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be due to increasing efforts in debt utilization sales mix or errors in Caution should always be exercised. collection inventory counting when drawing conclusions on the. liquidity of a company because an, Ratio analysis 2 Liquidity ratios entity s liquidity may be affected. Liquidity ratios measure the company s by many factors these include. 1 Profitability ratios ability to pay its maturing obligations the business cycle or seasons. Profitability ratios measure the and to meet unexpected cash needs in manipulation of year end balances. operating success of a company for a the short run A reasonable level of the nature of the business overtrading. given period of time When the profit liquidity is essential to the survival of or potential liabilities not included in. figure is expressed as a percentage a company Liquidity problems may the financial statements. of sales or capital employed these also be caused by overtrading The. ratios can be compared with those most common ratios for measuring a 3 Management efficiency ratios. of previous years or those from company s liquidity are Management s efficiency in managing. companies in the same industry Current ratio This ratio a company s working capital is. Examples of ratios used in assessing measures a company s ability essential to the company s continuing. profitability of a company are to met short term obligations operations The following are examples. Gross profit margin This with current assets As liquidity of ratios that measure working capital. ratio measures the gross profit is essential to the success of a management efficiency. generated per dollar sales A business a higher current ratio is Receivables collection period. decrease in this ratio may indicate normally preferred to a lower one This ratio measures a company s. more intensive competition in the Nevertheless a very high ratio ability to collect cash from its credit. market declining selling prices or may suggest that funds are being customers Most companies offer. an increased cost of purchases tied up and may not be earning their customers credit in order to. An increase in this ratio may high returns The current ratio boost their sales However there. indicate that the company has should be between 1 5 and 2 to are opportunity costs in holding. a competitive advantage in the 1 however it can vary depending cash for financing receivables and. market and therefore is able upon the business that the there is also the risk of bad debts. to charge higher prices for company is engaged in A long receivables collection. its products or can source its Quick ratio Limiting the period may be an indication of. purchases at a lower cost If this numerator to very liquid current worsening credit control or that. ratio remains constant while assets gives a stricter test of an allowance for doubtful debts is. the net profit margin is falling a company s liquidity since required. this might indicate control over inventories cannot be readily Payables payment period This. expenses is weak converted into cash If the ratio links the value of accounts. liquidity ratios appear to be payables with the amount. Return on capital employed outside normal ranges further of goods and services that a. ROCE This ratio measures review of inventory receivables company is purchasing on credit. how efficiently and effectively and payables is required For If the payables payment period. management has deployed the example a company may be is short creditors are being paid. resources available to it A change forced to sell its inventories at a relatively early or there may be. in the ROCE may be due to lower price than normal during a unrecorded payables However. changes in profit margins asset period of severe cash shortages if the payables payment period is. too long the company may have repayments as well as in raising. liquidity problems this can also further finance Moreover when. be harmful to its relationship a company borrows it increases. with suppliers its risk which in turn leads to, Inventory holding period This higher cost of borrowing The. indicates how quickly a company appropriateness of a suitable. is turning over its inventory When gearing level will be influenced by. deciding the appropriate level of factors such as the risk preferences. inventory a company should strike of owners and managers industry. a balance between the cost of norm interest rates required. tying up capital and the demands return to shareholders stability of. from the customer Generally a profits the availability of equity. high inventory turnover short funds availability of suitable. inventory holding period is assets for security and terms. preferred An unreasonably long of loan agreements In general. inventory holding period may higher gearing can also benefit. indicate an economic recession shareholders if the entity becomes. obsolete inventory poor sales more profitable since earnings of a. and marketing a change of highly geared company are more. customer taste or bad inventory sensitive to profit changes. management Interest cover This ratio,compares the amount of income. 4 Solvency ratios that has been earned with the, Solvency ratios measure the company s interest obligations for the same. ability to survive over a long period of period The lower the level of. time Current and potential investors interest cover the greater the. will be interested in a company s default risk to lenders. financing arrangements and also its, risk A company that has borrowed 5 Investment Ratios.
money obviously has a commitment There are ratios that use the current. to pay future interest charges and market price of a share to indicate. make capital repayments This can the return an investor might earn by. be a financial burden and possibly purchasing that share. increase the risk of insolvency Earnings per share This ratio. Examples of solvency ratios are represents the earnings made and. Gearing ratio This measures available to shareholders during. the company s commitments to an accounting period The trend. its long term lenders against its in earnings per share over time is. long term capital High gearing used to help assess the investment. is viewed as risky for companies potential of a company s shares. as they may face difficulties in Some companies retain a. meeting their interest and debt significant proportion of the. earnings they generate and Free cash flow refers to the cash flow assets for operating a company If. hence their earnings per share from operations minus dividends a statement of cash flows shows. will increase even if there is no and capital expenditure This gives a considerable investment in property. increase in profitability measure of a firm s ability to engage in plant and equipment and there are no. Price earnings ratio This ratio long term investment opportunities significant disposals an increase in. provides a clear indication of and its financial flexibility The cash investment represents an increase in. the value placed by the capital position of a company can be further capacity rather than the replacement. market on a company s earnings analyzed into the following of old assets and the company may. and what it is prepared to pay have expanded, for investors Subject to overall 1 Cash flows from operating. market sentiment and economic activities 3 Cash flows from financing. conditions the price earnings Cash flows from operating activities activities. ratio reflects the capital market represent the cash receipts from trade Financing activities are those through. assessment of both the amount debtors and cash sales less the cash which a company acquires and. and the risk of these earnings paid for inventory salaries and other manages its financial resources so as. Dividend yield This ratio gives activities to maintain the operations to pay to maintain its daily operations. the percentage return dividend To enhance the viability of the and to expand further Provided that. on the investment in one share It company it is essential that interest a return on the new investments in. is a crude measure of the return tax dividend and short term costs property plant and equipment can. to shareholders but it does ignore are funded from operating cash flows generate returns that are in excess of. capital growth which is often then the company can use its surplus the loan interest and dividend yield. much higher than the return on to finance any increase in property then the shareholders wealth is not. dividends plant and equipment reduced,A reduction in investments in both. Analysis of Cash Flows inventory levels and trade receivables Points to note when assessing a. may be the result of more efficient company s financial performance. A statement of cash flows identifies inventory control and receivables. whether cash has increased or collection However when there is Most performance appraisal is based. decreased from the previous year a reduction in inventory and trade on interpreting various comparative. to the current year and also the receivables together with a large ratios. sources and applications of cash The reduction in trade payable balances 1 Environment faced by the. deterioration in cash position of a this may indicate that trading volumes company. company can be relieved by operating may be contracting Performance assessment should. cash inflows and hence the liquidity take into account the business. of the company can be improved 2 Cash flows from investing environment in which a business. in the near future if the ability to activities operates and separate the controllable. generate cash flows from operating Investing activities are the acquisition from the uncontrollable For example. activities is more than sufficient to and maintenance of investments if a company faces a difficult trading. pay interest dividend and tax by companies to sell products or environment and a shrinking market. When analyzing the statement of to provide services this includes this is probably outside the control. cash flows managers and analysts the acquisition and disposal of of the business and may lead to a. often calculate the free cash flow investments and in non current reduction in sales volume and prices. 2 Nature of business its current results for example a sale Conclusion. Business nature is another factor to and leaseback arrangement. consider when assessing financial Accounting ratios and the statement. performance Low margin businesses 5 Interrelationship among different of cash flows are important in. e g supermarkets usually have a types of ratios interpreting accounting statements. high asset turnover while capital Looking at a single ratio in isolation is Candidates should be aware of the. intensive industries e g electrical rarely useful in building a full financial limitations of financial performance. products manufacturers usually picture Instead it is necessary assessment and be careful in. have a relatively low asset turnover to consider one type of ratios in formulating their conclusions In. but higher margins combination with another type of the examination it is suggested that. ratios For example we have to look you take a structured approach when. 3 Causes of a change in ratios at management efficiency ratios when dealing with this type of question. There is usually no absolute answer interpreting the current ratio Prepare a statement of cash flows. to an interpretation question and if required by the question. remember there may be clues in the 6 Comparison among different Calculate ratios in important areas. scenario given that would account periods and different companies such as profitability liquidity and. for identifying plausible causes for For inter company comparisons gearing. changes in a company s ratios and cash and comparisons made over time Use the background information. position For example liquidity may considerations should be made given in question to identify. have deteriorated dramatically due to on factors that can distort these possible causes of any changes. significant investment in non current comparisons such factors may include in ratios and the cash position. assets but without a proportionate differences in accounting policies express your opinions and draw. increase in sales Both financial off balance sheet financing inflation conclusions on the company s. and non financial factors should creative accounting and differences in financial performance. be considered when determining the basis of calculating the ratios. what caused the change in ratios,For example liquidity of a company. may also be affected by availability of,further finance and the due dates of. long term loans,4 Related party relationship and,transactions.
These transactions have the potential,to distort the results of a company. for example expertise provided to a,group company without charge being. made by the present company or,another group company A company. may have entered into certain,arrangements that make its previous. performance of a company This article provides guidance for candidates in dealing with examination questions regarding the assessment of a company s performance If the user is to make sense of the figures in the financial statements these figures need to be properly analyzed using accounting ratios and cash flows and then compared with previous years figures figures from other

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