It would be hard to say what ratio would be suitable for PQR as there is no definite answer. Current Asset ratios were quite high in 2002 (4.30:1) and 2003(3.50:1), which have been decreased in 2004 (2.63:1). Acid Test ratio shows that business had its money being tied up with debtors for a longer period in 2002 (1.54:1) and 2003 (1.83:1), which dropped in 2004 (1.29:1). This reflects better management and control. Overall the business doesn’t have any liquidity problems and it has been more efficient with its finances as the Current Asset ratio and Acid Test ratio suggests, however it will need to make sure that any investment made in fixed assets is utilised more efficiently by the business in generating more sales.
Efficiency
The stock turnover ratio has improved from 60.83 days in 2002 to 47.33 days in 2004. This means that the business is being more efficient in reducing its storage costs and it also means that the business is not tying up it money in unwanted stock. Due to an improved stock turnover it would also help PQR to respond to market changes quickly.
The credit control at PQR has improved from 60.83 days in 2002 to 47.33 days in 2004. This again shows an improved efficiency and should help PQR in maintain a good cash flow.
Fixed Asset Turnover ratio is the only ratio where PQR hasn’t improved a lot. The ratio increased from 3.60 (2002) to 4.20 times in 2003, which shows better utilisation of fixed assets. However this figure dropped in 2004 to 2.67 times. This was mainly because of an investment in fixed asset. It would be important to see whether this figure improves in the near future.
Overall the business has improved in terms of efficiency as it has reduced costs and improved credit control.
Interpretation of the Meaning of the ratios used
Profitability: The 3 ratios I have used to analyses PQR’s performance on its profitability are as follows:
- ROCE: This demonstrates the amount earned by the business for the shareholders in relation to the shareholders investment. There has been a 1.16% increase from 13.60% in 2002 to 14.76% in 2004. This means PQR has earned 14.76 pence from every £1 invested by a shareholder in 2004. The increase in ROCE is entirely due to increase in the net profits.
- Gross Profit Ratio: Looking at the P&L accounts one would think Gross profit has risen, however as this ratio measures how much profit an entity has made in relation to the amount of sales, the gross profit actually has fallen. There has been a decline in this as it went down from 10.42% in 2002 to 10.16% in 2003 and in 2004 it came up by .01% to be 10.17%. The decline in the gross profits could be due to various reasons. These may include:
- Suppliers may have increased their raw material prices and PQR may be still be selling at the normal prices to be more competitive and retain its existing customers.
- PQR might have lowered their prices to be more competitive and to increase their sales. This is quite likely, as the sales from 2002 have increased by about 11.4% in 2004.
Thus for every £1 of sales generated, the business earned 0.17 pence of gross profit in 2004. It should be noted that gross profit is not the net profit a business makes, as it does not include the costs a business has incurred and thus Net Profit ratios are worth noticing.
- Net Profit Ratio: Net Profit margin is the actual profit a business makes, as this would include all the costs incurred by a business. There has been a steady increase from 5.42% in 2002 to 5.79% in 2004. Despite a fall in gross profits PQR has managed to increase the net profits. This is quite remarkable and means that PQR has managed to control or decrease their costs.
Liquidity: The following are the liquidity ratios I have used
- Current Asset Ratio: in this ratio I will compare assets which will become liquid in approximately 12 months with liabilities which will be due for payments in the same period. PQR had a very high current asset ration in 2002, which was 4.30:1, which was lowered to 2.63:1 in 2004. It will be hard to say what ratio would be satisfactory as the type of industry; overall size and the reputation would play a part. However what I could say that, PQR being more efficient with its finances and is possibly releasing money for other uses, thereby increasing the overall return.
- Acid test Ratio: It increased from 1.54:1 in 2002 to 1.83:1 in 2003 and dropped to 1.29:1 in 2004. This shows that provided Creditors and Debtors are paid at the same time, the company has enough liquid resources to meet its current liabilities. However a higher ratio in 2002 and 2003 meant that PQR was not being efficient with its finances, which improved in 2004.
Efficiency: The following are the efficiency ratios I have used:
- Stock Turnover Ratio: This demonstrates the speed at which PQR moves it stock. The stock turnover has almost doubled from 2.69in 2002 to 4:00 in 2004. This means that PQR is holding a lower average stock and is perhaps working towards a Just-in-time production system. It also means PQR is more effective as it has reduced significant costs in terms of holding and financing the stock as wells as an opportunity cost of tying money up in assets which would be unproductive (there is no massive stock storage thus little amount of money is tied up)
Trade Debtor collection Period: There has been a significant decrease in Debtore collection period from 60.83 days in 2002 to 47.33 days in 2004. Every year since 2002 the period for debt collection has been decreasing which is good for PQR as the business is not tying more money up with its and is improving its credit control. It may also mean that PQR is encouraging its customers to pay earlier and may be achieving this by offering discounts as an incentive.
Fixed Asset Turnover Ratio: The Fixed Asset turnover ratio increased from 3.60 in 2002 to 4.20 in 2003. At this stage PQR was efficiently utilising its investment in fixed assets. However this figure has decreased to 2.67 times in 2004. This means that for every £1 worth of fixed assets PQR has only generated £2.67 of revenue in 2004. This decrease is mainly because of an increased investment in fixed assets in 2004. It would be useful to see if the figure improves in the near future or not. An increase is quite likely as the sales figure are increasing which would mean better utilisation of its fixed assets in order to increase their sales.
- Percentages and figures are rounded of to 2 decimal places.
Usefulness and Limitation of Ratio Analysis
Usefulness
- Ratios allow extraction of data from accounting statements and convert them into statistics, which is very useful in examining an entity’s performance over a period of time.
- It can be helpful in plotting a trend, which can assist in making future decisions.
- It can be used as a common measure to make comparisons with different companies.
Limitations
- No account is taken of changes in management over a period of time. Thus a business may have taken the decision to aim at the lower end of a particular market, meaning the profit margins may drop but current asset turnover may rise.
- Inflation is not taken into account, which can have an affect.
- External influences are not taken into account such as competitor’s action. If the competitor goes out of business, allowing the company to increase their price. This will be reflected in increased profit margin, implying the business has been more efficient which, in this case is not correct.
