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AL Chapter 18 - Analysis of published accounts - Coggle Diagram
AL Chapter 18 - Analysis of published accounts
Liquidity ratios
A measure of ability of a business to meet its short term financial obligations and to show ability to pay suppliers
Meaning and importance
Liquidity is the ability to pay short term debts
Is a business is liquid, it means it has assets that they can quickly turn into cash to pay bills
If a business is illiquid, then it doesn't have significant assets that can be turned into cash to pay bills, this means suppliers wont get paid
A business needs to stay liquid to survive and keep operating
Current Ratio
Current ratio is a comparison of the assets that are expected to become cash within 1 year, and liabilities to be paid in 1 year
Current ration = Current assets / Current Liabilities
Result shows how many times the current assets could cover the current liabilities
Acid test ratio
Current assets minus stock with current liabilities, and measures a businesses ability to meet its short term debts
Acid test ratio = Current assets - Inventory / Current liabilities
Acid test ratio ignores value of inventory due to the possibility that these assets might be difficult to be made into cash
A low figure indicated that a business could have difficulty paying bills
Profitability ratios
Meaning and importance of profitability
Profit is measured as an amount
Profitability measures profit as a percentage of something else, like revenue or capital employed
Return on capital employed
The return on capital employed measures how efficient the assets of a business are at generating profit
Shows how effectively managers are at using the assets to generate profit
ROCE = Operating Profit / Capital employed X 100
Gross Profit Margin
Measures gross profit as a percentage of sales revenue
Gross Profit Margin = Gross Profit / Sales revenue X 100
Affected by changes in the cost of sales and the price charged by a business
Profit Margin
Profit Margin = Operating Profit / Sales revenue X 100
The Profit margin will be influenced by any changes to the level of expenses incurred by the business
Methods of improving profitability
Increase the profit margin - reduce the unit costs by being more efficient and reducing waste
Focus on increasing sales with the existing assets
Financial efficiency ratios
Meaning and importance of financial efficiency
Financial efficiency ratios measure how well assets are being used
Inventory turnover
Inventory turnover is a measure of the rate at which inventory enters and leaves a business
Inventory turnover = Cost of goods sold / Inventory
Usual to use the average inventory figure for the year on the bottom line
The calculation reveals how many times the amount of average inventory is sold each year.
Days sales in receivables
Measures the average number of days taken by debtors to settle what they owe a business
The money owed to a business from sales made on credit is called trade receivables
Trade receivables = Receivables (debtors) / Credit sales X 365
Trade payables turnover
Money owed to suppliers
Measured relative to the total cost of sales to see what proportion is owed
Trade Payables turnover = Trade payables / Credit purchases X 365
Methods of improving financial efficiency
Adopt a JIT policy to reduce inventory held
Improve credit control to reduce receivables and shorten payables
Gearing Ratios
Meaning and importance
Gearing measures the relationship between the amount of capital supplied from outside the business that requires interest to be paid, and the capital supplied by the owners of the business
Calculation and interpretation
Gearing = Non current liabilities (long term loans) / (Shareholders equity + Long term loans) X 100
Shows how dependant a business is on borrowed money from an external point
Above 50% is high, below 50% is low
The lower the ratio the lower the risk to the busienss
A high gearing ratio can put a business at risk if interest rates are high, because businesses might find it difficult to pay interest.
High Gearing + high interests = High risk
Low gearing + Low interest = Low risk
The gearing ratio determines the sources of finance that are avaliable to a business
A business with a high gearing ratio is likely to have difficulty attaining loans from a bank
If a business is earning high profits, the interest payments might not pose a problem, when profitability is lower, it might not be able to pay debt
Methods of improving gearing
A business can improve gearing by reducing borrowing
This may reduce the options open to the business e.g. finance to invest in new equipment
You can rely on other sources of finance like selling non-current assets, or using up current assets
Investment ratios
Meaning importance of return to investors
Investors invest money into a business, they do this to influence decision making
They look for a financial return, Investment ratios are used to analyse these returns and can be compared with what can be earned elsewhere
Dividend Yield
Shows the return on an ordinary share from dividends in relation to market value
Dividend Yield = Dividend per share / Market price per share X 100
Dividend per share = Total amount of dividend / Number of issued normal shares
Dividend yeild considered in terms of return, dividend yield in other companies, level of risk
Dividend cover
Dividend cover ratio calculates how many times the total dividend could be paid out of companies profit after tax and interest
Gives an indication of how likely it is that the level of dividends being paid can be maintained in future years
Dividend Cover = Profit after tax and interest / Dividend paid
Price/earnings ratio
Shows the relationship between earning per share and the current market price of an ordinary share
Shareholders tend to have more confidence in shares that have a higher P/E ratio
Price/Earnings Ratio = Current market price per share / Earnings per share
Earnings per share = Profit after tax/ Number of issues normal shares
Strategies a business might adopt to improve ratio results
To improve liquidity you could arrange extra funds, sell unused equipment, sell or lease unused premises, sell inventory
A business seeking to improve profitability ratios you could increase labour productivity, increase selling price of product
Comparison of ratio results between businesses
Shareholders frequently compare ratios for different companies, hope that comparisons will show that their business is performing at least as well as others in the industry
If not they will analyse the reasons, it could be due to internal factors like lack of use of resources, or external like a global or national recession
Practical uses of ratio analysis
Compare businesses
Ratio analysis allows a business to compare ratios with those of others,
Negative differences might indicate action to be taken
Business needs to look at expenses incurred and see if inefficiencies are causing high costs
Compare with previous years
Information is obtained from a comparison between ratios of two different years, profit margin is used as an indication of how well a business is controlling its expenses
Share holders might want to look at financial accounts to judge impact of an investment project
Improve liquidity ratios
Acid test ratio can be improved by selling off inventory to increase cash and bank balance
Current ratio can be improved by selling off unused non current assets, because money raised will appear in the cash or bank balance
Improve profitability ratios
Gross profit margin can be improved by widening the gap between cost and selling price
Profit margin can be improved by reducing the expenses incurred in order to raise operating profit
Limitations of accounting ratios
Ratios are backwards looking, calculated based on published financial information, doesn't shoe what will happen
Ratios measure an outcome of business performance but don't convey causes
Using different accounting methods makes comparisons difficult
Published accounts are an overview, not departmental performance
Financial position records of assets and liabilities are on a day basis, not yearly