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Ratio Analysis No. 2 CMD
 

Ratio Analysis No. 2 CMD

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    Ratio Analysis No. 2 CMD Ratio Analysis No. 2 CMD Presentation Transcript

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