1. 3.6 Ratio Analysis
Chapter 23 – Part 2

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

3. Financial Efficiency Ratios
Purpose: Measures how efficiently the assets of a business are being used.
Stock Turnover Ratio
How often the inventory is bought and sold
Debtor Days Ratio
How long to collect payments from customers who purchased goods on credit
Creditor Days Ratio
How long it takes the company to pay its suppliers

4. Stock Turnover Ratio
Sales Revenue
Cost of Goods Sold
Current Assets
Current Liabilities
Stocks
(Inventory)
Accounts
Recvble
Net Profit
Gross Profit
ABC, Inc.
125 25
XYZ Corp.
2400
600
Purpose: How many times do we buy our inventory in a year?
Cost of Goods Sold / Value of Stock (average for the year)
ABC Inc: 125/25 = 5
XYZ Corp: 2400/600 = 4
Which company purchased inventory more frequently throughout the year?
ABC bought inventory 5 times XYZ bought inventory 4 times

5. Stock Turnover Ratio
Purpose: Measures how many times inventory is purchased during the year.
The higher the number, the more efficient a company is at selling its stock so it has to buy inventory more often.
Inventory turnover rate is dependent on the industry – restaurants should have a higher turnover than a car dealership
Service sector business do not use this ratio because they do not have inventory.

6. Debtor Days Ratio Accounts Receivable / Sales Turnover (Sales)
Sales Revenue
Cost of Goods Sold
Current Assets
Current Liabilities
Stocks
(Inventory)
Accounts
Recvble
Net Profit
Gross Profit
ABC, Inc.
250 75
XYZ Corp.
3200
600
Purpose: How many days does it take for our customers to pay us?
Accounts Receivable / Sales Turnover (Sales)
Can also be calculated using only credit sales – eliminating cash sales – since cash sales will never lead to debtors.
ABC Inc: (75/250) X 365 = days
XYZ Corp: (600/3200) X 365 = days
Which company takes the longest time to receive money from customers?
What does this do to cash flow?

7. Debtor Days Ratio
Purpose: Measures how long it takes to collect payments from customers who purchased goods on credit
There is no right or wrong answer.
Business who operate mainly in cash will have a very low ratio.
A high ratio could mean poor control over customer payment/credit arrangements.

8. Creditor Days Ratio Accounts Payable / Credit Purchases
Sales Revenue
Credit Purchases
Current Assets
Accounts
Payable
Stocks
(Inventory)
Recvble
Net Profit
Gross Profit
ABC, Inc.
100 20
XYZ Corp.
1125
250
Purpose: How many days does it take for us to pay our suppliers?
Accounts Payable / Credit Purchases
ABC Inc: (20/100) X 365 = 73 days
XYZ Corp: (250/1125) X 365 = days
Which company takes the longest time to pay their vendors?
What does this do to cash flow?

9. Creditor Days Ratio
Purpose: Measures how long it takes to pay vendors for goods purchased on credit
There is no right or wrong answer.
A high number days can reduce the cash outflows.
Vendors may be unhappy with slow payments and discounts may be missed or not offered.

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

11. Shareholder or Investment Ratios
Purpose: Measures the prospects of financial gain from investing.
Dividend Yield Ratio
The rate of return at the current share price
Earnings Per Share Ratio
The amount each share is earning

12. Dividend Yield Ratio
Sales Revenue
Cost of Goods Sold
Dividends
Number of Shares
Dividends per share
Market Share Price
Net Profit
After Tax
Gross Profit
ABC, Inc. 21
140
.15
1.50 50
XYZ Corp.
200
.70
10.00
500
Purpose: How much is my return on the investment at the current share price?
(Dividend Per Share / Current Share Price) X 100 (Market Share Price)
Dividend Per Share:
Total Dividend / Total # of Shares
ABC Inc / 140 = .15
XYZ Corp / 200 = .70
ABC Inc: .15/1.50 X 100 = 10%
XYZ Corp: .70/10.00 X 100 = 7%
Which company produces more return per share?

13. Dividend Yield Ratio Purpose: Measures the rate of return per share.
If share prices rise dividends are not increased, this rate of return will fall.
If share prices stay the same or fall and the dividends are increased, this rate of return will increase.
Results need to be compared within the industry.
Shareholders may be attracted to a high dividend yield as long as stock prices do not fall.
Board of Directors may choose to not pay a dividend to keep retained profits to be reinvested back into the business.
A high dividend yield could be caused by a recent drop in stock price not profitability of the company.

14. Earnings Per Share Ratio
Sales Revenue
Cost of Goods Sold
Dividends
Number of Shares
Dividends per share
Market Share Price
Net Profit
After Tax
Gross Profit
ABC, Inc. 21
140
.15
1.50 50
XYZ Corp.
200
.70
10.00
500
Purpose: How much is each share earning?
Profit After Tax / Total Number of Shares
ABC Inc: 50/140 = .358
XYZ Corp: 500/200 = 2.50
Which company produces more earnings per share?

15. Earnings Per Share Ratio
Purpose: Measures how much is each share earning.
Allows a way to compare stocks from different companies to help evaluate investment options.
Can also be compared with the price of the share.

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

17. Gearing Ratio
Purpose: Measures the degree that capital of the business is financed by long-term loans.
Gearing Ratio
The amount of long-term loans in comparison to the total capital

18. Gearing Ratio (Long-Term Loans / Capital Employed) X 100
Sales Revenue
Cost of
Goods Sold
Current Assets
Current Liabilities
Long Term
Loans
*Capital
Employed
Net Profit
Gross Profit
ABC, Inc. 40
400
XYZ Corp.
2000
5000
*capital employed = non-current liabilities + shareholders equity
Purpose: How much is the company relying on long-term loans vs other capital?
(Long-Term Loans / Capital Employed) X 100
A rate above 50% indicates a “highly” geared company.
ABC Inc: 40/400 X 100=10%
XYZ Corp: 2000/5000 X 100 = 40%
Which company is using more “borrowed” capital to operate their business?

19. Gearing Ratio
Purpose: Measures the degree that capital of the business is financed by long-term loans.
The higher the ratio the greater the risk:
Heavy borrowing indicates large interest payments which will affect dividends and profits.
Debts have to be repaid and could leave the company with low liquidity.
Low gearing is a “safe” business strategy, but could indicate that management is not using borrowing as a strategy to expand the business which limits growth.
The gearing ratio can be lowered by raising cash in other ways: selling more stock, decreasing the dividend. Result: “pump up” capital without borrowing

20. Summary: Be careful
Ratios should not be used singly but compared with other companies in the industry or internal company records utilizing data trends over time.
Slightly different data and/or formulas can be used and reported by various companies.
Ratios only deal with financial accounting items and do not take into consideration environmental stewardship or human rights considerations.
Ratios do not solve problems or bring attention to the cause of business problems.