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3.6 Ratio Analysis Chapter 23 – Part 2 Ratio Analysis Profitability Ratios Liquidity Ratios Financial Efficiency Ratios Shareholder or Investment Ratios Gearing Ratio Financial Efficiency Ratios Purpose: Measures how efficiently the assets of a business are being used. Stock Turnover Ratio Debtor Days Ratio How often the inventory is bought and sold 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 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 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. 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 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. 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 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 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 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. 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. 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 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 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.