shows whether creditors will be paid or if investors can expect a good return on their money

• Indicates the reliance on debt or equity funding

Profitability— GPR

Gross Profit/sales

shows the % of each dollar sales that is across profit

• does NOT take into account expenses

• high GP is preferable

• Improvement strategies:

  • increase level of sales

  • raise prices

  • lower stock prices

Profitability— NPR

Net Profit/sales

shows % of each dollar of sales that is net profit, including cost of expenses and tax

• higher NP preferred, indicated level of expense incurred

• raising costs can cause the figure to fall

• improvement strategies include:

  • reduce expenses

  • increase sales

Profitability— Return on Equity ratio

net profit/owners equity

indicates return in investment and the risk for reward

• critical for owners and shareholders

• higher figures preferred (unhappy with below 10%)

• ROI is dependent on risk

• to improve:

  • reduce expenses

  • increase sakes

  • improve efficiency

Efficiency— expense ratio

total expenses/sales

indicates the proportion of each dollar that is loss to expenses

• measure cost of producing each unit

• determine what % of revenue is taken up by expenses

• want a lower % as that = company managing costs more efficiently

• to improve:

  • reduce business expenses

Efficiency— Accounts receivable turnover ratio

sales/AR

Measure of how often AR is converted to cash over a period of time

• ratio is divided by 365 days

• lower figure=quicker and more efficient cash collection

• to improve:

  • remind customers that account is outstanding

  • outsource retrieval money to a credit control company

limitations of financial reports

normalised earnings, capitalising expenses, debt repayments, valuing assets, timing issues, ethical issues

Normalised earnings

• refers to earnings being adjusted in financial reports to remove the effects of inflation

• earnings adjusted to take into account cyclical growth

• removes one off factors and boosts earnings

• may give better idea of the strength of the business in the market

Capitalising earnings

• accounting method where a business records an expense as an asset in the balance sheet rather than as an expense on income sheet

• understates expenses and overstates profits and the assets

• results in cost in current year being lower

• expenses may be inappropriately capitalised in order to mislead

Debt repayments

• limit usefulness of financial reports as they may not be clear when repayments have to be made—can create a misleading impression about the financial position of the business

• businesses may have relatively little debt but if it has to repay this in one go, may be more financially unstable than it looks at first glance

valuing assets

• difficult to place value on some assets— businesses can exploit this to create misleading impression on their financial position

• value of assets change over time but it is not always clear as to how much

• assets must be valued at the price for which they were originally bought— thus financial reports don’t show the market value of the assets held by a business

Timing issues

• businesses can exploit timing issues in financial statements to give a misleading impression of the financial position of the business

• revenues can be delayed or accelerated to manipulate them into or out of the period covered by the report to give an inaccurate picture of the business’ earnings

• costs may be manipulated

ethical issues— audited accounts

• all private and public companies are required to have their accounts audited (checked)

• auditing is process designed to establish the truth and fairness pf the financial record

• conducted by independent accountants who check samples, chosen at random, to ensure overall accounts are accurate

Misuse of funds

• refers to a range of dishonest anf illegal practices

• system and procedures should be put in place to prevent fraud

Government and companies

ASIC Ensures companies follow the Corporations Act

ASX includes listing rules, disclosure requirements and other regulations which listed companies must comply with