Profitability and Ratio Analysis Unit 3 5 Source

Profitability and Ratio Analysis Unit 3. 5 Source: BM Textbook (by Paul Hoang)

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)

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 net profit as a percentage of sales. NPM = Net profit before int. and tax x 100 Total sales revenue l Should 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

Exercise Question 3. 5. 3 Calculating Ratios

Uses of ratio analysis Employees and trade unions can use financial ratios to assess the likelihood of pay rises and the level of job security. l Managers and directors can assess the likelihood of getting management bonuses for reaching profitability, liquidity and efficiency targets. l Trade creditors look at short-term liquidity ratios to ensure that customers have sufficient working capital to repay them. l

Uses of ratio analysis Shareholders use ratios to assess the return of their investment compared with other investments. l Financiers use ratios to consider if the business has sufficient funds and profitability to repay any loans that may be approved. l The local community can use a range of financial ratios to gauge job opportunities for local residents. Or they may use to secure sponsorship for local community projects. l

Limitations of ratio analysis Ratios are historical accounts of a firm’s performance. They do not indicate current or future financial situation of a business. l Changes in the external business environment can cause a change in the financial ratios without there being any underlying change in the performance of a business. l l Example: Higher interest rates will reduce profitability, although sales revenues may have actually increased.

Limitations of ratio analysis There is no universal way to report company accounts so this means that businesses may use different accounting policies (straight line vs. reducing balance method for depreciation – HL topic). l Qualitative factors that affect the performance of a firm are totally ignored. (Ex. Staff motivation, customer perceptions) l Organizational objectives differ between businesses, so comparing results from a ratio analysis could be meaningless. l

Summary l Profitability Ratios: Gross Profit Margin (GPM) l Net Profit Margin (NPM) l l Liquidity Ratios: Current Ratio l Acid Test (Quick Ratio) l l Efficiency l Ratio: ROCE (Return on Capital Employed)

EXAM TIP! n Often in ratio analysis questions it is more important to consider what data are not given rather than just to examine the financial data provided. Good management decision-making considers a range of information, both quantitative and qualitative.

Theory of Knowledge In 2014, Facebook acquired Whats. App for $19 billion. At the time, Whats. App’s annual sales revenue was $20 million. Why would a business pay $19 billion to buy a business without annual sales revenue of $20 million (with a payback period of 950 years!)?

Key Terms Review

Acid test ratio • Is a liquidity ratio that measures a firm’s ability to meet its short-term debts. It ignores stock because not all inventories can be easily turned into cash in a short time frame.

Capital Employed • Is the value of all long-term sources of finance for a business (bank loans, share capital and reserves).

Current Ratio • Is a short-term liquidity ratio that calculates the ability of a business to meet its debts within the next twelve months.

Efficiency Ratios • Indicate how well a firm’s resources have been used, such as the amount of profit generated from the available capital used in the business.

Gross Profit Margin (GPM) • Is a profitability ratio that shows the percentage of sales revenue that turns into gross profit.

Liquid Assets • Are the possessions of a business that can be turned into cash quickly without losing their value (ie. cash, stock and debtors).

Liquidity Crisis • Refers to a situation where a firm is unable to pay its short-term debts (ie. current liabilities exceed current assets)

Liquid Ratios • Look at the ability of a firm to pay its short-term liabilities, such as by comparing working capital to shortterm debts.

Net Profit Margin (NPM) • Shows the percentage of sales revenue that turns into net profit, ie. the proportion of sales revenue left over after all direct and indirect costs have been paid.

Profitability Ratios • Examine profit in relation to other figures, e. g. the GPM and NPM ratios. These ratios tend to be relevant to profit-seeking businesses rather than for not-for-profit organizations.

Ratio Analysis • Is a quantitative management tool that compares different financial figures to examine and judge the financial performance of a business.

Return on capital employed (ROCE) • Is an efficiency ratio (although it also reveals the firm’s profitability) measuring the profit of a business in relation to its size (as measured by capital employed).