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Ratio Analysis Question 1 Ratio Analysis is the process of determining and interpreting numerical relationship between the figures

which are given in the financial statements. It is concerned with the calculation of relationships, which after proper identification and interpretation may provide information about the operations and state of affairs of a business enterprise. The analysis is used to provide indicators of past performance in terms of critical success factors of a business. This assistance in decision-making reduces reliance on guesswork and intuition and establishes a basis for sound judgments.

Question 2 1. Profitability ratios i) Return on capital employed (ROCE) - Return on capital employed (ROCE) is used as a measure of success of a business. It indicates the percentage of return on capital employed in the business and it can be used to show the overall profitability and efficiency of the business. It is the rate of return a business is making on the total capital employed in the business. ROCE = Net profit Capital employed

ii) Gross profit as a percentage of sales - The gross profit as a percentage of sales, tells us the profit a business makes on its cost of goods sold. It is one of several key measurements a company uses in evaluating its financial performance. It helps the company to see what percentage of its earning after costs (for products and/or services) is profit. Gross Profit Margin = Gross Profit * 100 Turnover

iii) Net profit as a percentage of sales - The profit margin tells you how much profit a company makes for every $1 it generates in revenue or sales. Net Profit Margin = Net profit * 100 sales

2. Solvency/ Liquidity ratios: i) Current ratio - Current ratio is also known as working capital ratio or 2 : 1 ratio. Current ratio indicates the liquidity of current assets or the ability of the business to meet its maturing current liabilities. It is the ratio of total current assets to total current liabilities. Current ratio = Current assets Current liabilities

ii) Acid Test Ratio - It establishes relationship between liquid assets and current liabilities. It measures the ability of a business to use its current assets (not including stock and prepayment) to pay its current liabilities. Acid Test Ration = Current assets stock & prepayments Current liabilities

3. Efficiency Ratio i) Stock turnover - shows how many times over the business has sold the value of its stocks during the year. It is also a measure of how long it takes, on average, for a company to sell and replace its inventory. Stock turnover can help a company determine how well it manages its inventory. Higher inventory turnover is considered to be desirable. Stock turnover = Cost of Goods Sold Average or Current Period Inventory

ii) Debtors / Sales ratio Debtors turnover ratio (or Accounts receivable turnover ratio) indicates how long, on average, people take to pay a firm for their purchases. Generally the higher the ratio, the more efficient is the management of debtors. Debtors Turnover Ratio = Net Credit Sales Average Trade Debtors

iii) Creditors/ Purchases ratio - Creditors Turnover Ratio (also known as Accounts Payable Turnover Ratio) is calculated by taking the total purchases made and dividing it by the average accounts payable during the period. It is used to measure the rate at which a firm pays off its suppliers. Creditor Turnover Ratio = Net Credit Purchases Average Creditors

4. Shareholders ratio i) Earnings per share (EPS) This measures the company's potential dividends that it could pay to shareholders. EPS is the amount of money the company actually earns for each share of stock that is outstanding. Earnings per share = Net profit after interest & tax and preference dividends Number of ordinary shares issued

ii)

Price/ Earnings ratio this is a valuation ratio of a companys current share price compared to its per share earnings. The earnings used for the calculation can be either the amount most recently reported by the company, or an analyst's projection of future earnings (normally the current year or the year after that). Price/ Earnings ratio = Market Value per Share Earnings per Share (EPS)

iii)

Dividend yield ratio - Dividend yield ratio is calculated to evaluate the relationship between dividends per share paid and the market value of the shares. It shows the amount of dividends that a company pays to its investors in comparison to the market price of its stock. Thus, the dividend yield ratio is the return on investment to an investor if the investor were to have bought the stock at the market price on the measurement date. Dividend yield = Gross dividend per share Market price per share

iv)

Dividend cover - This show how many times over the profits could have paid the dividend. It shows how easily a business can pay its dividend from profits. A high dividend cover means that the company can easily afford to pay the dividend and a low value means that the business might have difficulty paying a dividend. Earnings per share = Net profit after tax and preference dividends Ordinary dividends paid and proposed

5. Capital structure i) Gearing - Gearing is a comparison between the amount of borrowings a company has to its shareholders funds (net worth). The result of the calculation will show as a percentage the proportion of capital available within the company in relation to that owed to sources outside the company. Gearing = Long term-loans + Preference shares * 100 Ordinary share capital + Reserves + Preference shares + long term loans

Question 3b The liquidity ratios show the firms ability to meet short-term obligations. Therefore a higher ratio would indicate a greater liquidity and lower risk for short-term lenders. The Rule of Thumb (for acceptable values): Current Ratio (2:1), Quick Ratio (1:1). Adil Zahir should consider "sweeping" or transferring the funds into an interest-bearing account when the funds aren't needed and only bring them into operating account when he needs theses funds, this will improve his short-term debt-paying ability and working capital figure. Another step he should consider is keep inventory levels as low as possible without running out of stock. This can ultimately help him keep money in the free in the future. To do this effectively, he should make sure the business is using a good system to forecast inventory needs. Adil Zahir should look to get rid of all unproductive assets that the business is just storing. Assessing his overhead costs to see if there are opportunities to decrease them. He should monitor accounts receivables effectively to ensure that payments from debtors are received promptly. He might need to negotiate longer payment terms with his vendors whenever possible to keep money longer. He should take steps to review the profitability on his products and assess where prices can be increased on a regular basis to maintain or increase profitability. As costs increase and markets change, prices may need to be adjusted as well. Monitor the amount of money that's being taken out of the business for non-business purposes, as taking too much money out can put an unnecessary cash drain on the business.

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