Ratio Analysis No. 2 CMD


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Ratio Analysis No. 2 CMD

  1. 1. Ratio Analysis No. 2 Higher/Int 2 Business Management 2009-2010
  2. 2. Today’s Ratios <ul><li>Today we will look at the following ratios in more detail: </li></ul><ul><li>Liquidity </li></ul><ul><ul><li>Current Ratio (Working Capital Ratio) </li></ul></ul><ul><ul><li>Acid Test (Quick) Ratio </li></ul></ul><ul><li>Efficiency </li></ul><ul><ul><li>Return on Capital Employed </li></ul></ul>
  3. 3. Current Ratio <ul><li>A reminder of the ratio: </li></ul><ul><li>Current Assets : Current Liabilities </li></ul>
  4. 4. Current Ratio <ul><li>This ratio checks to see if Current Assets will cover Current Liabilities . </li></ul><ul><li>In other words, can the business meet its short term debts without having to borrow money? </li></ul>
  5. 5. Current Ratio <ul><li>What is a good figure ? </li></ul><ul><li>The ratio of 2:1 represents a satisfactory liquidity position . </li></ul><ul><li>This means that for every £2 of current assets the organisation would have £1 of current liabilities . </li></ul>
  6. 6. Current Ratio <ul><li>A higher ratio than 2:1 would indicate that the organisation is holding assets in liquid form which may be better use invested in the organisation (e.g. new machinery) . </li></ul><ul><li>Spare cash can be invested , even in the short term , and earn additional revenue for the organisation. </li></ul>
  7. 7. Current Ratio <ul><li>If this ratio is allowed to fall then the business may not be able to pay its creditors on time. </li></ul><ul><li>If this happens, no matter how profitable the organisation, it can still become bankrupt . </li></ul><ul><li>Bank overdrafts , for example, are repayable on demand . </li></ul>
  8. 8. Current Ratio <ul><li>Improvement of this ratio is a positive sign when it comes from better use and control of credit and banking . </li></ul>
  9. 9. Current Ratio <ul><li>However, if this ratio improves because of increased stock holding this can signal a problem . </li></ul><ul><li>Having a large stock holding is inefficient , both in terms of money and wastage . </li></ul>
  10. 10. Current Ratio <ul><li>How can an organisation improve the Current Ratio ? </li></ul><ul><li>An organisation can improve the current ratio by: </li></ul><ul><ul><li>Increasing assets. </li></ul></ul><ul><ul><ul><li>(e.g. cash in the bank) </li></ul></ul></ul><ul><ul><li>Decreasing liabilities. </li></ul></ul><ul><ul><ul><li>(e.g. value of trade creditors) </li></ul></ul></ul>
  11. 11. Acid Test (Quick) Ratio <ul><li>A reminder of the ratio: </li></ul><ul><li>(Current Assets - Stock) : Current Liabilities </li></ul>
  12. 12. Acid Test (Quick) Ratio <ul><li>This ratio shows the ability of an organisation to pay its short term debts in a crisis situation . </li></ul><ul><li>Can the organisation meet its short term debts without having to sell any stock ? </li></ul>
  13. 13. Acid Test (Quick) Ratio <ul><li>There is no guarantee that the stock that the organisation holds can actually be sold . </li></ul><ul><li>Even if stock is sold, the cash is not necessarily available immediately (30 days). </li></ul><ul><li>In addition stock may have to be sold at a reduced price . </li></ul>
  14. 14. Acid Test (Quick) Ratio <ul><li>Even if stocks could be disposed of immediately and cash received , the organisation would have run into difficulties with no stock left to trade with . </li></ul>
  15. 15. Acid Test (Quick) Ratio <ul><li>In order for an organisation to survive it must have enough working capital to pay for its day to day bills . </li></ul><ul><li>A result of 1:1 from the ratio is ideal as it shows that current assets can cover current liabilities if required. </li></ul>
  16. 16. Return on Capital Employed <ul><li>A reminder of the ratio: </li></ul><ul><li>ROCE % = Net Profit </li></ul><ul><li>Capital Employed </li></ul>x 100 1
  17. 17. Return on Capital Employed <ul><li>This ratio provides information in particular to potential investors . </li></ul><ul><li>Should they invest in the company or place their money in a savings account at a bank. </li></ul><ul><li>Improvement in this ratio is a positive sign that will be due to better use of invested capital in the generation of profit . </li></ul>
  18. 18. Return on Capital Employed <ul><li>This ratio uses the historic costs of the organisation’s assets . </li></ul><ul><li>If asset values are inaccurate , then the capital employed figure will also be inaccurate . </li></ul>
  19. 19. Return on Capital Employed <ul><li>Imagine two companies X and Y . </li></ul><ul><li>Company X reports a profit of £500,000 . </li></ul><ul><li>Company Y reports a profit of £1m . </li></ul><ul><li>If X earned £500,000 from capital of £4m . </li></ul><ul><li>If Y earned £1m from capital of £10m . </li></ul><ul><li>Company X has made better use of resources , and will have a higher ROCE ratio. </li></ul>
  20. 20. Task <ul><li>Using the example of Edward’s Electrical Supplies Ltd , answer the questions based on the ratios covered today. </li></ul><ul><li>Remember that for your NAB and final exam , it is important that you are able to describe ratios , give reasons for the results and be able to offer suggestions on how the ratios can be improved . </li></ul>