RATIO ANALYSIS FOR DECISION MAKING GCE PROFESSIONAL BUSINESS SERVICES AS 3 RATIO ANALYSIS FOR DECISION MAKING

RATIO ANALYSIS FOR DECISION MAKING

Ratio Analysis – Decision Making Different types of accounting ratios are used for different purposes: Profitability/Performance Ratios – to assess profitability levels Liquidity Ratios – to assess solvency levels Gearing Ratio – to assess debt levels Financial Efficiency Ratios – to assess efficiency levels Shareholder Ratios – to assess equity investments

Profitability/Performance Ratios Return On Capital Employed (ROCE) Gross Profit Margin Net Profit Margin

Return on Capital Employed (ROCE) This shows a firms profitability in relation to the investors capital investment. ROCE = Profit before tax x 100% = x % (Total Assets-Current Liabilities)

Gross Profit Margin This shows the gross profit made relative to sales revenue/turnover. Gross Profit Margin = Gross Profit x 100% = x % Sales Revenue A large range of profit may affect the true results Useful when comparing against the margins of previous years.

Net Profit Margin This indicates amount of profit available, relative to the sales revenue after deducting trading costs and business expenses. This shows how well a business controls its expenses/ overheads. Net Profit Margin = Net Profit x 100% = x % Sales Revenue

Liquidity Ratios Measures the ability of a business to meet short-term obligations, collect receivables, and maintain a cash position Indicates how well the business is able to meet its short-term obligations from cash/near-cash resources

Current Ratio Measures the ability of a business to pay short-term obligations. Currrent Ratio = Current Assets Current Liabilities = :1 Suggested Rule of thumb 2:1

Gearing Ratio Compares owner's equity (or capital) to borrowed funds. Shows extent of financial risk of a business, particularly limited companies. Gearing ratio = Non−Current Liabilities Total Equity + Non−Current Liabilities × 100 = x %

Financial Efficiency Ratios Trade Receivables Ratio (Debtors Collection): Shows length of time taken to recover monies from debtors Trade Receivables Ratio = Trade Receivables x 365 = x days Sales Revenue 1 Benchmark – customers are expected to settle their accounts within 30 days of the date of the invoice It is prudent to ensure that monies are received from customers, prior to the payment of outstanding supplier invoices

Financial Efficiency Trade Payables Ratio (Creditors payment) Shows the length of time taken to pay monies to suppliers Trade Payables Ratio = Trade Payables x 365 = x days Cost of Sales 1 Benchmark – it is expected that a customer would pay a supplier for goods purchased within 30 days of the receipt of the invoice

Shareholder Ratios Earnings Per Share (EPS) Return On Equity (ROE)

Earnings Per Share (EPS) This ratio measures how many pence the company is earning for every share held Earnings per Share = Net Profit after tax No. of ordinary shares = x pence Must be disclosed in the Income Statement

Return on Equity (ROE) Equity x 100 = x % A measure of how well a company used reinvested earnings to generate additional earnings Return On Equity = Net Profit after Tax Equity x 100 = x %

Benefits of using Ratio Analysis Can assist in interpreting and evaluating the income statement and statement of financial position by reducing the amount of data contained in them to a workable amount Can make financial data more meaningful Help to determine relative magnitudes of financial quantities

Benefits of using Ratio Analysis Help managers or business analysts make effective decisions about the firm's credit worthiness Can assist with predicting potential business earnings Can assist in seeing financial business strengths Can assist in spotting business weaknesses

Limitations of using Ratio Analysis Comparing the ratios with past trends and with competitors may be inaccurate as the data may not be easily comparable due to differences in accounting policies, accounting period etc. It is based on current and past trends, but not future trends. Impact of inflation is not properly reflected, as many figures are taken at historical numbers, several years old.

Limitations of using Ratio Analysis There are differences in approach among financial analysts on how to treat certain items, how to interpret ratios etc. The ratios are only as good or bad as the underlying information used to calculate them – “window dressing” may be used by management to manipulate the financial results

Making Recommendations Ratio analysis may be used to make recommendations for improvement, but will also depend on other factors such as: Inflation External factors e.g. changes in interest rates Management changes Business Performance State of the economy Performance of competitors

Ratio Analysis Notes: