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3.6 Ratio Analysis

3.6 Ratio Analysis. Chapter 23 – Part 2. Ratio Analysis. Profitability Ratios Liquidity Ratios Financial Efficiency Ratios Shareholder or Investment Ratios Gearing Ratio. Financial Efficiency Ratios. Purpose: Measures how efficiently the assets of a business are being used.

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3.6 Ratio Analysis

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  1. 3.6 Ratio Analysis Chapter 23 – Part 2

  2. Ratio Analysis • Profitability Ratios • Liquidity Ratios • Financial Efficiency Ratios • Shareholder or Investment Ratios • Gearing Ratio

  3. Financial Efficiency Ratios • Purpose: Measures how efficiently the assets of a business are being used. • Stock Turnover Ratio • How often the inventory is bought and sold • Debtor Days Ratio • How long to collect payments from customers who purchased goods on credit • Creditor Days Ratio • How long it takes the company to pay its suppliers

  4. Stock Turnover Ratio Purpose: How many times do we buy our inventory in a year? Cost of Goods Sold / Value of Stock (average for the year) ABC Inc: 125/25 = 5 XYZ Corp: 2400/600 = 4 Which company purchased inventory more frequently throughout the year? ABC bought inventory 5 times XYZ bought inventory 4 times

  5. Stock Turnover Ratio • Purpose: Measures how many times inventory is purchased during the year. • The higher the number, the more efficient a company is at selling its stock so it has to buy inventory more often. • Inventory turnover rate is dependent on the industry – restaurants should have a higher turnover than a car dealership • Service sector business do not use this ratio because they do not have inventory.

  6. Debtor Days Ratio Purpose: How many days does it take for our customers to pay us? Accounts Receivable / Sales Turnover (Sales) Can also be calculated using only credit sales – eliminating cash sales – since cash sales will never lead to debtors. ABC Inc: (75/250) X 365 = 109.5 days XYZ Corp: (600/3200) X 365 = 68.62 days Which company takes the longest time to receive money from customers? What does this do to cash flow?

  7. Debtor Days Ratio • Purpose: Measures how long it takes to collect payments from customers who purchased goods on credit • There is no right or wrong answer. • Business who operate mainly in cash will have a very low ratio. • A high ratio could mean poor control over customer payment/credit arrangements.

  8. Creditor Days Ratio Purpose: How many days does it take for us to pay our suppliers? Accounts Payable / Credit Purchases ABC Inc: (20/100) X 365 = 73 days XYZ Corp: (250/1125) X 365 = 81.395 days Which company takes the longest time to pay their vendors? What does this do to cash flow?

  9. Creditor Days Ratio • Purpose: Measures how long it takes to pay vendors for goods purchased on credit • There is no right or wrong answer. • A high number days can reduce the cash outflows. • Vendors may be unhappy with slow payments and discounts may be missed or not offered.

  10. Ratio Analysis • Profitability Ratios • Liquidity Ratios • Financial Efficiency Ratios • Shareholder or Investment Ratios • Gearing Ratio

  11. Shareholder or Investment Ratios • Purpose: Measures the prospects of financial gain from investing. • Dividend Yield Ratio • The rate of return at the current share price • Earnings Per Share Ratio • The amount each share is earning

  12. Dividend Yield Ratio Purpose: How much is my return on the investment at the current share price? (Dividend Per Share / Current Share Price) X 100 (Market Share Price) Dividend Per Share: Total Dividend / Total # of Shares ABC Inc 21 / 140 = .15 XYZ Corp 140 / 200 = .70 ABC Inc: .15/1.50 X 100 = 10% XYZ Corp: .70/10.00 X 100 = 7% Which company produces more return per share?

  13. Dividend Yield Ratio • Purpose: Measures the rate of return per share. • If share prices rise dividends are not increased, this rate of return will fall. • If share prices stay the same or fall and the dividends are increased, this rate of return will increase. • Results need to be compared within the industry. • Shareholders may be attracted to a high dividend yield as long as stock prices do not fall. • Board of Directors may choose to not pay a dividend to keep retained profits to be reinvested back into the business. • A high dividend yield could be caused by a recent drop in stock price not profitability of the company.

  14. Earnings Per Share Ratio Purpose: How much is each share earning? Profit After Tax / Total Number of Shares ABC Inc: 50/140 = .358 XYZ Corp: 500/200 = 2.50 Which company produces more earnings per share?

  15. Earnings Per Share Ratio • Purpose: Measures how much is each share earning. • Allows a way to compare stocks from different companies to help evaluate investment options. • Can also be compared with the price of the share.

  16. Ratio Analysis • Profitability Ratios • Liquidity Ratios • Financial Efficiency Ratios • Shareholder or Investment Ratios • Gearing Ratio

  17. Gearing Ratio • Purpose: Measures the degree that capital of the business is financed by long-term loans. • Gearing Ratio • The amount of long-term loans in comparison to the total capital

  18. Gearing Ratio *capital employed = non-current liabilities + shareholders equity Purpose: How much is the company relying on long-term loans vs other capital? (Long-Term Loans / Capital Employed) X 100 A rate above 50% indicates a “highly” geared company. ABC Inc: 40/400 X 100=10% XYZ Corp: 2000/5000 X 100 = 40% Which company is using more “borrowed” capital to operate their business?

  19. Gearing Ratio • Purpose: Measures the degree that capital of the business is financed by long-term loans. • The higher the ratio the greater the risk: • Heavy borrowing indicates large interest payments which will affect dividends and profits. • Debts have to be repaid and could leave the company with low liquidity. • Low gearing is a “safe” business strategy, but could indicate that management is not using borrowing as a strategy to expand the business which limits growth. • The gearing ratio can be lowered by raising cash in other ways: selling more stock, decreasing the dividend. Result: “pump up” capital without borrowing

  20. Summary: Be careful • Ratios should not be used singly but compared with other companies in the industry or internal company records utilizing data trends over time. • Slightly different data and/or formulas can be used and reported by various companies. • Ratios only deal with financial accounting items and do not take into consideration environmental stewardship or human rights considerations. • Ratios do not solve problems or bring attention to the cause of business problems.

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