1. IB Business and Management
3.6 Ratio Analysis

2. Types of Ratio RATIOS Efficiency Liquidity Profitability Shareholder
Gearing

3. Learning Outcomes You will be expected to: Calculate the ratios
Use the ratios to interpret and analyse financial statements
Evaluate possible financial strategies and other strategies to improve the value of ratios (HL)

4. Formulae Re-cap Questions……
What are the formulae for:
Gross Profit
Net Profit
c. Cost of Goods Sold
d. Working Capital
e. Net Assets Employed
f. Capital Employed

5. Give an example of……… A current asset An expense A current liability
Something which appears on the appropriation account
A fixed asset

6. Explain why….. Gross profit is always higher than net profit
Closing stock is not included in the calculation for COGS
Selling a dis-used vehicle will improve liquidity but not profitability

7. Why do we need Ratios?

8. Who uses final accounts?
The users of financial reports are wide ranging and include a variety of stakeholders:
Investors
Creditors
Banks
Customers
Managers
Employees
Tax Authorities
What would each of these stakeholder groups want to find out from the company’s accounts?

9. What do stakeholders want to know?
Is the business profitable?
Does the business have a good liquidity position?
How is the business financed?
How well does the business manage their creditors/debtors?
Is the business heavily reliant on borrowed funds?
Does the business provide a good return on investment?

10. Task Look at the accounts for Imperial Ltd for 2010 to 2013.
What conclusions can you draw from the accounts about the performance of Imperial Ltd?
Can you answer the stakeholder questions from the previous slide?

11. Why are ratios useful?
Financial ratios provide tools to interpret and understand complex final accounts.
They provide useful KPIs on business performance
They consider proportionality rather than nominal values
Ratios can help compare the business performance to:
Industry Norms
Aggregate Economy
Past Performance

12. Ratios for the IB
SL and HL Ratios Net Profit Margin Gross Profit Margin Current Ratio Acid Test Ratio ROCE Stock turnover (number of days) Gearing
HL Only Earnings per Share Dividend Yield Debtor Days Creditor Days
For each of these ratios, you need to know:
How to calculate it
What they show about the business
What a business would like to see in the results (value, trend etc)
How to improve it (HL only)

13. Calculating and interpreting ratios
Fill in your
Calculating and interpreting ratios

14. Ratios: Gross Profit Margin Net Profit Margin
Profitability Ratios
Ratios:
Gross Profit Margin
Net Profit Margin

15. Gross Profit Margin
The gross profit made as a percentage of sales revenue
Indication of a businesses ability to control it’s cost of goods sold/sales
Always expressed as a %

16. Interpreting Gross Profit
Sales Revenue
Cost of Goods Sold
Minus
Gross Profit
Questions:
What would a business want to see happening to this ratio over time?
Will all industries have the same expectations for GPM?
Can this ratio be more than 100%?
Will a increase in COGS always lead to an decrease in GPM?
What factors could lead to a company's Gross Profit Margin decreasing over time?

17. Net Profit Margin The net profit made as a percentage of sales revenue
Indication of a businesses ability to control it’s expenses
Always expressed as a %
Formula:

18. Interpreting Net Profit Margin
Sales Revenue
Cost of Goods Sold
Minus
Gross Profit
Expenses/Overheads
Net Profit
Questions:
What would a business want to see happening to this ratio over time?
Will all industries have the same expectations for GPM
Can this ratio be more than 100%?
Can the NPM be higher than the GPM?
Will the NPM always decrease if the GPM decreases?
6. What factors could lead to a company's NPM decreasing over time?

19. Ratios: Current Ratio Acid Test Ratio
Liquidity Ratios
Ratios:
Current Ratio
Acid Test Ratio

20. Liquidity Ratios Profits are not the only requirement for survival.
A firm must have liquid assets - assets that can be turned easily into cash - to meet day to day payments.
Liquidity ratios are a quick way of assessing the liquidity position of a business

21. Task
Think of 4 reasons why a firm can be profitable yet not liquid

22. Current Ratio
This ratio shows how many £ of current assets a firm has to every £1 of current liabilities
Expressed as a ratio
For Example: 1.43:1

23. Interpreting the Current Ratio
Questions:
What would a value lower than 1 indicate?
How does this ratio relate to the Working Capital figure from the balance sheet?
What would a high figure indicate? Would this be ideal?

24. Changes to the Current Ratio?
Will the following changes make the current ratio go up, or down or will it stay the same? Why?
The business takes out a bank loan of $10,000
The business buys $400 worth of stock on credit
One of the firm’s debtors pays the balance of their account in cash
The business sells one of it’s buildings
The business sells $200 worth of stock to a customer for cash
The business pays it’s VAT bill
The business sells $10,000 of shares

26. Acid Test Ratio
Stock is the most difficult of a firms current assets to turn into cash (least liquid)
The acid test ratio is like the current ratio but does not include stock as a current asset
Also expressed as a ratio

27. Interpreting the Acid Test Ratio
Questions:
Why will the result always be lower than the Current Ratio?
What would a steady Current Ratio accompanied by a falling Acid Test Ratio indicate?

28. Financial Efficiency Ratios
ROCE
Stock Turnover
Debtors Days HL
Creditor Days HL

29. Return on Capital Employed (ROCE)
This is sometimes referred to as the primary efficiency ratio and is perhaps the most important ratio of all.
It measures the efficiency with which the firm generates profit (in a year) from the funds invested in the business
It is expressed as a %

30. Reminder: Where can Total Capital Employed come from?
Owners / Share Capital
Retained Profits
Long term liabilities such as Bank Loans or Debentures

31. Total Capital Employed
Interpreting the ROCE
Questions
Could the result be over 100%?
What will potential investors compare this result with?
What could cause capital employed to increase?
Will an increase in Net profit always lead to an increase in ROCE?
How could a business decrease the capital employed figure?
Sales Revenue
Cost of Goods Sold
Minus
Gross Profit
Expenses/Overheads
Net Profit
Owners/Share Capital
Retained Profits
Plus
Long Term Liabilities
Total Capital Employed

32. Stock Turnover (times per year)
This ratio measures the number of times in a trading year that a business sells and replaces its stock
A fruit stall which, every day, buys stock in the morning and sells it all by the evening is turning its stock over 365 times per year.
Formula:
Expressed as times per year

33. Stock Turnover (number of days)
This ratio measures the average number of days the business takes to completely use it’s stock
Expressed as a number of days

34. Interpreting Stock Turnover
Questions:
Would a business want these figures to be increasing or decreasing?
What could a worsening figure indicate?
What problems could a worsening figure cause for a business?
How might this ratio differ between different types of businesses?

35. Debtor Days (HL)
This ratio shows the average number of days the firm takes to receive cash from it’s debtors.
It is expressed as a number of days
Formula:

36. Interpreting Debtor Days
Questions:
Would a business want these figures to be increasing or decreasing?
What could a worsening figure indicate?
What problems could a worsening figure cause for a business?
How might this ratio differ between different types of businesses?

37. Creditor Days (HL)
The creditor days ratio measures the number of days it takes, on average, for a business to pay its creditors.
It is expressed as a number of days

38. Interpreting Creditor Days
Questions:
Would a business want these figures to be increasing or decreasing?
Why would it be useful to look at this ratio in conjunction with the Debtor Days result?
What problems could a decreasing figure cause for a business?
What might a very high result indicate?

39. Gearing

40. Gearing
Examines the extent to which the business is dependent upon borrowed money.
It calculates the % of the Total Capital Employed that comes from loan capital

41. Interpreting Gearing Questions:
Questions:
What problems would be caused by a very high figure?
What figure do you think would be considered high?
What do you think would be an acceptable result?

42. Ratios: Earnings Per Share Dividend Yield
Shareholder Ratios
Ratios:
Earnings Per Share
Dividend Yield

43. Higher Level Extension: Shareholders Ratio
Shareholders generally buy shares in a company for two main reasons:
Capital Gain
Dividends
Investors will use these ratios to assess whether a business is a worthwhile investment

44. Earnings per Share (HL)
The Earnings per Share shows the maximum dividends that could, in theory, be paid to shareholders.
It is expressed as a value in currency

45. Interpreting Earnings per Share (HL)
Questions:
Does a high value mean that shareholders will get a good return on their investment?
What might cause a falling value?

46. Dividend Yield (HL)
The dividend yield ratio measures the % dividend return per share in relation to its current market price.
It is expressed as a %
Formula:

47. Interpreting Dividend Yield (HL)
Questions:
Which stakeholders would be particularly interested in this figure
What might happen if the value was too low?
What might cause a fall in this result?