Managing Financial ResourcesRatio example 1 solutionGMP Inc.Q1Ratio results:RatioYear 1Calculation for year 2Year 2

ROCE21.6%Operating profit / Total capital = 1,031 / (2,143 + 2,800)20.9%

ROE15.2%Profit after tax / Equity capital= 584 / 2,14327.3%

Fixed Asset Turnover0.58Sales / Assets= 3,220 / 4,4000.73

GP%44%Gross profit / Sales= 1,560 / 3,22048.4%

OP%28.2%Operating profit / Sales= 1,031 / 3,22032%

Debtor days41.5Debtors x 365 / Credit sales= (410 x 365) / 3,22046.5

Creditor days23.5Creditors x 365 / Cost of sales= (295 x 365) / 1,66064.86

Stock days46.9Stock x 365 / Cost of sales= (320 x 365) / 1,66070.4

Current ratio2.54Current assets / Current liabilities= 980 / 4372.24

Acid test ratio1.77Current assets - stock / Current liabilities= 660 / 4371.51

Gearing ratio68.7%Long term debt / Total capital= 2,800 / (2,143 + 2,800))56.6%

Interest cover 3.7Operating profit / Interest charges= 1,031 / 2074.98

Dividend cover2.6Profit after tax / Dividend= 584 / 1503.9

ProfitabilityROCE 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. 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 CapitalDebtor 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 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 riskGearing 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.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.

Q2RatioSRG Inc.Calculation for GMP Inc.GMP Inc.

Dividend yield2.5%Dividend per share / Market price per share= (150 / 2,500) / 2.302.6%

EPS0.34Profit after tax / No. of shares= 584 / 2,5000.23

PER7.45Market price / EPS= 2.30 / 0.2310.0

Market to Book ratio3.21Market value / Balance Sheet Net Asset value= (2.30 x 2,500) / 2,1432.68

InvestmentDividend 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 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.