To analyse the
performance of the business we accountants must interpret accounts. This is
extremely useful to understand financial statements of a business.
“So how do we analyse
the business?”
A very good question!
We do this by looking at the businesses accounts through 4 aspects. They are as
follows:
Liquidity: This
highlights if the company has enough liquid resources or in other words cash to
pay off bills creditors etc.
Profitability:
Highlights the earnings or profit compared to expenses over a certain period of
time i.e. usually a year.
Efficiency: Highlights how well a company can perform in
regards to use of assets.
Liquidity
Current Ratio: Current
Assets: Current Liabilities
This ratio determines
if a firm can pay its liabilities. A ratio of 2:1 is an average for most
industries. This shows that a company has twice as many assets as to
liabilities. For example, Mazon Ltd. has current assets worth €1000. They also
have current liabilities of €800. If we use the current ratio asset we get.
1000: 800
1.25:1
While it is not the
preferred ratio of 2:1, the company still has more assets than liabilities and
is in relatively good health.
Quick (Acid Test) Ratio
Current Assets
(-Inventory): Current Liabilities
This ratio determines
if a firm can pay its liabilities without the inventory within the other
current assets. As stated above an average of 2:1 is highly desired however it
will be very difficult to achieve without inventories within the current
assets. Lets’ use the example again of Mazon Ltd. They have current assets of
€1000 inventories worth €100 and current liabilities of €800. This is what
would happen if used the acid test ratio.
1000 (-100): 800
900:800
1.125:1
While the company does
not have liquidity, it is perilously close to having some problems. The company
might have to look at ways to improve this ratio quickly.
Days Receivables
Outstanding Receivables X 365
Sales
This ratio deals with the number of days that a business takes to gather revenue after the sale has been completed. If a company has a high number of days to collect its income it might mean it is giving too much credit to its customers. While if a company has a low number of days to collect its income meaning they collect their income faster. We use the number 365 for the amount of days in one year.
For example our friends
at Mazon Ltd have sales of €5000 for year. The company has receivables of
€1000.
1000 X
365 = 73 days
5000
This means that the company will collect its receivables in 73 days. This might be seen as been too high for some industries where the industry average is 30 days. The answer here might be due to poor management of funds or with a recession on it is more difficult to collect the revenue of customers.
Days
Payables Outstanding Payables
X 365
Purchases
This ratio deals with
the number of days that a business takes to pay its creditors after the
purchases has been completed. If a company has a high number of days to pay its
creditors this might mean the company have problems with liquidity or poor
management of funds. While if the company has a low number of days to pay its
creditors the company has enough resources and management of funds is very
efficient.
For example our friends
at Mazon Ltd have purchases of €4000 for year. The company has payables of
€2000.
2000
X 365 = 182.5 days = 183 days
4000
This means that the
company pays its creditors on average 183 days. This might be seen as been very
high for some industries where the industry average is 30 days. The answer here
might be due to poor management of funds again or with a recession on it is
more difficult to pay the bill of creditors.
Days
Holding of Inventory Inventory
X 365
Cost of Goods Sold
This
ratio deals with the number of days it takes to convert inventory into sales.
If the number is high it might mean there is a slowdown in trading. Or that the
company is holding onto too much inventory.
For
example Mazon Ltd. has sales for the year of €5000. The company also has
inventory worth €800.
800 X 365 = 58.4 days = 58
days.
5000
From this example we see that the company holds onto stock for 58 days. The average will depend on what industry the company is in and its competitors average as well.
To learn more about liquidity ratios check out this video:
Financial Performance 4 Liquidity Ratios
Uploaded by SusanCrosson on Nov 26, 2007
Profitability
Operating Profit
Percentage Operating
Profit X 100
Sales
This ratio calculates
the amount of sales that end up as operating profit. The ratio shows how
efficient the company converts sales into operating profit.
For example Bbay Ltd.
had sales for the year were €15,000. The operating profit was €3000. (The
operating profit is before interest and taxes).
3000
X 100 = 20%
15000 1
We see the company has a 20% operating profit percentage. The higher the percentage highlights that the company is controlling costs. This can also highlight that the company is making higher sales faster than its costs. Generally the higher the percentage the better the position the company is in.
Gross Profit Percentage Gross
Profit X 100
Sales
This ratio calculates
the amount of sales that end up as gross profit. The ratio shows how efficient
the company converts sales into gross profit.
For example Bbay Ltd.
had sales for the year were €15,000. The gross profit was €8000.
8000
X 100 = 53.33%
15000 1
The gross profit
percentage is 53.33%. Generally the higher gross profit percentage the better.
As we see the company has a high gross profit percentage which indicates that
it is converting sales into gross profit very effectively.
Mark Up Gross
Profit X 100
Cost of Sales
This ratio is the gross
profit i.e. mark-up divided the total cost i.e. cost of sales. It is the total
amount added to the cost to determine the sales price.
For example Asons Ltd.
costs of sales were €10000 and gross profit was €5000. Calculate the mark up.
5000 X 100 = 50%
10000 1
Thus he makes an 50%
mark up on their cost of goods sold. This type of formula is frequently used in
retail industry.
To see more examples of profitability check out this video:
Financial Performance 8 Profitability Ratios
Uploaded by SusanCrosson on Nov 26, 2007
Efficiency
Usage of Working
Capital Sales
Working Capital
For starters, working
capital is the money that is used for the day to day running of the company. It
is calculated by current assets less current liabilities. This ratio measures
how well working capital is used to generate sales for the company.
For example, Woods plc
have current liabilities of €10,000, current assets of € 12,000. Sales for the
company were €20,000 for the year. Working capital is €2,000. (Remember the
formula for calculating working capital).
20,000 = 10
times
2000
This means that the
company uses €2,000 of working capital to generate sales of €20,000 10 times
over. Generally the higher the working capital turnover the better because it
means the company generates a lot of sales relative to its working capital.
Usage of Non Current
Assets Sales
Non Current Assets
This ratio determines
how a company generates sales from its non-current assets i.e. fixed assets.
Examples of fixed assets include plant, machinery, equipment, etc.
Let’s take an example.
Boods plc has €50,000 worth of fixed assets. Sales for the year were €20,000.
80000 = 1.6
times
50000
As we see here the
company usage of non-current assets has a turnover of 1.6 times. This means
that the company has the ability to generate sales for fixed assets by 1.6 times.
As stated from the previous formula the higher the turnover the better.
Usage
of Assets
Sales
Total Capital Employed
This
is a measure of how much sales are generate from total amount of assets
employed by the business. Total capital employed is total assets minus total
liabilities.
For
instance Goods ltd has sales of €40,000 for the year and total capital employed
is €20,000. Now for the formula
40,000 = 2
times
20,000
Thus for every 1 euro
the company has of total capital employed it generates 2 times of that worth of
sales. The higher turnover figures the better.
Inventory
Turnover Cost of Goods Sold
Inventory
This
ratio deals with what is the relationship of money tied up in stock. Is it too
much or too little? In other words how effective can a company convert
inventory into sales.
For
example Doods Ltd. cost of goods sold for the year was €20,000. Inventory was
worth € 12,000.
20,000
= 1.67 times
12,000
This turnover figure here is the number of times that inventory that has been sold for the year. A low turnover means that there are bad sales and there is too much inventory. While a high turnover means that the there could be strong sales or poor management of buying.
No comments:
Post a Comment