3.6 Ratio Analysis Topic 3– Part 1. The Purpose of Ratio Analysis The profitability of a company is not the whole story of its financial health. Does.

3.6 Ratio Analysis

Topic 3– 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 Profit

Gross Profit

ABC, Inc. 250 125

XYZ Corp.

3200 800

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 Profit

Gross Profit

ABC, Inc. 250 50 125

XYZ Corp.

3200 500 800

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.

Return on Capital Employed (RoCE) (Primary efficiency ratio)

Sales Revenue

Cost ofGoods Sold

Current Assets

Current Liabilities

Stocks(Inventory)

*CapitalEmployed

Net Profit

Gross Profit

ABC, Inc. 400 50

XYZ Corp.

5000 500

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)

AccountsRecvble

Net Profit

Gross Profit

ABC, Inc. 60 30

XYZ Corp.

240 240

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

Purpose: Do we have the ability to payoff our current debts?

A healthy current ratio is 1.5-2.0

For every $1.50 - $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 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

Sales Revenue

Cost of Goods Sold

Current Assets

Current Liabilities

Stocks(Inventory)

AccountsRecvble

Net Profit

Gross Profit

ABC, Inc. 60 30 30

XYC Corp.

240 240 60

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

Purpose: Do we have the CASH to payoff our current debts?

A healthy current ratio is 1 or above

For every $1 – 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.