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Ratio Analysis Review

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Published in: Accountancy | Business
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Ration Analysis

Joanne O / Dubai

8 years of teaching experience

Qualification: BSc Business Management and PGCE

Teaches: Business, IB Exam Preparation, Business Studies

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  1. tarter or 10! Samantha currently operates at 80% capacity utilisation selling satchels at E 25. She produces 60 000 satchels a year. Research has shown that her PED is -0.8. 1) What is Samantha's current sales revenue assuming she sells all of her satchels? 2) How many satchels could Samantha's factory make if she operated at 100% capacity utilisation? Samantha's current wage bill is €192 000. She employs 3 supervisors and 12 operatives. 1) 2) 3) 4) What is the average span of control per worker? If Samantha paid a 10% performance related bonus for meeting targets what would be her total wage bill Assuming the bonus is paid what are employee costs as a percentage of sales revenue assuming Samantha operates at 100% capacity utilisation and sells all of the items. Samantha is considering lowering her selling price by f2.50. She currently sells 60 000 satchels a year. What would be Samantha's new sales revenue if she lowered her price?
  2. 1) Sales Revenue = €25 x 60 000 Sales Revenue = El 500 000 = 1.25 80% capacity = 60 000 100% capacity = 60 000 x 1.25 100% capacity = 75 000 units 1) Average span of control = 12/3 = 4 2) f192 000 x 1.1 = E211 200 3) 75 000 units x €25 = fl 875 000 sales revenue at full capacity. Employee Costs/Sales Revenue x 100 €211 200/f1 875 000 x 100 = 11.264 = 11% 4) Current Selling Price = E25 at 60 000 units Lowering by E2.50 = €22.50 PED = % Change in Quantity Demanded/ % Change in Price PED = -0.8 % change = original — new/ original x 100 % change in price = 25-22.50/25 x 100 = % change in quantity demanded = 0.8 x 10 Quantity Demanded = 60 000 x 1.08 = 64 800 satchels New Sales Revenue = E22.50 x 64 800 New Sales Revenue = El 458 000
  3. Limitations of Ratio Analysis Reliability of information - The data on which the ratios are based may be unreliable - Some figures e.g. asset valuation are subjective - Different accounting methods may be employed - Impossible to account for all 'bad debts' - 'window dressing' — financial situation changes daily and it may manipulate its accounts to provide a favourable view on the date on which they are prepared
  4. Limitations of Ratio Analysis Historical basis - Accounts indicate where a company has been, rather than where it is going. Past performance not necessarily a useful guide to the future - Accounts show what happened, rather than why, and so they can only serve to point out potential problems Comparisons - Ratios rely on comparision, but they always involve difficulties because no two firms or divisions face identical circumstances
  5. Limitations of Ratio Analysis Corporate Objectives owe Ratio analysis ignores other objectives that may be important to a firm: Reputation - Human Relations - Relationship with suppliers - Product quality Future profit - na yse owc anges In a car manu cturer s orporate objectives might influence the ways in
  6. alyse fa an A car manufacturer aiming to maximise profit will focus very closely on performance ratios, such as ROCE and net profit margin. However if the business gets into cash flow difficulties, liquidity ratios such as the current ratio may become more important as short term objectives Financial efficiency ratios may take priority if specific problems are faced bv the car manufacturer. In recent years, the growing use of JIT has meant that reduction in the rate of inventory turnover has been a key meaure of effective performance within the industry The car industry has suffered from excess capacity globally. Therefore, many car manufacturers have focused on the effective use of resources as a means of assessing efficency. This has meant that the financial efficiency ratios have become more important measures of performance. Car manufacturers may also focus on other aspects of their business, such as welfare of their workforce or their reputation for quality, and possibly the relationship with their suppliers. In these cases, ratio analysis may be less important, although in the case of suppliers, creditor days may be used as a measure of the manufacturers promptness in paying
  7. Limitations of Ratio Analysis External factors Company performance is very dependent on outside factors.. - The stage of the economic cycle - Government legislation - Changes in trends - New technology - Level of competition sing a particular ratio, show how i ight be affected by any of the two xtern If t
  8. sing a particular ratio, show how it might be affected by any of the two externa t Ratio - ROCE External Factors — Rate of economic growth and Government legislation One external factor is the rate of economic growth. The return on capital employed will depend on the state of the economy. For most products, an increase in economic growth will lead to an increase in sales and profit, especially if the product has high income elasticity of demand. Similarly, a recession in the economy will lead to a fall in the sales of a typical product - the change will probably reduce ROCE Another external factor is government legislation. Changes in the law may lead to increased costs, as businesses need to modify their production or systems to comply. However, they may lead to opportunities to provide new goods or services for customers. ROCE may increase as the business takes advantage of the situation.
  9. 'Ratio analysis is of limited use because it shows the past, not the future'. Agree To what extent is this statement valid? Disagree
  10. 'Ratio analysis is of limited use because it shows the past, not the future'. To what extent is this statement valid? -Any ratio only reflects the past and is therefore no guarantee of a business's future prospects. -Ratio analvsis does not show external changes such as the state of the economy and market conditions, which may dramatically affect a business's success. However, separate research into these Jactors, combined with an understanding of a business s mance will enable it to plan the future more rigorous -The pace of change is tending to accelerate and so firms are facing new challenges and circumstance all the time. As a consequence past performance is unlikely to be a reliable guide to future performance -Corporate objectives are constantly changing and so it becomes difficult to com are ratios over time because performances may have een influenced by changes in priorities over time. - Ratios do help a company to recognise where its strengths lie and where it is weak. This information will help a business to recitify problems and build on its strenghts, and therefore will guide its future performance. - Business activity tends to be cyclical and so if a company correctly identifies the stage of the business cycle that is currently in existence, it can use ratio analysis from past years to gain an indiction of how well or not so well it should be preforming at present
  11. Why did Toys R Us fail? https://www.cnbc.com/2019/01/26/tovs-r-us- built-a-kingdom-and-the-worlds-biggest-tov-store- then-they-lost-it. html https://www.bbc.com/news/business-43210854
  12. Non current assets Current assets Inventory Recievables Current liabilities Payables Other unpaid bills Income tax payable Net current assets Long-term debt Net Assets Shareholders' funds Reserves Total Equity 2017 1,967 1,290 1,114 1,950 2016 2,045 1,159 1,153 1,746 Revenue Cost of Sales Gross Profit Operating expenses Operating profit Interest Profit after interest Net profit for the year 2017 2,996 1,680 1,316 1,268 48 180 -132 -132 2016 3,084 1,724 1,360 1,328 32 144 -112 -112
  13. Toys R Us failed in early 2018. Can you explain why? ROCE= 1.6% ROCE= 2 2% Measure Profitability — looking back over the previous year Liquidity — looking forward for the next year Gearing — did they have too much long-term debt 2016 1.01:1 85.1% 2017 1.2:1 91% Analysis Missed opportunities to keep up to date with comeptitors. They also had the chan Long term debts increased Thos can have future implications
  14. https:(/www.cnbc.com/2019/01/26/tovs-r-us-built-a-kingdom-and-the- worlds-biggest-tov-store-then-thev-lost-it. html
  15. Gearing examples https://www.tutor2u.net/business/blog/gearing-whv-big-companies- like-debt-as-a-source-of-finance-but-problems-lie-ahead https://www.tutor2u.net/business/blog/gearing-up-for-growth- microsoft-sources-huge-debt-finance
  16. Gearing Up for Growth - Microsoft Sources Huge Debt Finance 1) Why was the demand from investors for these bonds very strong? 2) Does this create a gearing problem for Microsoft?

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