1. Announcements
It’s LSAT week! I take the test on Saturday. If you are sick, stay AWAY from me
Most of IA material will be covered this week
Summatives won’t be graded for another week. Don’t hate the player. Hate the game
I won’t be here Thursday or Friday!!! BYE, FELICIA!
If you need anything, text me at (240)

2. Ratio Analysis
Mini Lesson for IA

3. Two main types of financial statements (or final accounts)
Profit and Loss Account
Also known as the income statement
Shows records of income and expenditure flows for a business over a given period of time
Establishes whether a business has made a profit or loss and how it was distributed at the end of that period
Balance Sheet
Also known as the statement of financial position
Lists the assets, liabilities, and equity of a company at a specific point in time
It tells us what the company owns (total assets) and owes (total liabilities), including how much shareholders have invested in the company (equity)

4. Example: Profit and Loss Account for McDonald’s
In Thousands $
For Year Ending 12/31/2014
Sales
27,441,300
Cost of Goods Sold
16,250,000
Gross Profit
11,191,300
Expenses
3,083,700
Net Profit before interest and tax
8,107,600
Interest Expense -
Net Profit before tax
Tax Expense
3,450,000
Net Profit after interest and tax
4,657,600
Dividends
Retained Earnings
Gross Profit = Sales – Cost of Goods Sold
Net Profit before interest and tax = Gross Profit - Expenses
Net Profit before tax = net profit before interest and tax - interest
Net Profit after interest and tax = net profit before tax – tax expense
Retained earnings or profit = net profit after interest and tax – dividends

5. Example: Balance Sheet for McDonald’s
Fixed assets are long term assets that last a business more than 12 months. For e.g. buildings, equipment, machinery, etc.
As of 12/31/14
Fixed Assets
26,557,500
Intangible Assets
2,846,900
Current Assets:
Cash
3,082,400
A/R
1,214,400
Inventory
110,000
Other
783,200
Total Current Assets
5,190,000
Current Liabilities:
A/P
2,747,900 -
Total Current Liabilities
Working Capital
2,442,100
LT Loans
12,881,500
Net Assets
18,965,000
Equity:
Share Capital
4,736,000
Retained earnings
14,229,000
Total Equity
Current assets are short term assets that last a business for up to 12 months. For e.g. cash, accounts receivable (debt that is yet to be paid to the business), inventory, etc.
Current liabilities are short term debts payable within 12 months
Working capital = total current assets – total current liabilities
Long term liabilities are long term debts payable after 12 months
Net assets = fixed assets + working capital – long term liabilities
Total Equity = share capital + retained earnings
Bottom line: Net assets = Equity!!!

6. Ratio Analysis
Profitability ratios: assess the performance of a firm in terms of its profit-generating ability
Gross Profit Ratio
Net Profit Ratio
Efficiency ratios: assess how well a firm internally utilizes its assets and liabilities
Return on Capital Employed
Liquidity ratios: measure the ability of a firm to pay off its short term debt obligations
Current Ratio
Acid Test (Quick) Ratio

7. Gross Profit Ratio Gross profit ratio = Gross Profit x 100
Sales Revenue
Result is a percentage %
Indication of profit available to pay for expenses
Solution for low ratio: Increase sales without increasing COGS, by increasing the sale price or finding ways to cut COGS (new suppliers). May impact quality.
Things to consider: Is the business labor or capital intensive? This may impact the amount of cost of goods sold

8. Net Profit Ratio
Net Profit Ratio = Net profit before Interest & Tax x 100
Sales Revenue
Result is a percentage %
Measures how much of each dollar of sales represents net profit
Rule of Thumb: 10% is usually a minimum
Solution for low ratio: Generate higher levels of Gross profit, or cut other costs such as salaries or energy costs without reducing sales. An investment in advertising may also lead to higher sales. May impact quality.
Things to consider: Increased expenses may be due to growth plans

9. Return on Capital Employed (ROCE)
ROCE = Net Profit Before Interest & Tax x 100
Capital Employed
Result is a percentage %
Capital employed = Loan capital (or long-term liabilities) + share capital + retained profit
Measures how much profit the business is generating as a percentage from its main sources of finance
Rule of Thumb: Should be greater than current interest rates if an investor was to put money into the bank (for example, 5%). Bank investment significantly less risk, so ROCE should be several percent more.
Solutions for low ratio: Same as net profit solutions. Could also reduce amounts payable to lenders by repaying loans, returning share capital to investors or pay dividends to reduce the retained profits. Need cash to be able to do these.
Things to consider: If the business has recently received a large amount of finance, it may not have had time to generate profit from it yet.

10. Current Ratio Current Ratio = Current assets _ Current liabilities
Result is a ratio X:1
Measures the ability of the business to cover (pay) its debts in the next 12 months.
Rule of thumb: Should be about 2:1. Anywhere between 1.5: :1 acceptable. If too low business unable to pay liabilities. Too high, current assets not used adequately to increase profits
Solution: Increase current assets such as cash at bank or debtors by increasing sales or taking a loan; or decrease liabilities by reducing creditors (however this will require cash)
Things to consider: Business may not be able to get more cash through borrowing if already highly geared

11. Acid Test (Quick) Ratio
Acid Test (Quick) Ratio = Current assets – stock
Current liabilities
Result is a ratio X:1
Measures the ability of the firm to cover (pay) immediate debt obligations (next month)
Rule of Thumb: Should be above 1:1. below 1:1 business at high risk (not able to cover current liabilities)
Solution: Increase cash held by holding lower levels of stock when possible. Decrease current liabilities by reducing creditors.
Things to consider: Nature of business may require higher levels of stock to meet fluctuating demand.