Financial Reports and Ratios

Analytical Techniques

Analytical Techniques permit businesses to study end of period reports in order to base decisions for the future. Techniques may include:

• Ratio analysis• Vertical and horizontal analysis• Trend analysis

Ratio Analysis

• Valuable tool for interpreting financial ratios

• Efficient way to express relationship of one number to another

• 3 areas of analysis:– Profitability– Financial stability– Management effectiveness

Vertical Analysis

• Analysis of items or a group of items in the same financial period.– Eg comparison of Net

Sales to Expense groups

Horizontal Analysis

• Analysis of items or a group of items across consecutive accounting periods.– Eg comparison of Sales in ’07 to ‘08

Trend Analysis

• Analysis of items across at least three consecutive accounting periods.– Eg Sales are progressively increasing over the five

year period.

RATIOS

• Presented as % or as ratios• Assist in:– decision making– Interpreting financial reports– Assessment of enterprise’s:• Profitability• Stability• Effectiveness

Ratios

ProfitabilityProfitability is the ability to earn income within the present financial structure of an enterprise.

Profitability Ratios

• Gross profit ratio• Net profit ratio• Ratio of expenses to sales• Return on equity ratio• Return on total assets ratio

Gross Profit Ratio

Indicates the ability of a trading enterprise to generate gross profit from sales.

Compare result to industry benchmarks to determine suitability of business performance

x100Sales NetProfit Gross

Result indicates:

• for every $ of sales – number of cents retained as gross profit

• how effective business is in passing on increases in COGS to customers

High result may indicate:• ability of business to cover all costs• capacity to earn acceptable net profit

and return to owner

Low result may indicate inability to:• meet further costs• return satisfactory net profit• return satisfactory rate to owner

Recommendations

Improve sales• Ascertain:– stock levels - should be high enough to meet

demand– appropriateness of stock to appeal to market– demand for stock held– Appropriateness of selling price

• Conduct market research/analysis to assist with the above.

Institute policy to minimise COGS

• Investigate alternative suppliers selling similar quality products for less

• Take advantage of discounts offered to lower costs

Net Profit Ratio

•Indicates the ability of a trading enterprise to generate a return on the owner’s investment.

•Compare result to industry benchmarks to determine suitability of business performance

x100Sales NetProfit Net

• Result indicates:

• for every $ of sales – number of cents retained as net profit

• how effective business is in minimising expenses

• poor GP ratio will impact on NP ratio

High result may indicate:• High operating revenue• Low operating expenses

Low result may indicate:• inappropriate pricing policy• inadequate stock• inappropriate stock• expenses too high

RecommendationsImprove sales• as per Gross Profit recommendations

Minimise expenses• Set budgets for departments• Investigate alternative suppliers to lower

costs• As per Gross Profit recommendations

Expense Groups to Sales

Indicates the amount of the sales dollars needed to cover expenses.

Compare result to industry benchmarks to determine suitability of business performance.

x100Sales NetExpensesof Group

High result may indicate:• weak control over expenses in proportion

to the sales

Low result may indicate:• tight control over the expenses in

proportion to the sales

RecommendationsInvestigate unusually high or low expense items to ensure errors have not been made in recording.

Increase net profit while retaining expense levels at current level.

Decrease expenses while retaining or improving sales.

Rate of Return on Equity Ratio

Indicates the return to the owner on the amount invested in the business

Aim for a return of, around, 14% which allows funding for future growth and a return on investment.

x100Equity sOwner' Average

Profit Net

OE Avg /2end OE beg OE

High result may indicate:• efficient operation• business may be under-capitalised (owner

has not contributed equity to the optimum level)– Under-capitalisation can be identified when NP

ratio is close to or under industry benchmark yet ROE is well above industry benchmark

Low result may indicate:• owner’s money may perform better

invested elsewhere• business may be over-capitalised (if owner

has invested over the optimum sum into the business)– Can be identified when NP ratio is close to

industry benchmark yet the ROE result is well below industry benchmark

• management may take little risk therefore business is cautiously run

• inefficient management making poor decisions, lack of foresight.

RecommendationsImprove net profit result using previous recommendations.

Check level of capitalisation to ensure appropriateness for industry.

– If under-capitalised owner should consider investing further funds into the business.

– If over-capitalised owner should consider investing excess funds into alternative investments.

Rate of Return on Total Assets Ratio

Indicates the ability of the enterprise to generate profits using its assets.

•Compare result to industry benchmarks to determine suitability of business performance.

x100Assets Total Average

Expense Interest Profit Net

High result may indicate:• efficient use of assets• wise decisions made regarding asset

acquisition

Low result may indicate:• inefficient use of assets• inappropriate levels/types of assets leading

to poor performance• high purchase price for assets

RecommendationsIncrease net profit.

Decrease average total assets – ensure optimum level of assets retained.

Carefully consider potential of assets prior to acquisition.

Financial Stability

Financial Stability indicates the short-term liquidity and long-term solvency of an enterprise.

Financial Stability Ratios

• Current Ratio• Quick Ratio (Acid Test)• Equity Ratio• Debt Ratio

Current Ratio

Measures the ability of the enterprise to meet its short-term financial obligations; that is, commitments due in the current financial year.

Ideal result = 2:1; for every $1 of CL (short-term financial obligations) business carries $2 CA to cover.

CLCA

High result indicates:• assurance that obligations can be met• if too high (3:1+) may indicate ‘idle funds’.

Funds better invested in higher interest bearing assets.

Low result may indicate:• inability to meet obligations

RecommendationsPay off bank overdrafts as soon as possible.

Investigate alternative suppliers (accounts payable) to lower cost of stock.

Invest ‘idle funds’ in areas likely to attract a higher return.

Quick RatioIndicates the entity’s ability to meet its immediate financial obligations such as accounts payable from its immediately accessible or quickly converted assets such as cash and accounts receivable.

Does not include inventories and prepayments because they are difficult to convert to cash in the short term. Bank overdrafts are usually not due in the next accounting period, therefore; not included.

Ideal result = 1:1; for every $1 of CL (immediate financial obligations, not including bank overdraft) business has $1 CA (not including stock/prepaids) to cover.

Overdraft Bank - CLs)Prepayment es(Inventori -CA

High result indicates:• High degree of assurance that immediate

debts can be paid• Excessive levels of quick assets held eg

cash

Low result may indicate:• inability to meet immediate debts• Business is relying on turnover of stock to

meet obligations

RecommendationsConsider level of accounts payable

Ensure cash flow is optimal – accounts receivable pay on time.

Maintaining adequate levels of cash rather than excessive (better invested in higher returning applications)

Equity RatioIndicates the extent to which the owner has financed the business’s assets as opposed to using alternative source of finance – borrowings (debt).

Mirror of Debt Ratio – both ratios should equal 100%.

A = L + Oe

Ideal is 50% - that is business assets are half funded by equity and half by debt.

Finance companies will “move in” when ratio reaches 70:30 debt to equity.

100*Assets Total

Equity sOwner' Total

High result indicates:• Most funds provided by owner to finance

business

Low result may indicate:• Most funds provided by borrowings to

finance business

RecommendationsHeavy dependence on equity indicates business is not highly geared. (Gearing refers to level of debt).

In times of low interest rates on money market and if business is performing well owner should invest further in business.

Decrease debt through repayment to achieve 50:50 balance of debt/equity.

Minimise need to carry hold/own large assets.

Debt Ratio

Indicates the way in which business is financed and extent of borrowing in relation to assets.

100*Assets Total

sLiabilitie Total

High result indicates:• Most funds provided by borrowings to

finance business

Low result may indicate:• Most funds provided by owner to finance

business

RecommendationsHeavy dependence on debt indicates business is highly geared.

Places high burden on business to meet repayments.

Repay as soon as possible.

Carefully consider any further investment in future beyond the 50:50 balance of debt/equity.

Effectiveness of Management Policies

Management effectiveness is a measurement of how successfully managers have been in directing and maintaining the set policies of an enterprise.

Management Effectiveness Ratios

• Turnover of Accounts Receivable• Turnover of Inventories

Turnover of Accounts Receivable Ratio

Measures the efficiency of the business in managing its accounts receivable.

Business operations are dependant upon the collection of this debt.

Cash flow into the buisness is required to maintain operations eg pay wages, bills etc.

High result indicates:• Inefficient Collection Policy – should state

collection rate between 20-40 days – if number of days too high strong possibility of high bad debts figure.

• Poor cash flow• Loose credit policy

Low result may indicate:• Effective credit policy, efficient collection

of Accounts Receivable

RecommendationsTighten credit policy and communicate to debtors. All business offering credit should establish a credit policy.

– Policy conditions include:• Repayment time (usually 30 days)• Discounts offered for prompt payment• Interest to be charged on overdue account• Method to determine credit worthiness of applicant.

– Business should issue monthly statements which serve as a reminder

Factor Accounts Receivable – debts are sold to financial institute for 90-85% of value.

– Attractive option because it offers immediate cash flow

– Saves the business the cost of phone calls, reminders legal action etc.

Turnover of Inventories Ratio

Measures how efficiently the inventory of the business is being managed.

Comparison against industry averages will indicate acceptable turnover.

Inventory AverageSold Goodsof Cost

365/

High result indicates:• Slow-moving inventory• Large holding of inventory ready for sale

Low result may indicate:• Fast-moving inventory• Shortage of inventory available for sale

RecommendationsStock at appropriate levels – JITInvestigate methods of lowering COGS.

Target customers more effectively – marketing.