Analysis and explain trends of the accounting ratios you have calculated in P3 (M2) Profitability Profitability ratios measure the profit of the firm in relation to another by comparing profit with sales. Profitability ratios figures shows how profitable a business is and it’s another great way to analyse the company’s overall performance compare to other businesses. If the company is making more profit shows that they are performing well and are good at managing their cost.
These are 3 different ratios under profitability ratios: 1.) Gross profit percentage of sale This ratio measures the percentage of Gross profit on sales. Gross profit margin = (Gross profit / Sales) * 100 2006 2007 22% 15% The Gross profit margin for the ECO PLC year 2006 is 22%, whereas ideally a business should have a gross profit margin of at least 50% as the business have to spend many other expenses. Also, the gross profit for 2007 is 15% which is less than 2006 by 7%. This shows that the overall performance of the business is bad as they failed to attain the ideal gross profit percentage of sale for both years and also failed to increase their gross profit percentage for year 2007, causing it to fail by 7%.
2.) Net profit percentage of sales This ratio measures the percentage of Net profit on sales. Net profit margin = (Net profit / Sales) * 100 2006 2007 11% 2% The net profit for ECO PLC for year 2006 is 11% which is lower than the ideal net profit margin of 20%. Also, the net profit margin for year 2007 is 2% which is lower than year 2006 by 9% and is still lower than the ideal net profit margin of 20%. This may indicate that the business may not have enough income to survive in the business which could lead the business to shut down as they did not manage the business efficiently.
3.) Return on capital employed (ROCE) ROCE measures the return obtained on the amount of capital invested. ROCE = (Net profit before interest and tax / Capital employed) * 100 2006 2007 43% 9% The ROCE for ECO PLC for year 2006 is 43% is above the ideal ROCE of 20% which indicate they have high percentage of return from their investment. Unfortunately, for year 2007 ECO PLC ROCE has changed to 7% which is below the ideal ROCE of 20%. This shows 36% change of ROCE from year 2006 to 2007 which indicates that the business is not using its resources efficiently.
OVERALL FOR PROFITABILITY: SOLUTION: • Business should examine expenses in the business and see how they are able to use the business resources efficiently which could help them increase the ROCE (return on capital employed) for the business. • Use budget to control business expenses which could help business manage finance efficiently. Liquidity Liquidity ratios measures how solvent is the business. This means it measure the business ability to pay its short term debts and how quickly they can pay their debt. This is done by comparing business assets to their short term liabilities. There are two ratios under liquidity ratios. 1.) Current Ratio • Current ratio measures the company’s ability to meet its shortterm liabilities with its short-term assets. • A current ratio greater than or equal to one indicates that current assets should be able to satisfy short-term debts, therefore the business is solvent as they can pay their debt on time. 2006 2007 1.9:1 1.6:1 • A current ratio that is less than one may mean the firm has liquidity issues as they do not have enough assets to pay their liabilities. Therefore, the business is insolvent as they cannot pay their debt on time.
Current assets / Current liabilities = Ans :1 Current ratio of ECO plc for year 2006 is 1.9:1, which means that the business have £1.90 of assets for every £1 of liability. The ideal position for current ratio is 2:1 i.e, a business must have at least £2 of assets for every £1 of liability. Also, the year 2007 ECO PLC is 1.6:1 there they have £1.60 of assets for every £1 liability. This shows that even though the ECO PLC for year 2006 ratio is a bit closer to the ideal situation it may not be able to survive in the next year as the ECO PLC current ratio has decrease from year from 2006 to 2007 (they have £0.30 less of assets per £1 liability). However, a business cannot depend on the current ratio because it includes stock which is very difficult to sell and the answer may be misleading.
2.) Acid test Ratio/Quick Ratio • This ratio eliminates certain assets such as inventory that they may be more difficult to convert to cash. • Having an acid test ratio above 1 indicates that company should have little problem with liquidity • A ratio less than one indicates that the business has liquidity issues. (current assets – inventory)/current liabilities = ANS:1 2006 2007 0.8:1 0.6:1 Acid test ratio for ECO PLC for year 2006 is only 0.80:1 i.e, the business is having only £0.80 assets for every £1 of liability. Also, acid test ration for ECO PLC for year 2007 is 0.6:1 which means that they are only have £0.60 every £1 liability. Acid test ratio is more dependable by the business because it does not include stock. The ideal position for acid test ratio is 1.5: 1. The business is far away from the ideal position which suggests that the business may not have sufficient funds to cover their liabilities and may become insolvent in the near future.
Moreover, the table show that the acid test ratio has decrease from year 2006 to 2007 which shows that the business is not solvent to pay any short term debts on time (insolvent) as they do not have enough assets to pay for their liabilities. OVERALL FOR LIQUIDITY: SOLUTION: • Business should increase current assets so that they could have enough assets to pay liabilities or decrease their liabilities. Efficiency Efficiency ratio measure how well the business is controlled and managed like how business manage their finance and stock. (How well the business uses its assets like land and liabilities like taxes payable). These are 3 ratios under efficiency ratios. 1.) Debtors payment period
• Measures how long the debtors to pay back the money to the business. · This ratio is measured in days Debtor/credit sales*365 The Debtors payment period for ECO PLC for year 2006 is 39 days which is higher than the ideal Debtors payment is 20-30 days. This shows that ECO PLC is giving its customers more time to pay their debt. However, ECO PLC debtor’s payment for year 2007 is 37 days which is still higher than the ideal Debtors payment of 20-30 days but is lower by 2 days from year 2006. This could indicate that ECO PLC is having cash flow problem in their business as they are reduce Debtors payment period. 2006 2007 39 days 37 days Creditor’s payment period • Measures how long it takes for the business to pay back the money to the suppliers.
• This ratio is measured in days. Creditors / credit purchases for year x 365 The creditor payment period for ECO PLC year 2006 is 46 days which is an ideal creditor payment period as the ideal creditor payment period is 40-50 days. Also, for year 2007 has increase their creditor payment period to 50 days. The increase in creditor payment period may indicate that the business has cash flow problems as they have increase the creditor payment period. However, overall the creditor payment period for ECO for year 2006 and 2007 is ideal. 2006 2007 46 days 50 days Rate of stock turnover • Measures the average amount of time the stock is held by the business and is express in days. • However, this ratio depends and varies on the type of business. Average stock/cost of goods sold*365 **average stock = (opening stock+closing stock)/2 2006 2007 31 days 45 days Overall for efficiency Solution TASK 4: Budgetary techniques Describe how budgets can be used to set targets, to monitor and control an organisation? (P5) What is Budget? Budget is forecast or estimate of what a business is going to earn or spend for the future.
Budget can helps business manage its cost effectively because if business fails to do so then this may affect profit being damaged and makes business unable to pay their expenses and debt on time. How budget can be used to control, set targets and control the business? Control Budget are mainly prepared the business to control the activities of the business. For example, business owners are able to use master budget which enables business to manage their financial activity in the business. Master budgets combines information about business financial activity like their sales, production cost and income which enables business see their overall performance by looking at their financial activity.
For example, they are able to control any financial activity which can affect overall expenses like an increase in cost in supplies but not enough units of sales being sold therefore they have to find a plan to decrease their expenses. Set targets Budget can also help business set financial targets in the business which can help them manage their finance effective. For example, business are able to set targets budgets for different financial activity in the business like setting a limit to how much money they will spend on their production cost and also set targets to how many unit of sales they want to sell in the business.
By providing each department responsible for their own budget provides them sense of responsibility and involvement in the business. This may make them more motivates to work harder as they need to meet this target. Monitor Budgets can be monitored monthly, quarterly or yearly by using cash flow budget. A cash flow budget enables business to monitor their cash inflows and outflows in the business which can help business see if they are managing their finance wisely in the business to keep sufficient fund to keep the business.