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Ratio analysis is to do with the past and the firms past performance.
Liquidity ratios:
Current ratio = current assets current liabilities
e.g. 1.1.5 which means for every 1 of current liabilities the business has 1.15 of current assets
Acid test ratio = (Current assets Inventories) divided by current liabilities
e.g. 0.95 which means that for every 1 of current liabilities, it has only 0.95 in current assets
Profitability ratios
Profitability ratios allow for the analysis of a firms profits in relation to either its trading performance e.g.
its sales revenues
Gross profit margin: Gross Profit X100
Revenue
Gross Profit = Turnover - Cost of Sales = the profit before cost of sales has been deducted
The gross profit margin ratio tells us the profit a business makes on its cost of sales, or cost of goods sold. It
is a very simple idea and it tells us how much gross profit per 1 of turnover our business is earning.
Net profit margin (operating profit margin): Net profit X100
Revenue
Net profit = Gross Profit Expenses = it is the profit before interest and taxation
The net profit margin ratio tells us the amount of net profit per 1 of turnover a business has earned. That is,
after taking account of the cost of sales, the administration costs, the selling and distributions costs and all
other costs, the net profit is the profit that is left, out of which they will pay interest, tax, dividends and so
on.
Operating profit margin (OPM)
Operating profit margin % = Operating profit Sales Revenue x 100
R.eturn O.n C.apital E.mployed (ROCE)
Definition: a measure of how efficiently a business is using its capital to generate profit
ROCE % = Operating profit (Total equity+non-current liabilities) x 100
Financial efficiency ratios
Used to asses how efficiently management are controlling the financial operations of the business.
Asset turnover = Sales Net Assets
Inventory turnover is a measure of how many times a business turns over its inventories in a year.
Inventory turnover = Cost of sales Inventory
Payables (creditor days)
Payables days is a measure of the average amount of time it takes to pay for supplies purchased on credit
and is expressed as a number of days.
Key Terms
Debenture: A form of long-term loan that carries a fixed rate of interest, a specific repayment date and is
often secured against the companys assets.
Profit centre: Any part of a business that can be identified as having its own costs and revenues, and for
which an individual income statement can be drawn and profit for that area calculated.
Retained profits: The part of the profit after tax that is available for distribution, kept by the company for
reinvestment purposes.
Rights issues of shares: When a PLC offers existing shareholders the right to buy more shares in the
company, often at a discount on the current market value to encourage purchase.
Sources of finance
Short, medium and long-term finances long term used to fund capital expenditure in fixed assets or longterm projects. Finances to fund strategic development or retrenchment. Largest source is retained profit.
External sources of finance: equity share capital and debt (loans).
The assumption that any enterprise will try to produce its output at the lowest possible cost. It refers to the
cost of providing goods or services of a specified quality; it does not mean achieving lower costs by cutting
standards.
It allows a business to compete on price a business that has a high market share or is a market leader will
be in a position of power when it comes to negotiating terms and conditions with suppliers and so may
adopt a strategy which includes an aggressive approach to negotiating prices for goods and services.
Alternatively a business might aim to reduce the cost of managing resources by adopting just-in-time. This
is when raw materials are received when they are needed and finished goods despatched onto the customer,
then it can avoid the costs associated with holding stocks.
Capital expenditure
Is when the purchase of assets that will remain in the business in the medium to long term are accounted for
in the balance sheet e.g. a machine, delivery van etc
Investment appraisal
The process of analysing the financial merits of a possible future investment