Bm Unit 3.6 Ratio Analysis


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IB Business and Management (Standard Level)
All material taken from the IB Business and Management Textbook:
"Business and Management", Paul Hoang, IBID Press, Victoria, 2007

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Bm Unit 3.6 Ratio Analysis

  1. 1. Unit 3.6 Ratio AnalysisLesson 1: Purpose of Ratios Analysispp. 417-419<br />IB Business and Management<br />
  2. 2. Think about it…<br />“Many of the things you can count, don’t count. Many of the things you can’t count, really count.” – Albert Einstein (1879-1955)<br />What did he mean by this?<br />…<br />
  3. 3. 2a. The Purpose of Ratio Analysis<br />You are probably thinking right about now, great more math…oh joy. <br />Remember Unit 3.5 and learning about how to read and use financial accounts?<br />Well, Ratio Analysis is used by YOU the manager, as a tool for analyzing and judging the financial performance of a business.<br />You do this by calculating financial ratios from a company’s final accounts (the balance sheet and the P&L account.)<br />Remember: Do not just learn the formulae, you need to understand what they actually mean, focus on:<br />How the business is performing based on the ratios.<br />How the business has performed over the years.<br />What else needs to be considered that is not presented in the data.<br />..<br />
  4. 4. 2b. The Purpose of Ratio Analysis<br />Has several purposes:<br />To analyze short and long term liquidity.<br />To asses a firm&apos;s ability to control expenses.<br />To compare actual figures with projected ones.<br />To help in the decision making process.<br />Should investors risk their money in the business.<br />Ratios can be compared in two ways:<br />1. Historical comparisons<br />2. Inter-firm comparisons<br />In the same industry; McDonald’s should compare their ratios with rivals of similar size, like Burger King.<br />..<br />
  5. 5. 3. Types of Financial Ratios<br />Five types of ratios:<br />1. Profitability ratios:<br />Assess the financial performance of a business.<br />Will show how well a firm has performed.<br />2. Liquidity ratios:<br />Looks at the ability of a firm to pay its short-term liabilities.<br />The firm’s ability to repay its debts.<br />3. Efficiency ratios:<br />Shows how well a firm’s resources are being used.<br />4. Shareholder ratios:<br />Measures the returns to shareholders in a company.<br />Shareholders will be interested in earnings per share.<br />5. Gearing ratio:<br />Looks at the long-term liquidity position of a firm.<br />A high degree of gearing could mean a inadequate long-term liquidity because the firm must repay its loans.<br />If a firm is highly geared it will be considered a risky business.<br />..<br />
  6. 6. Unit 3.6 Ratio AnalysisLesson 2: Financial Ratiospp. 420-426,430-431<br />IB Business and Management<br />
  7. 7. 1a. Financial Ratios: Profitability Ratios<br />These ratios measure profit in relation to other variables such as sales turnover or capital employed.<br />The main profitability ratios are:<br />Gross Profit Margin (GPM)<br />Net Profit Margin (NPM)<br />So why are these ratios useful?<br />If a company makes 5 million dollars, is the company financially successful?<br />Yes? NO? Maybe?<br />These ratios will help us determine the answer.<br />Note: The profitability ratios only apply to profit-oriented businesses.<br />Let’s take a closer look shall we…<br />
  8. 8. 1b. Financial Ratios: Profitability Ratios<br />Gross Profit Margin (GPM):<br />This ratio will show the value of gross profit as a % of sales revenue.<br />GPM = Gross profit x100 (remember Gross Profit = sales revenue – COGS)<br /> Sales Revenue (remember COGS= opening stock + purchases – Closing stock)<br />The higher the GPM ratio, the better it is for a business.<br />Gross profit goes towards paying overheads and expenses of the business.<br />You can improve your GPM by two main ways:<br />1. Raising revenue: increasing or decreasing selling price, marketing strategies, etc.<br />2. Reducing costs: find cheaper suppliers, cheaper materials, reduce staff, etc.<br />..<br />
  9. 9. 1c. Financial Ratios: Profitability Ratios<br />Net Profit Margin (NPM):<br />This ratio will show the % of sales turnover that is turned into net profit.<br />Example, if NPM is 35%, then every 100 dollars of sales, $35 is net profit.<br />Net Profit is what? <br />Profit that is left after all the costs of production have been accounted for.<br />NPM = Net profit x 100<br /> Sales revenue<br />The NPM is a better ratio to measure a firm’s profitability because it takes into account both cost of sales and expenses. <br />NPM can be improved by reducing costs:<br />Obtain better payment terms with creditors and suppliers.<br />Negotiate cheaper rent.<br />Reduce indirect expenses. <br />
  10. 10. 2a. Financial Ratios: Liquidity Ratios<br />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.<br />These assets are called liquid assets.<br />Short term liquidity ratios calculate how easily a firm can pay its short-term financial obligation from its current assets.<br />Two main short term ratios are:<br />1. Current ratio= current assets<br /> current liabilities<br />A ratio of 1.5 to 2.0 is good.<br />The ratio would look like this 1.5:1 or 2.0:1<br />So for every $1 of current liability, the firm has $1.5 or $2 of current (liquid) assets.<br />This also means that there is sufficient working capital.<br />If the ratios is 1:1, it would mean that the short-term debt of the business is greater than its liquid assets.<br />This could spell disaster for the company’s survival.<br />A high current ratio would also suggest that there is too much cash, too many debtors, or too much inventory<br />…<br />
  11. 11. 2b. Financial Ratios: Liquidity Ratios<br />2. Acid test ratio (quick ratio):<br />Similar to the current ratio except that it ignores stock when measuring short term liquidity of a business.<br />Acid test ratio = current assets less stock<br /> current liabilities<br />The general guideline is a 1:1 ratio.<br />Anything less that 1:1 means that the firm will experience working capital difficulties.<br />Could possible have a liquidity crisis. Where the firm is unable to pay its short term debts.<br />Investors will be interested in your company’s acid ratio.<br />This ratio can be improved by increasing the level of current assets or lowering your current liabilities.<br />… <br />
  12. 12. 3a. Financial Ratios: Efficiency Ratios<br />These ratios look at how well a firm’s financial resources are being used.<br />There are four main efficiency ratios. For the standard level course we will be covering only two out of the four:<br />1. Stock turnover:<br />Measures the number of times a firm sells its stock within a year.<br />Two ways to calculate this:<br />a. Stock turnover = costs of goods sold<br /> average stock<br />b. stock turnover = average stock x 365<br /> Cost of goods sold<br />In general, the higher that ratio the better it is for the business.<br />The higher the stock turnover, the more stock is being sold.<br />If more stock is being sold, you will have more profit.<br />How to increase stock turnover?<br />Hold lower levels of stock<br />Divestment; get rid of any slow selling stock.<br />Reduce the range of products offered, by only keeping the ones that sell.<br />
  13. 13. 3b. Financial Ratios: Efficiency Ratios<br />2. Return on capital employed (ROCE):<br />IF we look at a P&L account which shows that a company made $20 million in profit, has that company really performed well? <br />Well it all depends on how well other firms performed in the same year and the historical profit of the firm.<br />It would also depend upon the size of the firm; MacDonald&apos;s vs some mom and pop hamburger joint.<br />ROCE measures the financial performance of a company compared with the amount of capital invested.<br />ROCE = Net profit before interest and tax x 100<br /> capital invested (<br />remember: capital invested = shareholder’s funds + reserves + long-term liabilities<br />The higher the ROCE the better.<br />Some believe that 20% ROCE is a good target to achieve.<br />This figure will depend on many factors: such as the context of the business and industry the company is in.<br />So a 20% ROCE means that every $100 invested, $20 profit is generated.<br />But really, this number should be greater than what the bank offers in interest rate for a savings account.<br />To many, this is the key ratio or the primary ratio.<br />
  14. 14. 4. Financial Ratios: Gearing Ratio<br />This is used to assess a firm’s long term liquidity position.<br />We look at the firm’s capital employed that is financed by long term debt.<br />Gearing ratio = long-term liabilities x 100 or loan capital x 100<br /> capital employed capital employed<br />The higher the gearing ratio the larger the firm’s dependence on long term sources of borrowing.<br />This means that the firm will incur higher costs due to debt financing.<br />This will reduce net profits and if a firm is highly geared it has a gearing ratio of 50% or more.<br />Banks will be less willing to loan you more money.<br />Investors will see you as a huge investment risk.<br />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.<br />Gearing may be acceptable if:<br />The size and status of the business.<br />The level of interest rates.<br />Potential profitability.<br />..<br />
  15. 15. Unit 3.6 Ratio AnalysisLesson 3: Uses and Limitations of Ratio Analysispp. 431-436<br />IB Business and Management<br />
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  18. 18. 3 Remember… <br />With all the quantitative data that you are given or that you calculate, it still does not give the entire picture of the company.<br />There are other considerations you need to investigate in order to be able to make a better assessment of a company:<br />Look at:<br />Historical comparisons.<br />Inter-firm comparisons.<br />The nature of the business and its aims and objectives.<br />The state of the economy.<br />Social factors.<br />Good management decision-making considers a range of information, both quantitative and qualitative.<br />..<br />
  19. 19. End<br />