Unit 3.6 Ratio AnalysisLesson 1: Purpose of Ratios Analysispp. 417-419

IB BUSINESS AND MANAGEMENT

Think about it…• “Many of the things you can count, don’t

count. Many of the things you can’t count, really count.” – Albert Einstein (1879-1955)– What did he mean by this?– …

2a. The Purpose of Ratio Analysis• You are probably thinking right about now, great more math…

oh joy. • Remember Unit 3.5 and learning about how to read and use

financial accounts?• Well, Ratio Analysis is used by YOU the manager, as a tool for

analyzing and judging the financial performance of a business.– You do this by calculating financial ratios from a company’s

final accounts (the balance sheet and the P&L account.)• Remember: Do not just learn the formulae, you need to

understand what they actually mean, focus on:– How the business is performing based on the ratios.– How the business has performed over the years.– What else needs to be considered that is not presented in the data.

– ..

2b. The Purpose of Ratio Analysis• Has several purposes:

– To analyze short and long term liquidity.– To asses a firm's ability to control expenses.– To compare actual figures with projected ones.– To help in the decision making process.

• Should investors risk their money in the business.

• Ratios can be compared in two ways:– 1. Historical comparisons– 2. Inter-firm comparisons

• In the same industry; McDonald’s should compare their ratios with rivals of similar size, like Burger King.

– ..

3. Types of Financial Ratios• Five types of ratios:

– 1. Profitability ratios:• Assess the financial performance of a business.• Will show how well a firm has performed.

– 2. Liquidity ratios:• Looks at the ability of a firm to pay its short-term liabilities.• The firm’s ability to repay its debts.

– 3. Efficiency ratios:• Shows how well a firm’s resources are being used.

– 4. Shareholder ratios:• Measures the returns to shareholders in a company.• Shareholders will be interested in earnings per share.

– 5. Gearing ratio:• Looks at the long-term liquidity position of a firm.

– A high degree of gearing could mean a inadequate long-term liquidity because the firm must repay its loans.

– If a firm is highly geared it will be considered a risky business.– ..

Unit 3.6 Ratio AnalysisLesson 2: Financial Ratiospp. 420-426,430-431

IB BUSINESS AND MANAGEMENT

1a. Financial Ratios: Profitability Ratios• These ratios measure profit in relation to other variables

such as sales turnover or capital employed.– The main profitability ratios are:

• Gross Profit Margin (GPM)• Net Profit Margin (NPM)

• So why are these ratios useful?– If a company makes 5 million dollars, is the company

financially successful?• Yes? NO? Maybe?• These ratios will help us determine the answer.• Note: The profitability ratios only apply to profit-oriented

businesses.

• Let’s take a closer look shall we…

1b. Financial Ratios: Profitability Ratios• Gross Profit Margin (GPM):

– This ratio will show the value of gross profit as a % of sales revenue.• GPM = Gross profit x100 (remember Gross Profit = sales revenue – COGS)

Sales Revenue (remember COGS= opening stock + purchases – Closing stock)

– The higher the GPM ratio, the better it is for a business.

– Gross profit goes towards paying overheads and expenses of the business.

• You can improve your GPM by two main ways:– 1. Raising revenue: increasing or decreasing selling price, marketing

strategies, etc.– 2. Reducing costs: find cheaper suppliers, cheaper materials, reduce staff,

etc.– ..

1c. Financial Ratios: Profitability Ratios• Net Profit Margin (NPM):

– This ratio will show the % of sales turnover that is turned into net profit.• Example, if NPM is 35%, then every 100 dollars of sales, $35 is

net profit.• Net Profit is what?

– Profit that is left after all the costs of production have been accounted for.

• NPM = Net profit x 100 Sales revenue

• The NPM is a better ratio to measure a firm’s profitability because it takes into account both cost of sales and expenses. – NPM can be improved by reducing costs:

• Obtain better payment terms with creditors and suppliers.• Negotiate cheaper rent.• Reduce indirect expenses.

2a. Financial Ratios: Liquidity Ratios• These ratios assume that certain assets can be turned into cash quickly, without losing

their value, in order to meet the company’s financial commitments.– These assets are called liquid assets.– Short term liquidity ratios calculate how easily a firm can pay its short-term financial

obligation from its current assets.• Two main short term ratios are:

– 1. Current ratio = current assets current liabilities

– A ratio of 1.5 to 2.0 is good.– The ratio would look like this 1.5:1 or 2.0:1

• So for every $1 of current liability, the firm has $1.5 or $2 of current (liquid) assets.• This also means that there is sufficient working capital.• If the ratios is 1:1, it would mean that the short-term debt of the business is

greater than its liquid assets.– This could spell disaster for the company’s survival.

• A high current ratio would also suggest that there is too much cash, too many debtors, or too much inventory

• …

2b. Financial Ratios: Liquidity Ratios• 2. Acid test ratio (quick ratio):

– Similar to the current ratio except that it ignores stock when measuring short term liquidity of a business.• Acid test ratio = current assets less stock current liabilities

• The general guideline is a 1:1 ratio.– Anything less that 1:1 means that the firm will experience working capital

difficulties.– Could possible have a liquidity crisis. Where the firm is unable to pay its

short term debts.– Investors will be interested in your company’s acid ratio.

• This ratio can be improved by increasing the level of current assets or lowering your current liabilities.

• …

3a. Financial Ratios: Efficiency Ratios• These ratios look at how well a firm’s financial resources are being used.

– There are four main efficiency ratios. For the standard level course we will be covering only two out of the four:• 1. Stock turnover:

– Measures the number of times a firm sells its stock within a year.– Two ways to calculate this:

» a. Stock turnover = costs of goods sold average stock

» b. stock turnover = average stock x 365 Cost of goods sold

• In general, the higher that ratio the better it is for the business.– The higher the stock turnover, the more stock is being sold.– If more stock is being sold, you will have more profit.

• How to increase stock turnover?– Hold lower levels of stock– Divestment; get rid of any slow selling stock.– Reduce the range of products offered, by only keeping the ones that sell.

3b. Financial Ratios: Efficiency Ratios• 2. Return on capital employed (ROCE):

– IF we look at a P&L account which shows that a company made $20 million in profit, has that company really performed well?• Well it all depends on how well other firms performed in the same year and the

historical profit of the firm.• It would also depend upon the size of the firm; MacDonald's vs some mom and

pop hamburger joint.– ROCE measures the financial performance of a company compared with the amount

of capital invested.• ROCE = Net profit before interest and tax x 100 capital invested (

– remember: capital invested = shareholder’s funds + reserves + long-term liabilities

• The higher the ROCE the better.– Some believe that 20% ROCE is a good target to achieve.

• This figure will depend on many factors: such as the context of the business and industry the company is in.

• So a 20% ROCE means that every $100 invested, $20 profit is generated.• But really, this number should be greater than what the bank offers in interest

rate for a savings account.

• To many, this is the key ratio or the primary ratio.

4. Financial Ratios: Gearing Ratio• This is used to assess a firm’s long term liquidity position.

– We look at the firm’s capital employed that is financed by long term debt.• Gearing ratio = long-term liabilities x 100 or loan capital x 100 capital employed capital employed

• The higher the gearing ratio the larger the firm’s dependence on long term sources of borrowing.– This means that the firm will incur higher costs due to debt financing.– This will reduce net profits and if a firm is highly geared it has a gearing

ratio of 50% or more.• Banks will be less willing to loan you more money.• Investors will see you as a huge investment risk.

• You as the manager will need to assess how much debt the company can handle before the benefits of growth outweigh the cost of high gearing.

• Gearing may be acceptable if:– The size and status of the business.– The level of interest rates.– Potential profitability.– ..

Unit 3.6 Ratio AnalysisLesson 3: Uses and Limitations of Ratio Analysispp. 431-436

IB BUSINESS AND MANAGEMENT

1.Uses

ofRatio Analysis

Employees and trade unions

(pay raises / job security)

Managers and directors

(bonuses for reaching targets)

Trade creditors(makes sure

customer has enough working

capital)

Shareholder(capital gain and

dividends)

Potential financiers(looks at

profitability and funds to repay

loans)

Local community(secure funding for local projects/jobs)

2.Limitations

ofRatio Analysis

Historical account of a firm’s

performance

change in external business environment can change the ratios

No universal way to report company

accounts

Qualitative factors that affect performance of a firm are totally

ignored

organizational objectives differ from firm to firm

3 Remember… • With all the quantitative data that you are given or that you

calculate, it still does not give the entire picture of the company.• There are other considerations you need to investigate in order

to be able to make a better assessment of a company:– Look at:

• Historical comparisons.• Inter-firm comparisons.• The nature of the business and its aims and objectives.• The state of the economy.• Social factors.

• Good management decision-making considers a range of information, both quantitative and qualitative.

• ..

End•