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- The capacity of the business to generate profit.
- usually expressed in a percentage
- profit is usually compared to a base such as sales/capital/assets to determined profitability
- Accrual accouting - revenue earned less expenses incurred
- expressed in dollar terms
What are the 3 common bases in profitability?
- Average Assets
- Average owner's investment (capital)
What are the other key points of KPIs?
- Assessment of performance should be ongoingfrequent assessment increases the chances of detecting problems whereby the management can react to quickly and minimise any damage
- computers enable access to data quickly, cheaply and accurately
What are benchmarks?
points of comparisons for KPIs
Give 4 examples of benchmarks
- Past performace (trends)
- Budgeted or goal performance (variance reports)
- industry average (performance of competitors)
- opportunity cost (for return on owner's investments)
Define Opportunity cost
By investing in the business, the opportunity cost of the owner is the benefit forgone by not investing in alternatives (shares, other businesses)
Vertical anaylsis is also known as
Common size statements
What is vertical analysis?
- vertical analysis converts dollar information to percentage information and creates key performance indicators
- reports on the profit/loss statement KPIs
Why is vertical analysis important?
It allows stakeholders to easily evaluate the information because they can compare common units of measurement, the percentages, rather than the different dollar values.
How can profitability increase?
- By increaseing the net profit ratio - profit per sales dollar
- only can happen if expenses per sales dollar decrease
What is horizontal anaylsis?
- Horizontal anaylsis is the evaluation of side by side information from more than one reporting period so that stakeholders can compare dollar values and KPIs over time
- allows stakeholders to quickly identify and monitor trends in the KPIs overtime
What is the difference between vertical and horizontal anayslsis?
Vertical anaylsis compares profit and loss information to sales for one reporting period whilst horizontal analysis compares information overtime. (trends)
What does return on revenue measure?
- measures net profit per dollar of sales
- can be indicator of expense control
- if ROR (NPR) increases, means that TER (total expense ratio) has improved
Is Return on Revenus or Net Profit Ratio a funtion of the other KPIs in the PLStatement?
Yes, because the ROR/NPR will change due to changes in the GPR, AGRP and ER
Why would a business buy assets?
- To assist in revenue and profit generation
- agrees with the definition of assets
- Assets - resournces under the control of the business, due to past events, that will provide economical benefits to the business in the future
What is the Return on Assets formula?
Net profit/average assets
Return on owners investment formula
net profit/average owner's investment (capital)
Stategies to improve net profit include
- Improving sales
- improving expense control
Strategies to improve sales include
- improving stock mix
- improving marketing (mark up, advertising, merchandinsing)
What does marketing relate to?
- Mark up
Strategies to improve expense control include
- Improving mark up (lowering COGS)
- reducing stock loss/write down
- controlling growth of other expenses in relation to sales
What is the aim of ROA ratio?
The aim is for the growth of profit to be faster than the growth of assets
Strategies to improve assets management (ROA) include
- improving stock-mix - more sales from the same quantity of stock or the same sales from less stock (Stock turnover)
- Improve debtor management (credit screening, see Debtor's turnover)
- improve NCA manage by purchasing the most productive NCA, maintaing NCA and training staff to fully exploit NCA
Over a reporting period, average assets remained constant and sales decreased yet ROA increased. How?
ROA is net profit over average assets. Net profit is revenue earned less expenses incurred. Although sales has decreased, better expense control has been put into place to decrease total expenses, which lead to an increase in net profit.
Is vertical analysis relevant to calculating the ROA and ROI? Explain.
No. To calculate ROI and ROA, it requires the dollar value of net profit from the PLStatement and the value of assets or capital from the balance sheet at the beginnning and at the end of the reporting period.
Suggest strategies to improve Return on Owner's Investment
- reduce in capital contributions
- rely more on gearing - borrowings instead of equities
- Gearing - liabilities/total equities
- however increase in gearing also puts pressure on the business's liquidity
To improve in ROI, drawings should increase. Comment
- Drawings tend to decrease average capital thus improving ROI
- however, excessive drawings can lead to liquidity problems
- "excessive drawings" - when drawings>profit, over a long time will have a negative impact on assets and equities