Managing Financial Resources

Ratio example 1 solution

GMP Inc.
Q1
Ratio results:

Ratio
ROCE

Year 1
21.6%

ROE

15.2%

Fixed Asset Turnover

0.58

GP%

44%

OP%

28.2%

Calculation for year 2

Operating profit / Total capital
= 1,031 / (2,143 + 2,800)
Profit after tax / Equity capital
= 584 / 2,143
Sales / Assets
= 3,220 / 4,400
Gross profit / Sales
= 1,560 / 3,220
Operating profit / Sales
= 1,031 / 3,220
Debtors x 365 / Credit sales
= (410 x 365) / 3,220
Creditors x 365 / Cost of sales
= (295 x 365) / 1,660
Stock x 365 / Cost of sales
= (320 x 365) / 1,660
Current assets / Current
liabilities
= 980 / 437
Current assets - stock / Current
liabilities
= 660 / 437
Long term debt / Total capital
= 2,800 / (2,143 + 2,800))

Year 2
20.9%

4.98

Debtor days

41.5

Creditor days

23.5

Stock days

46.9

Current ratio

2.54

Acid test ratio

1.77

Gearing ratio

68.7%

Interest cover

3.7

Operating profit / Interest charges

2.6

= 1,031 / 207
Profit after tax / Dividend
= 584 / 150

Dividend cover

27.3%
0.73
48.4%
32%
46.5
64.86
70.4
2.24

1.51

56.6%

3.9

Profitability
ROCE has decreased slightly, indicating a drop in the efficiency of use of total
capital. Operating profit has increased, but there has also been a substantial
increase in the level of equity investment into the business- this is not being
used as effectively as in previous year to generate profits for the business. This is
only a small % drop in performance. ROCE is an overall measure of efficiency and
performance, and could be improved by improving the top line profit figure
(better control of costs etc) or reduction in the capital employed- if reduced
investment is viable.

Managing Financial Resources

Ratio example 1 solution
ROE has increased considerably, indicating improved efficiency in the use of
shareholder equity to generate returns for shareholders. Profits have increased
to a greater extent than the equity capital invested in the business. This
represents improved returns for the shareholders. As per ROCE, the ratio could
be improved by an increase in the top line profit figure (better control of costs
etc). Shareholders now generate a 27.3% return on their investment, or 0.27
per 1 of investment.
Asset turnover has improved significantly for the business. The assets are now
being used more efficiently to generate sales for the business; this could mean
the business is using existing assets more effectively, or is benefitting from
investment in new assets. Old assets may have been replaced with new ones.
The sales revenue has increased; whereas the asset valuation on the balance
sheet remains almost unchanged- management may consider the effects on
these ratios of the valuation and depreciation methods. The business now
generates 0.73 of sales per 1 of asset used in the business.
Gross Profit % indicates that the business has managed to improve its trading
performance. Sales revenue has increased which could indicate higher sales
volume or a higher selling price for goods, or a different sales mix of goods. The
Cost of Sales figure hasnt increased by the same proportion- this indicates an
improvement in the management of purchases and stocks i.e. more efficient
control of stock levels and reduced costs of purchasing. The business can
achieve further improvements through: negotiations with new or existing
suppliers for discounts, and the ordering of stocks by JIT method etc. The
business now generates 0.48 in trading profit per 1 of sales.
Operating Profit% has increased by 4% representing a higher overall profit return
per level of sales. This would usually indicate an improvement in the control of
various business overheads in generating the business operating profit.
However, there was also a 4% improvement in the GP%, which suggests that
efficiency savings are a result of better control of Cost of Sales carried over to
the improvement in OP%. The business now generates 0.32 profit per 1 of
sales. The OP% could be improved through better control of heat & light e.g.
monitor energy use and change supplier, debt interest e.g. reduce debt level or
manage bank balances to avoid charges, wages and salaries e.g. reduce
overtime or restructure staff. The business may also reconsider depreciation
method used and keep in mind that depreciation is a book entry and not a real
cash outflow.
Liquidity and Working Capital
Debtor days have increased by around 6 days. This represents a decline in
performance since cash is now withheld from the business for a longer period- so
is bad for liquidity. On the other hand the business may have extended credit
terms to attract new customers. A higher debtor days ratio may indicate a
higher risk of customer bad debts. There are a number of steps the business
could take to improve the debtor days ratio: reduce credit levels, improve credit

Managing Financial Resources

Ratio example 1 solution
control i.e. credit checks and debt collection procedures, employ invoice
discounting or factoring services, offer discounts for prompt payments.
Creditor days ratio has increased significantly. This represents an improvement in
terms of cash flow since the business retains the cash for a longer period; but
may damage relations with suppliers if the figures are due to a number of late
payments. The very large increase may be a result of negotiation with existing
suppliers or seeking out new suppliers with generous credit terms. The business
may lose out on discounts and may lose its supplier completely, unless these
credit terms are negotiated and agreed with the suppliers.
Stock days ratio has increased significantly, indicating that stock is now
remaining in stores or on shelves for longer. The business must consider the
consequences of holding too much stock e.g. holding costs, insurance costs,
danger that stock becomes out-of-date. Alternatively, the business may have
decided to hold or order additional stocks to: decrease ordering costs, stockpile
for future periods, reduce problem of stock shortages. The business should
consider improving stock levels, control and ordering systems e.g. through use of
JIT or EOQ; and selling off old older or obsolete stocks.
Current ratio has dropped to 2.24:1, which shows that the business is less liquid
i.e. less sources of cash in to cover sources of cash out. However, the ratio
appears to be more efficient since holding high levels of current assets can be
wasteful and unnecessary- the ratio has moved closer to an ideal ratio of 2:1
(although this depends on the industry). The current ratio could be improved
through improvements in working capital management i.e. reductions in: stocks,
debtors and bank balances. The acid-test ratio comments are similar: the trend
indicates that the business is less liquid, but the ratio has moved towards a more
efficient ratio of 1:1. The acid-test ratio may be a more meaningful measure of
liquidity since stock is removed from the calculation.
Working capital cycle = stock days + debtor days creditor days = 70.4 + 46.5
64.86 = 52.04 days. Overall, cash is tied up in working capital for around 52
days. This compares favourably to last years figure of 65 days- so a significant
overall improvement in cash management for the business. The improvement is
due to the increase in creditor days.
Financial risk
Gearing ratio has decreased by around 12%- meaning that the business is less
reliant on long term debt to finance the business. This represents an
improvement in the risk profile of the business since interest payments and
capital repayment obligations are reduced. The level of debt finance (bonds) has
decreased; the level of equity has increased. However, debt may be available at
relatively lower cost to equity, especially since interest payments are tax
deductible. The business may consider its current debt or gearing level to be
appropriate- but could be scope to increase or decrease further dependent on
management attitude to risk and availability of finance.

Managing Financial Resources

Ratio example 1 solution
Interest cover ratio has improved to a level of around 5 times. This is a safe level
of interest cover- suggesting the business is able to cover interest payments 5
times out of current profits. The interest charges have actually increased slightly,
but profits have increased to a greater extent- so offering more cover. The
business has already restructured its capital to reduce long term debt as per
gearing ratio, and may continue to do this to further reduce financial risk, and it
may also consider reducing its short term debts. Increased profits would also
increase the interest cover ratio.
Dividend cover has increased to around 4 times- meaning that current dividend
payments can be made safely out of the profits available to shareholders. The
business has increased its dividend payment, but this is adequately covered due
to a greater increase in the level of profits.

Q2

Ratio

SRG Inc.

Calculation for GMP Inc.

Dividend yield

2.5%

EPS

0.34

PER

7.45

Market to Book
ratio

3.21

Dividend per share / Market price per

share
= (150 / 2,500) / 2.30
Profit after tax / No. of shares
= 584 / 2,500
Market price / EPS
= 2.30 / 0.23
Market value / Balance Sheet Net
Asset value

GMP
Inc.
2.6%
0.23
10.0
2.68

= (2.30 x 2,500) / 2,143

Investment
Dividend yield is close to SRG Inc. at around 2.5% for both businesses. This
represents an equal return for shareholders in terms of dividend earned per price
of a share. Shareholders may be satisfied that returns match those of its closest
business rival. Dividend yield can be improved by increasing the dividend paid
out to shareholders- the dividend cover ratio suggests that the business would
be able to do this. However, a business must consider consequences of changing
its dividend policy: reduces retained profits for re-investment, shareholders dont
like unstable policy, dividend increases may be difficult to sustain and reverse.
EPS for the business is significantly less than its competitor. EPS is often cited by
investors as a key indicator of financial performance, and so some investor
groups may conclude that GMP is not performing well enough in terms of the

Managing Financial Resources

Ratio example 1 solution
returns on shares- and so act to sell their shares. The effect of both earnings (top
line) and number of shares (bottom line) on the calculation must be considered
since EPS can be distorted by unusual or exceptional items that impact these
figures.
PER is another key indicator for investors. The PER for the business compares
favourably with its closest competitor. PER is a market multiple indicator, and
shows that the market is currently valuing GMP shares at 10 times the current
earnings level. This suggests that the market predicts future success in terms of
profits and growth for the business. PER could be considered a better indicator of
future prospects for the business than EPS.
Market to Book ratio of GMP is less than its competitors. This indicates that the
market attributes higher valuation to factors other than business assets within
SRG; or the market may have concluded that SRG is more efficient in using its
assets to generate value. There may be a number of items that contribute value,
or earnings potential to a business other than its assets such as: management
expertise, business strategy and structures, market share, customer and supplier
relations etc.