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Flashcards in UNIT 4 AOS 2 Deck (57):
1

Profitability

Ability of a business to generate profit when compared to sales, assets and owners investment.

2

Liquidity

Ability of a business to meet its shot term commitments as they fall due.

3

Efficiency

Ability of a business to manage its use of its assets and liabilities

4

Stability

Ability of the business to meet its debts and continue its operations in the long term.

5

Financial Indicators

- Gross Profit Margin
- Net Profit Margin
- Return on assets
- Return on Owners Investment
- Asset turnover
- creditors turnover
- Debtors turnover
- Stock Turnover
- Working Capital Ratio
- Quick Asset Ratio
- Cash Flow Cover
- Debt Ratio.

6

Profitability Indicators

- Gross Profit Margin
- Net Profit Margin
- Return on Assets
- Return on Owners Investment

7

Gross Profit Margin

Gross Profit
----------------- X100
Sales

- Expressed as a %
* Measures the average markup by showing the % of sales which is kept as Gross Profit .

- Higher the GPM indicates a increase in Profitability.

8

Gross Profit Margin Possible Causes of Change:
Improved GPM

Increase Margin between selling price and cost price:
- Could be caused by increase in selling price more than increase in cost price.
- Or Decrease in Cost price without Decreasing selling price

9

Gross Profit Margin Possible Causes of Change:
Poorer GPM

Decrease Margin between selling price and Cost Price:
- Could be caused by Decrease in Selling Price without a decrease in Cost price
- Or increase in Cost price that has not yet been passed onto the Selling Price

10

Gross Profit Margin:
Advice/ Strategies for Improvement

- Increase in selling price although this could lead to a decrease in demand and lower sales volume
- Decrease the cost price of stock by:
- Find cheaper supplies of stock. Negotiate with suppliers, change supplier, by in bulk, use cheaper materials
- Decrease Quality of Stock
Although may result in other problems such as a increase in sales returns and decrease in demand.

11

Net Profit Margin

Net Profit
-------------- X100
Sales

- Expressed as Percentage
* Measures expense control. The % of sales that are kept as profit.

- Higher the NPM indicates a increase in Profitability.

12

Net Profit Margin Possible Causes of Change: Improved NPM

Better NPM = Better Expense Control:
- Increase in Sales more quickly than expenses
- Or Decrease In expenses while maintaining sales

13

Net Profit Margin Possible Causes of Change: Poorer NPM

Poorer NPM = Poorer Expense Control:
- Increase in Expenses more than Sales
- Or Decrease in Sales more than Expenses

14

Net Profit Margin:
Advice/ Strategies for Improvement.

- Improved GPM can result in a increase in NPM so same advice applies about improving the mark up ( increase in selling price - as long as sales volume is maintained, Decrease cost price of Stock.
- Increase in Sales volume while maintaining expense growth: Identify expenses that may produce an increase in sales e.g Advertising.
- If sales cannot be increased, identify expenses that could be decreased without affecting Sales. e.g wages & Underused assets.

15

Return on Assets

Net Profit
------------------------------ X100
Average total assets

- Expressed as a Percentage
* Measures how effectively a business uses its assets to generate profit.
- Higher ROA indicates improved Profitability

16

Return on Assets possible causes of change:
Improved ROA

Higher ROA = More Effective use of Assets
- Increase in net profit more than assets have increased.
- Or Decrease Assets while maintaining Net profit

17

Return on Assets possible causes of change:
Poorer ROA

Poorer ROA = Less Effective use of Assets
- Increase assets more quickly than Net Profit
- Or Decrease Net Profit more than Assets.

18

Return on Assets:
Advice/ Strategies for Improvement.

Increase Net profit while maintaining the level of Assets, Get more out os assets by:
- Improving The Net Profit Margin. e.g improving Expense control
- Improving the Asset Turnover: Get more sales out of assets e.g replace inefficient assets and introduce improved technology
If Net profit cannot by increased: Reduce the asset level.
- Identify and remove unproductive assets
- Lease rather than own assets
- Carry less stock.

19

Return on Owners investment

Net Profit
------------------------ X100
Average Capital

- Expressed as %
* Measures how effective a business has used owners capital to earn Profit

- Higher ROI indicates improved Profitability

20

Return on Owners Investment possible causes of change:
Improved ROI

Higher ROI = More Effective use of Capital
- Increase Net Profit more than Capital
- Or Decrease capital while Maintaining Net Profit

21

Return on Owners Investment possible causes of change:
Poorer ROI

Poorer ROI = Less Effective use of Capital
- Increase capital more quickly than Net Profit
- Decrease Net Profit more than Capital

22

Return on Owners Investment:
Advice/ Strategies for Improvement.

Increase Net Profit while maintaining the level of Investment
- Improving Net Profit Margin
- Maintain level of Investment through appropriate level of drawings

If Net Profit cannot be increased: Reduce the owners investment by withdrawing Capital.
however if assets remain at the same level this will increase debt
to avoid increase in debt, assets will have to be reduced.

23

Relationship between ATO, NPM & ROA

8888

24

Debtors Turnover

Average total Debtors X 365
-------------------------------------------
Credit Sales

- Expressed as a Number of Days
*Measures how quickly a business is collecting its Debt
- Lower days of DTO indicates improved efficiency which will also increase Liquidity as cash is collected quickly.

25

Debtors Turnover: possible causes of change:
Improved DTO

Improved DTO (Less days) = More efficient debt collection
- Improved procedures
- Tighter Terms
- Better enforcement/encouragement

26

Debtors Turnover: possible causes of change:
Poorer DTO

Poorer DTO (More Days) = Less efficient debt collection
- Decrease in efficiency of debt collection
- Or a significant long standing debt

27

Debtors Turnover:
Advice/ Strategies for Improvement.

Enforce credit terms more strictly
make credit more difficult to get
Reduce terms on offer
Identify and target slow paying debtors
offer discounts for early payments
sell off long term debtors

28

Stock Turnover

Average stock X365
---------------------------------
Costs of Goods Sold.

-Expressed in number of days
*Measures how quickly the business is selling its stock
- Lower STO indicates improved efficiency

29

Stock Turnover: possible causes of change:
Improved STO

Improved STO = More efficient use of stock
- Increase sales more than increase stock
- Or Decrease stock levels while maintaining sales

30

Stock Turnover: possible causes of change:
Poorer STO

Poorer STO = Decrease in efficiency use of stock
- Increase stock more than sales
- Or Decrease sales more quickly than stock

31

Stock Turnover:
Advice/ Strategies for Improvement.

Reduce average stock levels
identify and clear slow moving stock
identify fast moving stock and carry more if there are more opportunities
Decrease lead time with suppliers so less stock has been carried and more efficient distribution methods
Increase sales while maintaining stock levels (Decrease price, increase advertising)

32

Asset Turnover

Sales
------------------------------
Average Sale Assets

- Expressed as a number of times per period
*Measures how productively a business has used its assets to earn revenue
-Higher ATO indicates improved efficiency

33

Asset Turnover: possible causes of change:
Improved ATO

Improved ATO = More efficient use of assets
- Increase in sales more quickly than increase in assets
- Or Decrease asset levels while maintaining sales

34

Asset Turnover: possible causes of change:
Poorer ATO

Poorer ATO = Decreased efficiency in use of Assets
- Increase asset levels more than sales
- Or Decrease in sales more quickly than asset levels

35

Asset Turnover:
Advice/ Strategies for Improvement.

increase sales while maintaining assets: Get more out of existing assets by promoting sales through increase advertising, decrease selling price.

If sales cannot be increased: Reduce assets by identifying and selling unproductive assets or sell assets and lease back.

improve stock turnover

36

Creditors Turnover:

Average creditors X365
------------------------------------
Credit Purchases

- Expressed as number of days
*Measures how quickly a business is paying its creditors
-

37

Creditors Turnover: possible causes of change:
Improved CTO

8888

38

Creditors Turnover: possible causes of change:
Poorer CTO

8888

39

Liquidity

Working Capital Ratio
Quick Asset Ratio
Cash Flow Cover

40

Stability

Debt Ratio

41

Creditors Turnover:
Advice/ Strategies for Improvement.

if turnover is less than terms than:
slow down payments take advantage of the terms and retain cash for use elsewhere
if turnover is higher than terms than:
business needs to pay creditors more quickly to keep strong relationship with the creditor.
Improve operating cash flow.

42

Working Capital Ratio

Current assets
----------------------------
Current Liabilities

-Expressed as ratio :1
*Asses the firms ability to meet its short term debts
-Higher WCR indicates Improved Liquidity

43

Working capital Ratio: possible causes of change:
Improved WCR

Improved WCR = GREATER SHORT TERM LIQUIDITY
- Increase in Current Assets more than increase in Current Liabilities
- Or decrease current liabilities, build up of stock, debtors or cash on hand

44

Working Capital Ratio: possible causes of change:
Poorer WCR

poorer WCR = decrease shot term liquidity

- Increase Current liabilities more than increase current assets
- Or Decrease Current assets, lower levels of stock, use of overdraft,long term loan has become over due.

45

Working Capita Ratio:
Advice/ Strategies for Improvement.

if WCR is low:
- improve cash flow from operation: linked to profitability advice and cash cycle
- Reduce drawings or owner inject cash
- Renegotiate short term debts to long term
if WCR is too high:
-Reduce stock levels, reinvest excess cash or withdraw cash if it is not needed by the business

46

Quick Asset Ratio

Current Assets - ( Stock and Prepaid expenses)
------------------------------------
Current liabilities - Bank Overdraft

-Expressed as ratio :1
* (MEANING)
- Higher QAR indicates improved liquidity

47

Quick Asset Ratio: possible causes of change:
Improved QAR

improved QAR = Greater liquidity

- Increase QA more than increase in QL
- Or decrease in QL, Build up cash on hand, debtors

48

Quick Asset Ratio: possible causes of change:
Poorer QAR

Poorer QAR = Decreased Liquidity

- Increase in QL more than increase in QA
- Or Decrease QA. Loe levels of cash, higher creditors,long term loan has become due.

49

Quick Asset Ratio:
Advice/ Strategies for Improvement.

is QAR is Low:
-Reduce drawings or owner injects cash
- Improve cash flow from operation, linked to profitability advice, turnovers and cash cycle
- Renegotiate short term debts to long term

If QAR is too High:
- Reinvest excess cash or withdraw cash if it is not needed by the business

50

Cash flow Cover

Net cash flow from operating Activities
------------------------------------
Average current liabilities

- Expressed as times per period
* Shows whether the normal cash flow from operating activities covers liabilities due in the next period, shows whether the business can cover these debts without needing to resort to investing or financing cash flows.
-Higher CFC indicates improved Liquidity

51

Cash Flow Cover: possible causes of change:
Improved CFC

Improved CFC = Greater short term Liquidity

- Improved operating cas flow

52

Cash Flow Cover: possible causes of change:
Poorer CFC

Poorer CFC = Decreased short term liquidity

- Poorer operating cash flow
- Or Increase current liabilities due to long term loan becoming due

53

Cash Flow Cover:
Advice/ Strategies for Improvement.

-Improve cash flow from operating, Linked to profitability advice, turnovers and cash cycle
( Increase profitability and improved turnovers will increase cash flow and decrease current liabilities )
-Redice current liabilities with capital injection

54

Debt Ratio

Total Liabilities
------------------------ X100
Total Assets

-Expressed as a percentage
*Indicates the extent to which the business is reliant on liabilities/Debt (Rather than owners capital) to finance its assets
-Lower debt ratio indicates improved stability

55

Debt Ratio: possible causes of change:
Improved DR

Improved Debt Ratio = Greater stability

-Paying off debt, increasing owners investment

56

Debt Ratio: possible causes of change:
Poorer DR

Poorer Debt Ratio = Decreased stability

- Taking out new loans,, delaying payments and decreasing owners investment

57

Debt Ratio:
Advice/ Strategies for Improvement.

Increasing the debt ratio is not necessarily a problem: But an ongoing trend of increasing debt indicates higher risk and threats of stability

To Reduce Debt Ratio
-Use capital contributions to pay off debt
- Reduce drawings
-In the longer term increase profitability and increase cash flow to decrease debt.