Financial Ratio Analysis Lecture

Asset Turnover Analysis

• Ratio Definition and Formula:

  • Measures the efficiency with which a business deploys its assets to generate sales.

  • Formula: $\text{Asset Turnover} = \frac{\text{Revenue}}{\text{Assets}}$

• Causes of a Declining Asset Turnover:

  • Mathematical drivers: A decrease in revenue (numerator), an increase in assets (denominator), or a combination of both.

  • Balance sheet expansion: Significant acquisition of assets, particularly property, plant, and equipment (PPE).

  • Timing of asset purchases: Capital purchases made at the very end of the financial year increase the denominator immediately on the balance sheet but have had insufficient operational time to generate revenue on the top line.

  • Teething problems: Newly acquired operational assets routinely face onboarding friction, operational adaptation periods, and the requirement to train staff before they begin effectively converting into revenue.

Inventory Holding Period

• Core Concept and Purpose:

  • Measures the average number of days an item of stock remains in the warehouse before being sold.

  • General objective: The holding period should be kept as low as possible to prevent capital from remaining locked up in unsold warehouse stock.

• Formula and Case Study Calculation:

  • Formula: $\text{Inventory Holding Period} = \frac{\text{Inventories}}{\text{Cost of Sales}} \times 365$

  • Case study inventories: $\$1{,}762.04$

  • Case study cost of sales: $\$2{,}598.67$

  • Calculation: $\frac{1762.04}{2598.67} \times 365 = 24.8\,\text{days}$

  • Interpretation: Stock sits in the warehouse for an average of $24.8\,\text{days}$ prior to being sold.

• Trend Evaluation:

  • Prior year baseline: $33.9\,\text{days}$

  • Current year figure: $24.8\,\text{days}$

  • Trend direction: Better performance, as stock is turning over faster by $9.1\,\text{days}$.

• Implications of a Faster Turnover:

  • Lower warehouse and holding costs: Reduced storage expenses due to shortened holding times.

  • Reduced spoilage risk: Lower likelihood of stock suffering physical damage, expiration, or becoming obsolete.

  • Improved cash liquidity: Faster conversion of stock to sales benefits overall cash flow.

  • Reversal scenario: If the ratio deteriorates (lengthens), it causes adverse cash flow strain, escalated warehousing costs, and a heightened risk of damaged or outdated goods.

• Underlying Drivers of Improvement:

  • Lower selling prices: Price reductions can stimulate market demand and accelerate inventory turnover.

  • Increased marketing: Stepped-up marketing and advertising campaigns can boost customer uptake.

  • Enhanced stock control: Better warehouse management practices preventing over-purchasing and excessive stockpile accumulation.

Trade Receivables Collection Period

• Core Concept and Purpose:

  • Evaluates debt collection efficiency by measuring the average duration required to collect cash balances owed by credit customers.

  • Vulnerability context: Small businesses frequently experience operational struggles with this specific metric.

• Formula and Case Study Calculation:

  • Formula: $\text{Trade Receivables Collection Period} = \frac{\text{Trade Receivables}}{\text{Revenue}} \times 365$

  • Case study trade receivables: $47{,}185$

  • Case study revenue: $355{,}982$

  • Calculation: $\frac{47185}{355982} \times 365 = 48.4\,\text{days}$

  • Interpretation: The business takes an average of $48.4\,\text{days}$ to collect cash from customers.

• Trend Evaluation:

  • Prior year baseline: $41.1\,\text{days}$

  • Current year figure: $48.4\,\text{days}$

  • Trend direction: Worse performance, as debt collection takes $7.3\,\text{days}$ longer than the previous year.

• Adverse Effects of a Lengthened Collection Period:

  • Cash flow strain: Cash inflows are delayed, creating working capital pressure.

  • Higher bad debt risk: Extending customer payment periods increases the statistical probability of customer default, insolvency, or bankruptcy.

• Potential Causes of a Lengthened Collection Period:

  • Inefficient credit control: Administrative delays in dispatching invoices promptly or a failure to actively follow up and chase outstanding debts.

  • Commercial sales strategy: Deliberate commercial decisions to offer flexible or extended credit terms (such as "buy now, pay September" promotional terms) designed to attract buyers and expand sales.

• Drivers of a Shortened Collection Period (Opposite Trend):

  • Cash flow optimization: Rapid debt recovery improves cash reserves and reduces bad debt exposure.

  • Early payment incentives: Offering cash discounts to customers in exchange for expedited settlement.

Trade Payables Payment Period

• Core Concept and Operational Significance:

  • Tracks the average duration taken by a business to pay its trade suppliers.

  • Commercial implications: Prospective suppliers examine this ratio to verify payment reliability before offering commercial credit terms.

• Formula and Case Study Calculation:

  • Formula: $\text{Trade Payables Payment Period} = \frac{\text{Trade Payables}}{\text{Cost of Sales}} \times 365$

  • Case study trade payables: $\$3{,}865.04$ (marked increase from the prior year)

  • Case study cost of sales: $259{,}867$

  • Calculation: $\frac{3865.04}{2598.67} \times 365 = 54.3\,\text{days}$

  • Interpretation: The company takes an average of $54.3\,\text{days}$ to settle invoices with its suppliers.

• Trend Evaluation and Analytical Causes:

  • Trend direction: Taking longer to pay suppliers.

  • Cash constraint indicator: The company previously held positive cash reserves last year but has transitioned into a bank overdraft position in the current year, indicating severe liquidity pressure.

  • Commercial terms: Alternatively, the extended duration could be the product of successfully negotiated extended credit terms with suppliers.

  • Commercial risk assessment: In the presence of a bank overdraft and missing cash reserves, prospective suppliers would exercise extreme caution before conducting business with the firm.

Gearing Ratio and Financial Risk

• Definition and Core Concept:

  • Measures the proportion of total capital raised that is financed via long-term borrowing (bank loans) versus equity.

  • Evaluated heavily by lending institutions whenever a firm applies for commercial debt financing.

• Formula and Case Study Calculation:

  • Formula: $\text{Gearing Ratio} = \frac{\text{Non-Current Liabilities (Bank Loans)}}{\text{Equity} + \text{Non-Current Liabilities (Bank Loans)}} \times 100$

  • Case study bank loans (non-current liabilities): $50{,}000$

  • Case study shareholder funds (equity): $\$3{,}359.24$

  • Computed gearing result: $13\%$

  • Interpretation: $13\%$ of the total long-term funding raised by the business consists of debt.

• Trend and Comparative Analysis:

  • Prior year baseline: Just under $9\%$

  • Current year figure: $13\%$

  • Trend direction: Worse performance due to an escalating reliance on debt financing.

• Risk Assessment and Financial Headroom:

  • Fundamental focus: The evaluation of gearing is centered entirely on the concept of risk.

  • Future borrowing constraints: Greater debt burdens make securing additional finance progressively more difficult.

  • Cost of borrowing: Increasing risk profiles cause lenders to charge higher interest rates on future credit facilities.

  • Drivers: Caused mathematically by higher non-current liabilities (bank loans doubled) rather than a contraction in equity.

  • Institutional thresholds: While the trend has worsened, an absolute level of $13\%$ remains low, leaving ample capacity for further borrowing. Lending banks generally do not express concern until the gearing ratio surpasses $50\%+$.

Interest Cover Ratio

• Definition and Underlying Concept:

  • Acts as a safety margin measuring the buffer between operating profits and finance costs.

  • Determines how easily a business can meet its contractual interest payments out of current operating earnings.

• Formula and Case Study Calculation:

  • Formula: $\text{Interest Cover} = \frac{\text{Operating Profit}}{\text{Finance Costs}}$

  • Expressed as a multiple (\text{times}$Cover).\n * Case study operating profit: \$6{,}793.06\n * Case study finance costs (interest): Just under 10{,}000\n * Computed cover result: 6.8\,\text{times}\n * Interpretation: Operating profits are nearly seven times greater than interest expenses, establishing a secure safety cushion.\n\n* **Trend and Banking Thresholds:**\n * Trend direction: Downward trend relative to the previous year.\n * Underlying causes of a falling ratio: A contraction in operating profit (numerator) or an escalation in finance costs and interest obligations (denominator).\n * Operational benchmark: While 6.8\,\text{times}$represents a healthy and secure coverage buffer, commercial banks become concerned and scrutinize operations once interest cover drops toward$2\,\text{times}$to$3\,\text{times}.\n\n# Questions & Discussion\n\n* **Evaluation of Shorter Inventory Holding Period:**\n * Query: Is studying/selling stock quicker considered better or worse?\n * Clarification: A faster inventory turnover is better because it reduces storage and warehousing costs, minimizes stock damage and obsolescence risks, and strengthens cash flow.\n\n* **Hypothetical Drivers for Lengthened Supplier Payments:**\n * Query: What causes a business to take longer to pay its suppliers?\n * Clarification: The primary driver can be cash shortages from declining sales, forcing reliance on overdraft facilities, or positive commercial leverage through negotiated credit terms.\n\n# Assessment and Exam Execution Strategy\n\n* **Time Allocation:**\n * Standard allowance: Calculations should take no more than 3\,\text{minutes}$$ per ratio using the formulas provided.

• Higher-Level Evaluation Criteria:

  • Interpretation: Accurately determine whether a ratio's multi-year movement represents an improving or deteriorating trend.

  • Explanations: Explain why a change is positive or negative (e.g., impact on cash flow, bad debt risk, storage costs, or risk profile).

  • Potential causes: Identify plausible operational and mathematical causes behind movements in both the numerator and denominator of each ratio equation.