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3.6 Ratio Analysis Topic 3– Part 1

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The Purpose of Ratio Analysis The profitability of a company is not the whole story of its financial health. 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?

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Ratio Analysis Ratios fall into 5 different categories Profitability Ratios Liquidity Ratios Financial Efficiency Ratios Shareholder or Investment Ratios Gearing Ratios

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Ratio Analysis Profitability Ratios Liquidity Ratios Financial Efficiency Ratios Shareholder or Investment Ratios Gearing Ratios

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Profitability Ratios - Margins Purpose: Measures the ability to convert sales revenue into profit. Gross Profit Margin % of gross profit to total sales revenue Net Profit Margin % of net profit to total sales revenue

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Gross Profit Margin Sales Revenue Cost of Goods Sold Current Assets Current Liabilities Stocks (Inventory) Accts Recvble Net ProfitGross Profit ABC, Inc.250125 XYZ Corp.3200800 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 Purpose: How well are we generating profits before overhead expenses?

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Net Profit Margin Sales Revenue Cost of Goods Sold Current Assets Current Liabilities Stocks (Inventory) Accts Recvble Net ProfitGross Profit ABC, Inc.25050125 XYZ Corp.3200500800 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 Purpose: How well are we generating profits after overhead expenses?

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Profitability Ratios- RoCE Purpose: Measures the ability of using capital employed effectively to earn a profit 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.

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Return on Capital Employed (RoCE) (Primary efficiency ratio) Sales Revenue Cost of Goods Sold Current Assets Current Liabilities Stocks (Inventory) *Capital Employed Net ProfitGross Profit ABC, Inc.40050 XYZ Corp.5000500 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) Purpose: How effective is the capital invested in the company at earning a profit? *capital employed = non-current liabilities + shareholders equity

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Ratio Analysis Profitability Ratios Liquidity Ratios Financial Efficiency Ratios Shareholder or Investment Ratios Gearing Ratios

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Liquidity Ratios Purpose: Measures the ability to payoff current debt. Current Ratio Current assets to current liabilities Acid Test Ratio Liquid assets to current liabilities

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Current Ratio Sales Revenue Cost of Goods Sold Current Assets Current Liabilities Stocks (Inventory) Accounts Recvble Net ProfitGross Profit ABC, Inc.6030 XYZ Corp.240 Current Assets / Current Liabilities ABC Inc:60/30 = 2 XYZ Corp:240/240 = 1 Which company has the larger capacity to payoff debts? (Cash + Accts Receivable + Inventory) – Accts Payable Purpose: Do we have the ability to payoff our current debts? A healthy current ratio is 1.5-2.0 For every $1.50 - $2 of assets I can pay off $1 of liabilities.

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Current Ratio Purpose: Measures the capacity to payoff current debt 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)

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Acid Test Ratio Sales Revenue Cost of Goods Sold Current Assets Current Liabilities Stocks (Inventory) Accounts Recvble Net ProfitGross Profit ABC, Inc.6030 XYC Corp.240 60 Liquid Assets / Current 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 Purpose: Do we have the CASH to payoff our current debts? A healthy current ratio is 1 or above For every $1 – liquid assets I can pay off $1 of liabilities. Liquid Assets = Current Assets - Stocks

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Acid Test Ratio Purpose: Measures the capacity to payoff current debt with liquid assets 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.

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