Download 3.6 Ratio Analysis

3.6 Ratio Analysis
Chapter 23 – Part 2
Ratio Analysis
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Profitability Ratios
Liquidity Ratios
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Financial Efficiency Ratios
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Shareholder or Investment Ratios
Gearing Ratio
Financial Efficiency Ratios
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Purpose: Measures how efficiently the assets
of a business are being used.
Stock Turnover Ratio
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Debtor Days Ratio
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How often the inventory is bought and sold
How long to collect payments from customers who
purchased goods on credit
Creditor Days Ratio
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How long it takes the company to pay its suppliers
Stock Turnover Ratio
Sales
Revenue
Cost of
Goods
Sold
Current
Assets
Current
Liabilities
Stocks
(Inventory)
ABC, Inc.
125
25
XYZ Corp.
2400
600
Accounts
Recvble
Net Profit
Purpose: How many times do we buy our inventory in a year?
Cost of Goods Sold / Value of Stock
ABC Inc:
125/25 = 5
XYZ Corp:
2400/600 = 4
(average for the year)
Which purchased inventory more frequently throughout the year?
ABC bought inventory 5 times
XYZ bought inventory 4 times
Gross
Profit
Stock Turnover Ratio
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Purpose: Measures how many times
inventory is purchased during the year.
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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.
Debtor Days Ratio
Sales
Revenue
Cost of
Goods
Sold
Current
Assets
Current
Liabilities
Stocks
(Inventory)
Accounts
Recvble
ABC, Inc.
250
75
XYZ Corp.
3200
600
Net Profit
Gross
Profit
Purpose: How many days does it take for our customers to pay us?
Accounts Receivable / Sales Turnover
(Sales)
ABC Inc:
(75/250) X 365 = 109.5 days
XYZ Corp:
(600/3200) X 365 = 68.62 days
Can also be calculated using only
credit sales – eliminating cash
sales – since cash sales will never
lead to debtors.
Which company takes the longest time to receive money from customers?
What does this do to cash flow?
Debtor Days Ratio
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Purpose: Measures how long it takes to
collect payments from customers who
purchased goods on credit
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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.
Creditor Days Ratio
Sales
Revenue
Credit
Purchases
Current
Assets
Accounts
Payable
ABC, Inc.
100
20
XYZ Corp.
1125
250
Stocks
(Inventory)
Accounts
Recvble
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 = 81.395 days
Which company takes the longest time to pay their vendors?
What does this do to cash flow?
Net Profit
Gross
Profit
Creditor Days Ratio

Purpose: Measures how long it takes to
pay vendors for goods purchased on
credit
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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.
Ratio Analysis

Profitability Ratios
Liquidity Ratios
Financial Efficiency Ratios

Shareholder or Investment Ratios

Gearing Ratio


Shareholder or Investment Ratios


Purpose: Measures the prospects of
financial gain from investing.
Dividend Yield Ratio

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The rate of return at the current share price
Earnings Per Share Ratio

The amount each share is earning
Dividend Yield Ratio
Sales
Revenue
Cost of
Goods
Sold
Dividends
Number
of Shares
Dividends
per share
Market
Share
Price
Net Profit
After Tax
ABC, Inc.
21
140
.15
1.50
50
XYZ Corp.
140
200
.70
10.00
500
Gross
Profit
Purpose: How much is my return on the investment at the current share price?
(Dividend Per Share / Current Share Price) X 100
ABC Inc:
.15/1.50 X 100 = 10%
XYZ Corp:
.70/10.00 X 100 = 7%
Which company produces more return per share?
(Market Share Price)
Dividend Per Share:
Total Dividend / Total # of Shares
ABC Inc
21 / 140 = .15
XYZ Corp
140 / 200 = .70
Dividend Yield Ratio
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Purpose: Measures the rate of return per share.
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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.
Earnings Per Share Ratio
Sales
Revenue
Cost of
Goods
Sold
Dividends
Number
of Shares
Dividends
per share
Market
Share
Price
Net Profit
After Tax
ABC, Inc.
21
140
.15
1.50
50
XYZ Corp.
140
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?
Gross
Profit
Earnings Per Share Ratio

Purpose: Measures how much is each
share earning.
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Allows a way to compare stocks from
different companies to help evaluate
investment options.
Can also be compared with the price of the
share.
Ratio Analysis

Profitability Ratios
Liquidity Ratios
Financial Efficiency Ratios
Shareholder or Investment Ratios

Gearing Ratio



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
Gearing Ratio
Sales
Revenue
Cost of
Goods
Sold
Current
Assets
Current
Liabilities
Long
Term
Loans
*Capital
Employed
ABC, Inc.
40
400
XYZ Corp.
2000
5000
Net Profit
Gross
Profit
*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
ABC Inc:
40/400 X 100=10%
XYZ Corp:
2000/5000 X 100 = 40%
A rate above 50%
indicates a “highly”
geared company.
Which company is using more “borrowed” capital to operate their business?
Gearing Ratio
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Purpose: Measures the degree that capital of the
business is financed by long-term loans.
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The higher the ratio the greater the risk:
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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
Summary: Be careful
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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.