1. RATIOS Flashcards
Profitability ratios (8)
Gross profit margin (gross profit/rev)
Operating profit margin (op profit/rev)
Net profit margin (net profit/rev)
Return on capital employed (EBIT/CE)
Asset turnover (rev/CE)
Return on equity (net prof/equity)
Operational gearing ratio ((Revenue-Variable Cost)/Profit before tax)
Equity multiplier (total assets/equity)
generally - higher = better = comp better at converting sales to profit
gross profit margin (profitability)
both from income statement
gross profit = rev - COGS
- compare to last year comment on trend (where have rev/COGS moved?)
- higher = can spend higher proportion of income on other op expenses
GOOD : relationship between turnover and direct cost of providing product/service
BAD: may portray bis in too pos a light - ignores operating expenses which are v real
operating profit margin (profitability)
operating profit margin % = operating profit / rev (x100)
rev = top of income statement
op profit = rev - cogs - operating costs
-compare to last year and say what that means
- varies widely between sectors (supermarkets v low, jewellers v high)
- effected by competition, economic climate, industry etc
-higher = better, yoy increase = sales up more than costs
GOOD: provides relationship between turnover and all costs of providing service including op costs
GOOD: appropriate for making comparisons because differences in way bis is financed wont influence measure
BAD: discrepancies can arise between comps for various reasons e.g. method of depreciation used - so hard to make comparisons
net profit margin (profitability ratio)
net profit margin (%) = net profit / revenues (x100)
net income = bottom of income statement (all expenses removed)
revs = top
- compare to last year
GOOD: all costs accounted for, so measures how successful a comp is at making profit on each sale
GOOD: provides final pic of comps overall health
BAD: can be influenced by one off items e.g. sale of an asset
BAD: doesnt provide insight into whether management is managing production costs
return on equity (ROE)
profitability ratio
ROE (%) = net income / equity (x100)
net profit = bottom of income statement
equity = assets - liabilities = share capital + share premium + retained earnings
measures rate of profit earned for shareholders
higher = better conversion of equity finance to profits
must be compared to comp previous and industry - varies by industry, lifecycle of bis
GOOD: shows how well comp benefits shareholders beyond earnings
GOOD: shows return on investments
BAD: doesnt show risk associated with high level of return - e.g. may use lots of debt to generate high net profit and this isnt reflected
BAD: easily manipulated - inflating income by overvaluing assets or deflating equity (increasing liabilities or with buybacks)
BAD: v low with new comps and capital requirement high in early days
Equity multiplier - profitability ratio
eq multiplier = total assets / shareholders funds
fin. leverage ratio - evaluates companies use of debt to purchase assets - higher debt = lower shareholder funds and higher eq multiplier
- comps wiht horrible sales and margins can take on excessive debt to artificially increase ROE - eq multipier allows you to see what portion of return on eq is result of debt
DuPont analysis
breaks ROE into 3 distinct elements after analysing drivers of ROE
operating efficiency - measured by net profit margin (less pre fdivi)
- as net profits increase (reducing costs or increasing prices) ROE will increase
asset use efficiency - measured by total asset turnover (rev/CE) - industry specific
- as asset turnover increases ROE increases
financial leverage - measured by equity multiplier (assets/ shareholder funds)
- if ROE increases with increases eq multiplier - could indicate overleverage and higher risk
ROE = net profit margin x total asset turnover x equity multiplier
extended DuPont analysis
ROE (%) = (Operating profit margin x Tax retention rate - Interest expense rate) x Equity multiplier x Total asset turnover
removed effect of tax and interest
Asset turnover
asset turnover = revenue / capital employed
= x: 1 ratio
capital employed = assets - current liabilities
OR = non current liabilities + equity
measures efficient use of assets to produce sales - helps measure productivity of company’s assets
high = better but too high could indicate overtrading (insufficient assets to sustain level of sales rev)
comps with low profit margins tend to higher assets turnover
retail tends to be higher (2-3)
utilities with large asset base will be lower
compare to prev years as ever
ROCE = OPM x asset turnover
v diff quality bis can achieve same ROCE (e.g. high asset turnover x low margin = low asset turnover x high margin)
operational gearing ratio
profitability
operational gearing ratio = (revenues - variable costs) / Profit before tax
Ratio of fixed to variable costs - higher level = grater risk
if comp has greater level of fixed = greater variation in profit as a result of revenue changes
effect of op gearing ratio can be calced by taking increase/decrease in normal output and x by geearing ratio
Breakeven point
graphshows relationship between sales and total costs
denominator = contribution per unit because it contributes to meeting fixed costs
contribution margin = margin profit per unit sale
computed using contribution income statements which separate fixed and variable costs
ROCE
profitability
ROCE = operating profit / capital employed
capital employed = assets - current liabilities
OR = non current liabilities + equity
often regarded as one of best measures for judging management of comp in its utilization of available cap resources
compare ROCE to target figs
useful for cap intensive comps as it analyses debt and liabilities as well as probability - gives clear pic of financials
cant be considered in isolation - must compare to last year and across sector
unlike ROE - doesnt capture risk associated with generation of return
older comps generally have higher ROCEs than newer - due to depreciation which can be misleading
Liquidity ratios
current ratio (CA/CL)
acid test ratio (CA-Inv/CL)
Altman Z score- quantifies likelihood of insolvency
Current ratio (x)
Liquidity
aka working cap ratio
current ratio = current assets / current liabilities
- ideally 1.5-2
- purpose is to determine if the cover that current assets provide to cover liabilities that fall due within a year
ISSUES
-overdrafts may actually be long term but are a current liability
-doesnt take timing of CF into account
-inventory may not be easily liquidated (recession, distressed prices)
5 TYPES OF ACCOUNTING RATIO
profitability - asses trading/operating performance: profits needed to provide investors with returns
liquidity -evaluates trading risk of the company
operational efficiency
gearing -assesses ability of bis to meet lLT debts and risks to those financing comp
investor - asses returns to those financing the comp
current ratio modified form
to address critisim that current ratio is static
current ratio = CA/CL
= net sales to working capital
working cap turnover ratio = net annual sales/ avg amount of working cap
working cap = current assets - current liabilities
Quick/acid test
liquidity
quick ratio = (current assets - inventory) / current liabilities
<1 may be cause for concern depending on industry
akak (Cash + marketable secs + trade receivables) / current liabilities
still doesnt take CF timing into account
if quick ratio is much lower than working cap - current assets are highly dependent on inventory - retail stores big e.g. of this = sensitivity to recession
Altman Z score
liquidity
determine prob of comp going into liquidation - analyses sales and gearing and distills to single score
only as good as sata that goes into it
cannot asses comp with little or no earnings (new)
highly sensitive to write offs in accounts which may falsely indictae bankruptcy
A - tests corporate distress
B - reflects extent of gearing
C - assesses ability to squeeze profits from assets
D - how much must MV fall by for liabilities to exceed assets
E- how efficiently assets used to generate sales
working capital/cash cycle
/working cap = current assets - liabilities
= funding avail for conducting day to day bis
aka operational efficiency ratios
efficiency can be increased by
- minimising inventory elvels
- ensuring debtors pay quickly, delaying payments to creditors
comps should maintain at least an equal balance between coleection period and payment period for receivables and payables
considers velocity of CF within working cap cycle
payables payment period (Payables/COGS)
receivables payment period (Receivables/Revenue)
inventory holding days (INV/COGS)
receivables collection period
op efficiency
receivables collection period = 365 x trade receivables / revenue
asses how quickly comp can realise cals of receivables
indicates proportion of year’s sales which are unpaid (@ bal sheet date)
may be distorted by large comps either v quick or slow to pay
static - can be distorted espec by seasonal sales
payables payment period
op efficiency
average time cycle for outward payment
payables payment period = 365 * trade payables/ COGS
want this to be even balance with receivables collection period
could upset creditors if too high
inventory holding days
365 * inventory / COGS
indicates how quickly a comp is selling its inventory
high turnover bis will have low inventory day
generally prefer shorter as there are costs to hold inventory
compare to industry - low suggests strong sales or ineffective buying
static so bad for seasonal bis
inventory management
- likely demand
-possibility of supply shortages
- likelihoo dof price rises
- amount of storage
- perishability
- prospect of obsolescence
financial gearing ratios (4)
debt to equity (Interest bearing debt + pref shares) / (Equity S/H Funds – pref)
net debt to equity (Interest bearing debt + pref shares - cash) / (Equity S/H Funds – pref)
interest cover (operating profit + int received + other receivables)/ int paid)
asset cover (Total Assets – Current Liabs)/ Loans payable
high levels of gearing can indicate greater levels of financial risk
debt to equity
gearing
debt includes liabilities with an interest bearing component (bot ST and LT)
trade payables, deferred income and divi payables generally excluded
sometimes pref shares included in equity
overdrafts included? case by case - ST anomaly or LT financing
generally >100% indicates comp would struggle to pay LT debt if loans called in
bis like utilities with steady earnings can tolerate a higher level than vol sectors e..g banking/tech - utility bis tend to be monopolies
