Unit 3.5 : Profitability and ratio analysis Flashcards
1
Q
Ratio analysis
A
ratio analysis is a quantitative management tool for analysing and judging the financial performance of a business
2
Q
How to compare financial ratios
A
- Historical comparisons involve comparing the same ratio in two different time periods for the same business. This will help to show trends and help managers to assess the financial performance of a business over time
- Inter-firm comparisons involve comparing the ratios of businesses in the same industry (competition)
- In reality businesses use both historical and inter-firm comparisons when analysing their financial ratios
3
Q
Profitability ratios
A
- Profitability ratios examine profit in relation to other figures, such as the ratio of profit to sales revenue
- These ratios tend to be relevant to profit-seeking businesses rather for not-for-profit organizations.
- Managers, employees, and potential investors are interested in profitability ratios as they show how well a firm has performed in financial terms
- Measure profit in relation to other variables such as sales turnover
- A key limitation of using profitability ratios is that they only apply to profit-oriented businesses
4
Q
Efficiency ratios
A
- Efficiency ratios show how well a firm’s resources have been used, such as the amount of profit generated from the available capital used by the business
- Only efficiency ratio to know is ROCE
5
Q
Types of profitability ratios
A
- Gross profit margin (GPM)
2. Net profit margin (NPM)
6
Q
Gross profit margin
A
GPM = Gross profit / sales revenue * 100%
- Expressed as a percentage
- If GPM is 60% then for every $100 of sales, $60 is gross profit (with costs of production accounting of the other 40)
- The higher the GPM, the better it is for a business as gross profit goes towards paying its expenses
7
Q
How to improve gross profit margin
A
- Raising revenue by reducing the selling price or products for which there is a lot of competition/substitutes in order to gain a competitive advantage and increase sales
- Raising the selling price of products without a lot of substitutes (especially if it is inelastic) as customers are not as responsive to changes in price so higher sales revenue is collected
- Marking strategies to raise sales revenue (promotions)
- Seeking alternative revenue streams especially when affected by seasonal demand
- Cut direct material costs (using cheaper suppliers or cheaper materials) - however cost cutting can have a negative effect on the quality of the product
- Cut direct labour costs - however it could lead to demotivation
8
Q
Net profit margin
A
NPM = Net profit / Sales Revenue * 100%
- Is a better measure of a firm’s profitability than GPM as it accounts for both cost of sales (direct) and expenses (indirect costs)
- A NPM ratio of 35% means that for every $100 of sales, $35 is net profit
- The difference between a firm’s GPM and NPM represents its expenses, and therefore the larger the difference, the more difficult overhead control tends to be
- The higher the NPM, the better it is for the firm
- It is common for high volume products (like fast food) to have a relatively low profit margin however high sales volume compensates for this. On the other hand, low volume products like aircrafts and luxury goods, profit margin tends to be high to compensate for the lower unit of sales
- REMEMBER: common practice to use Net Profit before interest and tax to calculate NPM as it allows historical comparisons to change not subjected to interest rates and tax rates (outside of control of the business)
9
Q
How to reduce NPM
A
- SAME AS GPM remember it !!
- Negotiate preferential payment terms with creditors and suppliers (delaying payment to improve working capital)
- Negotiate cheaper rent or delay payment of rent to improve cash flow
- Reduce indirect costs such as advertising or stationary
10
Q
ROCE
A
- Return on capital employed
- Measures the financial performance of a firm compared with the amount of capital invested
- Can also act as an indicator of the profitability of a firm
- Seen on the balance sheet
- Shows profit as a percentage of the capital used to generate it
- The higher the ROCE figure, the better it is for the business
- Some sources refer to a 20% ROCE as being a target benchmark, although this needs to be put into the context of the business and the industry in which it operates
- General rule is that ROCE should at least exceed the interest rate offered at banks otherwise it would be better to simply deposit the capital in an interest-bearing bank account - also cause banks in general carry less risk
11
Q
ROCE equation
A
ROCE = Net profit before interest and tax / Capital employed * 100%
12
Q
Liquidity ratios
A
- Liquidity ratios look at the ability of a firm to pay its short-term liabilities, such as comparing working capital to short-term debts
- Creditors and financial lenders are interested in liquidity ratios to help assess the likelihood of getting back the money they are owed
- Certain assets of a business can be turned into cash quickly without looking their form, others are harder
- Essentially, liquidity ratios calculate how easily a firm can pay its short-term financial obligations from its current assets
13
Q
Liquid assets
A
- assets that can be turned into cash quickly
2. These can be in the form of cash, stocks, and debtors
14
Q
Types of liquidity ratios
A
- Current ratios
2. Acid Test ratio
15
Q
Current ratio
A
- Current ratio deals with a firm’s liquid assets and short-term liabilities (working capital)
- It reveals whether a firm is able to use its liquid assets to cover its short-term debt
- e.g. if a business has a current ratio of 2:1, the firm has $2 of current assets for every $1 of short-term liabilities
- You want a current ratio of 1.5 to 2 - allows for a safety margin because its hard to sell assets quickly without losing value, have enough working capital, and does not have too much cash which is not being used (opportunity cost)
- However, places like supermarkets will most probably have a 2:1 ratio because they hold huge amount of stocks and their stocks are highly liquid
16
Q
Current ratio equation
A
Current assets/Current liabilities
17
Q
How to improve current ratio
A
- Can be improved by raising the value of current assets or reducing the value of current liabilities
- e.g. opting for long-term loans instead of overdrafts that offer more attractive rates of interest which will also free up working capital in the short term however in the long term it will negatively affect liquidity
18
Q
Acid test ratio
A
- Similar to current ratio except it ignores stock when measuring the short-term liquidity of a business
- Stocks are not easily converted into cash hence the need to subtract it
- Should be at least 1:1 or the firm might experience working capital difficulties or liquidity crisis
19
Q
Acid test ratio equation
A
Current Assets - Stock / Current Liabilities
20
Q
Limitations of financial ratio analysis
A
- Ratios are a historical account of a firm’s performance and do not indicate the current or future financial situation of a business (although they given indication of financial health)
- Changes in the external business environment can cause a change in the financial ratios without there being any underlying change int he performance of a business (e.g. higher interest rates will reduce profitability, although sales revenue may have actually increased)
- There is no universal way to report company accounts so this means that businesses may use different accounting policies making inter-firm comparisons more difficult
- Qualitative factors that affect the performance of a firm are totally ignored (e.g. level of staff motivation)
- Organizational objectives differ between businesses so comparing results from a ratio analysis could be meaningless
21
Q
Gross profit formula
A
Gross profit = sales revenue - cost of goods sold (direct)
22
Q
COGS Formula
A
COGS = Opening stock + Purchases - Closing stock
23
Q
Net profit (before interest and tax) formula
A
Net profit = gross profit - expenses
