3.7.2 Analysing the existing internal position of a business to asses strengths and weaknesses: financial ratio analysis


    3.7.2 Analysing the existing internal position of a business to asses strengths and weaknesses: financial ratio analysis

    How to assess the financial performance of a business using balance sheets, income statements, and financial ratios

    Balance Sheet = this shows the assets (what a business owns) and liabilities (what a business owes) at a particular time throughout the financial year

    • Assets and liabilities must equal each other else the balance sheet won’t balance. If a firm owes more than what it owns, then this will limit their growth potential and they may have to consider retrenching (selling off stock)
    • Fixed Assets = anything the firm owns as long as it is useful to operating the firm (must last longer than a year)
    • Current Assets = these represent the working capital and are directly linked to what is sold to the customers (lasts less than 12 months)
    • Current Liabilities = things that a firm will need to pay out for within 12 months
    • Working Capital (Net Current Assets) = this shows the liquidity of the business – so if liabilities acceded assets, they the firm would go into liquidation
      • = current assets – current liabilities


    Influences on the amount of working capital:

    • The volume of sales – rising sales indicate that costs will rise as well to pay for the resources that create the goods and services
    • The amount of trade credit offered by a business – a long pay back time requires more working capital
    • Growth of the business – over trading can occur if the business grows too fast without arranging the needed working capital
    • Length of the operating cycle – the time between paying for materials and receiving payments for goods and services (the longer the period, the greater the need for working capital)
    • The rate of inflation – when prizes rise, greater working capital is needed


    Depreciation = when the value if a non-current asset decreases

    • Assets will eventually become worthless over time without continuous investment Income Statement = this describes the income and expenditure of a business over a given period of time (usually a year) – it shows the profits and losses of a firm

    • Gross Profit = revenue – cost of sales
    • Operating Profit = gross profit – expenses
    • Profit Before Tax = operating profit – finance costs + finance income
    • Profit for the Year = profit before tax – tax expenses


    Purpose of an income statement:

    • Legal requirement
    • Review progress
    • Allows shareholders to access if investment is needed
    • Comparisons can be made
    • Used to show potential investors


    Analysing expenditure:

    • Capital expenditure – when spending money on items that will be used in the long run (e.g. property, machinery, vehicles, and office equipment)
    • Revenue expenditure – spending on day to day items (e.g. raw materials, wages, and power)


    Order of an income statement:

    • Revenue
    • Cost of sales
    • Gross profit
    • Expenses
    • Operating (net) profit
    • Finance costs
    • Profit before tax
    • Taxation
    • Profit for the year (retained)


    Ratio Analysis = ratios assess the financial information by comparing two sets of linked data

    Stakeholders who are interested in financial ratios:

    • Shareholders
    • Customers
    • Employees
    • Government
    • Competitors
    • Manager
    • Banks
    • Suppliers


    Liquidity and Gearing Ratios:

    • These allow managers to control the business’ cash flow and ensure they have sufficient working capital


    The Current Ratio = this is used the keep track of the working capital within a business and make sure it can pay off the debts

    • = current assets / current liabilities
    • The ratio should be between 1:1 and 3:1
    • If the figure is below 1, the business doesn’t have sufficient short term assets and many need to raise additional finance
    • If the figure is above 3, then they may have to much cash and aren’t using it effectively


    The Gearing Ratio = this is used to show whether a firm’s structure is likely to be able to co tune to meet interest payments and to repay long term borrowing

    • = long term liabilities / capital employed x 100 (capital employed = long term liabilities + total equity (total capital and reserves))
    • The figure should be between 25% and 50%
    • If > 50%, then the business is highly geared
    • If < 25%, then the business is low geared
    • Between 25% and 50% is considered normal for a well established business


    The Profit Ratios:

    • These allow managers to measure the performance if the business in generating profit compared to the costs involved


    Profit Margins = this is an indication of a business’ ability to control costs

    • = ‘X’ profit / sales revenue x 100
    • Profit includes gross, operating, net, and retained
    • The higher the percentage the better as they are receiving more profit for the money they are investing in to the business and its products
    • The percentage reduces as further costs are subtracted
    • Profit margins depend upon the product life cycle and the placing of the product on the Boston matrix


    Return on Capital Employed (ROCE) = this shows what returns (profits) the business has made on the resources available to it

    • = operating profit / capital employed x 100
    • The higher the figure the better as the firm will be getting more profit back for the resources and money it has used
    • The figures can be compared with previous figures as other competitors to gain an idea of where they stand in the market


    Efficiency Ratios:

    • These allow managers to measure how well the business is managing its stock and working capital


    Payables (Creditor Days) = this estimates the average time it takes a business to settle its debts with the trade suppliers

    • = trade payables / cost of sales x 365
    • In general, a firm that wants to maximise its cash flow should take as long as possible to pay its bills
    • However a high figure could illustrate liquidity problems which could cause legal claims
    • Thus figure should be higher than the debtor days


    Receivables (Debtor Days) = this is the time is takes for trade debtors to settle its bills

    • = trade debtors / sales revenue x 365
    • A high figure could suggest a general problem with debt collection or the financial position of major customers
    • This should be lower than the payables


    Inventory Turnover = this helps firms to answer questions like ‘how much money do we have tied up in stock?’

    • = cost of sales / average stock held
    • The quicker a firm turns over its inventories, the better
    • But, it is also important to do that profitable rather than sell inventory at a low gross profit margin or worse a loss
    • A high inventory turnover figure could indicate poor stock management


    The value of financial ratios when assessing performance

    Internal users who need to know the financial position of the business:

    • Managers – whether the firm is reaching objectives and using resources efficiently
    • Employees – whether the firm is stable and secure and if they are receiving the right amount of pay for the job they are doing
    • Shareholders – how does the return on investment compare with other investors


    External users who need to know the financial position of the business:

    • Creditors – how much cash a firm had and if it will be able to pay its bills
    • Government – the tax liability
    • Competitors – how the business is performing in relation to others in the industry


    Financial ratios help for firms to compare with competitors in the same market as them and therefore to set objectives in order to beat them and gain a higher market share overall. Also, it can be analysed over time internally.






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