IB Business Lincoln High School Mrs. Dill

Chapter goals: Calculate & interpret Profitability and efficiency ratios – Gross Profit Margin, Net Profit Margin and Return on Capital Employed Examine possible strategies to improve profitability and efficiency ratios Calculate and interpret liquidity ratios – current ratio and acid test ratio Discuss possible strategies to improve liquidity ratios

Ratio Analysis Financial Analysis Tool used to interpret and assess a firm’s financial statements Used to determine trends Used to expose strengths and weaknesses Aids in decision-making We will look at: Profitability Ratios Efficiency Ratios Liquidity Ratios

Profitability Ratios Assess the performance of a firm in terms of generating profit. Gross Profit Margin – GPM Gross Profit divided by Sales Revenue X 100 Should show how much profit you are making for each dollar of revenue Ex: Sales revenue of $100 Million; gross profit $70 Million – 70mil divided by 100mil = X 100 = 70% For every $1 of sales revenue.70 is gross profit

Strategies to Improve GPM Increase prices for products in less competitive markets Reduce cost of sales by finding a cheaper source of raw materials Adopt more aggressive promotional strategies to increase sales Reduce labor costs; make sure staff are productive; unproductive workers may need to be shed

Profitability Ratios – cont’d Net Profit Margin – measure of the profit that remains after deducting all costs from the sales revenue Net Profit before interest & tax divided by Sales Revenue X 100 Only difference from gross profit margin – working with net profit; expenses have been deducted

Additional strategies to improve NPM Carefully check indirect costs; try to avoid unnecessary expenses Negotiate with key stakeholders to cut costs Reducing rent, suppliers, etc.

Efficiency Ratios Assess how well a firm internally uses assets and liabilities Return on Capital Employed Measures both the efficiency and profitability of a firm’s invested capital. Capital Employed – long-term liabilities + share capital + retained profits ROCE = net profit before interest and tax divided by Capital Employed X 100

ROCE Example Share Capital $1 mil; Retained Profit $0.5 mil; Loan capital $2 mil Net profit $700,000 ($0.7 mil) Capital Employed = $3.5 million ROCE = $0.7 million / $3.5 million X 100 = 20% For every $100 of capital invested, the firm generates $20 as its net profit before interest and tax Important – analyzes and judges how well a firm is able to generate profit from its sources of finance

Strategies to improve ROCE Try to reduce the amount of loan capital while still ensuring that net profits remain unchanged or do not fall A firm might declare and pay additional dividends to shareholders; reduces retained profit and raises the ROCE.

Liquidity Ratios Measures the ability to pay off short-term debt Current Ratio = Current Assets / Current Liabilities Example – current assets $500,000, / current liabilities $250,000 = 2 Expressed as 2:1 -- For every $1 of current liabilities the firm has $2 of current assets Differing opinions on what is optimal – many recommend 1.5:2; A firm needs enough money to pay current debts;

Strategies to improve current ratio Reduce bank overdrafts and choose to seek long-term loans, thereby reducing current liabilities Sell existing long-term assets for cash to increase working capital

Acid test (quick) Ratio A more stringent indicator of how well a firm is able to meet short-term obligations Current Assets – Inventory / current liabilities By removing the Inventory (stock) from the ratio, the business gets rid of the least liquid of the current assets. Should be a more accurate ratio of whether a business has the assets to meet their current obligations Example – same as Current Ratio with inventory subtracted: 500,000 – 150,000 / 250,000 = 1.4

Add’l strategies to improve acid test ratio Sell off stock at a discount for cash; will help to improve the liquidity position of the business Increase the credit period for debtors to purchase more stock on credit

Summary Ratio analysis a tool that assesses financial statements and aids decision-making Profitability ratios include gross profit margin and net profit margin An example of an efficiency ratio that assesses how well a firm internally utilizes its assets and liabilities is return on capital employed (ROCE) Liquidity ratios measure the ability of a firm to pay off short-term debt obligations – current ratio and acid test (quick) ratio