BUSINESS & MANAGEMENT

BUSINESS & MANAGEMENT Unit 3.6 Ratio Analysis 1/30

KEY TOPICS • Purpose of Ratio Analysis • Types of financial ratios: • Profitability Ratios • Liquidity Ratios • Efficiency Ratios • Gearing Ratio • Uses and limitations of ratio analysis • Efficiency Ratios: Debtor Days and Creditor Days • Shareholders Ratios: Earnings Per Share and Dividend Yield • NB: - Ratio formulae are given in the first Appendix item of the Syllabus Guide and a copy of which will be provided to candidates in the examinations. 2/30

Some Definitions • Turnover – Sales amount • Overhead – Expenses of doing business • Replenish – to get more of something that is about to go out or has went out in quantity. • 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” (i.e. decay) after a short period of time. Examples are: food, drink, roses and etc. • Durable goods are goods that do not “go bad”. Examples are: pens, desks, light bulbs, plates, etc. 3/30

Some Definitions • Elasticity – The number and availability 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. If something is very elastic, it means that there are many substitutes. Hence the more you charge, the less people would want to buy your product because they can use an alternative product. That is, demand for the product will fall. Ex. Many drugs are considered inelastic; especially drugs that people need to save their lives. Hence, the price does not matter to these people. They will pay whatever price they have to for the product. 4/30

Introduction to Ratio Analysis • It is a management tool for analyzing and judging the financial performance of a business. • Many times businesses will make year to year comparisons in order to judge performance. • Examples of basic ratios: • There are 9 economics classes and 3 business classes in the year 2008. So the Econ to Bus ratio is 3:1 for the year 2008. • Out of all 60 teachers in IB, only 4 are blond. Hence the blond to non blond ratio is 1:14. 5/30

Basic Ratio Exercises • 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 of them are female. The ratio of males to females is ______. 1:5.25 1:1.25 6/30

Purposes of Ratio Analysis • To help understand a firm’s financial position. • To show how well a business controls expenses. • To compare real figures against past projections (guesses). • Helps investors decide on putting money into a firm or not. 7/30

Ways to compare ratios • Historical comparisons - look at the same ratio at different times for a business. This can help see trends.(i.e. things that repeatedly happen for some reason). (e.g. 2011 to 2012). • Inter-firm comparisons – Comparing the same ratio in different firms (businesses). • Firms will use both kinds to help them understand how their business operates. It’s very important that when doing inter-firm comparisons that they compare themselves to similar businesses. (e.g. HTC to iPhone). 8/30

Profitability ratios Gross Profit Margin Net Profit Margin • These 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 (i.e. derived from) the Balance Sheet and P&L Account. 9/30

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/or Reducing costs. Most businesses use some combination to increase the GPM • Gross profit margin = Gross profit/Sales Revenue 10/30

Net Profit Margin (NPM) • This figure shows how much net 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 the actual expenses incurred. • The difference between NPM and GPM helps to understand costs especially when operating in different environment (e.g. countries). • Net profit margin = Net profit/Sales Revenue • Use P&L Account. 11/30

Profit Margins • 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 being sold. 12/30

Raising Revenue can be done by: • If a product is inelastic; raising the price should not affect demand. • If a product is elastic; a business can drop its prices to 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. 13/30

Reducing Product 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. 14/30

Ways to reduce 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 businesses with good credit • Making sure not to spend unnecessary money on “stupid expenses” Ex. Luxury hotels, first class tickets, expensive meals, company cars, corporate jets that are unnecessary, etc. 15/30

Reduce GPM but increase NPM • Explain how a price reduction for a product could reduce the gross profit margin but increase the Net Profit Margin BeforeAfter • Turnover 1000 1200 • Cost of goods sold 600 740 • Gross profit • GPM • Indirect costs 300 300 • Net profit • NPM 400 460 40% 38.33% 100 160 10% 13.33% 16/30

Liquidity Ratios • These are used to help understand how much of a firm’s 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 (i.e. high liquidity). But the building that the store is in cannot be sold very quickly. Hence, the building’s liquidity is very low. • These help understand how easily businesses can pay their short term costs. 17/30

Current ratio • 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 business if creditors were to start cutting credit. • If the current ratio is too high then a business may have to much cash or stock on hand. • It is important to remember that stock cannot always be turned into cash very easily because you need to get customers to buy them! • This ratio can be improved by reducing liabilities and/or increasing current assets. 18/30

Acid test ratio (quick ratio) • Acid Test Ratio = (Current Assets – Stock)/Current Liabilities • Is useful for businesses that can’t turn their stock into cash very easily. Ex. Large machines, planes, buildings etc. • Is useful for lenders to know the possibility that they will get their money back on time. • Go to the Balance Sheet and work out the Current Ratio and the Acid Test Ratio. • Why is it dangerous for businesses to increase their debtors? 19/30

Efficiency ratios Stock Turnover Ratio Return on Capital Employed • These concentrate on how well a business is using their resources. 20/30

Stock Turnover Ratio • 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 as time progresses and they may go bad. • Usually measured over a year. • 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 ? 21/30

Stock Turnover Ratio Exercises Exercise 1 • Betty has a business that sells $300,000 worth of stock a year and she usually carries $50,000 worth of stock. • What is her stock turnover ratio? • How many days does it take for her to sell off her stock? Exercise 2 • Henry has a business sells $400,000 worth of stock a year and he usually carries $20,000 worth of stock. • What is his stock turnover ratio? • How many days does it take for him to sell off his stock? 6:1 60.83 Days 20:1 18.25 Days 22/30

Ways to increase stock turnover ratio DESCRIPTION ADVANTAGE DISADVANTAGE Amount of cash tied up in stock inventory is lesser. Higher risks in getting caught in low/no stock availability. • Holding low stock levels will make businesses replace them more often. • Divestment: getting rid of stock that is not popular. • Try to sell less products. Chances of cash being tied up in stock is low. Customer have a narrower stock selection. 23/30

Return on Capital Employed (ROCE) • Return on Capital Employed Ratio = (Net profit before interest and tax)/(Capital employed) x 100% • 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 changes over time, this is calculated without them so that comparisons are easier and more importantly, more consistent. • 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. That is, if a business cannot even earn what the bank interest income is generating, then it doesn’t make sense to bear the increased risks compared to the safe haven of having money in the bank. 24/30

Gearing ratio • 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 giving back to shareholders or used for expansion. Gearing ratio of 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 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. 25/30

Factors effecting 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 lots of risks but also have the potential for large rewards will tend to be highly geared. (e.g. IT firms) 26/30

Stakeholders uses for Ratio Analysis • Stakeholders use financial ratios to determine the strengths and weaknesses of the business. From this, they can determine what their dividends will be (to some extent). • Employees and unions can use these to determine job security and the likelihood 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. • 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. 27/30

Limitations to financial ratio analysis • Ratios are not current. They’re always the past performance. Although the same ratios show a trend over time, it’s still not a sure indication of what the future would be for the company. • If two things change at the same time it will not be shown in the ratio. Ex. Interest rates and sales rise simultaneously – i.e. two compensating effects. • 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; as some businesses are trying to do different things. Financial ratios may not be very applicable to organizations which are not profit-motivated (e.g. museums). 28/30

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 an 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 an 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. 29/30

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 (financial or non-financial). • Making proper comparisons is always important for a business. 30/30

BUSINESS & MANAGEMENT