Profitability and Ratio Analysis The need for ratios

Profitability and Ratio Analysis

The need for ratios l To examine the profitability of the firm. l To find out the ability of the firm to meet its debts (liquidity). l To see how efficiently the managers of the firm uses its resources. l So that investors in the firm can see the returns on their investment.

EXAM TIP! Don’t just simply learn the formulae for the ratios without understanding what they actually mean. Instead, focus on why or how the ratios could be used in the context of the given organization. Address issues such as: n n n How the business is performing (based on financial data) How the business has performed over time (trends) What else needs to be considered that is not presented in the data, such as business objectives and any external constraints on business activity.

Ratios are compared in 2 ways: l Historical Comparisons l involve comparing the same ratio in two different time periods for the same business. Such comparisons show trends, thereby helping managers to assess the financial performance of a business over time.

Ratios are compared in 2 ways: l Inter-firm comparisons l Involve comparing the ratios of businesses in the same industry. l Ratio analysis can therefore show the relative financial performance of a business.

EXAM TIP! When learning the different financial ratios, make sure that you understand the various units of measurement used. Some ratios are expressed as a number in terms of another (e. g. 2: 1), while others are shown as a percentage, or a currency (e. g. $1 per share) and yet others may be shown as ‘number of days’. The important thing is to understand the meaning of the ratio and to be able to put the ratio into the context of the organization.

Types of Financial Ratios l Profitability ratios l Efficiency ratios l Liquidity ratios l Gearing ratios (HL)

Profitability Ratios Examine profit in relation to other figures, such as the ratio of profit to sales revenue l Relevant to profit-seeking businesses rather than for not-for-profit organizations l Managers, employees and potential investors are interested in profitability ratios as they show well a firm has performed in financial terms. l

Profit l Is a key objective for most businesses and acts as a measure of a firm’s success l It is the surplus of earnings of a firm once all costs have been deducted from sales revenue l Main profitability ratios are the gross profit margin (GPM) and net profit margin (NPM)

Efficiency Ratios l Shows how well a firm’s resources have been used, such as the amount of profit generated from the available capital used by the business. l Ex. Firm A and B generate the same profit but Firm A used less capital than Firm B. Firm A has a greater return than Firm B. l See table 3. 5 a (page 273)

EXAM TIP! When dealing with finance, it is important to look at the bigger picture and to put the figures into context. For example, in February 2007, sportswear manufacturer Puma announced a 26% drop in profits to 38. 2 million Euro ($43 m). Does this represent poor performance? Not necessarily. This very limited information can, on its own, be misleading. In fact, Puma was undergoing expansion and was using its profits to finance this (hence the fall in its declared profits). Puma’s sales had actually increased by more than 33%.

Profitability Ratios: Gross Profit Margin l Shows sales GPM = l Does gross profit as a percentage of Gross Profit X 100 Total sales revenue not show the impact of overheads on profits. l Shows how well a firm has performed in financial terms.

Printing Firms: Calc. GPM

GPM Nairobi: for every $100 of sales, $50 is gross profit (with costs of production accounting for the other $50) The higher the GPM, the better it is for a business as gross profit goes toward paying its expenses.

Possible reasons for lower GPM: l Low-price l Higher l strategy to increase sales cost of sales Higher material costs or higher direct labor costs

Ways to increase GPM: l Reducing cost of sales while maintaining revenue l Use cheaper suppliers l Increase revenue without increasing cost of sales l Raising prices but offering better service Summary: Raise revenue and reduce direct costs

Profitability Ratios: Net Profit Margin l Shows sales. NPM = l Should net profit as a percentage of Net profit Total sales revenue X 100 be compared with previous period or with similar business

Net

l Nairobi has relatively high overheads compared to sales l Port Louis could narrow the gap further by reducing overhead expenses while maintaining sales or by increasing sales without increasing overhead expenses

Profitability Ratios l http: //www. investopedia. com/terms/p/pro fitabilityratios. asp

EXAM TIP! n n Many candidates state that to “increase profit margins the business should increase sales”. This is a poor answer unless sales revenue can be increased at a greater rate than the costs of the business. Many examination questions will ask for methods of increasing profitability of a business. If the question needs an evaluative answer, it is very important that you consider at least one reason why your suggestion might not be effective.

EXAM TIP! n See page 275 ‘worked example’

Exercise Question 3. 5. 1 Calculating Profitability

Efficiency Ratios l Shows how well a firm’s resources have been used, such as the amount of profit generated from the available capital used by the business. l Ex. Firm A and B generate the same profit but Firm A used less capital than Firm B. Firm A has a greater return than Firm B. l See table 3. 5 a (page 273)

Efficiency Ratios: ROCE l Return On Capital Employed (ROCE) Net profit before tax & interest Total capital employed X 100 Capital employed = LT Liabilities + share capital + retained profit Expressed as a percentage

ROCE

ROCE l The higher the value of this ratio, the greater the return on the capital invested in the business. l ROCE can only be raised by increasing the profitable, efficient use of the assets owned by the business, which were purchased by the capital employed.

Using ROCE l Larger figures indicate higher profitability l Must be compared with previous year or similar firm to be meaningful.

ROCE l http: //www. investopedia. com/terms/r/roc e. asp

Exercise Question 3. 5. 2 Calculating ROCE

Liquidity Ratios l Measure the indebtedness of the firm. l Assess the ability of the firm to pay its short-term debts. l Current Ratio = Current Assets Current Liabilities l Expressed as a ratio (ex. 3: 1) l Not expressed as a percentage! l Ideal value = 1. 5: 1 or 2: 1

Current Ratio

Current Ratio l Nairobi is in a more liquid position than Port Louis l Nairobi = for every $1 of ST debt it has $2 of current assets to pay for them (relatively safe position) l Port Louis only has $1 of current assets to pay for each $1 of ST debt l Could be in trouble if ST creditors demanded repayment at the same time

High Current Ratio Current ratio results over 2 might suggest that too many funds are tied up in unprofitable inventories, debtors and cash and would be better placed in more profitable assets, such as equipment to increase efficiency. l Suggests the firm is not making full use of its current assets (eg. cash idle in a bank a/c) l Debtors credit policy is too loose l Too much stock being held l

Low Current Ratios l. A low current ratio might lead to corrective management action to increase cash held by the business. l Sale of redundant assets l Cancelling capital spending plans l Share issue l Long term loans

Acid Test Ratio (or quick ratio) l Does not treat stocks as liquid assets Acid Test Ratio = Current Assets – stocks Current Liabilities l. A value of 1: 1 is considered acceptable

Acid test ratio

Acid test ratio l Port l Louis may have liquidity problem Less than $1 of liquid assets to pay each $1 of short-term debt l Whereas selling inventories for cash will not improve the current ratio – both items are included in current assets – this policy will improve the acid test ratio as cash is a liquid asset but inventories are not.

Liquidity Ratios l http: //www. investopedia. com/terms/l/liqui dityratios. asp

Efficiency Ratios l Stock Turnover This shows how many times over the business has sold the value of its stocks during the year. STOCK TURNOVER RATIO = Cost of Goods Sold Average Stock Or Average Stock x 365 Cost of Goods Sold

Stock Turnover

Stock Turnover l The result is not a percentage but the number of times stock turns over in the time period – usually 1 year. l Very efficient stock management – use of just-in-time system – will give a high inventory turnover ratio.

Efficiency Ratios The higher the stock turnover the better, because money is then tied up for less time in stocks. A quicker stock turnover also means that the firm gets to make its profit on the stock quicker, and so the firm should be more competitive. However, it will vary between industries and so it is important to compare within an industry, as well as from year to year.

Efficiency Ratios l Gearing Ratio – examines the firm’s capital employed that is financed by long-term debt Loan capital Capital Employed X 100 or Long-term liabilities x 100 Capital employed Note: firm is said to be highly geared if it has a gearing ratio of 50% or above

Gearing Ratio

Gearing Ratio The higher this ratio, the greater the risk taken by shareholders when investing in the business l The larger the borrowing, the more interest must be paid l Affect the ability of the company to pay dividends and earn retained profits l A low gearing ratio is an indication of a ‘safe’ business strategy (management are not borrowing to expand the business) l Issuing more shares or retaining profits l

Ratio Analysis Evaluation l See l pages 378 and 379 of the text Uses and Limitations of Ratio Analysis