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.
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.
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.
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
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.
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.
What do you think would be an acceptablerate of Inventory Turnover for the following Businesses?
Your turn!Calculate the AssetTurnover ratio andInventory/ StockTurnover ratio forAlquimia Plc. Where doesWhat can you infer from thethe analysis? information come from?
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.
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.
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?
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.
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.
Your turn!Calculate the Gearingratio for Alquimia Plc.What can you infer fromthe analysis? Where does the information come from?
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!
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.