Analyse Performance Of A Business Using Suitable Ratios Finance Essay
It is thought that the sales in July will be 10 per cent higher than for June. After that, you are to assume that sales will grow each month by 2 per cent of the previous month’s sales figure. Assume that all sales for cash and will be received in the same month as the sale. Sale should be rounded to the nearest pound.
Purchases are to be calculated at 60 per cent of the sales figure for the same month. However, goods are bought on credit terms and the company is allowed a month’s credit before actually paying creditors.
The owner is expecting to receive £7000 when an investment matures in December. This will be invested in the business in December.
Cash drawings should be £1200 per month for the first six months.
The owner is planning to buy some computer equipment in August, at a cost of £2500, paying by cash.
The owner is planning to buy a new company car for the sales manager in July, by cheque, at a cost of £10000.
Overdraft charge will be 2% on any negative closing balance
Wages are £1500 per month.
General expenses will cost £100 per month.
Revenue expenses will be as follows from July to December:
Rent is payable at £400 per month, payable in arrears in September and December.
Light and heat is payable in August and November and should cost £300 in August and £450 in November.
From the following January to June
Rent should increase by 2% year on year, payable in March and June
Light & heat is payable in February & May and should cost GBP 600 in February and 450 in May
Owner withdrawal will be in 1400 per month
Note: The sales and purchases figures are before VAT (17.5%) has been added.
This task addresses P3
Look closely at the results shown in your cash flow forecast for July to June and then write a report:
Analyze any problems that are evident in your figures and
Consider the actions that your company might take to resolve these problems.
(Write a brief report showing your analysis of the cash flow problems and on the action that might be taken.)
This task addresses M1
Complete your report from Task 4 by recommending any action that needs to be taken to avoid cash flow problems in the next six months. You should justify each recommendation. You should include a copy of the cash flow forecast with your analysis and suggestions
This task addresses D1
Red Exchange has a subsidiary – called Red Exchange Design & Textile which is specialized in designing and contract manufacturing clothes for Red Exchange and other businesses. The following is a summary of transactions that occurred during the trading year ended 31 Dec 2011.
Opening Stock (inventory)
Salaries and wages
Van (net- value)
Van running expenses
Premises (net value)
In addition to the balances on these ledger accounts Red Exchange Design & Textile has a closing stock balance of £33000 at 31 December 2011. Assume that the company is eligible to 0% tax.
Your line manager asked you to prepare a balance sheet as at 31 December 2011 and a profit and loss account for the year to that date.
This task addresses P4
The owners of Red Exchange have been presented with the following comparative
Balance sheet as at 31 December 2011
Stock in trade
Less current liabilities
Other creditors and accruals
Net current assets
Profit and Loss Account for the year ended 31 December 2011
Less Cost Sales
Profit before tax
Net Profit for the year
Calculate the following financial ratios for both 2010 & 2011 (using the year-end figure for balance sheet and profit and loss account items)
Return on capital employed
Net profit margin
Gross profit margin
Acid test ratio
Settlement period for debtors (Debtors’ payment period)
Settlement period for creditors (Creditors’ payment period)
Stock turnover period (Rate of stock turnover)
This task addresses P5
Using suitable ratios, analyze the performance of the business from the business owners’ point of view.
This task addresses M2
Evaluate the financial performance and position of the business using ratio analysis.
This task addresses D2
The unit will be graded as follows.
All pass criteria achieved = Pass
All pass criteria plus all merit criteria achieved = Merit
All pass criteria plus all merit criteria plus all distinction criteria achieved = Distinction.
This is a brief write up to acknowledge the people whom you have consulted, or have contributed in completing the assignment.
Table of Contents Page
Task 1 14
Task 3 20
Task 4 22
Task 8 31
The purpose of this project is to introduce Business Accounting that I studied. I have included the following documents for each part: the purpose of accounting, cash flow forecast, profit and loss accounts and how to business performance using simple ratio analysis. Also, I have included a discussion of how apprentice satisfies requirements of manager that given in the project outline.
The purposes of accounting activities for an organization
First of all, I should mention is the role of accounting department. Particularly, it plays an important role in Red Exchange. Maybe, a business won’t know how to operate money flow without some knowledge of the accounting process. An accountant who records, analyzes and provides financial report. The report is useful information for director who makes decision and planning of further direction at Red Exchange.
The agency, organization or company, they also have to know the situation of revenues and expenditures monthly, quarterly, annually. Especially as Red Exchange needs to grasp the situation obtained frequently by the main interest is the purpose of their work, determining the existence or development of bankruptcy of Red Exchange. In addition, base on the figures of finance report is also necessary for the external users in order to be acceptable investment or loan by the investors as well as the banks.
There are five main purposes in accounting:
Record transactions: It also called accounting notes which is very important for Red Exchange as it helps you archive whenever all of the money coming into Red Exchange (from sales) and all of the money going out (from expenses). Record transactions relate to the activities of the stores all day, so the owner may see which store profit or loss. It should be accurate and up to date. Bookkeeping also help you prepare before a decrease in revenue and other issues such as avoiding tax payment problems.
Monitor activity: With 'bookkeeping' you need to make sure that you follow regularly, how to Red Exchange operate. In addition, monitoring activity should also relate to keep an eye on the bank balance to ensure financial capacity of the business.
Control: As result of two purposes above is an ability to control finance issues. Control can be said that it checks the balance between money flowing in and out of Red Exchange. For example, the expenses increase suddenly but sales drop off, so the owner has to find out ways to control costs.
Management of the business: It helps the owner clearly understands financial situation of Red Exchange to have reasonable expenses such as wages, stock, materials and money.
Measurement of financial performance: To evaluate the business was making profit and loss or know how value owed to the business or in debt to others, they can measure financial performance.
Basically, measurement can help Red Exchange have the right decision when they action. Key indicators of financial performance include:
Gross profit: This is the total revenue subtracted by the cost of generating that revenue. In other words, gross profit is sales minus cost of goods sold.
Net profit: This is the revenue subtracted by all expenditure from the gross profit. It also called profit after tax.
Value owned to the business: the amount of money that Red Exchange received from selling goods.
Value owned by the business: the amount of money that Red Exchange must pay to others for purchasing.
At Red Exchange, we can say accounting department collects all the business’s transactions and using the figures to set up financial reports for the users. Whether the company is large or small, accounting department have the same functions. To set up a store, Red Exchange also works with payment accountant, cost accountant, and bookkeeper.
Capital Income - Revenue Income - Capital Expenditure - Revenue Expenditure
In this task, it will be described clearly about types of capital and revenue, after that, explained the differences between the each term. Finally, the writer will compare three different kinds of organization and decide, as a group, the different categories of capital income, capital expenditure, and revenue income and revenue expenditure for each organization I selected.
Capital income: this is the money and other lawful assets (vehicle, office building…etc) to carry out investment of Red Exchange’s activities that invested by the owner and partners for a medium-to-long period of time. When setting up this company, capital income might also be used to buy opening stock, but as the company develops, stock should be paid for by sales income. The sources of capital income come from sole trader, partnership, shares, loan and mortgages.
Sole trader is a proprietor who owns and manages Red Exchange. Looking after the finance, including effective credit control procedure, as a sole trader they have personal liability for all business debts.
Partnership includes two or group join together to establish Red Exchange, it also called partner. They invest money, experiences and share profit and loss as well as making decision in accordance with term of the partnership agreement.
Shares is when Red Exchange considered a joint stock company, it includes shareholders who hold shares. The shareholders can participate in the management of the business. This act entitles all shareholders to vote during Red Exchange’s meetings, the greater their ability is to influence decision making.
Loan: the amount of money lent to Red Exchange from the bank. This is charging for the loan as interest rate over the period of time, maybe from one to five years.
Mortgages: is similar to the loan, but it tends to be for a larger sum of money and over a longer period of time, about 25 years.
Revenue income: If capital income is the money invested in Red Exchange to set up business, but revenue income is the money come into the company by selling goods performing day-to-day, and three main sources are:
Sales, or sales turnover, is money coming in from the sales of clothing. Sales can be either cash sales (the customer pays cash at that time) or credit sales (the customer pays later date). When the customers want to buy a T-Shirt at Red Exchange’s store, but they do not enough money. The customers can pay deferred.
Rent received is the revenue income from the customer who rent building. If Red Exchange has some office building, it will get other revenue from rent.
Commission received is the percentage of the profit that can be receivable when Red Exchange is successful in selling clothing. For example, a store has highest sales of month, it will get commission to encourage employees.
Capital expenditure: when Red Exchange spends money either to buy fixed assets or upgrade existing fixed assets such as office building or machinery… for a long period of time. Capital items consist of tangible assets and intangible assets, as explained below.
Tangible assets are items owned by a business with a long-term useful life that uses to make its products or provide its services.
Intagible assest is an asset that cannot be touched. There are three common intangibles in marketplace today as goodwill, patents, trademarks.
Revenue expenditure: is spending related to the costs of doing business on a day-to-day basis. The types of costs incurred vary from business to business, but some of the more common types include: premises costs, administrative costs, staff costs, selling and distribution costs, finance costs, purchase of stock.
Administrative costs involve items such as postage, telephone, business card, catalogues…ect which are paid quarterly after use.
Premises costs is the total of direct material costs, direct labor costs, and direct expenses. Such as: rent, rates, heating and lighting, insurance.
Staff costs: salary, wages, training, insurance and pension.
Selling and distribution costs: marketing, transportation, sales staff salary.
Finance costs: bank charges, loan and mortgages interest.
Purchase costs: cash basis, credit.
The following table is the differences between the terms.
The different point between Capital income and Revenue income
The owners/shareholders or loans from bank
Running Red Exchange
Pouring the money into when it has finance problems.
What use it for
Set up Red Exchange or buy additional equipment and fixed assets
Payment of daily expenses
The different point between Capital expenditure and Revenue expenditure
Red Exchange is established
What spend it for
to buy capital items, which are assets that will stays in Red Exchange for a long period of time
Spent on items on a day to day or regular basis
Now, I will take the example of capital income, capital expenditure, revenue income, revenue expenditure in three different kinds of organization.
(Retail fashion company)
Shareholder, bank loans, owner
Money of customer (from selling clothing)
Come from selling foods or consumer product
Money come from transportion service)
Factory, building, premises, equipment, vehicles etc…
Material, salaries and wages etc…
Wages, taxes, electronics…
Wages, insurance, training
Red Exchange’s cash flow forecast
I will show the forecast opening and closing cash and bank balance for each month from July to June at Red Exchange.
Analyzing & solving of the cash flow problems
Looking at the cash flow forecast from an overall perspective, we can see clearly the result. The closing balance sheet of first five months is negative number, then the total outflow is more than the total inflow in the next months. We will recognize that Red Exchange met serious difficulties as well as lack of funds in that period.
The closing balance from July to November is the negative number. Firstly, it starts by buying a new car worth up to £10000 and some computer equipment (£2500) based on the costs of Red Exchange. The secondly, the company has to pay the owner for £1200, although it get loss the money. Therefore, it lead to the money of total outflow is higher the money of total inflow. In that case, this company might resolve these problems by the better solutions. It can include the following solutions:
Solution 1: Car payment should be on credit term instead of buying them at cost of £10000
Red Exchange can pay £2000 in five months instead of only once payment £10000. It leads to keep the cash for long time and invest some expenses with higher return rate than credit rate. In addition, buying with credit business has to pay the interest rate. Buying car with cash will save this money.
Solution 2: Increasing of reasonable sales figure
It means the price of sales are not as equal as the purchases, Red Exchange buy materials more than they sell goods. Purchases are to be calculated at 60 per cent of the sales instead of purchases can be calculated at 50 percent of the sales. Why we have invested quite a lot of money for good service (car, computer…) and high quality goods, whereas the price of sale is lower than we pay.
Solution 3: Investing £10000 for capital expenditure
There are some advantages for this method:
The company can manage in capital.
No paying for overdraft cost.
Receiving more discount of suppliers if Red Exchange can purchase the large amount of goods. Then, they will launch the product with higher price when events are coming (end of season, Christmas…).
Solution 4: Without cash drawing in the first six months and receiving of withdrawal in the next six months.
That means the owner will not withdraw any cash from company in the first 6 months. Consequently, Red Exchange will have more capital income investing in other expenses. As we can see from the cash flow forecast, the profit is increasing significantly without cash drawing £1200 in the first six months. So, the company can be easy to withdraw £2600 from the last six months without worry about loss.
Solution 5: Reducing of expenses is not necessary.
Some of unnecessary expenses are heat and light, cash drawing and general expenses. Particularly, Red Exchange can reduce the heat and light in order to save money. Maybe, when the owner withdraws £1200, they spend money for other expenses. Thus, they must decrease £200 per month, it already can be calculated into the general expenses.
Solution 6: Deferment of payment.
Contract agreement between Red Exchange and the suppliers, the supplier accept to expand the credit period from one month to two month. That means Red Exchange will not have to pay £6000 for purchase in July. It lead to the closing balance now is the positive number.
The consequence of the solutions
According to the methods above, the closing balance is not the negative numbers and less loss than previous loss. The total inflow and total cash available absolutely rise, Red Exchange has enough money spending for expenses. However, some solutions are not suitable with Red Exchange, which has been trading for five years.
We need to anticipate the consequence of the solutions, some disadvantages that Red Exchange cannot do. At solution 2, increasing of reasonable sales figure. If Red Exchange increases the price of product, it will be loss the customer who likes the product with lower price.
Another solution is number 3, investing £10000 for capital expenditure. The owner can not ensure when they pour more money into the business, they will get more profit in the future. For example, if Red Exchange’s inventory contains the numerous product for selling in events. It is easy to get risk, the clothes can be old-fashioned. Therefore, no one want those clothes, Red Exchange will meet immersion capital.
And solution 5 is reducing of expenses is not necessary. Maybe, this is the best way to solve financial situation, but Red Exchange should be careful. If they want to attract the customer, they will use variety advertisement. I mean Red Exchange need to spend the money for advertisement (designing of stores, advertising of brand), so they cannot cut down the expenses.
I recommend solution 1, 4 and 6 are the best ways for solving serious problems.
Firstly, with solution 1, car payment should be on credit term instead of buying them at cost of £10000. You also can invest into the others which have higher return rate than credit rate. Otherwise, the total cash available is £15125 and the total outflow is £10650. It lead to see without cost of car £10000, the number of closing balance is a positive number in July.
With solution 4, without cash drawing in the first six months and receiving of withdrawal in the next six months. As we can see, the total outflow increase approximately the total inflow, it means the expenses were creeping out while sales staying the same. Particularly, the owner withdraws £1200 per month, it does not fit in with the requirements profitably. If without cash drawing, the money should be retained profit. Therefore, the closing balance increases gradually, it is no longer a negative number for five continuous months (from July to Nov). Then, the company can be easy to withdraw £2600 in next 6 months that does not worry about loss profit.
And the last one is solution 6, deferment of payment. If the suppliers accept to expand the credit term from one month to two months, the company can be easy to use money for other purposes. Paying later, you can keep the money in bank to earn more interest rates. Besides that, you can keep at other investments for profit, this solution does not affect any benefit of Red Exchange.
I enclosed the cash flow forecast that I revised as recommendation. In this section, I have already combined solution 1 (car payment should be on credit term instead of buying them at cost of £10000) and solution 4 (without cash drawing in the first six months and receiving of withdrawal in the next six months).
Profit and loss account – Balance sheet of Red Exchange
Balance Sheet for Red Exchange as at 31 December 2011
Financial ratios for both 2010 and 2011 of Red Exchange
The following financial ratios can help to compare between company and company or this year with last year in the company.
Return on capital employed (ROCE):
In 2010, it means that every £1 capital invested in the business, it generates 31 percent net income before interest and tax.
In 2011, it means that every £1 capital invested in the business, it generates 21 percent net income before interest and tax.
Net profit percentage of sales:
In 2010, every £1 sales turnover made, 17 percent left is net profit.
In 2011, every £1 sales turnover made, 10 percent left is net profit.
Gross profit percentage of sales:
In 2010, every £1 sales turnover made, 42 percent left is gross profit.
In 2011, every £1 sales turnover made, 38 percent left is gross profit.
In 2010, it means that the business has £1.27 in current assets to pay £1 in short- term debt.
In 2011, it means that the business has £1.66 in current assets to pay £1 in short- term debt.
Acid test ratio:
This means that for every £1 Red Exchange owes in short-term debts, it only has 53p to pay after deducted stock in 2010.
This means that for every £1 Red Exchange owes in short-term debts, it only has 67p to pay after deducted stock in 2011.
Settlement period of debtors:
In 2010, on average it takes a customer 63 days to pay for purchases.
In 2011, on average it takes a customer 95 days to pay for purchases.
Settlement period of creditors:
In 2010, Red Exchange can pay to suppliers in 66 days.
In 2011, Red Exchange can pay to suppliers in 92 days.
Stock turnover period:
In 2010, this means that an average the company holds each item of stock for 119 days.
In 2011, this means that an average the company holds each item of stock for 93 days.
Analyse the performance of the business using suitable ratios
Taking a general overview, the financial ratios table above helps the stakeholders easy to compare the performance of the business between year 2011 and year 2010. In view of the owner can be seen as follows:
Return on capital employed (ROCE): the figure of year 2011 is less than year 2010 about 10 percent. We can see the less cost sales in 2011(£22500) increases higher than in 2010 (£204000), it leads to the gross profit in 2011 go down. The expenses in 2011(£87300) are higher than in 2010 (£79800). The reason why the profit before tax is just £47700 in 2011, whereas the profit before tax in 2010 is £70200. Obviously, the capital employed in 2011 is added higher profit but it does not seem to be effective. The owner should review the less cost sales and the expenses to find out the suitable return. However, this figure is certainly higher than the owner could expect from a bank.
Net profit percentage of sales: net profit percentage of sales in 2010 is more than in 2011. A fashion retailer is likely to have reasonably high expenses due to the nature of their business. However, Red Exchange should review the expenses and depreciation. Why money going out seemed to be on the increase while sales were dropping off. In addition, may be Red Exchange expanded many new stores in 2011, a new store may have high overhead costs such as space, closets, light and heat. When a new store just set up, it takes time to get profit. Therefore, the figure (10%) is not really bad in 2011.
Gross profit percentage of sales: According to statistics that accounting department provided, we can see the cost of goods sold in 2011 is higher than in 2010 at £21000. So gross profit percentage of sales in 2011 is lower than in 2010. This is alarming. Specially, the inflation is booming gradually, it can make the supplier increases material price. Moreover, the number of the consumer is falling for saving money. Red Exchange needs to solution to solve the problem.
Current ratio: for every £1 Red Exchange owes in short-term debt, it owns £1.27 (2010) and £1.66 (2011) in current assets. Therefore Red Exchange has sufficient liquidity to meet short-term debts.
Acid test ratio: After deduction of inventory, Red Exchange only has 53p (2010) and 67p (2011) to pay for every £1 the company owes in short-term debts. This figure shows the firm to be illiquid, as well as Red Exchange has to face with short- term debts if repayment was required immediately.
Settlement period of debtors: If Red Exchange has a debtors’ payment, on average it takes debtors two months (2010) and three months (2011) to pay for goods purchased on credit. If the company needs to reduce cash flow problems, it should shorten the time as soon as possible. It helps the company can be able to manage capital for other investment.
Settlement period of creditors: On average Red Exchange has 66 days (2010) and 92 days (2011) to pay for suppliers. This may mean that some suppliers offer two month’s credit and others three months. The company can constitute capital for long time, so they can use the money for the other purposes.
Stock turnover period: Clothes are different from foods, so Red Exchange has more conveniences holding the items in stock. On average clothes can keep 3 months (2010) and 2 months (2011) in stocks. Be careful, if the rate of stock turnover appears high for the nature of product, the model of clothes might out of date fashion.
Evaluate the financial performance and position of the business using ratio analysis
Base on using ratio analysis, it helps make a judgement of the financial performance. It also allows for both inter-firm and intrafirm comparisons. The next, I will show you each ratio is the good or bad.
Look at the table of financial ratios for both 2010 and 2011 of Red Exchange, all of figures (ROCE, net profit percentage of sales, gross profit percentage of sales) in 2011 are lower than in 2010. It leads to the business becomes loss profit gradually in the future. The expenses are more and more higher, but the sales do not significantly increase than last year. If it continues, the company will not have enough capital to business. May be Red Exchange will bankrupt.
Although current ratio shows the amount of current asset in relation to current liabilities is over 1.66:1 in 2011. But acid test ratio let we know Red Exchange does not have ability of repayment if creditors ask to pay immediately. It is shown by the figure that after deduction of inventory, Red Exchange only has 67p to pay for every £1 the company owes in short-term debts. Whereas, Red Exchange is likely to have a large amount of current assets in the stock as clothes. It leads to the supplier will not provide material goods for Red Exchange as soon as possible, the company cannot be produced on time.
On average Red Exchange has 66 days to pay for purchase. In the cash flow, the company is allowed a month’s credit, this gives Red Exchange want agreement with supplier to get more time for payment.
Generally, Red Exchange meets the serious problems of expenses. These ratios show us clearly impact upon the future performance. The company should consider carefully the expenditures. Besides, Red Exchange should care about the cost of goods sold too. If the economic is inflationary in the present, the company should have reasonable price for profit. The prices are high, sellers want to sell more but buyers want to buy less. So there is a surplus, the many items of stock are held for long time as in 2011. A fashionable can be out of fashion, Red Exchange will not sell many products.
Accounting department plays an important role in the company. It must provide the exact number as well as analysis of financial documents help the owner anticipate the serious problem in the future. Without the accounting department, the owners and manager cannot control their finances to ensure that the money is coming in to cover and preferably exceed the amount of money going out.
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