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Learning ObjectivesBy the end of this lesson you should be able to:1. Understand how to select, calculate and interpret financial ratios to assess performance.2. Explain the value and limitations of ratio analysis in measuring a businesses performance.
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Let’s practice from last lesson!TASK 1 – Liquidity Ratios TASK 2 – Profitability Ratios Current Ratio Gross Profit Margin Acid Test Ratio Operating Profit Margin (OPM) ROCEComplete the Thomas Cook Complete the Comparing TwoGroup case study. Companies activity.
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LIQUIDITY RATIOS (The Acid Test)Remember…. The acid test ratio accepts that it may not be able to convert all stock into cash – Why? What can they do/ use? Sell Debts – ‘debt factoring’ Cash at bank Sell a non-current asset Consider just-in-time production.
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Financial Efficiency Ratios In order to become profitable and remain liquid, firms must carefully choose debtors, creditors and stock and monitor their efficiency. Four common measures: Asset Turnover Inventory (Stock) Turnover Payables (Creditor) Days Receivables (Debtor) Days
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FINANCIAL EFFICIENCY RATIOS (Asset Turnover) Measures how efficiently assets have been used to generate sales revenue. Businesses generally aim to achieve a high turnover to show assets are working hard for the company.Asset Turnover = Sales Asset Turnover = £1,495 = 1.70 Net Assets £1,400This means that for every £1 invested in assets, the business was able togenerate sales of £1.07 in one year.This figure can vary from business to business depending on the industry andcan be used to make comparisons to other organisations.
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FINANCIAL EFFICIENCY RATIOS (Inventory or Stock Turnover)Measures how many times a business turns over itsinventories in a year. A high turnover indicates that a firm isselling inventories frequently to generate revenue.Cost of sales = number of times stock is turned over in the year Inventory£10,000 = 50 times per year £200 This means that the Business is selling its inventory 50 times per year – this may mean that it needs to reorder stock 4 timer per month.
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What do you think would be an acceptablerate of Inventory Turnover for the following Businesses?
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Your turn!Calculate the AssetTurnover ratio andInventory/ StockTurnover ratio forAlquimia Plc. Where doesWhat can you infer from thethe analysis? information come from?
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FINANCIAL EFFICIENCY RATIOS (Payables (Creditor) Days)Measures the amount of time it takes to pay forsupplied purchases on credit.Payables Days = Payables (Creditors) x 365 Credit PurchasePayables Days = £38,500 x 365 = 35 days (app) £400,000If the credit purchase figure is not available, cost ofsales, can be used instead. In this example, it takes justover one month to pay suppliers.
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FINANCIAL EFFICIENCY RATIOS (Receivables (Debtor) Days) Measures the number of days it takes to receive payment from customers.Debtors Payment Period = Accounts Receivable (Debtors) x 365 Revenue Debtors Payment Period = £50,000 x 365 = 52 days £350,000 This means on average, this organisation can expect to receive payment for sales in 52 days.
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Your turn!Calculate the Payables(Creditor) Days ratio andReceivables (Debtor)Days ratio for AlquimiaPlc. Where doesWhat can you infer from thethe analysis? information come from?
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Gearing Ratios There is only one gearing ratio. It measures the percentage of a firms capital that is financed by long-term loans or – compulsory interest generating sources that the company has to pay interest on regardless of profit.
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Gearing Ratio Measures the percentages of capital employed comes from non-current liabilities.Gearing Ratio % = Non-current Liabilities x 100 (Total Equity + Non-current liabilities)Debtors Payment Period = £2,735 x 100 = 64% £4,254 This means that for every £ invested in the business, 64p is from non- current/ long-term liabilities where interest payments are compulsory. If the interest rate increases then businesses are at risk of loan payments increasing.
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Your turn!Calculate the Gearingratio for Alquimia Plc.What can you infer fromthe analysis? Where does the information come from?
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What are the Value and Limitations of Ratio Analysis? VALUES LIMITATIONSHelp analyse financial Accuracy of financialdocuments documents – may have been ‘window dresses’Provide structure and put The balance sheet is afigures in context ‘snapshot’Provide a framework for Only show financialmeaningful comparisons performance and not theProvide management with a bigger picture – what antool to monitor and set targets investor may be looking for!
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Re-cap Learning ObjectivesBy the end of this lesson you should be able to:1. Understand how to select, calculate and interpret financial ratios to assess performance.2. Explain the value and limitations of ratio analysis in measuring a businesses performance.
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