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B USINESS P ERFORMANCE What sort of things would you want to know from a set of accounts?

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R ATIO A NALYSIS - W HO WILL USE IT ? Owners -information to make decisions Investors -are they getting a fair return on their money? Suppliers -is the business credit worthy? Employees -enough profit to pay bonuses, wage rises etc.? Customers -is the business financially healthy to keep supplying them? Creditors - such as the bank. Is the business in a position to pay back a loan?

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T HE NEED FOR RATIOS Company A Sales£1,927 Gross Profit£400 Company B Sales£1,252 Gross Profit£295 Which company has the ‘best’ profit?

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A SSESSING F INANCIAL P ERFORMANCE Profitability Ratios Liquidity Ratios Efficiency Ratios Financial Position Ratios Investor Ratios

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R ATIOS ? Although they are referred to as ratios, many are calculated as a percentage. Some are calculated as days, some times, and only a few as ratios.

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We need a common measure If we do Gross Profit as a proportion of Sales, we can compare the profitability of the two companies. Company A 20.75% Company B 23.56%

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Gross Profit Expense Margin Profit from Operations Net Profit ROCE ROI EPS Profitability Ratios

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Gross Profit Net Profit ROCE Stated as a Percentage Profitability Ratios

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P ROFITABILITY Gross Profit Margin = Gross Profit x 100 Sales This ratio shows you how much gross profit is being made, and is shown as a percentage of sales. What could cause the gross profit to change?

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P ROFITABILITY Net Profit Margin = Net Profit x 100 Sales This ratio shows you how much net profit is being made, and is shown as a percentage of sales. What could cause the net profit to change?

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P ROFITABILITY Return on Capital Employed (ROCE) Net Profit for year before interest and tax x 100 Capital Employed Capital Employed is Fixed Assets plus Current Assets less Current Liabilities What do you think this ratio is telling us?

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CCurrent Ratio QQuick Ratio or Acid Test SStated as a Ratio Liquidity Ratios

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L IQUIDITY We know that working capital is very important. The following ratios are commonly used to measure how solvent the firm is. What do we mean by Liquidity?

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L IQUIDITY RATIOS Current Ratio = Current assets Current liabilities Shows how many times you can cover your current liabilities with your current assets. Shows the proportion of current assets to current liabilities. How easily the business could raise the money to pay the debts which are due in the near future.

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A ratio of 2:1 is generally considered to be adequate liquidity, but it depends on the nature of the business. A liquidity ratio that is too low may indicate that the business may have solvency problems. What might a liquidity ratio that is too high indicate?

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L IQUIDITY RATIOS Acid test = Current assets minus Stocks Current liabilities For this ratio we take the stocks out of the current assets as stocks may take a long time to convert into cash to pay debts. A result of less than 1:1 indicates that a business could have problems paying its debts.

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Debtor days Creditor Days Stock Turnover Fixed Asset Turnover Cash Cycle Efficiency Ratios

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Debtor days Creditor Days Stock Turnover Stated as Days or Time Efficiency Ratios

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E FFICIENCY Debtors Payment Period Debtors x 365 Credit sales for the year This ratio shows the debtors collection period in days. If you are not sure which sales were on credit, just use the sales figure from the P&L account. This ratio shows on average how long it takes debtors to pay for goods bought on credit. What is happening if the number of days is increasing?

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E FFICIENCY Creditors Payment Period Creditors x 365 Credit purchases for the year This ratio shows the credit payment period in days. If you are not sure which purchases were on credit, just use the purchases figure from the P&L account. This ratio shows on average how long it takes the business to pay for goods bought on credit. What is happening if the number of days is increasing?

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E FFICIENCY Rate of Stock Turnover Average stock x 365 = stock turnover in days Cost of goods sold (Average stock is calculated by adding together opening and closing stock and dividing by 2) This ratio tells you the average amount of time items of stock are held in the business. Is it better to have a high rate of stock turnover or a low one? Why?

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Gearing Ratio Interest Cover Financial Position Ratios

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G EARING R ATIO Measure of how much of the long term capital in the company is provided by outside parties (eg long term bank loans, debentures) Different ways to calculate but usually Long term debt x 100 Long term debt + equity

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I NTEREST C OVER Shows how many times the business is able to pay interest charges out of the operating profit. If interest cover falls, because either profitability is falling or interest charges are rising, it may indicate a future inability to meet interest charges as they become due. This ratio is an indicator for profitability, level of borrowing and liquidity Profit before interest and tax=times Interest

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IB Business and Management

IB Business and Management

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