Ratio analysis Essay Example for Free

Ratio analysis Essay Ratio analysis is a tool brought by individuals used to evaluate analysis of information in the financial statements of a business. The ratio analysis forms an essential part of the financial analysis which is a vital part in the business planning. There are 3 different ways of assessing businesses performance and these are: solvency, profitability and performance. Ratio analysis assists managers to work out the production of the company by figuring the profitability ratios. Also, the management can evaluate their revenues to check if their productivity. Thus, probability ratios are helpful to the company in evaluating its performance based on current earning. By measuring the solvency ratio, the companies are able to keep an eye on the correlation between the assets and the liabilities. If, in any case, the liabilities exceed the assets, the company is able to know its financial position. This is helpful in case they wish to set up a plan for loan repayment. Ratio analysis is also helpful in analysing the performance of a company. Through financial analysis, companies can review their performance in the past years. This is also helpful in identifying their weaknesses and improving on them. Polish Fine Foods needs to use ratio analysis because it is a valuable tool for the business’s management to determine the performance of a business and to control the cost measures when necessary. Also, ratio analysis helps them monitor and identify issues that can be highlighted and resolved. However, ratio analysis doesn’t take into account external factors such as a worldwide recession. Measuring the Solvency of Polish Fine Foods Now, I will use 2 rations to measure the solvency of Polish Fine Foods. First, I will calculate the current ratio for Polish Fine Foods. This estimates whether the business can pay debts due within one year from assets that it expects to turn into cash within that year. It is measured dividing current assets by the current liabilities. By looking at balance sheet I can see that Polish Fine Food’s current asset value is  £28500 and the current liability value is  £17000. I will need to divide  £28500 by  £17000 to find out the current ratio. This would give me an answer of  £1.7. This means that for each  £1 owned they have  £1.70 current asset. The figure should normally not fall below 1.5. If it reaches a value of 1 then there might be concerns  there about not being able to meet the debts of the short-term assets. However, we can see that Polish Fine Food’s current ratio tells us that this is a solvent business. This means that it is able to settle its debts when they are due to be paid. If the business is not solvent, then it means that it can’t do this. Being solvent would help the business to maintain their confidence. On the other hand, if the current ratio goes higher than 2 might indicate that too much finance is tied up in a short-term assets, which can result that not too much money are being used within the organisation. Secondly, I will measure the acid test. This is the same as the current ratio; however it is a harsher test of ability to settle short-term debts. It is more accurate as it takes away the stock and shows how well a business can meet its current liabilities. To find out the acid test I first need to subtract stock from the current assets and then divide the current liabilities by the answer of that. So Polish Fine Food’s amount of stock is  £8500 from the current assets which is  £28500. The answer of the subtraction is  £20000. Now I would need to divide the answer by the current liability which is  £17000 which would give me the final acid test ratio of  £1.20. This calculation removes the uncertain variable of stock, which might be not too important to the business. Similarly, this data shows us that Polish Fine Foods is a solvent business and it has the ability to meet its short-term debts. The business could continue to operate as it is currently looking to be successful. With the current ratio of  £1.70 and the acid test of  £1.20 Polish Fine Foods is a stable business. It is a healthy figure and shows that the business is in a good position. We can see that  £0.50 was tied up in stock and this is not a lot. Both rations show that the business is able to pay for its debts and they can also earn more income which means that the business would gave more profit as the business is solvent. Measuring the Profitability of Polish Fine Foods Profitability ratios show a companys overall efficiency and performance. To measure the profitability of Polish Fine Foods I will use 3 ratios. First ratio is gross profit margin. The gross profit margin looks at cost of goods sold as a percentage of sales. This ratio looks at how well a company controls the cost of its account and the manufacturing of its products. The larger the gross profit margin, the better for the company. To calculate the  gross profit margin I need to divide the gross profit by the sales and then time it by 100 to find the percentage. So, to find the gross profit margin for Polish Fine Foods I have to divide  £45900 by  £145400 and this would give me the answer  £0.3156. To find out the percentage, I now need to multiply it by 100 and the answer is 32%. The gross profit margin for Polish Fine Foods is used to compare how much value is added to an item in between being bought in as stock or materials and being sold by the business. A low gross profit margin could show that there are high stock costs or maybe that retail price is being too low. If the business has a high gross profit margin then it indicates that the business is financial stable. We can see that Polish Fine Foods doesn’t have a high gross profit margin- it is a bit more than a quarter. This means that the business is in a secure position. They could be more successful if they are going to try and sell all the stock they have first instead of getting other, so in this way the profit might increase. Next ratio that I’m going to use in order to measure the profitability of Polish Fine Foods is net profit margin. The net profit margin shows how much of each sales amount shows up as net income after all expenses are paid. The net profit margin measures profitability after consideration of all expenses including taxes, interest, and depreciation. To calculate the net profit margin I need to divide the net profit by the sales and then mul tiply by 100. Therefore, to find the net profit margin for Polish Fine Foods I need to divide  £14500 by  £145400 and this would give me an answer of  £0.0997. So after multiplying the answer by 100, I got 10% which shows the amount of net profit margin. This ratio is used to decide which of a range of products are worth continuing with. A low net profit margin might indicate that costs are too high. Polish Fine Foods’ net profit margin is quite low, so they could try to improve this by trying to sell the stocks first and then get other instead of buying lots of them at once which would get more money out. At the moment, the business is in a stable position, but they should try and reduce their costs in order to increase the profit they’re making. Lastly, I would use return on capital employed (ROCE) ratio to measure Polish Fine Foods’ profitability. This is the percentage return which makes the business able to generate the long-term capital employed. To calculate ROC, I need to divide the net profit by the capital employed and then multiply it by 100. Therefore, to fine the ROCE  for Polish Fine Foods I need to divide their net profit which is  £14500 by the capital employed which is  £24500; this will then give an answer of 0.591, and then multiply that by 100. The final answer for ROCE is 60%. This ratio has been used to show how efficiently a business is using its capital. The ROCE shows us now that Polish Fine Foods is doing well at the moment and they are using their money carefully. Polish Fine Foods overall has good ratios that currently keep them stable. Basically, all these ratios show the amount of profit generated by the company as a per cent of the sales generated. The objective of margin analysis is to detect consistency or positive or negative trends in a companys earnings. Polish Fine Foods is doing well, and looks like it is a stable business. However, there is still place for improvement, e.g they could try and reduce their costs and increase their profits. Measuring the Performance of Polish Fine Foods A growing business needs to be closely and carefully managed to ensure the success of new investment and expanding plans. Putting performance measurements in place can be an important way of keeping track on the progress of their business. It gives vital information about whats happening now and it also provides the starting point for setting targets that will help owner apply their plans for growth. Now I will measure the performance of Polish Fine Foods using 3 ratios. First ration is stock turnover. This measures how long stock is being held before it is replaced. To calculate stock turnover ratio I need to divide average stock by cost of sales and the multiply it by 365 days. To find Polish Fine Foods’ stock turnover I need to find the average stock first. The opening stock is  £5250 and the closing stock is  £8500. By adding them two and then divide it by 2, it would give me the average stock which is  £6875. Then I need to divide  £6875 by the cost of sales  £99500 and it would give me the answer of 0.06909547738. Then if I will multiply it by 365 it would give me the answer 25 days which is the average number of says the stocks are being held before being replaced. If the stock goes out of date and this could happen to Polish Fine Foods as their selling food, stock should be held for a shorter period of time. It is a disadvantage to the business if they held stock for a long period of time because it can be expensive and the stock can deteriorate in value. However, a high turnover of stock can be seen as an  indicator of a stable business. Polish Fine Foods has a low stock turnover, and this might be because it is a sole trader and it has been opened up recently. Polish Fine Foods can run successfully as they are able to sell their stock in less time than a month which means that the products don’t go out of date by the time they replace the stock. Next ratio I’m goi ng to use is debtor collection period. This measures how long debtors take to pay. To calculate debt collection period for Polish Fine Foods I need to divide  £18000 which is debtors by  £145400 being the sales and multiply the answer by 365 days. This gives me the answer 45 days, on average. It means that it takes 45 days for the debtors to pay the business. Other businesses allow the debtors 90 days until they pay the money. For Polish Fine Foods it only takes 45 days which means that is less time, so they won’t face any financial problems, struggling to get money from the debtors in order to buy some stock. This ratio shows that the business is performing well as they don’t face any cash shortage which would slow the business down. The last ratio I’m going to use in order to measure the performance of Polish Fine Foods is asset turnover. It measures how high the level of sales are in relation to the assets of the business. To calculate the asset turnover I have to divide the amount of sales by the assets. For Polish Fine Foods the sales amount is  £145300 and the assets value is  £24500. By dividing them two it would give me the answer of  £6. This shows that the business earns approximately  £6 in sales for every  £1. Knowing all this measurement is very important for the business owner because they can see how they are performing in different areas. Conclusion This report was written to illustrate the financial state of Polish Fine Foods. So I used accounting rations as evidence to measure its solvency, profitability and performance. First of all, I found out that Polish Fine Foods’s current ratio is 1.70. Another ratio I used is the acid test which gave me an answer of 1.20. This is the same as the current ratio; however it is a harsher test of ability to settle short-term debts. These ratios tell us that this is a solvent business. This means that it is able to settle its debts when they are due to be paid. If the business is not solvent, then it means that it can’t do this. Being solvent helps the business to maintain their confidence and make it operate more successfully. Another set of 3  ratios that show us the profitability of Polish Fine Foods are: gross profit margin which was 31.56%, net profit margin being 10%, then ROCE which is 60%. All these ratios show how well the business is running. Also, whether they are making any money and how profitable it is compared with other competitors. From all these ratios, I have found out that Polish Fine Foods is doing well at the moment. They are making enough profit to keep their business going, as they didn’t make any loss. Lastly, I measured the performance of Polish Fine Foods using 3 ratios: stock turnover which was  £6875; then it was debt collection period which was 45 days on average, and then the asset turnover which was  £6. Each of these ratios measure different segments of a companys overall performance. These ratios look at how efficiently and effectively Polish Fine Foods is using its resources to generate sales and increase profit. This is important for the business because Ania can notice any unusual fluctuations in the financial ratios over time and can see how the business is performing. This could also help Ania decide whether or not to grow her business and turn it into a LTD as it would give her enough information to see if she is financial stable to do so.