Accounting & Financial Analysis 111 Lecture 8

1. Accounting & Financial Analysis 111Lecture 8 Ratio Analysis, Break-even point

2. Ratio analysis • Ratio analysis provides the manager with the tools necessary to analyse the performance of the business. • The business can then compare its current performance with its past performance to establish whether it is doing better or worse than previous years. • It can also compare its performance with that of similar types of business by extracting the relevant ratios from business statistical publications.

3. Ratio analysis 2 • Ratios are use to measure different aspects of the business namely: • The trading performance - (P & L) • The trading performance in relation to assets, liabilities and shareholder's equity - (P & L / BS) • An analysis of the company's worth - (BS)

4. Ratio analysis 3 • Ratios are viewed under the following headings: • 1) Profitability • 2) Activity • 3) Liquidity • 4) Leverage • 5) Valuation

5. Ratio analysis e.g. • In your notes are the Profit & Loss and Balance Sheet of Pizza Delight Ltd for the years 2003 & 2004. • We will use these figures in the ratios that follow.

6. Measuring Profitability • The ratios used to measure profitability are usually: • 1. Gross profit margin % • 2. Net profit margin % • 3. Return on total assets % • 4. Return on shareholder's funds % 5. Return per employee $

7. Gross profit margin • = Gross profit * 100 • Sales • $880,000 * 100 = 40% • $2,200,000

8. Net profit margin • = Net profit * 100 • Sales $218,500 * 100 = 6.95% $2,200,000

9. Return on net assets = Net profit after tax * 100 • Total assets - current liabilities • $152,950 . * 100 = 14.37% $1,064,300

10. Return on shareholder's funds = Net profit after tax *100 Shareholder's equity = $152,950 * 100 = 36.92% $414,300

11. Return per employee • Net profit after tax • Number of employees • $152,950 = $7,648 20

12. Measuring Activity • The ratios used to measure activity are: • 1. Average inventory • 2. Stock turnover • 3. Average accounts receivable turnover • 4. Average daily credit sales • 5. Average collection period • 6. Asset / employee ratio

13. Average inventory • Opening stock + closinq stock 2 • $32,000+$29,000 = $30,500 2

14. Stock turnover • Cost of qoods sold Average inventory • = $1,320,000 = 43.28 times $30,500

15. Average accounts receivable turnover • Annual Credit sales Accounts receivable • = $2,200,000 = 28 times $78,200

16. Average daily credit sales • Annual credit sales Number of working days • =$2,200,000 = $6,027 • 365

17. Average collection period • Accounts receivable Average daily credit sales • = $78,200 = 13 days • $6,027

18. Asset/ Employee ratio • Total assets Number of employees = $1,182,650 = $59,133 20

19. Measuring Liquidity • Liquidity ratios are a means of calculating the working capital available to meet the short term debts of the company. • It is an expression of how cash liquid the company is. • The higher the number the stronger the company position.

20. Current ratio • Current assets Current liabilities • $345,000 = 2.92 times $118,350

21. Quick ratio • Current assets - inventory • Current liabilities- bank overdraft • $316,000 = 2.67 times • $118,350

22. Measuring leverage - gearing • Debt to equity (Gearing) • Long-term debts Shareholder's equity • = $650,000 = 1.57 times • $414,300

23. Total debt to total assets Total debt Total assets = $768,350 = 0.65 times $1,182,650

24. Interest coverage • Profit before Interest* & Tax Interest = $218,500 + $68,000 =4.21 times $68,000 * Shown as “Finance Costs” in P&L

25. Fixed charge coverage PBIT* + Lease payments Interest + lease payments $286,500 + $130,000 $68,000 + $130,000 = 2.1 times * Profit Before Interest & Tax

26. Measuring valuation Earnings per share Profit after tax No. of Ordinary shares issued = $152,950 = $0.76 p.s. 200,000

27. Dividend per share • Ordinary dividends paid No. of Ordinary shares issued • = $50,000 = $0.25 p.s. • 200,000

28. Earnings yield % per share • Earnings per share * 100 Market price per share • =$0.76 * 100 = 18.09% • $4.20

29. Dividend yield % per share • Annual dividend paid per share * 100 Market price per share $0.25 * 100 = 5.95% $4.20

30. Price / earnings ratio • Market price per share • Earnings per share • = $4.20 = 5.5 times • $0.76

31. Break-even Point • Selling price - Variable costs = Contribution margin • Contribution margin - Fixed costs = Profit

32. Selling price • is the price per unit sold. • Total number of units sold * selling price per unit = Total revenue • E.G. sale of 15,000 meals *$25 per meal =$375,000 revenue

33. Variable costs • are costs that increase/decrease according to the level of activity. (Sales, production) • They relate to PER UNIT COST • E.G. If each meal cost $9 to purchase the ingredients. • The cost of the meals will change depending on the number of meals produced. 10,000 =$90,000 and 15,000 = $135,000. • If the kitchen staff are paid by the number of meals produced and sold, their wages would be variable costs otherwise they are fixed costs.

34. Semi-variable costs • are costs that change slightly as the level of production increases but not in proportion to the increase in production. • A semi-variable cost has an element of fixed costs in it. • E.G. Telephone account has a fixed service charge, only the call charge increases as the calls increase. • Electricity/gas charges in a kitchen will not change too much as the number of meals increase. • Semi-variable costs are not normally classified within small to medium sized industry. • It is only the very large corporations that may apply semi-variable costs in management applications. Most companies consider semi­variable costs as part of the fixed costs.

35. Fixed costs • are costs that remain the same irrespective of the level of sales or production. • E.g. Occupancy costs - (Rent, rates, electricity, telephone, insurance), long-term finance costs, Depreciation, Administration costs, Marketing costs.

36. Break-even point • It is in the interest of every business to calculate the amount of sales required at a given profit margin that will equal the fixed costs. • That number of sales is the break-even point for the business. • If the business cannot finance its fixed costs within a short time of commencement and has no alternate funding its chances of success are limited.

37. Break-even point 2 • The break-even point is influenced by three components. • An adjustment to any of the components will change the break-even number. • Change in the selling price per unit • Change in variable costs • Change in fixed costs

38. Break-even point e.g. • A manufacturing company producing one product has the following data: • Sale price $52 • Variable costs $31 • Fixed costs $325,500 • Before the company starts to make any profit it must produce enough contribution equal to the fixed costs ($325,000). • Therefore it must sell 15,500 units.

39. Break-even point e.g. ctd. • $52 - $31 = $21 contribution $325,500 / $21 = 15,500 units • At this stage the company has not made any profits it has only made sufficient contribution to cover its costs. • Every unit sold in excess of 15,500 will produce a profit of $21. • Therefore if the company sells 18,000 units it should make a profit of $52,500. (18,000 - 15,500) * $21

40. Break-even point e.g. ctd • The company may decide that $52,500 is not sufficient return on assets employed and it is not likely to increase sales beyond 18,000 units. • Therefore an adjustment to any of the three components could improve the profit margin.

41. Break-even point e.g. ctd • E.g. If selling price was to be increased to $54 the break-even point would be reduced to 14,152 units. • The outcome will be a profit of $88,504. • (18,000 - 14,152) * $23 = 88,504 • OR:((18,000 * $54) - (18,000 * $31)) - $325,500 = $88,500

42. Break-even equation • The equation to calculate the break-even point is: • Break-even point = Fixed costs • Contribution

43. PRACTICE ACTIVITY! • Class Exercise 8A & 8B • Do it manually or use Excel