Interpreting published accounts chapter 4

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  • Interpreting published accounts chapter 4
    • Ratio analysis-A method of assessing a firm's financial situation by comparing two sets of linked data
      • Comparisons
        • Inter-firm
          • Comparisons between companys
        • Intra-firm
          • These are comparisons within the company. The efficiency of different divisions or areas of a company can be compared
        • Comparisons to a standard
          • Certain levels of performance are recognised as efficient within the business community
        • Comparisons overtime
          • Whatever basis is used, a company's ratios should be compared over time in order to register trends in efficiency and allow for exceptional circumstances in a particular year.
      • Limitations of Ratio Analysis
        • Some valuations of assets on the balance sheet are unreliable or inaccurate e.g. the value of patents and brand names
        • Accounts can be window dressed e.g. using different assumptions for depreciation to make profits look better
        • Ratios are based on historic accounts are always out of date
        • It is very hard to compare ratios with other businesses since they are all different
        • Ratios only look at quantitative information-it would be useful to analyse the quality of management, product development , brand loyalty, location and customer feedbavck
        • Ratios need to be considered in the context of external factors-shouldn't make decisions about management before assessing things like the economic climate
    • Types of ratio
      • Profitability Ratios
        • ROCE=OPERATING PROFIT/TOTAL EQUITY X100
        • Capital employed indicates the size of the business by adding together the share capital+retained profit+long term loans
        • A Business wants as high a ROCE as possible. It should be higher than bank interest rates otherwise it would be better to invest in the bank rather than the business. A good trend would be increasing ROCE and the business wants a higher ROCE than its competitors in that industry
      • Liquidity ratios
        • These show whether a firm is likely to to be able to meet its short-term liabilities. Although profit shows long-term success, it is vital that firms hold sufficient liquidity to avoid difficulties in paying debts
        • Liquidity:the ability to convert an asset into cash without delay or loss
        • Current Ratio: Current assets/ Current liabilities
          • The ideal current ratio is between 1.5:1 and 2:1 meaning the business has between £1.50 and £2.00 of current assets for every £1.00 of current liabilities so it is unlikely to run out of cash
          • If the ratio is too high it is bad because the business has too many current assets
        • Acid Test ratio: (current assets-inventories) divided by current liabilities
          • The ideal acid test ratio is between 0.75:1 and 1:1. If the figure is too low they will run out of cash and if the figure is too high they have too much cash which is not earning profit
      • Financial Efficiency ratios
        • Asset Turnover: Revenue/ Net Assets
          • The business wants a high asset turnover to maximize sales. A capital intensive business may have a relatively low asset turnover because it has a lot of fixed assets
        • Inventory turnover= Cost of good sold/ Average inventories held
          • Inventory turnover shows how many times a year a business sells its stock. The higher the better as cash flows in quicker
          • 365/ Stock turnover shows how many days it takes to sell the stock
        • Receivables days= Receivablesx365/ Revenue
          • Shows how many days it takes on average before the customers pay. Businesses want a low number of days so that they get the cash in quicker but in some industries it is important to offer the customer trade credit for up to 90 days.
        • Payables days= payables x 365/ Cost of Sales
          • This is the opposite to receivables. This measures the time the business takes to pay money out to its suppliers. It wants to take as long as possible so a higher figure is better. It wants long term credit from suppliers in order to help with cash flow.
      • Gearing Ratio
        • This measures the proportion of long term capital that is borrowed. It therefore helps to measure long term solvency.
        • Gearing= non-current liabilities/ total equity+ non current liabilities
        • A sensible target for gearing would be between 25% and 50%. Above 50% is a danger sign regarded as too high because the business has borrowed too much. It may have difficulties repaying loans and will be vulnerable if interest rates increase. Will increase fixed costs. Below 25% is regarded as possibly too low, the business is relying too much on shareholders and retained profit. It may have missed out on growth opportunities had they been willing to borrow more.
      • Shareholders ratios
        • A dividend is a part of the company's profits that are distributed to the shareholders' rather than reinvested into the business as retained profit
        • Dividend per share= Total dividend paid/ number of ordinary shares issued. To be useful, the dividend per share needs to be compared to the share price
        • Dividend yield= Dividend per share/ market price per sharex100
          • The % yield should be compared to the % yield of other shares and with bank interest rates to assess whether it is worth buying, holding or selling shares

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