3.6 Ratio Analysis Chapter 23 – Part 1

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 fall into 5 different categories Profitability Ratios Liquidity Ratios Financial Efficiency Ratios Shareholder or Investment Ratios Gearing Ratios

Ratio Analysis Profitability Ratios Liquidity Ratios Financial Efficiency Ratios Shareholder or Investment Ratios Gearing 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 ProfitGross Profit ABC, Inc XYZ Corp (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 Purpose: How well are we generating profits before overhead expenses?

Net Profit Margin Sales Revenue Cost of Goods Sold Current Assets Current Liabilities Stocks (Inventory) Accts Recvble Net ProfitGross Profit ABC, Inc XYZ Corp (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 Purpose: How well are we generating profits after overhead expenses?

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.

Methods to Increase Profits Margins Method to increase profit margins ExampleEvaluation Increase gross and operating profit margin by reducing direct costs. Use cheaper materials…use rubber not leather soles on shoes. Cut labor costs by relocating production to low labor-cost countries….Dyson relocating the manufacture of vacuum cleaners to Malaysia. Cut labor costs by increasing productivity through automation in production…Hyundai production lines uses some of the most advanced labor- saving robots in the world. Cut wage costs by reducing workers’ pay. Perception of quality may be damaged; consumers may expect lower prices. Quality may be at risk. Purchasing machinery will increase overhead costs; staff may need training. Gross profit might rise…but net profit might fall. Motivation levels might fall which could reduce productivity.

Methods to Increase Profits Margins Method to increase profit margins ExampleEvaluation Increase gross and operating profit margin by increasing price. Increase net profit margin by reducing overhead costs Raise the price of the product with no significant increase in variable cost. Cut overhead costs, such as rent, promotion costs, management costs, but maintain sales level by: moving to a cheaper location reducing promotion costs delayering the organization Total profit could fall if too many consumers switch to competitors Consumer’s may consider this to be profiteering and long-term image of the business may suffer Moving to a cheaper location could damage image. Cutting promotion costs could lead to sales falling by more than cost savings. Fewer managers could reduce the efficient operation of the business.

Return on Capital Employed (RoCE) (Primary efficiency ratio) Sales Revenue Cost of Goods Sold Current Assets Current Liabilities Stocks (Inventory) *Capital Employed Net ProfitGross Profit ABC, Inc XYZ Corp (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) Purpose: How effective is the capital invested in the company at earning a profit? *capital employed = non-current liabilities + shareholders equity

Ratio Analysis Profitability Ratios Liquidity Ratios Financial Efficiency Ratios Shareholder or Investment Ratios Gearing Ratios

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 Sales Revenue Cost of Goods Sold Current Assets Current Liabilities Stocks (Inventory) Accounts Recvble Net ProfitGross Profit ABC, Inc.6030 XYZ Corp.240 Current Assets / Current 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 debt remaining Purpose: Do we have the ability to payoff our current debts? A healthy current ratio is For every $ $2 of assets I can pay off $1 of liabilities.

Current Ratio Purpose: Measures the capacity to payoff current debt Most firms are advised to have a ratio of 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 Sales Revenue Cost of Goods Sold Current Assets Current Liabilities Stocks (Inventory) Accounts Recvble Net ProfitGross Profit ABC, Inc.6030 XYC Corp Liquid Assets / Current Liabilities ABC Inc:30/30 X 100=1 XYZ Corp:180/240 X 100 =.75 Which company has the larger capacity to payoff debts? (Cash + Accts Receivable) – Accts Payable = Current debt remaining Purpose: Do we have the CASH to payoff our current debts? A healthy current ratio is 1 or above For every $1 of liquid assets I can pay off $1 of liabilities. Liquid Assets = Current Assets - Stocks

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.

Methods to Improve Liquidity Method to improve liquidity ExampleEvaluation Sell off fixed assets for cash and lease back if still needed. Sell off inventories for cash. Note: This will improve the acid test ratio, but not the current ratio. Increase loans to inject cash into the business and increase working capital. Land and property could be sold to a leasing company. Stocks of finished goods could be sold off at a discount. Just-in-Time (JIT) inventory management will achieve this objective. Long-term loans could be taken out if the bank is confident of the company’s prospects. If assets are sold quickly they might not bring their full value. If assets are still needed by the business, then leasing charges will add to overheads and reduce profit margins. This will reduce the gross profit margin if inventory is sold at a discount. Consumers may doubt the image of the brand if inventories are sold off cheaply. Inventories might be needed to meet changing customer demand levels – JIT maybe difficult to adobe in some industries. These will increase the gearing ratio. These will increase interest costs.