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# Financial Ratio Analysis.

Extracts from this document...

Introduction

1. Financial Ratio Analysis 1.1 Introduction As part of the system of financial control in an organisation, it will be necessary to have ways of measuring the progress of the enterprise, so that managers know how well the company concerned is doing. The financial situation of a company will obviously affect its share price. The answer to some of the following questions can be obtained from accounting reports produced by the company: i. Is the company profitable? ii. Is the company growing? iii. Does the company have satisfactory liquidity? iv. Is the company's gearing level acceptable? v. What is the company's dividend policy? The usual way of interpreting accounting reports is to calculate and then to analyse certain ratios (Ratio Analysis). The key to obtain meaningful information from ration analysis is comparison (that is, comparing ratios over time within the same business to establish whether the business is improving or declining, and comparing ratios between similar businesses to see whether the company you are analysing is better or worse than average within its own business sector. Ratio analysis on its own is not sufficient for interpreting company accounts, and there are other items of information, which should be looked at. These include the following: i. Comments in the Chairman's report and the director's report ii. The age and nature of the company's assets iii. Current and future developments in the company's markets, at home and overseas iv. Recent acquisitions or disposals of a subsidiary by the company v. The cash flow statement (where required by FRS 1) 1.1.1 Limitations and Strength of Financial Ratios Financial Ratios are used to compare actual results with something else. The comparison may be against a budget or a desire target, or perhaps against a previous period's results in order to detect trends. On the order hand, an entity's results may be compared with the results of another entity using ratios in order to ascertain whether current actual results are better or worse than those of other similar business units. ...read more.

Middle

1998 1999 2000 2001 Sales 506,000 566,720 623,390 673,260 Profit after Tax 29,940 35,310 36,020 48,630 Reserve 172,910 174,220 176,240 182,870 a. Percentage changes Sales 12% 10% 8% Profit after Tax 18% 2% 35% Reserve 1% 1% 4% a. Index number Sales 100 112 110 108 Profit after Tax 100 118 102 135 Reserve 100 101 101 104 � Appendix 3 - Financial Ratios (Formulas) Profitability Ratios (measured in Percentage) 1 Return on Capital Employed (ROCE) = Profit before interest and tax (PBIT) x 100% Capital Employed * [*where, Capital Employed = Total Assets - Current Liabilities] 2 Return on Equity (ROE) or = Profit after interest, tax and Preference Dividend x 100% Return on Owner's Equity (ROOE) Ordinary Share Capital and Reserve 3 Return on Shareholder's Fund (ROSF) = Profit before tax x 100% Ordinary Share Capital and Reserve 4 Profit Margin on Sales = Operating Profit x 100% (Operating Profit Margin) Sales 5 Gross Profit Margin = Gross profit x 100% Sales 6 Net Profit Margin = Net Profit x 100% Sales Liquidity Ratios 7 Current Ratio = Current Assets Current Liabilities 8 Quick Ratio / Acid Test Ratio = Current Assets less Stock Current Liabilities Efficiency Ratios (measured in Days or in Times) 9 Stock Turnover Period = Average Stock x 365 days Cost of Sales Stock Turnover = Cost of Sales Average Stock 10 Debtors Turnover Period = Average Debtors x 365 days Sales Debtors Turnover = Sales Average Debtors 11 Creditors Turnover Period = Average Creditors x 365 days Purchase Creditors Turnover = Purchase Average Creditors 12 Working Capital Turnover = Sales Net Current Assets 13 Assets Turnover = Sales Capital Employed 14 Fixed Assets Turnover = Sales Fixed Assets Gearing Ratios (measured in Percentage or in Times) 15 Gearing Ratio = Prior Charge Capital # x 100% Equity & Preference Share Capital & Reserve + Total Long Term Debt [# where, Prior Charge Capital = Total Long Term Debt + Preference Share Capital] or Total Liabilities less Current ...read more.

Conclusion

x. Forecasts can subsequently be monitored by the publication of variance statements, which compare actual cash flow against the forecast. The main disadvantages of cash flow accounting are essentially the advantages of accruals accounting (proper matching of related items) See 2.2.4. There is also the practical problem that few businesses keep historical cash flow information in the form needed to prepare a historical cash flow statement and therefore, extra record keeping is likely to be necessary. 2.4 Conclusion Cash flow information is relevant as a basis for making internal management decisions in relation to both fixed assets and working capital; and for stewardship and accountability. Cash flow information is also reliable being objective, consistent, prudent and neutral. However, professional accounting practice requires reports to external users to be on an accrual accounting basis. This is because the accrual accounting profit figure is a better predictor for investors of the future cash flows likely to arise from the dividends paid to them by the business, and of any capital gain on disposal of their investments. It could also be argued that the cash flow may not be a fair representation of the commercial substance of transactions; e.g. if a business allowed a year's credit to all its customers, there would be no income recorded. In comparison with the Financial Accounting Standards Board (FASB) in the United States of America, the accounting profession generally supports the views of the FASB that accrual accounting provides a better indication of an enterprise's present and continuing ability to generate favourable cash flows than information limited to the financial aspects of cash receipts and payments. Even the International Accounting Standards Committee (IASC) supported the FASB view in 1989 when it stated that Financial Statements prepared on an accrual basis inform users not only of past transactions involving the payment and receipt of cash, but also of obligations to pay cash in the future and of resources that represent cash to be received in the future, and that they provide the type of information about past transactions and other events that is most useful in making economic decisions. 3. ...read more.

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