IB Business and Management

3.6 Ratio Analysis

Types of Ratio

RATIOS

ProfitabilityEfficiency

Liquidity

GearingShareholder

Learning Outcomes

You will be expected to:•Calculate the ratios•Use the ratios to interpret and analyse financial statements•Evaluate possible financial strategies and other strategies to improve the value of ratios (HL)

Formulae Re-cap Questions……

What are the formulae for:a.Gross Profitb.Net Profitc. Cost of Goods Soldd. Working Capitale. Net Assets Employedf. Capital Employed

Give an example of………

a.A current assetb.An expensec.A current liabilityd.Something which appears on the appropriation accounte.A fixed asset

Explain why…..

a.Gross profit is always higher than net profitb.Closing stock is not included in the calculation for COGSc.Selling a dis-used vehicle will improve liquidity but not profitability

WHY DO WE NEED RATIOS?

Who uses final accounts?

The users of financial reports are wide ranging and include a variety of stakeholders: •Investors•Creditors•Banks•Customers•Managers•Employees•Tax Authorities

What would each of these stakeholder groups want to

find out from the company’s accounts?

What do stakeholders want to know?

• Is the business profitable?• Does the business have a good liquidity position?• How is the business financed?• How well does the business manage their

creditors/debtors?• Is the business heavily reliant on borrowed funds?• Does the business provide a good return on

investment?

Task

Look at the accounts for Imperial Ltd for 2010 to 2013.What conclusions can you draw from the accounts about the performance of Imperial Ltd?Can you answer the stakeholder questions from the previous slide?

Why are ratios useful?• Financial ratios provide tools to

interpret and understand complex final accounts.

• They provide useful KPIs on business performance

• They consider proportionality rather than nominal values

• Ratios can help compare the business performance to:– Industry Norms– Aggregate Economy– Past Performance

Ratios for the IBSL and HL RatiosNet Profit MarginGross Profit MarginCurrent RatioAcid Test RatioROCEStock turnover (number of days)Gearing

HL OnlyEarnings per ShareDividend YieldDebtor DaysCreditor Days

For each of these ratios, you need to know:a.How to calculate itb.What they show about the business c.What a business would like to see in the results (value, trend etc) d.How to improve it (HL only)

CALCULATING AND INTERPRETING RATIOS

Fill in your

Profitability Ratios

Ratios:Gross Profit MarginNet Profit Margin

Gross Profit Margin

• The gross profit made as a percentage of sales revenue• Indication of a businesses ability to control it’s cost of

goods sold/sales• Always expressed as a %

Interpreting Gross Profit

Questions:1.What would a business want to see happening to this ratio over time?2.Will all industries have the same expectations for GPM?3.Can this ratio be more than 100%?4.Will a increase in COGS always lead to an decrease in GPM?5.What factors could lead to a company's Gross Profit Margin decreasing over time?

Net Profit Margin• The net profit made as a percentage of

sales revenue• Indication of a businesses ability to control

it’s expenses• Always expressed as a %• Formula:

Interpreting Net Profit Margin

Questions:1.What would a business want to see happening to this ratio over time?2.Will all industries have the same expectations for GPM3.Can this ratio be more than 100%?4.Can the NPM be higher than the GPM?5.Will the NPM always decrease if the GPM decreases?6. What factors could lead to a company's NPM decreasing over time?

Liquidity Ratios

Ratios:Current Ratio

Acid Test Ratio

Liquidity Ratios

• Profits are not the only requirement for survival.

• A firm must have liquid assets - assets that can be turned easily into cash - to meet day to day payments.

• Liquidity ratios are a quick way of assessing the liquidity position of a business

Task

• Think of 4 reasons why a firm can be profitable yet not liquid

Current Ratio• This ratio shows how many £ of current assets a firm has to every £1 of current liabilities

•Expressed as a ratio

•For Example: 1.43:1

Interpreting the Current Ratio

Questions:

1.1.What would a value lower than 1 indicate?What would a value lower than 1 indicate?

2.2.How does this ratio relate to the Working Capital How does this ratio relate to the Working Capital figure from the balance sheet?figure from the balance sheet?

3.3.What would a high figure indicate? Would this be What would a high figure indicate? Would this be ideal?ideal?

Changes to the Current Ratio?

Will the following changes make the current ratio go up, or down or will it stay the same? Why?1.The business takes out a bank loan of $10,0002.The business buys $400 worth of stock on credit3.One of the firm’s debtors pays the balance of their account in cash4.The business sells one of it’s buildings5.The business sells $200 worth of stock to a customer for cash6.The business pays it’s VAT bill7.The business sells $10,000 of shares

Acid Test Ratio•Stock is the most difficult of a firms current assets to turn into cash (least liquid)

•The acid test ratio is like the current ratio but does not include stock as a current asset

•Also expressed as a ratio

Interpreting the Acid Test Ratio

Questions:

1.1.Why will the result always be lower than the Why will the result always be lower than the Current Ratio?Current Ratio?

2.2.What would a steady Current Ratio accompanied What would a steady Current Ratio accompanied by a falling Acid Test Ratio indicate?by a falling Acid Test Ratio indicate?

Financial Efficiency Ratios

Ratios:ROCE

Stock TurnoverDebtors Days HLCreditor Days HL

Return on Capital Employed (ROCE)

• This is sometimes referred to as the primary efficiency ratio and is perhaps the most important ratio of all.

• It measures the efficiency with which the firm generates profit (in a year) from the funds invested in the business

• It is expressed as a %

Reminder:

Where can Total Capital Employed come from?•Owners / Share Capital•Retained Profits•Long term liabilities such as Bank Loans or Debentures

Interpreting the ROCEQuestions1.Could the result be over 100%?2.What will potential investors compare this result with?3.What could cause capital employed to increase?4.Will an increase in Net profit always lead to an increase in ROCE?5.How could a business decrease the capital employed figure?

Stock Turnover (times per year)

• This ratio measures the number of times in a trading year that a business sells and replaces its stock

• A fruit stall which, every day, buys stock in the morning and sells it all by the evening is turning its stock over 365 times per year.

• Formula:

Expressed as times per year

Stock Turnover (number of days)

• This ratio measures the average number of days the business takes to completely use it’s stock

• Expressed as a number of days

Interpreting Stock Turnover

Questions:1.Would a business want these figures to be increasing or decreasing?2.What could a worsening figure indicate? 3.What problems could a worsening figure cause for a business?4.How might this ratio differ between different types of businesses?

Debtor Days (HL)

• This ratio shows the average number of days the firm takes to receive cash from it’s debtors.

• It is expressed as a number of days• Formula:

Interpreting Debtor Days

Questions:1.Would a business want these figures to be increasing or decreasing?2.What could a worsening figure indicate? 3.What problems could a worsening figure cause for a business?4.How might this ratio differ between different types of businesses?

Creditor Days (HL)• The creditor days ratio measures the

number of days it takes, on average, for a business to pay its creditors.

• It is expressed as a number of days

Interpreting Creditor Days

Questions:1.Would a business want these figures to be increasing or decreasing?2.Why would it be useful to look at this ratio in conjunction with the Debtor Days result? 3.What problems could a decreasing figure cause for a business?4.What might a very high result indicate?

Gearing

Gearing

• Examines the extent to which the business is dependent upon borrowed money.

• It calculates the % of the Total Capital Employed that comes from loan capital

Interpreting Gearing

Questions:1.What problems would be caused by a very high figure?2.What figure do you think would be considered high?3.What do you think would be an acceptable result?

Shareholder Ratios

Ratios:Earnings Per Share

Dividend Yield

Higher Level Extension: Shareholders Ratio

Shareholders generally buy shares in a company for two main reasons: •Capital Gain•Dividends

•Investors will use these ratios to assess whether a business is a worthwhile investment

Earnings per Share (HL)

• The Earnings per Share shows the maximum dividends that could, in theory, be paid to shareholders.

• It is expressed as a value in currency

Interpreting Earnings per Share (HL)

Questions:1.Does a high value mean that shareholders will get a good return on their investment?2.What might cause a falling value?

Dividend Yield (HL)

• The dividend yield ratio measures the % dividend return per share in relation to its current market price.

• It is expressed as a %• Formula:

Interpreting Dividend Yield (HL)

Questions:1.Which stakeholders would be particularly interested in this figure2.What might happen if the value was too low?3.What might cause a fall in this result?