Semester 2 - Lecture 2 Flashcards
(38 cards)
Why is ratio analysis important?
- the financial statements have been constructed …… but so what?
- interpretation of those statements is the key to in-depth understanding of performance.
- interpretation is the commentary on the results of the ratios calculated I.e. what do you mean? How is the company performing against benchmarks?
- ratios help to build up a picture of the position and performance of a business.
What is a ratio?
- a mathematical expression of the relationship between 2 or more variables
- there must be a significant relationship between the variable
Is the absolute value of a ratio significant?
- if you calculate a ratio in isolation it will not tell you a great deal about the financial health or performance of a business
- ratios are used for comparison
- therefore they must be used in context
What are comparisons used for?
- comparison of one period with another(last year)
- comparison of performance with planned performance (budget)
- review of trend over a number of periods
- inter firm comparisons within industry sectors
What are the key steps?
1) identify users and their information needs (e.g. investors, employees etc)
2) select and calculate the appropriate ratios (e.g. liquidity, gearing etc)
3) interpret and evaluate the results (I.e. using relevant benchmarks)
4) identify limitations
The 5 types of ratios?
- profitability
- efficiency
- liquidity
- gearing
- investor
Types of profitability ratios
- return on capital employed (ROCE)
- return on shareholders funds (ROSF)
What is the return on capital employed (ROCE) ?
Fundamental measure of business performance. Expresses relationship between operating profit and average long term capital invested in the business.
What is the return on capital employed (ROCE) calculation?
Operating profit (PBIT)
………………………………… X 100
Capital employed
How to calculate capital employed?
Equity (retained profit and reserves of a business) + long term liabilities
What is return on shareholders funds?
Measure the profit attributable to ordinary shareholders relative to the amount they have invested.
How to calculate return on shareholders funds?
Profit after tax (PAT)
……………………………. X 100
Shareholders funds
What are the interpretation of ROCE and ROSF?
- compares inputs (capital invested) with outputs (operating profit)
- assesses the effectiveness with which funds have been deployed during accounting period.
- could the business/shareholders be getting a better return by investing its fund’s elsewhere?
- ideally ROCE should be higher than the rate of interest ……. otherwise why not leave the money in the bank?
What is gross profit margin?
- relates gross profit to same period sales revenue
- measure of profitability in buying and selling goods/services before other expenses
How to calculate gross profit margin?
Gross profit
………………. X 100
Sales
What are the interpretation of GP margin?
- how much of our sales revenue are we retaining as GP?
- represents what a company made after paying off its cost of goods sold
- companies with high gross profit margin are more liquid and have more money to spend on indirect expenses
- if a company’s raw material cost start to increase, the gross profit margin will fall unless prices are increased
What is operating profit?
- Relates the operating profit for the period to the sales revenue generated in that period
- shows not just the margins earned on sales but also the firms ability to control its operating cost
Interpretation of OP margin?
- how much of our sales revenue are we retaining as operating profit?
- if our GP margin is remaining stable but our OP margin is falling - need to examine our operating costs
- the higher the better - less than 5% means the company is in a vary competitive sector or is going badly
- variations in operating profit margin over time, usually due to changes in sales mix, selling prices or indirect costs
What is a non current asset turnover ratio?
- a measure of how effectively the firm is using its long-term asset base to generate sales
- may be of particular relevance in comparing the performance of, for example, retailers (whose major asset is usually the selling space) of high-tech manufactures.
How to calculate non-current asset turnover ratio?
Sales
…………
Non-current asset
What are the interpretations of NCA turnover?
- amount of sales revenue generated per £ of non-current asset
- it is a measure of the level of activity and productivity (the company’s ability to generate sales revenue from its asset base)
- if the assets are not producing sales, they represent a drain on the company’s resources/efficieny
- BUT may be distorted by failure to replace assets in
What are average receivables collection period?
- measures the average time taken to collect money from receivables
- unless told otherwise, assume all sales are credit sales
What is the calculation of average receivables collection period?
Trade receivables
………………………… X 365
Credit sales
What is the interpretation of TR period?
- businesses will usually prefer shorter settlement periods (but it could result in lower sales)
- where the period is high compared with other businesses, this indicates inadequate credit control
- normal average around 45-75 days
