3.5 Profitability & Liquidity Ratio Analysis Topic 3: Finance and Accounts

The Purpose of Ratio Analysis The profitability of a company is not the whole story of its financial health. Does the company do a good job managing “cost of goods”? Does the company do a good job of managing overhead costs? Does the company have enough money to pay its liabilities? Does the company have too much long-term debt? Does the company do a good job of using its assets to generate profit?

Ratio Analysis Ratios 3 main categories in the IB Syllabus: Profitability Ratios Liquidity Ratios Financial Efficiency Ratios (HL ONLY) We will examine 2 of them.

Ratio Analysis Profitability Ratios Liquidity Ratios

Profitability Ratios - Margins Purpose: Measures the ability to convert sales revenue into profit. Gross Profit Margin % of gross profit to total sales revenue Net Profit Margin % of net profit to total sales revenue

Gross Profit Margin Sales Revenue Cost of Goods Sold Current Assets Current Liabilities Stocks (Inventory) Accts Recvble Net Profit Gross Profit ABC, Inc. 250 125 XYZ Corp. 3200 800 Purpose: How well are we generating profits before overhead expenses? Are we controlling Cost of Goods? (Gross Profit / Sales Revenue) X 100 = Gross Profit Margin % ABC Inc: 125/250 X 100=50% XYZ Corp: 800/3200 X 100 = 25% Which company is maximizing its profit at the GROSS profit level? (Sales – Cost of Goods Sold) = Gross Profit

Net Profit Margin Sales Revenue Cost of Goods Sold Current Assets Current Liabilities Stocks (Inventory) Accts Recvble Net Profit Gross Profit ABC, Inc. 250 50 125 XYZ Corp. 3200 500 800 Purpose: How well are we generating profits after overhead expenses? Are we controlling overhead expenses? (Net Profit / Sales Revenue) X 100 = Net Profit Margin % ABC Inc: 50/250 X 100=20% XYZ Corp: 500/3200 X 100 = 16% Which company is maximizing its profit at the Net profit level? (Sales – Cost of Goods Sold – Overhead Expenses) = Net Profit

Strategies to improve Profit Margin Ratios Strategy Example Evaluation Increase Gross and Net profit margins by reducing cost of goods sold (direct costs) Use cheaper materials Cut labor costs; outsource Cut labor costs by improving productivity Cut wages 1. Perception of quality by customers may fall and hurt company’s reputation. Quality maybe put at risk. Expensive equipment investment as well training costs. Overhead costs increase. Motivation levels, productivity, and quality may fall. Increase Gross and Net profit margin by increasing price Raise the price of the product with no increase in direct costs Total profit could fall as customers may switch to a different product. Customers may consider this “profiteering” and cause long term image damage to the company. Increase Net profit margin reducing overhead costs Cut overhead costs such as rent, insurance, promotion costs, or salaries while maintaining sales levels Moving to a lower rent district could damage company’s reputation. Cutting promotion costs could lead to falling sales. Reducing salaries by eliminating positions could result in inefficient of running of the business.

Profitability Ratios- RoCE Purpose: Measures the ability of using capital employed effectively to earn a profit The higher the % the greater return on your investment It can be compared with past performance to see if the ability to earn a profit is improving Can be compared with interest earned from other investments Should be compared with the interest rate of borrowing money. If it is less than the interest rate, borrowing money will further reduce returns to shareholders.

Return on Capital Employed (RoCE) (Primary efficiency ratio) Sales Revenue Cost of Goods Sold Current Assets Current Liabilities Stocks (Inventory) *Capital Employed Net Profit Gross Profit ABC, Inc. 400 50 XYZ Corp. 5000 500 *capital employed = non-current liabilities + shareholders equity Purpose: How effective is the capital invested in the company at earning a profit? Could I earn a higher rate of return elsewhere? (Net Profit / Capital Employed) X 100 = Return on Capital Employed ABC Inc: 50/400 X 100=12.5% XYZ Corp: 500/5000 X 100 = 10% Which company is maximizing its capital resources to generate a profit? (What are capital resources…long term loans, debentures, cash generated by sale of stock, retained earnings “ploughed back” into the company)

Strategies to improve RoCE Strategy Limitation Increase Net profit without increasing capital employed: Raise prices of products Develop innovative products and set prices high Reduce variable costs per unit Reduce overheads Increase capital invested in technology if it will lead to higher profits Reduce Capital Employed: 1. Sell assets that do not contribute to sales/profits and use raised capital to reduce debt Demand could be elastic This can only be a long term strategy Cheaper materials could reduce quality May not be effective in the short term and may have drawbacks – less promotion reduces sales Finance will be needed and increase in net profits may be less than the increase in capital employed 1. These assets may be needed in the future

Ratio Analysis Profitability Ratios Liquidity Ratios What do we mean by “liquid”? Liquidity is the ability of a firm to pay its short-term debts. (Cash or cash-like)

Liquidity Ratios Purpose: Measures the ability to payoff current debt. Current Ratio Current assets to current liabilities Acid Test Ratio Liquid assets to current liabilities

Current Ratio Current Assets / Current Liabilities Sales Revenue Cost of Goods Sold Current Assets Current Liabilities Stocks (Inventory) Accounts Recvble Net Profit Gross Profit ABC, Inc. 60 30 XYZ Corp. 240 Purpose: Do we have the ability to payoff our current debts? Current Assets / Current Liabilities A healthy current ratio is 1.5-2.0 For every $1.50 - $2 of assets I can pay off $1 of liabilities. ABC Inc: 60/30 = 2 XYZ Corp: 240/240 = 1 Which company has the larger capacity to payoff debts? (Cash + Accts Receivable + Inventory) / Accts Payable

Current Ratio Purpose: Measures the capacity to payoff current debt Most firms are advised to have a ratio of 1.5-2.0 to be in a safe position Low ratios may not be unusual for high-volume cash businesses like grocery stores, fast food restaurants, or gas stations Results over 2 might suggest that too much money is tied up in inventory or long credit terms to debtors (Accounts Receivables)

Acid Test Ratio Liquid Assets / Current Liabilities Sales Revenue Cost of Goods Sold Current Assets Current Liabilities Stocks (Inventory) Accounts Recvble Net Profit Gross Profit ABC, Inc. 60 30 XYC Corp. 240 Purpose: Do we have the CASH to payoff our current debts? Liquid Assets = Current Assets - Inventory Stocks Liquid Assets / Current Liabilities A healthy current ratio is 1 or above For every $1 – liquid assets I can pay off $1 of liabilities. ABC Inc: 30/30 = 1 XYZ Corp: 180/240 = .75 Which company has the larger capacity to payoff debts? (Current assets - inventory) / Accts Payable

Acid Test Ratio Purpose: Measures the capacity to payoff current debt with liquid assets Results below 1 are viewed with caution as there might not be enough cash to short-term debt. View the ratio results in context with last year….are we improving or declining? What is the natural inventory level expectations for your type of business? This will affect your ratio so it must be viewed in context with your type of business.

Strategies to improve Liquidity Ratios Strategy Example Evaluation Sell off fixed assets for cash – could lease back if needed Land and property could be sold to a leasing company. If assets are sold quickly, they may not bring their full value. If the asset is still needed and leased back, leasing charges will increase overheads and reduce net profit margin. Sell off inventories for cash Note: this improves the acid test ratio but the current ratio Finished goods inventory can be sold at a discount to raise cash. JIT (just-in-time) inventory strategies will limit inventory stock naturally. This will reduce the gross profit margin if inventory is sold at a discount. May damage brand image if inventory is sold at a reduced price. Inventory may be needed for higher customer demand levels in the near future. JIT strategies are not “right” for all industries. Increase loans to inject cash into the business to increase working capital Long-term loans could utilized if bank is confident of the ability of repayment. These will increase the gearing ratio (HL) These will increase interest costs.