# Tools used to measure and analyze the profitability

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## Financial analysis:-

Tools used to measure and analyze the profitability, validity and the stability of the project, business or of sub-business is called as the financial analysis. The financial statement analysis and the accounting analysis are also known as the financial analysis. (Sherman, S., 1992 [i] )

The decisions which lead the organizational financial performance are made from the information gained from the analysis of the financial reports and other statements. Senior or the top management utilizes the information for the further decision making, to attain the organization's goals.

Management uses the financial analysis for the following purposes,

To make decisions regarding the growth or suspension of a particular product, or industry and business operations

To make the decisions about whether to purchase an asset or lease

The financial analysis provides the management the information regarding the best combination of the owner ship and the debt.

The management can take the most important decisions of the investment in the projects which increase the value of the shareholders.

## Ratio analysis:-

The quantitative analysis of the financial statements to gain the financial information is called as the Ratio analysis. The manipulation is done by comparison of the current years ratios with the past performance of the same organization. This can be used to analyze the further decision making regarding the financial stability of the organization

## There are the following ways through which the Ratios can be used to gain financial history,

Past performance comparison: - In this the Ratios of the current year are compared with that of the previous down, within the same organization

Comparison with the future performance:-the future performance is measured through the analysis of the budget

Performance with respect to the industry:- the comparison of the ratios is done between the industry or any other firm within the same business.

(Sherman, S., 1992 [ii] )

## There are following important types of the ratios which are calculated to check the current situation of the organization.

Liquidity Ratios

Profitability Ratios

Efficiency Ratios

Gearing Ratios

Stock Market Ratios

## Liquidity Ratios:-

Liquidity Ratios are calculated to measure the organization's ability to pay or meet its short-term loans and debts. Higher the value of the liquidity higher is the performance of the organization.

## Two types of the liquidity ratios are calculated by the organizations to measure the current liquid position of the organization. These are

1. Current Ratio

2. Quick Ratio

Current Ratio = Current assets / current liabilities

= â‚¬240m/â‚¬120m

= 2:1

Quick Ratio =current assets-inventory /current liabilities

=â‚¬240m-â‚¬120m /â‚¬120

= 1:1

## Findings:-

The firm's liquidity is the most important element in the success or failure of the organization because the organizations can survive without profits but it cannot survive without liquidity. the above calculation reflects good liquidity position as compared to the market or industry standards because according to industry the current ratio must be with proportion of 2:1 and quick ratio to be 1:1, and the GlaxoSmithKline Plc has the current Ratio=2:1 and quick ratio 1:1. This shows good liquidity management of the organization.

## Profitability Ratios:-

The ability of the organization to produce profits and effectively manage the organizational expenses over a particular time period is called as profitability ratios.

Some of the most important profitability ratios are as given below,

Gross Profit Ratio

Net Profit Ratio

Return on Capital employed

Expense/ Revenue Ratio

Gross Profit Ratio = Gross profit / sales * 100

= â‚¬200m/ â‚¬400m*100

= 50.00%

Net Profit Ratio = Net profit / sales * 100 (W-1)

=â‚¬115m/â‚¬400m*100

= 28.750%

Return on Capital Employed = Profit after tax/Shareholders fund HF*100

= â‚¬70m/ (â‚¬300m+1â‚¬0m+â‚¬90m+â‚¬10m+â‚¬40m) *100

= 15.50%

Expense / Revenue Ratio = Operating Expenses / sales*100

= 21.250%

## Findings:-

The gross profit and the net profit ratio of the organization are better than the market standard. The expense to revenue ratio is lower than the industry standards which show that the company is managing its expenses quite effectively. On the other hand the Return on capital employed ratio is lower than the industry, which shows that there is need to improve the performance of the company in reference to utilize the assets of the organization properly.

## Efficiency ratios:-

The internal management performance in regard to the management of its assets and liabilities is measured with the help of the efficiency ratios. The efficiency ratios can be of following types,

Debtor's collection period

Creditors Payment Period

Inventory turnover ratio

Asset turnover ratio

Debtor's collection period = Trade Debtors / credit sales *365

= â‚¬80m/â‚¬400m*365

=73 Days

Creditor's payment period = trade Creditors / credit purchases*365

= â‚¬100/â‚¬200*365

=183 Days

Inventory turnover ratio = cost of goods sold/average inventory

=â‚¬200/â‚¬120

=1.67

Asset turnover Ratio = total sales/ total assets

=â‚¬400/â‚¬550

= 0.72

Findings:-

The above calculation reflects poor performance of the organization in the efficiency of the managing the internal aspects of the management. The debtor's collection period is higher than the industry and the longer the period to recover can lead to bad debts. The creditor's payment period is also higher. This can be due to the two reasons the first is the mismanagement and the next is the special facilities provided by the creditors. The inventory turnover is also low which shows decreased sales.

## Stock Market Ratios:-

The stock market ratios provide the investor information weather to sell or buy the shares of a particular organization.

Important stock market ratios are as given below,

## Dividend yield

Earnings Per share = PAT/ no of shares *100

## = â‚¬70m/â‚¬150m*100= 50 p per share

Price earnings ratio = Market price/ Earnings per share*100

## = 400p/50p = 8

Dividend cover ratio =Profit after tax/dividend

## =2.3 times

Dividend yield = (Dividend/share)/ market price of ordinary shares

## Findings:-

The company's earnings per share are higher than the market due to more profitability of the organization. The dividend cover of the company is lower than the industry standards but still the company can pay dividend to its shareholders easily. Dividend yield describe the growth of the organization. The company's stock market ratios reflect the better position of the company for the long term investor as compared to the short- term investors.

## Gearing Ratios:-

Debt to Equity Ratio = Total debt/shareholders fund *100

## =31.83%

Interest cover ratio =PBIT/interest

=â‚¬115m/â‚¬15m

=7.68 times

The industry average debt to equity at 27%, and GlaxoSmith used 32% of the debt to effectively run their operations. The company has 7 times the capacity to pay interest.

## Conclusion:-

The overall analysis of the performance of the Organization that shows the company is performing well, According to the standards of the market, but there is improvement in the area of the efficiency of the Organization.

## Budgeting:-

The process which is used to evaluate the expected and the actual performance outcomes of the organization is called as budgeting. The budgeting provides the basis to evaluate the actual performance with the comparison of the forecasted performance of the organization. After the evaluation the corrective measures can be taken by the management to improve the performance if there are any deficiencies.

## Karunakar Patra defined Budgeting as," the forecasted income and expenditures expected of the individuals or the company over a period of time in the future is called as the Budget."

The budget setting provides the individuals and the organization the idea of the resources and the expenses to be made over a period of time and also can be the basis for the analysis of the difference between the actual and the expected performance.

## Variance Analysis:-

The difference or the gap between the actual output and the expected outcome of the actions over a period of time is called as variance. The process through which the overall difference between the standard results and the actual results is evaluated is called as the variance analysis. The variance can be positive exceeding the expected performance or negative below the expected performance.

On the basis of the outcomes of the results the variance can be divided into following two types,

The adverse or the unfavorable variance represents the deficiency in the performance of the organization as compared to the actual performance. in this scenario the standard performance is greater than the actual performance thus leading to the unfavorable variance.

## Favorable variance:-

The favorable variance represents the positive results of the actual performance as compared to the standard performance or output of the organization.

## Reasons of Variance:-

According to Karunakar Patra the variance in the budgeted results and the actual results can be due to many reasons but the most important factors are given below,

Total variance in the variable production Overheads

Variance in the variable cost

Variance in the fixed production overheads

Variance in sales volume

The variance in the selling price of the product

## Total variance in the variable production overheads:-

The variance in the variable production overheads can be due to two reasons, the first is the variance in the variable production expenditures and the second one is the variance in the variable production efficiency. The variable expenditure variance can be favorable if the actual variable cost is less than the actual variable cost or variable expenditures. And the variance can be unfavorable or adverse if the expected variable expenditure is greater than the actual variable expenditures.

If the actual production is greater than the predicted or budgeted efficiency than the variance is favorable and if there is lack of actual production as compared to the budgeted than the variance will be adverse or unfavorable.

## Variable Cost Variance:-

The variable cost variance can be due to the changes in the following variable costs used to develop a product or service.

Variance in the material price

Variance in the quality of the used material

Variance in direct labor price

Variance in the direct labor rate

## Variance in the material price:-

The difference in the actual variable cost and the budgeted variable cost can be due to the change in the price of the direct material used for production. If the price of the material increases it leads to the adverse or unfavorable variance and if the price of the material used decreased the actual results are better than the predicted results leading to the favorable variance.

## Quantity of material used variance:-

the quality of the material depends upon the effectiveness of the utilization of the material in the best way. So if the material is used effectively by minimizing the wastage the variance will be favorable and if the material is not properly utilized it will lead to the negative outcomes resulting in the unfavorable variance.

## Variance in the direct labor price:-

If the price of the direct labor increases the actual results will be lower than the expected results and the variance will be unfavorable. The labor price can be increased due to many reasons like the govt. intervention and implementation of the price ceiling effect or due to the shortage of the labor. The variance can be positive if the price of the direct labor decreases.

## Variance in direct labor rate:-

The direct labor rate is the no. of hours used to produce a product. If the direct labor rate decreases the variance becomes favorable because the actual performance has high outcomes as compared to the predicted outcomes. On the other hand if the rate decreases the variance results in the adverse or unfavorable variance.

## Variance in fixed production Overheads:-

The variance in the fixed production overheads represents the under-absorption or over-absorption of the fixed cost used in the production of the product or service. The absorption rate can be determined from the below formula,

The error in developing the budgeted fixed overheads for the production causes variance in the budgeted and actual performance. The variance can be of two types, the first one is the fixed expenditure variance which represents the deference in the budgeted and the actual fixed costs. The second one is the volume variance which represents the budgeted and actual volume difference.

## Variance in the sales price:-

If the sales price increases as compared to the standard sales price the variance will be positive or favorable. If the sales price decreases as compared to the standard price the variance is unfavorable. The increase in price leads to the increased profit while the decrease in price causes profit to be decreased.

## Sales volume variance:-

If the actual sales volume is greater than the expected or budgeted sales volume the variance is favorable while the decrease in the actual sales volume causes the adverse outcomes. The increase in the sales volume increase profitability of the organization.

## Importance of the variance:-

The variance analysis is very important for the performance of the organization because it gives the management a tool to measure the performance of the organization after certain periods of time. There are the following usages of the variance which shows its importance,

Use of standards

Provide controllability

The variances are interdependent

The results of the variance depends upon the materiality

## Conclusion:-

The budget setting and its analysis is very important for the organization to manage its expenditures and the revenues over a given period of the time. By variance analysis the firms can take the corrective actions against the deficiencies occurring in different departments of the organization.

## Variance in the Production Overhead:-

The exact budgeting for the production over heads for a manufacturing organization which is producing many products at the same time is very difficult to calculate, because the departments and the products are interrelated and the costs can be mixed up in this scenario. The variances can be due to the following reasons,

## Variance in the variable overheads:-

The variance can be greater because when there are more products the more the variable costs will be utilized so any difference between the standard variable overheads and the actual variable overheads can lead to the variance in the variable overheads. The variance is considered as favorable if the actual overheard are lower than the predicted variable overheads.

The difference between the standard variable overhead and the actual variable over head for actual production is called as the variable overhead variance. The variable overhead variance can be calculated by subtracting actual variable over head from the standard variable overhead. If the answer is negative then the variance is unfavorable and if the answer is positive this shows the favorable variance. (Karunakar Patra, 2009)

## Variance of the fixed overhead:-

The variance of the fixed overhead is due to the difference in the expected fixed cost and the actual fixed cost of production.

The variance of the fixed overhead of the manufacturing firm of more than one product varies because of the expenditure and the volume of the production. The greater the volume differences the then the predicted the greater the volume variance is. (Karunakar Patra, 2009 [iii] )

## Departmental rate of production Overheads:-

The departmental rate of production overhead is used by the management to determine the true cost of production incurred in each department of the production process, for the each item to be produced. This leads the organization to the calculation of the exact production cost in each department of the organization. The management can use the departmental rate of production to determine the expenditure budget for each department and the business functions.

Effective utilization of the departmental rate of production leads the management to determine the exact budget and the control process for the each department of production. The cost incurred in different departments is different and so the departmental overhead gives management exact values of the costs in each department. (http://www.accountingcoach.com/online-accounting-course/36Xpg02.html [iv] )

The more effective the departmental overhead is used the more effective the allocation of resources is done by the management regarding each department of the organization, as the raw material process from one department to the other.

## Departmental rate's importance:-

The departmental rate of overhead helps the management in different ways which are given below,

It provides more accurate results regarding the cost of each department

This can be used as the basis of cost control in each department

The cost of different departments can be compared effectively with the help of departmental rate of production.

This rate is compulsory for the effective management of the organization's departmental cost management because the costs of each department are different.

This rate can be used for the development of quotations for the customers.

The exact value of the work-in-progress can be measured with the help of the departmental rate. (B.K.Bhar, 2000 [v] )

## Blanket Rate:-

The blanket rate of the production overhead represents the one single rate calculated for the whole organization or factory. The blanket rate can be expressed in the following formula as given below,

Blanket Rate= production Overhead Cost for whole factory/ total production

The organizations which are using more than one product should not use the blanket rate for calculating the production over head because this can provide the wrong forecasts and the problems can be caused like the blanket rate may cause the reduction of the organizational control on the organizational expenditures. The one benefit of the blanket rate is that it is very easy and convenient to calculate. The blanket rate can be used for the evaluation of the costs of the factory or the organization which is involved in the production of only one product.

## Activity-Based Costing:-

The activity based costing is the method in which the cost of the processes and the activities involved in production of a product are measured. This can be used by the management to reduce the wastage and can increase the accuracy and efficiency in costing the products, services, activities and the functions of the organization. (Ronald J. Lewis, 2007 [vi] )

## Zero-budgeting Vs. Conventional budgeting:-

In the process of zero budgeting in the first step the task which is to be performed is identified and in the next step is the allocation of the resources needed to accomplish these tasks. Many managers prefer the zero-budgeting due to the following reasons,

As the tasks are first identified the resources can be more effectively allocated

The inflationary budgets can be detected

The management can find the more proper ways to reduce the costs

Useful for service departments where the output is difficult to identify

Increases staff motivation by providing greater initiative and responsibility in decision-making.