ACCA F5: Chapter 12 - Performance Measurement and Control

1 Ratio analysis - Profitability- Liquidity- Risk

1 Ratio analysis - Many ratios use figures at a particular point in time and thus may not be representative of the position throughout a period. For example, seasonal trade or large one-off items may make year-end figures uncharacteristic. - Ratios are of little use in isolation. Comparisons could be made to last year’s figures to identify trends or competitors’ results and/or industry averages to assess performance - Ratios can be manipulated by management. A well known example of ‘window dressing’ is to issue spurious invoices before the year end and then issue credit notes just after. - As with variances, ratios indicate areas for further investigation, rather than giving a definitive answer for management.

1 Ratio analysis The primary objective of a company is to maximise profitability. Profitability ratios can be used to monitor the achievement of this objective. - Gross profit margin- Net profit margin- Return of capital employed (ROCE)- Asset turnover

1 Ratio analysis This is the gross profit as a percentage of turnover = (Profit / turnover) x 100 A high gross profit margin is desirable. It indicates that either sales prices are high or that production costs are being kept well under control.

1 Ratio analysis This is the net profit (turnover less all expenses) as a percentage of turnover = (profit / turnover) * 100 A high net profit margin is desirable. It indicates that either sales prices are high or that all costs are being kept well under control.

1 Ratio analysis This is a key measure of profitability. It is the net profit as a percentage of the capital employed. The ROCE shows the net profit that is generated from each $1 of assets employed. = (Net profit / capital employed) * 100 Where capital employed = total assets less current liabilities or total equity plus long term debt A high ROCE is desirable. An increase in ROCE could be achieved by - Increasing net profit, e.g. through an increase in sales price or through better control of costs or reducing capital employed (get rid of long term debt) ROCE = net profit margin × asset turnover

1 Ratio analysis This is the turnover divided by the capital employed. The asset turnover shows the turnover that is generated from each $1 of assets employed. = turnover / capital employed A high asset turnover is desirable. An increase in the asset turnover could be achieved by:- Increasing turnover, e.g. through the launch of new products or a successful advertising campaign.- Reducing capital employed, e.g. through the repayment of long term debt.

1 Ratio analysis A company can be profitable but at the same time encounter cash flow problems. Liquidity and working capital ratios give some indication of the company's liquidity.

1 Ratio analysis This is the current assets divided by the current liabilities = current assets/ current liabilites The ratio measures the company's ability to meet its short term liabilities as they fall due. A ratio in excess of 1 is desirable but the expected ratio varies between the type of industry (more assets than liab) A decrease in the ratio year on year or a figure that is below the industry average could indicate that the company has liquidity problems. The company should take steps to improve liquidity, e.g. by paying creditors as they fall due or by better management of receivables in order to reduce the level of bad debts.

1 Ratio analysis This is a similar to the current ratio but inventory is removed from the current assets due to its poor liquidity in the short term. = (Current assets – inventory) / current liabilites

1 Ratio analysis This indicates the average number of days that inventory items are held for = (Inventory/cost of sales) * 365 An increase in the inventory holding period could indicate that the company is having problems selling its products and could also indicate that there is an increased level of obsolete stock. The company should take steps to increase stock turnover, e.g. by removing any slow moving or unpopular items of stock and by getting rid of any obsolete stock A decrease in the inventory holding period could be desirable as the company's ability to turn over inventory has improved and the company does not have excess cash tied up in inventory. However, any reductions should be reviewed further as the company may be struggling to manage its liquidity and may not have the cash available to hold the optimum level of inventory.

1 Ratio analysis This is the average period it takes for a company's debtors to pay what they owe. = (receivables / turnover) * 365 An increase in the receivables collection period could indicate that the company is struggling to manage its debts. Possible steps to reduce the ratio include:- Credit checks on customers to ensure that they will pay on time- Improved credit control, e.g. invoicing on time, chasing up bad debts A decrease in the receivables collection period may indicate that the company's has improved its management of receivables. However, a receivables collection period well below the industry average may make the company uncompetitive and profitability could be impacted as a result.

1 Ratio analysis This is the average period it takes for a company to pay for its purchases. = (payables / purchases) *365 An increase in the company's payables period could indicate that the company is struggling to pay its debts as they fall due. However, it could simply indicate that the company is taking better advantage of any credit period offered to them. A decrease in the company's payables period could indicate that the company's ability to pay for its purchases on time is improving. However, the company should not pay for its purchases too early since supplier credit is a useful source of finance.

1 Ratio analysis This is the long term debt as a percentage of equity. = (debt/equity) * 100 =(debt / debt + equity) * 100 A high level of gearing indicates that the company relies heavily on debt to finance its long term needs. This increases the level of risk for the business since interest and capital repayments must be made on debt, where as there is no obligation to make payments to equity. The ratio could be improved by reducing the level of long term debt and raising long term finance using equity.

1 Ratio analysis This is the operating profit (profit before finance charges and tax) divided by the finance cost = operating profit / finance cost A decrease in the interest cover indicates that the company is facing an increased risk of not being able to meet its finance payments as they fall due. The ratio could be improved by taking steps to increase the operating profit, e.g. through better management of costs, or by reducing finance costs through reducing the level of debt.