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Ratio Analysis No. 2 CMD

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  • If helpful the balance sheet and trading profit and loss for Gill/Edward's businesses can be emailed ... contact Knox Academy (www.ka-net.org.uk)
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  • 1. Ratio Analysis No. 2 Higher/Int 2 Business Management 2009-2010
  • 2. 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
  • 3. Current Ratio
    • A reminder of the ratio:
    • Current Assets : Current Liabilities
  • 4. 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?
  • 5. 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 .
  • 6. 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.
  • 7. 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 .
  • 8. Current Ratio
    • Improvement of this ratio is a positive sign when it comes from better use and control of credit and banking .
  • 9. 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 .
  • 10. 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)
  • 11. Acid Test (Quick) Ratio
    • A reminder of the ratio:
    • (Current Assets - Stock) : Current Liabilities
  • 12. 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 ?
  • 13. 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 .
  • 14. 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 .
  • 15. 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.
  • 16. Return on Capital Employed
    • A reminder of the ratio:
    • ROCE % = Net Profit
    • Capital Employed
    x 100 1
  • 17. 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 .
  • 18. 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 .
  • 19. 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.
  • 20. 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 .

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