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3.6 Ratio Analysis

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Deborah Kelly

on 26 August 2014

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Transcript of 3.6 Ratio Analysis

The liquidity of both companies can be assessed by using the current ratio, and the gross and net profit margin ratios which can be calculated with the information given. This would be a starting point in comparing the two companies

Other ratios which use other information from the financial accounts would enable us to answer the following questions:
Which company is making more use of their capital?
Which one seems to handle inventories more effectively?
Who manages the payments from debtors better>
Which one is a better investment?
Comparing the accounts of the cola giants
Ratio analysis is widely used by shareholders, banks and managers to assess and compare company performance.

Below are extracts from PepsiCo and Coca-Cola published accounts (in $ millions).
3.6 Ratio Analysis
Calculate Ratios
Use ratios to interpret and analyze financial statements

Accounting Ratios
There are five main groups of ratios:

profitability ratios
liquidity ratios
financial efficiency ratios
shareholder or investment ratios (HL)
gearing ratios

Profitability Ratios
Gross profit margin and net profit margin ratios are used to assess how successful the management of a business has been at converting sales revenue into both gross profit and net profit. They are used to measure the performance of a company and its management team.
Profitability Ratios - Analysis
Gross Profit Margin
This ratios identifies the profit a firm achieves from trading - the buying and selling of goods.
Assuming that selling prices and purchase prices remain constant over a trading period this ratio should also be constant.
If the ratio starts to deteriorate the implication is that sales are not being transferred into trading profits - a potential cause for concern. Firms may wish to look at their purchases of stock to see if the cost of stock sold is rising.

Coca- Cola

43 232

30 900
Cost of

20 099

11 088

8 756

13 721

2 618

2 354

4 624

3 758

5 946

6 824

31 092

34 950
Points to think about...
Would it be sensible to compare these two companies with a construction company?
Why would it be useful for stakeholders to make a comparison between profits and capital invested into a business.
How to Improve Liquidity HL
Sell off fixed assets for cash
Liquidity Ratios
These ratios assess the ability of the firm to pay its short term debts. They are not concerned with profits but with the working capital of the business. If there is too little working capital then the business will be unable to meet its short term debts. If it has too much money tied up in working capital this could be used more effectively by investing in other assets.
A. Has BP plc got enough liquidity to pay its short-term debts?
More Practice:
B. Below are financial details for Ahmed and one of his competitors:
Efficiency Ratios
Return on capital employed =
gross profit margin (%) =
gross profit

sales revenue
x 100
net profit margin (%) =
net profit

sales revenue
x 100
Net Profit Margin:
This ratio serves as a signal as to the capacity the firm has to generate profits after overhead or indirect costs have been taken into account.
The net profit figure excludes interest or tax and is the favored ratio of managers as the final ratio will be higher that the net profit margin after tax.
The ratio should be constant over a trading period. If it starts to fall, it implies that overhead costs are rising faster than sales and an investigation should be carried out.
Given the above, the company may need to change suppliers or look for alternative insurance quotes to cover premises or vehicles to reduce fixed costs.
There is a link between gross profit margin, the industry the firm operates in and the rate of stock turnover.

Supermarkets and increasingly, e-commerce retailers can afford to set lower margins per unit given the faster stock turnover these firms experience. In industries where turnover is slower, especially in niche markets, much higher gross profit and net profit margins are the norm.
Current ratio =
current assets
current liabilities
The ratio is expressed as a ratio eg 2:1 or just as a number - 2. Many accountants recommend a ratio of around 1.5 to 2 but much depends on the industry and the recent trend in the current ratio.
acid test ratio = current assets - stock
current liabilities
The acid test ratio (or quick ratio) is a more stringent measure of liquidity as stocks of unsold goods are not included in current assets. It gives a clearer picture of the firm's ability to pay short term debts.
HL - How to Improve Profit Margins
Increase gross and operating profit margin by reducing direct costs.
This can be done by using cheaper materials (but customers perception of quality may be damaged), cutting labor costs (relocate to low labour-cost countries) (but quality could be at risk and communications problems), cut labour costs through automation in production (but will increase overhead costs and retraining of staff), cut wage costs by reducing worker's pay (but motivation may fall resulting in a loss in productivity and quality).
Increase gross and operating profit margin by increasing price.
This could be done by raising the price of the product.
Increase net profit margin by reducing overhead costs.
This could be done by cutting overhead costs such as rent, promotion costs or management costs. However, relocating could damage image if the area is not nice, promo cuts could lead to less sales and fewer managers could reduce efficiency of the business.
Sell off inventories for cash (will only improve acid test ratio).
Increase loans to inject cash into the business and increase working capital.
If assets are sold quickly they might not raise their true value. As well if the assets are needed by the business the leasing charges will add to overheads thus reducing net profit margin.
Stock of finished goods could be sold off at a discount to raise cash. Just-in-time stock management will achieve this objective.
Long-term loans could be taken out if the bank feels it is not a risk. This will increase costs and the gearing ratio.
The following information is taken from BP plc's accounts for the year ending December 31 2007 (all figures in $ million). The data has been simplified for ease of understanding.
current assets: Inventories 26 554; trade debtors 38 020; cash 3 560

current liabilities: trade creditors 43 152; short term loans 15 394
1. Calculate BP's current ratio
2. Calculate BP's acid test ratio
3. Comment on BP's liquidity.
4. Why would it be useful to BP's stakeholders to have liquidity ratio results for the previous year and for other oil companies?

Gross profit
Net profit
Sales revenue
Current assets
Current liabilities
. Calculate two profit margin ratios for both companies. Show all work.
2. Comment on the profitability of both businesses.
3. Explain and evaluate two ways in which Ahmed might attempt to increase the net profit margin for his business.
4. Calculate two liquidity ratios for both companies. Show all work.
5. Comment on your results to question 4.
6. Explain and evaluate two ways in which Flash might be able to improve its liquidity position.
net profit before interest and tax

total capital employed
x 100
capital employed = Assets - current liabilities OR
Non- current liabilities + shareholder's equity

ROCE is the most commonly used means of assessing the profitability of a business. It is often refereed to as the primary efficiency ratio.

This looks at how efficiently an organization uses its capital or total assets to create goods and services that are turned into profit.
It can be thought of as a measure of reward (profit) for the risk-taking by entrepreneurs.

stock (inventory) turnover ratio =
cost of goods sold
average stock
average stock
cost of goods sold
This gives the number of times the current level of stock is "turned over" or sold.
x 365
This formula converts the first figure into a number of days.
the importance of this ratio will depend on the type of industry the firm operates in and the nature of the good itself.
In fast-moving consumer goods industries, stock turnover will need to be quick or the firm may find itself with stockpiles of unsold goods. This will be critically important if the firm is supplying perishable goods such as dairy products, fruits or vegetables.
The gearing ratio is measured by observing how much of the firm's capital employed in the business is provided by long-term lenders.
Gearing ratio =
loan capital
total capital employed
The figure is usually expressed as a percentage.
A "high" gearing ratio such as 50% of capital employed, perhaps compared with other firms in the industry, indicates that the firm is vulnerable to changes in interest rates or external factors which may make credit more difficult to obtain.
If the firm has sufficient liquidity to pay short-term interest costs, then a high-gearing ratio may not be a major concern to some stakeholders.
The higher the ratio the greater the risk taken by shareholders when investing in the business.
A low gearing ratio is an indication of a "safe" business strategy. At the same time it suggests that management are not borrowing to expand the business.
Financial Efficiency and gearing ratios:

Company X
Company Y
Value of Stock
Cost of Sales
Sales Revenue
Capital Employed
Long term loans
1. Calculate for both companies:
a. stock turnover
b. gearing ratio [Show ALL work]

2. Company Y is plannign to invest in a new expansion project costing $75 million.
a. Would you advise the business to raise all of this finance by selling off stock and reducing its inventory levels? Explain your answer.
b. Would you recommend Company Y to finance the expansion with a bank loan? Explain your answer.

3. Recalculate the new gearing ratio. [Hint - you must increase both long-term loans and capital employed by the amount of the increased loan.
Limitations of Ratio Analysis
1. One ratio result is not very useful - to allow meaningful analysis to be made a comparison needs to be made between the result and
other businesses, called inter-firm comparisons
other time periods, called trend analysis

2. Inter-firm comparisons need to be done with companies in the same industry and ideally the same financial year end.

3. Trend analysis needs to take into account changing circumstances over time which could have affected ratio results. These could be outside the companies control such as economic recession.

4. Companies value their assets in different ways and use different depreciation methods which can lead to different capital employed totals, which will affect certain ratio results.

5. Ratios are useful analytical tools, but they do not solve business problems. Ratio analysis can highlight issues that need to be tackled - such as falling profitability or liquidity but on their own ratios do not necessarily indicate the true cause of business problems and it is up to good managers to locate these and form effective strategies to overcome them.
Additional Efficiency Ratios HL
These ratios measure how quickly customers pay and how quickly a business pays it supplies during the year.
debtor days =
total sales revenue
x 356
creditor days =
total sales revenue
x 356
The relationship between these two formula is critical and has important implications on working capital and liquidity. It is important that these two cycles are matched as closely as possible with, in a perfect world, debtor days being smaller than creditor days. This would imply that our organization on average receives payment for goods sold before we have to pay our suppliers.
Shareholder Ratios HL
Earnings per share (EPS) =
net profit after interest and tax
number of ordinary shares
This ratio is of particular interest to shareholders as it can reveal the after-tax profit available for distribution.
However, this does not mean that all the net profit will be distributed to shareholders in the form of dividends. The directors decided how much will be paid to the shareholders as dividends and how much will be kept in reserves as retained profit. This could be used to finance future investment opportunities.
Dividend yield =
dividend per share
current market share price
This is a kind of individual return or profit from owning one share of a company. Dividend yield is important to potential investors who may be looking to secure an annual income.
Again, a single ratio in isolation without comparison to other firms or the current state of the external environment over time is not a basis for making a considered financial decision.
Ratio Analysis Practice #1
Ratio Analysis Practice #2
Cima Ratio Analysis Case Study
HL Shareholder Ratio Practice
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