Turnover – number of sales made Overhead – Expenses of doing business

1. Turnover – number of sales made • Overhead – Expenses of doing business • Replenish – to get more of something • It is always important to compare things that are alike “apples to apples not apples to oranges” • Perishable goods are things that will “go bad” if not sold quickly enough. Food, drink • Durable goods are goods that do not “go bad” pens, desks, light bulbs, plates, etc.

2. Elasticity – The amount of substitutes that exist for a product. Ex. Coca-Cola has many other substitutes like Pepsi and the other soft drinks, water, juices, milk, etc. Because of this it is considered an elastic product. Something that is elastic means that the more you charge the less people want to by your product because they can use an alternative. (demand will fall) Ex. Many drugs are considered inelastic especially drugs that people need to save their life so the price does not matter people will pay whatever they have to for the product.

3. Ratio Analysis • It is a management tool for analyzing and judging the financial performance of a business. • Many times businesses will compares these year to year to judge performance. • Basic ratio • There are 9 economics classes in year 08 and 3 business classes. So the ratio is Econ to Bus ratio is 3:1 for year 08. • Out of all 60 teachers in IB only 4 are blond. So the blond to non blond ratio is 1:15

4. There are 50 hats at the store and 8 of them are from Chicago teams. The ratio of Chicago hats to non Chicago hats is _________ • There are 90 year 08 business students 50 are female. The ratio of males to females is ______

5. Purposes of Ratio Analysis • To help understand a firms financial position • To show how well a business controls expenses. • To compare real figures against past projections(guesses) • Helps investors decided on putting money into a firm or not.

6. Ways to compare ratios • Historical comparisons - look at the same ratio at different times for a business. This can help see trends. (things that repeatedly happen for some reason) • Inter-firm comparisons – Comparing the same ratio in different firms(businesses) • Firms will use both kinds to help them understand how their business operates. Very important that when doing inter-firm comparisons that they compare themselves to similar businesses.

7. Profitability ratios • Theses are used to see how much money a business makes compared to other factors. • These are helpful in determining how well a business is doing not just by profit but considering sales as well. • Is 2,000,000 profit good for a business? • These numbers are taken off the balance sheet and profit and loss sheet.

8. Gross profit margin (GPM) • This figure shows how much gross profit is made from each sale. • It is shown as a percentage • There are two main ways to increase the GPM Raising revenue and Reducing costs. Most businesses use some combination to increase the GPM • Gross profit margin = Gross profit/Sales Revenue

9. Raising Revenue can be done by • If a product is inelastic than raising the price should not affect demand. • If a product is elastic than a business can drop it’s prices which can give them an advantage over their competitors. • Marketing promotions may increase sales • Selling products with a higher GPM will increase revenue. Ex. Selling a Lexus will have a higher GPM than selling a Toyota

10. Reducing costs • Using cheaper suppliers will reduce costs but customers may not like a drop in quality • Reduce labor costs – Cutting workers or making workers do more may increase production but can cause a lack of motivation in the staff.

11. Net profit margin (NPM) • This figure shows how much gross profit is made from each sale. • It is shown as a percentage • This tends to be a better gauge of actual profitability because it takes into account expenses. • The difference between NPM and GPM helps to understand costs. • Net profit margin = Net profit/Sales Revenue • Use balance sheet.

12. Explain how a price reduction for a product could reduce the gross profit margin but increase the Net Profit Margin Before After • Turnover 1000 1200 • Cost of goods sold 600 740 • Gross profit • GPM • Indirect costs 300 300 • Net profit • NPM

13. Profit margins for high volume products like food tend to be very low but they make money by selling a lot of them. • Profit margins for luxury goods tend to be very high because a lot less of them are sold.

14. Ways to reduce costs (expenses) • Try to get as much credit as possible from suppliers to reduce costs and increase working capital. • Getting cheaper rent is possible for large or businesses with good credit • Making sure to not spend unnecessary money on “stupid expenses” EX. Luxury hotels, first class tickets, expensive meals, company cars that are unnecessary, etc.

15. Liquidity Ratios • These are used to help understand how much of a firms assets can be turned into cash without losing any value (money) Ex. Books at a book store can easily be turned into cash through sales. But the building the store is in can not be sold very quickly without losing value. These help understand how easily businesses can pay their short term costs

16. Current ratio • Current assets/current liabilities • It is usually considered better to have a 1.5:1 to 2:1 current ratio. • If a current ratio is below 1:1 then a business may not have enough working capital to stay in businesses if creditors start cutting credit. • If the current ratio is to high then a business may have to much cash or stock on hand. • It is important to remember that stock can not always be turned into cash very easily. • This ratio can be improved by reducing liabilities or increasing current assets

17. Acid test ratio (quick ratio) • (Current assets – stock)/current liabilities • Is useful for businesses that can’t turn their stock into cash very easily. Large machines, planes, buildings etc. • Is useful for lenders to make sure they will get their money back on time. • Go to balance sheet and work out current ratio and Acid test ratio • Why is it dangerous for businesses to increase their debtors?

18. Efficiency ratios • These concentrate on how well a business is using their resources.

19. Stock turnover ratio • COGS/Average stock • Measures how often a business can “sell out” their stock. • Perishable things may need to have a very high stock turnover ratio because they tend to make less profit per unit and they may go bad. • Usually measured in a years time. • Most businesses like to have a high stock turnover ratio. “ The more sales are made the higher the potential profit.” • It is important to remember to compare “Apples to Apples”. • Which business needs a higher stock turnover ratio? Al’s frozen pizza or Toby’s Luxury cars

20. Betty has a business that for a year has sold 300000 worth of stock and she usually carries 50000 worth of stock. • What is her stock turnover ratio? • How many days does it take for her to sell off her stock? • Henry has a business that for a year has sold 400000 worth of stock and he usually carries 20000 worth of stock. • What is his stock turnover ratio? • How many days does it take for him to sell off her stock?

21. Ways to increase the stock turnover ratio • Holding low stock levels will make businesses replace them more often. Advantages and Disadvantages • Divestment getting rid of stock that is not popular • Try to sell less products

22. Return on Capital employed (ROCE) • (net profit before interest and tax)/(Capital employed)X100 • Profit can only really be measured this way because if we simply look at a balance sheet’s profit number it can be hard to determine how well businesses are doing compared to each other. (Big vs. Small) • Is considered the most important ratio because it helps to understand how well a business is doing compared to the money they invest. • Because taxes and interest change this is calculated without them so that comparisons are easier. • 20% is what most businesses strive for. Most businesses will put their money in the bank instead of investing if their ROCE falls below the interest level.

23. Gearing ratio • Long-term liabilities / Capital employed X 100 • The higher the gearing ratio the more net profit needs to be spent paying off loans instead of back to shareholders or used for expansion. Gearing ratio over 50% is considered high. • A business with a high gearing ratio could be in trouble if interest rates rise or if the economy takes a turn for the worst and businesses don’t have as much money coming into the firm from sales. • Potential Shareholders will worry about investing in highly geared firms and leaders may be not lend them more money. • Some businesses need to be highly geared to continue to expand. If they don’t they may not be able to take advantage of all the possibilities in front of them.

24. Factors that effect level of gearing for a business • The size and status of a firm – MNCs are usually trusted with a higher gearing ratio than a small private limited company • The level of interest rates – When the rates are very low businesses with high gear ratios are not as risky as when their high • Potential profitability – businesses that take a lot of risk but also have the potential for large rewards will tend to be highly geared.

25. Stakeholders uses for ratio Analysis The stake holders will uses the ratios to determine the strength of the business • Employees and unions can use these to determine job security and likely hood of pay raises • Managers and directors – helps to determine weaknesses in a business as well as how well they are doing with their profitability. Finally they can help judge their pay raises and bonuses. • Trade creditors – will look at short-term liquidity ratios to make sure businesses have enough money to pay back their creditors. • Shareholders – they will try to determine what their dividends will be • Potential financers – how well can they pay back loans • Local community – how stable is the business especially if many other businesses are dependant on them.

26. Limitations to financial ratio analysis • Ratios are not current • If two things change at the same time it will not be shown in the ratio. Ex. Interest rates raise at the same time sales rise • Because of different methods of use on a balance sheet it can be hard to compare these between firms. • Qualitative factors are not considered • Organizational objectives are not considered some businesses are trying to do different things

27. Other considerations stakeholders have to make about a business • Historical comparisons – a good ratio this year may not seem that good when its compared to past years • Inter-firm comparisons – A firm with a ROCE of 50% may seem good but a smaller competitor may have one of 60% • Nature of a business – an NGO will have much different ratios than a MNC • State of the economy – If a business has a higher gearing ratio during a recovery it will be considered ok because expansion may be taking place • Social factors – highly profitable firms may be laying off workers as well as polluting the environment.

28. Business strategy • Businesses will look at lots of ratios together. It is always important for a firm to have enough liquid capital to stay in business • Non profit organizations have to come up with other ways to judge their success other than money. Ex. Schools are not usually run for profit so they may need to use college placement or test scores to judge success. Also they can see how well a business operates inside their budget. • Some businesses need to only go by how well they meet their objectives • Making proper comparisons is always important for a business