Ratio analysis Interpreting results for M3

1
Ratio analysis Interpreting results for M3

• The aim of the following slides is to provide
  some useful facts to help you with your
  explanations of the ratio analysis carried out in
  P7

2
Liquidity/Solvency Ratios

• Current Ratio See factsheet the ideal is 21
• Acid Test Ratio See factsheet the ideal is
  11
• A lower ratio implies not enough liquidity
  threat to survival
• A higher ratio suggests financial resources are
  not being fully utilised how could they put
  some of the excess cash flow to better use (so
  its earning money)?

3
Performance/Activity Ratios Asset Turnover

• The ratio should be as high as possible. A low
  ratio suggests inefficient use of assets.
• Consider the context of the business - haulage
  could be described as a capital intensive
  industry. How would this affect your
  interpretation of the ratio?
• You could break this down into a fixed asset
  turnover and a current asset turnover ratio
  and discuss the results

4
Performance/Activity Ratios Stock Turnover

• General rule - the greater the stock turnover,
  the greater the efficiency of the business
• You could convert your result into the number of
  weeks/months the stock of fuel is held to improve
  your analysis
• Too much stock can tie up cash and lead to cash
  flow problems - Did the liquidity ratios rule
  this danger out in Rapidos case?
• Consider reasons why they might hold so much
  stock could there be any benefits to buying in
  large volumes?
• Do you have sufficient information to form a
  definite opinion whether this is good management
  or not?

5
Performance/Activity Ratios Debtors Ratio

• State the assumption we have made that all sales
  are credit sales comment on whether this seems
  fair in context of the industry
• Assuming most companies who do offer trade credit
  will give 14-30 day terms and perhaps longer to
  their best customers is this a good performance?
• One bad debt could make a significant impact on
  the average number of days take to convert
  debtors to cash.
• What does all this say about their cash control?

6
Performance/Activity Ratios Creditors Ratio

• State the assumption we have made that all
  purchases are credit purchases comment on
  whether this seems fair in context of the
  industry and any other evidence.
• Is the number of days they take to pay their
  trade creditors greater or fewer than they take
  to get payments in from their debtors? Is this
  good or bad for their cash flow position?....why?
• Does the number of days suggest good credit terms
  have been negotiated with suppliers or that they
  are having difficulty paying their bills? Do you
  have any other information to help you
  decide?.....refer to your liquidity ratios here
  (are they likely to have problems paying?)

7
Gearing Ratio

• Balance sheet gearing shows how dependent the
  business is on borrowings (debt)
• Gearing that is too high may create a large
  interest burden and mean there are significant
  monthly repayments to be met from cash flow.
  Dangerous in an economic downturn! Lenders may
  view further applications for finance as high
  risk, so hard to borrow in future.
• Around 50 is often considered a happy medium as
  a general rule, but haulage is a capital
  intensive industry where gearing is more often
  around 100
• Gearing that is too low may suggest an overly
  cautious approach to managing the organisation
  and an unwillingness to invest and update assets
  etc. Would that be wise in the haulage business
  in particular? (consider the appearance and
  reliability of the fleet)

8
Profitability RatiosReturn on Capital Employed
(ROCE)

• This gives some context to good a certain level
  of profit is by showing it in relation to the
  amount of money invested in the business
• It tells an investor how attractive the company
  is as an investment.
• It allows you to compare one businesss
  performance with alternative investments e.g.
  stocks and shares, other businesses, putting it
  in the bank (bank is the lowest risk, but will
  only return 2-3 in the current economy)

9
Profitability RatiosGross Profit Margin Net
Profit Margin

• Generally the higher, the better
• Do they tell you much on their own?
• What else might you want to know for these to be
  useful? think about useful comparisons!

10
In Conclusion

• Sum up your judgement about the performance of
  your clients company as a result of your
  analysis of their accounts
• You could also
• Identify any limitations or caveats in your
  ability to comment confidently on the health of
  the company
• State any further information you would like to
  have had in order to be more certain of your
  conclusions