Tuesday, 24 July 2012

Liquidity, Profitability, Efficiency

When running a business it is best to know how the business is performing from year to year. For example, is profit up from last year? Can the firm support the interest from loans? Or does the company have enough cash?
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 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 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.

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