Financial reports and ratiosPresentation Transcript
Financial Reports and Ratios Analytical Techniques
Analytical Techniques permit businesses to study end of period reports in order to base decisions for the future. Techniques may include:• Ratio analysis• Vertical and horizontal analysis• Trend analysis
Ratio Analysis• Valuable tool for interpreting financial ratios• Efficient way to express relationship of one number to another• 3 areas of analysis: – Profitability – Financial stability – Management effectiveness
Vertical Analysis • Analysis of items or a group of items in the same financial period. – Eg comparison of Net Sales to Expense groups
Horizontal Analysis• Analysis of items or a group of items across consecutive accounting periods. – Eg comparison of Sales in ’07 to ‘08
Trend Analysis• Analysis of items across at least three consecutive accounting periods. – Eg Sales are progressively increasing over the five year period.
RATIOS• Presented as % or as ratios• Assist in: – decision making – Interpreting financial reports – Assessment of enterprise’s: • Profitability • Stability • Effectiveness
ProfitabilityProfitability is the ability to earn income withinthe present financial structure of an enterprise.
Profitability Ratios• Gross profit ratio• Net profit ratio• Ratio of expenses to sales• Return on equity ratio• Return on total assets ratio
Gross Profit RatioIndicates the ability of atrading enterprise togenerate gross profitfrom sales. Gross Profit x100Compare result to Net Salesindustry benchmarks todetermine suitability ofbusiness performance
Result indicates:• for every $ of sales – number of cents retained as gross profit• how effective business is in passing on increases in COGS to customers
High result may indicate:• ability of business to cover all costs• capacity to earn acceptable net profit and return to ownerLow result may indicate inability to:• meet further costs• return satisfactory net profit• return satisfactory rate to owner
RecommendationsImprove sales• Ascertain: – stock levels - should be high enough to meet demand – appropriateness of stock to appeal to market – demand for stock held – Appropriateness of selling price• Conduct market research/analysis to assist with the above.
Institute policy to minimise COGS• Investigate alternative suppliers selling similar quality products for less• Take advantage of discounts offered to lower costs
Net Profit Ratio•Indicates the ability of atrading enterprise togenerate a return on theowner’s investment. Net Profit•Compare result to x100industry benchmarks to Net Salesdetermine suitability ofbusiness performance
• Result indicates:• for every $ of sales – number of cents retained as net profit• how effective business is in minimising expenses• poor GP ratio will impact on NP ratio
High result may indicate:• High operating revenue• Low operating expensesLow result may indicate:• inappropriate pricing policy• inadequate stock• inappropriate stock• expenses too high
RecommendationsImprove sales• as per Gross Profit recommendationsMinimise expenses• Set budgets for departments• Investigate alternative suppliers to lower costs• As per Gross Profit recommendations
Expense Groups to SalesIndicates the amount ofthe sales dollars neededto cover expenses. Group of ExpensesCompare result to x100industry benchmarks to Net Salesdetermine suitability ofbusiness performance.
High result may indicate:• weak control over expenses in proportion to the salesLow result may indicate:• tight control over the expenses in proportion to the sales
RecommendationsInvestigate unusually high or low expenseitems to ensure errors have not been made inrecording.Increase net profit while retaining expenselevels at current level.Decrease expenses while retaining orimproving sales.
Rate of Return on Equity RatioIndicates the return tothe owner on theamount invested in thebusiness Net Profit x100Aim for a return of, Average Owner s Equityaround, 14% whichallows funding for futuregrowth and a return oninvestment. ( OE beg + OE end) /2 = Avg OE
High result may indicate:• efficient operation• business may be under-capitalised (owner has not contributed equity to the optimum level) – Under-capitalisation can be identified when NP ratio is close to or under industry benchmark yet ROE is well above industry benchmark
Low result may indicate:• owner’s money may perform better invested elsewhere• business may be over-capitalised (if owner has invested over the optimum sum into the business) – Can be identified when NP ratio is close to industry benchmark yet the ROE result is well below industry benchmark• management may take little risk therefore business is cautiously run• inefficient management making poor decisions, lack of foresight.
RecommendationsImprove net profit result using previousrecommendations.Check level of capitalisation to ensureappropriateness for industry. – If under-capitalised owner should consider investing further funds into the business. – If over-capitalised owner should consider investing excess funds into alternative investments.
Rate of Return on Total Assets RatioIndicates the abilityof the enterprise togenerate profitsusing its assets. Net Profit + Interest Expense x100•Compare result to Average Total Assetsindustry benchmarksto determinesuitability ofbusiness (AssetsBeg + AssetsEnd) / 2 = Avg Total Assets g lperformance.
High result may indicate:• efficient use of assets• wise decisions made regarding asset acquisitionLow result may indicate:• inefficient use of assets• inappropriate levels/types of assets leading to poor performance• high purchase price for assets
RecommendationsIncrease net profit.Decrease average total assets – ensureoptimum level of assets retained.Carefully consider potential of assets prior toacquisition.
FinancialStabilityFinancial Stability indicates the short-term liquidity and long-term solvency ofan enterprise.
Financial Stability Ratios• Current Ratio• Quick Ratio (Acid Test)• Equity Ratio• Debt Ratio
Current RatioMeasures the ability of the enterprise to meetits short-term financial obligations; that is,commitments due in the current financial year. CAIdeal result = 2:1; for every $1 of CL (short-termfinancial obligations) business carries $2 CA to CLcover.
High result indicates:• assurance that obligations can be met• if too high (3:1+) may indicate ‘idle funds’. Funds better invested in higher interest bearing assets.Low result may indicate:• inability to meet obligations
RecommendationsPay off bank overdrafts as soon as possible.Investigate alternative suppliers (accountspayable) to lower cost of stock.Invest ‘idle funds’ in areas likely to attract ahigher return.
Quick RatioIndicates the entity’s ability to meet itsimmediate financial obligations such asaccounts payable from its immediately CA - (Inventories + Prepayments)accessible or quickly converted assets such as CL - Bank Overdraftcash and accounts receivable.Does not include inventories and prepaymentsbecause they are difficult to convert to cash inthe short term. Bank overdrafts are usually notdue in the next accounting period, therefore;not included.Ideal result = 1:1; for every $1 of CL (immediatefinancial obligations, not including bankoverdraft) business has $1 CA (not includingstock/prepaids) to cover.
High result indicates:• High degree of assurance that immediate debts can be paid• Excessive levels of quick assets held eg cashLow result may indicate:• inability to meet immediate debts• Business is relying on turnover of stock to meet obligations
RecommendationsConsider level of accounts payableEnsure cash flow is optimal – accountsreceivable pay on time.Maintaining adequate levels of cash ratherthan excessive (better invested in higherreturning applications)
Equity RatioIndicates the extent to which the owner hasfinanced the business’s assets as opposed tousing alternative source of finance –borrowings (debt).Mirror of Debt Ratio – both ratios should equal100%. Total Owner s EquityA = L + Oe * 100 Total AssetsIdeal is 50% - that is business assets are halffunded by equity and half by debt.Finance companies will “move in” when ratioreaches 70:30 debt to equity.
High result indicates:• Most funds provided by owner to finance businessLow result may indicate:• Most funds provided by borrowings to finance business
RecommendationsHeavy dependence on equity indicatesbusiness is not highly geared. (Gearing refersto level of debt).In times of low interest rates on moneymarket and if business is performing wellowner should invest further in business.Decrease debt through repayment to achieve50:50 balance of debt/equity.Minimise need to carry hold/own largeassets.
Debt RatioIndicates the way in which business is financedand extent of borrowing in relation to assets. Total Liabilitie s * 100 Total Assets
High result indicates:• Most funds provided by borrowings to finance businessLow result may indicate:• Most funds provided by owner to finance business
RecommendationsHeavy dependence on debt indicates businessis highly geared.Places high burden on business to meetrepayments.Repay as soon as possible.Carefully consider any further investment infuture beyond the 50:50 balance ofdebt/equity.
Effectiveness of Management PoliciesManagement effectiveness is ameasurement of how successfullymanagers have been in directing andmaintaining the set policies of anenterprise.
Management Effectiveness Ratios• Turnover of Accounts Receivable• Turnover of Inventories
Turnover of Accounts Receivable Ratio Average Accounts Receivable e s *365 Net Credit Sales t tMeasures the efficiency of the business inmanaging its accounts receivable.Business operations are dependant upon thecollection of this debt.Cash flow into the buisness is required tomaintain operations eg pay wages, bills etc.
High result indicates:• Inefficient Collection Policy – should state collection rate between 20-40 days – if number of days too high strong possibility of high bad debts figure.• Poor cash flow• Loose credit policyLow result may indicate:• Effective credit policy, efficient collection of Accounts Receivable
RecommendationsTighten credit policy and communicate todebtors. All business offering credit shouldestablish a credit policy. – Policy conditions include: • Repayment time (usually 30 days) • Discounts offered for prompt payment • Interest to be charged on overdue account • Method to determine credit worthiness of applicant. – Business should issue monthly statements which serve as a reminder
Factor Accounts Receivable – debts are soldto financial institute for 90-85% of value. – Attractive option because it offers immediate cash flow – Saves the business the cost of phone calls, reminders legal action etc.
Turnover of Inventories RatioMeasures how efficiently the inventory of thebusiness is being managed.Comparison against industry averages willindicate acceptable turnover. Cost of Goods Sold 365/ Average Inventory
High result indicates:• Slow-moving inventory• Large holding of inventory ready for saleLow result may indicate:• Fast-moving inventory• Shortage of inventory available for sale
RecommendationsStock at appropriate levels – JITInvestigate methods of lowering COGS.Target customers more effectively –marketing.