CHAP 59 FINANCIAL RATIO ANALYSIS

1) REASON

2) IDENTIFICATION

3) PROCESS

4) CALCULATION

5) COMPARISON

6) INTERPRETATION

7) ACTION

PROFITABILITY RATIOS: Relationship between gross/net profit and revenue, assets and capital employed

LIQUIDITY RATIOS: Investigate short term financial stability of a firm by examining whether there are sufficient short term assets to meet short term liabilities (debts)

GEARING: Examines extent to which business is dependant upon burrowed money; concerned with long term financial position of company

EFFICIENCY RATIOS: Measure how efficiently an organisation uses its resources and controls credit.

CURRENT RATIO: Relationship between current assets and current liabilities. Examines liquidity position of firm.

Current Ratio = Current Assets / Current Liabilities

IDEAL RATIO = 1.5 : 1

So for every £1 of short term debts owed, it has £1.50 of assets to pay them.

ALTERING THE RATIO:

Bring more cash into balance sheet by:

-Selling under-used fixed assets

-Raising more share capital

-Increasing long-term burrowings

-Postponing planned investments

-Measures the firms level of debt (long term liabilities as a proportion of capital employed).

-Shows how reliant a firm is upon burrowed money. In turn idicates how vulnerable they are to financial setbacks

Gearing = (Non-current liabilities / Capital Employed) x 100

-Lower geared companies can negotiate loans more easily

RETURN ON CAPITAL EMPLOYED (ROCE):

ROCE = (Operating Profit / Capital Employed) x 100

OPERATING PROFIT: Profit after all operating costs and overheads have been deducted

CAPITAL EMPLOYED: All the long term finance of the business (debt plus equity)

-High ROCE suggets resources are being used efficiently

-Needs to be compared with previous years to determine if it's satisfactory

ROCE can be improved by:

-Increasing level of profit generated by same level of capital invested

-Maintaining level of profits generated but decreasing the amount of capital it takes to do so

INVENTORY TURNOVER:

-Measures the number of times a year a business sells and replaces inventory (stock)

Inventory Turnover = Cost of Goods Sold / Inventories

Expressed as times per year

-Can only be interpreted with knowledge of the industry in which the firm operates

Inventory Turnover Ratio could be improved by:

-Reducing the average level of inventories held, perhaps by a move towards just-in-time management

-Increasing the rate of sales without raising the level of inventory

RECEIVABLES DAYS (collection period from customers):

-Shows how long on average it takes a company to collect debts owed by customers

recievables days = recievables / annual revenue x 365

Expressed as days

-Improved cash position if money collected faster

IMPROVED BY:

-Reducing the amount of time for which credit is offered

-Offering incentives for clients to pay on time

PAYABLES DAYS (collection period for payables):

-Shows how many days on average it takes a company to pay its suppliers.

-PAYABLES: Bills owed to people / organisatons that have supplied products / services to a business but haven't yet been paid.

payables days = trade payables / cost of sales x 365

IMPROVED / REDUCED BY:

-Paying bills more promptly. Worsens short-term cash situation, but strengthens long term relationship with suppliers.

EARNINGS: Profit after tax

INTER-FIRM COMPARISONS: Comparisons of finacial performance between firms; to be valuable, these comparisons should be between firms of similar size within the same market.

LIQUIDITY: Ability of a firm to meet its short term debts. Also understood as the availability of cash or assets that can easily be converted into cash.

WHY FINANCIAL RATIOS NEEDED?

They cut through huge amount of data in company accounts, allowing user to focus on few key pieces of data analysis

WHY SOMETIMES SAID THAT RATIOS RAISE QUESTIONS BUT DON'T ANSWER THEM?

Ratio results don't tell you the thinking behind them, so fall in inventory turnover might be due to stockpiling before a new product launch - rather than incompetence.

WHY ROCE REGARDED AS SINGLE MOST IMPORTANT RATIO?

Shows real profitability of business measured against all capital invested, so measures financial efficiency.

WHY DO FINANCIAL ANALYSTS LIKE TO SEE SAME NUMBER OF RECIEVABLES AND PAYABLES?

Credit periods cancel each other out, meaning no net drain on firm's cash flow.

HOW MANY RATIOS NEEDED?

3 most important are ROCE, current ratio, and gearing.