3.6 Ratio Analysis
Chapter 23 – Part 1
The Purpose of Ratio Analysis
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The profitability of a company is not the
whole story of its financial health.
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Does the company do a good job managing “cost
of goods”?
Does the company do a good job of managing
overhead costs?
Does the company have enough money to pay its
liabilities?
Does the company have too much long-term debt?
Does the company do a good job of using its
assets to generate profit?
Ratio Analysis
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Ratios fall into 5 different categories
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Profitability Ratios
Liquidity Ratios
Financial Efficiency Ratios
Shareholder or Investment Ratios
Gearing Ratios
Ratio Analysis
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Profitability Ratios
Liquidity Ratios
Financial Efficiency Ratios
Shareholder or Investment Ratios
Gearing Ratios
Profitability Ratios - Margins
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Purpose: Measures the ability to
convert sales revenue into profit.
Gross Profit Margin
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% of gross profit to total sales revenue
Net Profit Margin
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% of net profit to total sales revenue
Gross Profit Margin
Sales
Revenue
Cost of
Goods
Sold
Current
Assets
Current
Liabilities
Stocks
(Inventory)
Accts
Recvble
Net Profit
Gross
Profit
ABC, Inc.
250
125
XYZ Corp.
3200
800
Purpose: How well are we generating profits before overhead expenses?
(Gross Profit / Sales Revenue) X 100 = Gross Profit Margin %
ABC Inc:
125/250 X 100=50%
XYZ Corp:
800/3200 X 100 = 25%
Which company is maximizing its profit at the GROSS profit level?
(Sales – Cost of Goods Sold) = Gross Profit
Net Profit Margin
Sales
Revenue
Cost of
Goods
Sold
Current
Assets
Current
Liabilities
Stocks
(Inventory)
Accts
Recvble
Net Profit
Gross
Profit
ABC, Inc.
250
50
125
XYZ Corp.
3200
500
800
Purpose: How well are we generating profits after overhead expenses?
(Net Profit / Sales Revenue) X 100 = Net Profit Margin %
ABC Inc:
50/250 X 100=20%
XYZ Corp:
500/3200 X 100 = 16%
Which company is maximizing its profit at the Net profit level?
(Sales – Cost of Goods Sold – Overhead Expenses) = Net Profit
Profitability Ratios- RoCE
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Purpose: Measures the ability of using capital
employed effectively to earn a profit
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The higher the % the greater return on your investment
It can be compared with past performance to see if the
ability to earn a profit is improving
Can be compared with interest earned from other
investments
Should be compared with the interest rate of borrowing
money. If it is less than the interest rate, borrowing money
will further reduce returns to shareholders.
Methods to Increase Profits Margins
Method to increase
profit margins
Example
Evaluation
Increase gross and
operating profit margin by
reducing direct costs.
Use cheaper materials…use rubber not
leather soles on shoes.
Perception of quality may be
damaged; consumers may expect
lower prices.
Cut labor costs by relocating production
to low labor-cost countries….Dyson
relocating the manufacture of vacuum
cleaners to Malaysia.
Quality may be at risk.
Cut labor costs by increasing
productivity through automation in
production…Hyundai production lines
uses some of the most advanced laborsaving robots in the world.
Cut wage costs by reducing workers’
pay.
Purchasing machinery will increase
overhead costs; staff may need
training. Gross profit might
rise…but net profit might fall.
Motivation levels might fall which
could reduce productivity.
Methods to Increase Profits Margins
Method to increase
profit margins
Example
Evaluation
Increase gross and
operating profit margin by
increasing price.
Raise the price of the product with no
significant increase in variable cost.
Total profit could fall if too many
consumers switch to competitors
Consumer’s may consider this to
be profiteering and long-term
image of the business may suffer
Increase net profit margin
by reducing overhead
costs
Cut overhead costs, such as rent,
promotion costs, management costs,
but maintain sales level by:
moving to a cheaper location
reducing promotion costs
delayering the organization
Moving to a cheaper location could
damage image.
Cutting promotion costs could lead
to sales falling by more than cost
savings.
Fewer managers could reduce the
efficient operation of the business.
Return on Capital Employed (RoCE)
(Primary efficiency ratio)
Sales
Revenue
Cost of
Goods
Sold
Current
Assets
Current
Liabilities
Stocks
(Inventory)
*Capital
Employed
Net Profit
ABC, Inc.
400
50
XYZ Corp.
5000
500
Gross
Profit
*capital employed = non-current liabilities + shareholders equity
Purpose: How effective is the capital invested in the company at earning a profit?
(Net Profit / Capital Employed) X 100 = Return on Capital Employed
ABC Inc:
50/400 X 100=12.5%
XYZ Corp:
500/5000 X 100 = 10%
Which company is maximizing its capital resources to generate a profit?
(What are capital resources…long term loans, debentures, cash generated by
sale of stock, retained earnings “ploughed back” into the company)
Ratio Analysis
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Profitability Ratios
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Liquidity Ratios
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Financial Efficiency Ratios
Shareholder or Investment Ratios
Gearing Ratios
Liquidity Ratios
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Purpose: Measures the ability to payoff
current debt.
Current Ratio
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Current assets to current liabilities
Acid Test Ratio
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Liquid assets to current liabilities
Current Ratio
Sales
Revenue
Cost of
Goods
Sold
Current
Assets
Current
Liabilities
ABC, Inc.
60
30
XYZ Corp.
240
240
Stocks
(Inventory)
Accounts
Recvble
Net Profit
Gross
Profit
Purpose: Do we have the ability to payoff our current debts?
Current Assets / Current Liabilities
ABC Inc:
60/30 = 2
XYZ Corp:
240/240 = 1
A healthy current ratio is 1.5-2.0
For every $1.50 - $2 of assets I can
pay off $1 of liabilities.
Which company has the larger capacity to payoff debts?
(Cash + Accts Receivable + Inventory) – Accts Payable = Current debt remaining
Current Ratio
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Purpose: Measures the capacity to payoff
current debt
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Most firms are advised to have a ratio of 1.5-2.0
to be in a safe position
Low ratios may not be unusual for high-volume
cash businesses like grocery stores, fast food
restaurants, or gas stations
Results over 2 might suggest that too much
money is tied up in inventory or long credit terms
to debtors (Accounts Receivables)
Acid Test Ratio
Sales
Revenue
Cost of
Goods
Sold
Current
Assets
Current
Liabilities
Stocks
(Inventory)
ABC, Inc.
60
30
30
XYC Corp.
240
240
60
Accounts
Recvble
Net Profit
Gross
Profit
Purpose: Do we have the CASH to payoff our current debts?
Liquid Assets = Current Assets - Stocks
A healthy current ratio is 1 or above
Liquid Assets / Current Liabilities
For every $1 of liquid assets I can
pay off $1 of liabilities.
ABC Inc:
30/30 X 100=1
XYZ Corp:
180/240 X 100 = .75
Which company has the larger capacity to payoff debts?
(Cash + Accts Receivable) – Accts Payable = Current debt remaining
Acid Test Ratio
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Purpose: Measures the capacity to payoff
current debt with liquid assets
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Results below 1 are viewed with caution as there
might not be enough cash to short-term debt.
View the ratio results in context with last
year….are we improving or declining?
What is the natural inventory level expectations
for your type of business? This will affect your
ratio so it must be viewed in context with your
type of business.
Methods to Improve Liquidity
Method to improve
liquidity
Example
Sell off fixed assets for
cash and lease back if still
needed.
Land and property could be sold
to a leasing company.
Sell off inventories for
cash.
Note: This will improve
the acid test ratio, but not
the current ratio.
Increase loans to inject
cash into the business and
increase working capital.
Stocks of finished goods could
be sold off at a discount.
Just-in-Time (JIT) inventory
management will achieve this
objective.
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Long-term loans could be taken
out if the bank is confident of the
company’s prospects.
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Evaluation
If assets are sold quickly they might not
bring their full value.
If assets are still needed by the
business, then leasing charges will add to
overheads and reduce profit margins.
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This will reduce the gross profit margin
if inventory is sold at a discount.
Consumers may doubt the image of the
brand if inventories are sold off cheaply.
Inventories might be needed to meet
changing customer demand levels – JIT
maybe difficult to adobe in some
industries.
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These will increase the gearing ratio.
These will increase interest costs.
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