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Exam technique for analysing performance
The below steps must be adopted when answering a question on analysing performance:
Step 1 Review figures as they are and comment on them.
Step 2 Calculate relevant ratios according to performance, potential and position (if possible).
1 Performance (profitability) -how well has the business done
Return on capital employed (ROCE)
{Profit before interest & tax (PBIT)/Capital employed (CE)} X 100%
Operating profit margin
(PBIT/Turnover)X 100%
Asset turnover
Turnover/Total assets (number of times)
(Operating profit margin x asset turnover = ROCE)
Return on equity (ROE)
[Profit aftertax/ Shareholder funds (capital + reserves) ] x 100%
2 Position (liquidity)-short term standing of the business
Current ratio
Current assets/Current liabilities(number of times)
Quick ratio
Current assets -inventory/ Current liabilities (number of times)
Gearing -equity
Debt capital/ Equity (shareholders' funds)X 100%
Gearing -total
Debt capital/ [Debt + equity (total capital] X 100%
Interest cover
Profit before interest & tax (PBIT) / Interest paid (Number of times)
Trade payable days
Trade payables/Cost of sales (or purchases)x 365 days
Inventory days
(Inventory/Cost of sales) x 365 days
Trade receivable days
(Trade receivable/ Sales) x 365 days
Working capital cycle
Trade receivable days + inventory days -trade payable (Days)
3 Potential (investor) -what investors are looking at
Earnings per share (EPS)
Profit after tax/Number of shares
P/E ratio
Share price/Earnings per share
Dividend yield
(Dividend per share/ Share price) X 100%
Dividend cover
(Earnings per share/ Dividend per share)
The above is not the complete list, but are the main ratios.
Step 3 Add value to the ratios by:Interacting with other ratios and giving reasons
a) State the significant fact or change (i.e.decrease orincrease)b) Explain the change or how it may have occurred by looking at business activities and other information.c) Explain significance of the ratio in terms of implications for future and how it fits in with the user’s needs.d) Limitations of ratio analysis. Look at the 2 figures used to compute ratio and criticise them. Also look at other factors that may distort the information (seasonal fluctuations, creative accounting etc.)
Another way of at discussing ratio's is to adopt 3W'sfor each ratio calculated:
WHAT
What has happened to the figures or ratios? Have theydecreased orincreased?
WHY
Explain why changes may have occurred by giving illustrations (think creatively!).
WOW
How do these changes affect the user of information -WOW that's great or not so great!
How can we interpret financial ratios??
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