RATIO ANALYSIS Ratio Analysis Attempts to judge a
- Slides: 23
RATIO ANALYSIS
Ratio Analysis • Attempts to judge a firm’s financial performance • Based on the assumption that firms will be aiming to make a profit
Judging performance • In order to be successful, a company must: • Make a profit • Ensure that it has enough liquidity ot meet immediate payments • Plan its long-term financing to make sure that it can pay creditors • Control its financial transactions efficiently • Remain attractive to existing and prospective shareholders
Performance (or profitability) Ratios • To judge how well the firm is making profit
Liquidity ratios • To study how well a firm is managing its cash and liquid assets
Gearing ratios • To see how well the long-term financing is being managed
Financial efficiency ratios • To assess the effectiveness of management of particular aspects of the firm
Shareholders’ ratios • To measure the attractiveness of the firm to its shareholders
Which best summarise financial performance?
Which best summarise performance? • Performance & liquidity ratios
Using ratios • On their own, useful but limited • Better to compare to other results so the company can be judged in relative terms
Bases for comparison • Comparisons to a standard • Inter-firm comparisons • Intra-firm comparisons • Ratios should be compared over time in order to register trends in efficiency & allow for unusual occurrences in one particular year
RATIO ANALYSIS Profitability & liquidity
Profitability/performance ratios • ROCE Net profit Capital employed x 100 Compare to interest rate in bank? • Operating/gross profit margin Operating/gross profit Sales (turnover) x 100
Liquidity ratios • Cash-flow problems cause the closure of 20% of businesses that fail in the UK • Liquidity ratios compare short-term (current) assets with short-term (current) liabilities • If creditors do not receive payment, they can force the liquidation of the firm
Current ratio • Current ratio = current assets: current liabilities • ‘Ideal’ current ratio is between 1. 5: 1 and 2: 1 • Maximum as well as minimum is recommended • Opportunity cost of holding too many current assets is lost opportunity to purchase non-current assets
Acid test (quick) ratio • Inventories – are they quickly converted into cash or not? • Acid test ignores inventories, considering only cash, bank balances & receivables • Acid test ratio = (current assets – inventories): current liabilities • Ideal is between 0. 75: 1 and 1: 1
Gearing • Examines capital structure of a firm and its likely impact on firm’s ability to stay solvent • Gearing (%) = non-current liabilities total equity + non-current liabilities x 100
Gearing • If ratio is greater than 50%, high capital gearing • If less than 25%, then low capital gearing • 25%-50% is within normal range
High capital gearing - benefits • Relatively few shareholders means greater control for existing shareholders • Company can benefit from a very cheap source of finance when interest rates are low • In times of high profit, interest payments are usually much lower than shareholders’ dividend requirements
Low capital gearing - benefits • Less risk of creditors forcing company into liquidation • Avoids problem of having to pay high levels of interest on borrowed capital when interest rates are high • Avoids pressure facing highly geared companies that must repay their borrowing at some stage
Ideal gearing ratio • It depends!
Liquidity ratios • Current ratio
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