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