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Basic Ratio Analysis Part 1 – Concept of Financial Statement Analysis 1 How to Evaluate the Performance of a Business? • Your uncle is carrying a trade business. He knows you are studying business, accounting, and financial studies and asks if you could provide him with some ideas on the financial performance and position of his business. • Can you give him some advise? 2 How to Evaluate the Performance of a Business? • Three basic aspects 1. Financial Status: is the company financially sound, solvent, or liquid? 2. Operational Efficiency: how successfully is the business being run? 3. Investment Potentials: how do the financial status and operational efficiency relate to investments of fund provider? 3 Financial Analysis • Financial analysis is about the use of accounting information to access the financial performance and financial position of a company in order to help management to make decisions on investment, operation and financing. • Therefore, it is important to understand the format and contents of the financial reports of a company. 4 Financial Reports • There are two major financial reports for a company: – Income statement – Statement of financial position • These reports can provide information for various users in making business decisions. 5 Users of Financial Reports • The users of financial reports can broadly be categorised as: – Resource providers (e.g. creditors, lenders, shareholders, employees). – Recipients of goods or services (i.e. customers, debtors). – Government departments/Regulatory bodies (e.g. Inland Revenue Department, Census and Statistics Department). – Internal management to assist in their decision-making capacity. 6 Income Statement • Purpose – Measure of profit / loss for a trading period. – Provide factors which have caused the profit / loss. 7 Income Statement • Presenting the revenues and expenses of a company for one year. • Layout of an income statement: Sales A Cost of Goods Sold B Gross Profit C=A–B Expenses D Net Profit E=C–D Major component: Sales: Income generated by the company Cost of Goods Sold: Cost that a company pays directly for the products sold/services rendered to customers Expenses: Expenditures that a business incurs as a result of performing its normal 8 business operations Income Statement – Example ABC Ltd Income Statement For the year ended 31 December 20X5 $'000 1,850 (935) 915 Sales Cost of sales Gross profit Expenses Distribution Selling and marketing General and administrative Operating profit Interest expenses Profit before tax Income tax expenses Profit after tax (135) (182) (174) 424 (26) 398 (66) 332 20X4 $'000 1,560 (753) 807 (108) (161) (155) 383 (24) 359 (56) 303 9 Activity 1 – Class Discussion • What can we know by reviewing a company’s income statement? 10 Activity 1 – Solution • An income statement indicates the amount of profits generated by a company over a given time period, i.e. 1 year. • By reviewing the income statement, we can understand the financial performance of a company in the following ways: • How much sales it generated for the year? • How much costs incurred for the production/merchandise of goods for the year? • What is the gross profit for the year? • How much a company spent on operation such as administrative cost, sales and marketing etc. for the year. • What is the net profit earned for the year? 11 Statement of Financial Position • The statement of financial position is a ‘snapshot in time’ which shows the financial health of the company. • It does not explain how well / poor the company has performed over the year. 12 Statement of Financial Position • Presenting the assets and liabilities of a business at a specific point in time i.e. end of the year. • Major components: – Assets • Fixed Assets – including land, buildings, equipment, motor vehicles etc. • Current Assets – including inventory, account receivable (money owing to the company), cash etc. – Liabilities • Non-current liabilities –those obligations the business has to meet beyond a year. E.g. long-term loan etc. • Current liabilities – those obligations the business has to meet within a year. E.g. account payables (money owed by the company). – Shareholders capital put into the business by the ‘owners’ • Paid-in capital/share capital – money contributed by the owners of the business. • Retained profit/loss – cumulative profit/loss from prior years after distributions to owners. 13 Statement of Financial Position – Example ABC Ltd Statement of Financial Position As at 31 December 20X5 $'000 Non-current assets Equipments Current assets Inventories Trade receivables Cash and bank Current liabilities Trade payables Tax payable Total assets less current liabilities Financed by: Share capital Retained earnings Non-current liabilities Long-term loan 20X4 $'000 3,200 3,000 212 304 118 634 189 286 225 700 285 66 351 250 56 306 3,483 3,394 2,200 786 2,986 2,200 454 2,654 497 3,483 740 3,394 14 Activity 2 – Class Discussion • A company’s financial statements consist of the income statement and statement of financial position. Compare these two statements. 15 Activity 2 – Solution Purpose Income statement Measures the financial performance/result of a company’s operation. Time frame Covers a specified period. i.e. 1 year Major items Sales, Cost of sales, Gross profit, Operating expenses, Operating profit, Interest expenses, Income tax and Net profits after tax etc. Statement of financial position Measures the financial position of a company. i.e. shows the company’s assets, liabilities, and shareholders equity. At a given point in time. i.e. end of the year Non-current assets, Current assets, Non-current liabilities, Current liabilities, Share capital and Retained earnings etc. 16 The End 17 Basic Ratio Analysis Part 2 – Concept and General Function of Accounting Ratios 18 Financial Statements Analysis • Financial statement analysis is a study of the relationship between Income Statement and Statement of Financial Position. • Financial Statement Analysis – helps users to understand the financial performance and financial position of a business so as to make business decisions. 19 Four Aspects of Financial Statements Analysis Ability to meet short-term obligations and to efficiently generate revenues Ability to provide financial rewards sufficient to attract and retain source providers Liquidity and Efficiency Profitability Solvency Market Prospects Ability to generate future revenues and meet long-term obligations Ability to generate positive market expectations 20 Class Activity 1 – Class Discussion • Your uncle has then provided you with the income statement and statement of financial position of his business for the last two financial years (see next slide) for your viewing. • What can you find out from the information provided on the financial statements? 21 Class Activity 1 – Class Discussion ABC Ltd Income Statement For the year ended 31 December 20X5 $'000 1,850 (935) 915 Sales Cost of sales Gross profit Expenses Distribution Selling and marketing General and administrative Operating profit Interest expenses Profit before tax Income tax expenses Profit after tax (135) (182) (174) 424 (26) 398 (66) 332 20X4 $'000 1,560 (753) 807 (108) (161) (155) 383 (24) 359 (56) 303 ABC Ltd Statement of Financial Position As at 31 December 20X5 $'000 Non-current assets Equipments Current assets Inventories Trade receivables Cash and bank Current liabilities Trade payables Tax payable Total assets less current liabilities Financed by: Share capital Retained earnings Non-current liabilities Long-term loan 20X4 $'000 3,200 3,000 212 304 118 634 189 286 225 700 285 66 351 250 56 306 3,483 3,394 2,200 786 2,986 2,200 454 2,654 497 3,483 740 3,394 22 Purpose of Financial Statements Analysis Using Ratios What is ratios? • A ratio expresses the relationship between two numbers, e.g., a given ratio of A:B = 5:1 means A is 5 times B. • A ratio by itself may have no meaning. Therefore comparison is required. For example: – Compare the ratios of current year with last year. – Compare the ratios with other companies. – The use of ratios for financial analysis is a quantitative method to explain the financial performance and position of a company. 23 Purpose of Financial Statements Analysis Using Ratios • Ratios analysis is one of the popular ways to evaluate a company’s performance and financial position by using data from a company’s income statement, statement of financial position and certain market data. • It involves the expression of the reported numbers in relative terms rather than relying on the absolute numbers. • It can highlight the strengths and weaknesses of companies. 24 Comparative Analysis • Performance of a company cannot be determined by the amount presented on the financial statements alone. • The amount must be compared with other financial data to provide more relevant information for decision-making. • The following three types of comparisons can enhance decision making usefulness of financial information: – Intracompany comparison – Intercompany comparison – Industry averages comparison 25 Intracompany Comparison • Comparisons within a company are often useful for identifying changes in financial relationships and significant trends. • E.g. a comparison of a company’s current year’s cash amount with the prior year’s cash amount shows either an increase or a decrease in the company cash position. 26 Intercompany Comparison • Comparisons with other companies (e.g. competitors) provide an insight into a business’s competitive position. • Company can therefore make appropriate strategy in respond to its competitors. E.g. pricing strategy 27 Industry Averages Comparison • Comparisons with industry averages provide information about a business's relative position within the industry. • A business can understand its strengths and weaknesses in the industry. – E.g. compare the profit margin with the industry to see whether there is a good control on spending. 28 Class Activity 2 – Group Discussion • Divided into three groups which represent the 1. internal management; 2. lenders; 3. shareholders (investors) of a company and discuss how financial ratios can help each group to make business decisions. 29 Class Activity 2 – Solution Internal Uses of Financial Ratios: • Financial ratios are internally used by – management to • Identify deficiencies of the company and take immediate remedial action such as poor control on costs. • Understand and compare the financial performance of different divisions, e.g. which product lines are more profitable than the others within a company. – employee to • Ensure job security. • Assess the potential for a pay rise. 30 Class Activity 2 – Solution External Uses of Financial Ratios: Financial ratios are externally used by: • Lenders in deciding whether or not to provide loans to a company. • Investors (shareholders and debenture holders) in deciding whether or not to invest in a company e.g. buying the shares/debentures issued by the company. • Major suppliers in deciding to whether or not to provide credit to a company. 31 The End 32 Basic Ratio Analysis Part 3 – Calculation and Interpretation of Profitability Ratios (Gross Profit and Net Profit Margin) 33 Ratio Analysis • Key types of ratios: – Profitability ratios - to measure how profitable is its operating activities. – Liquidity ratios – to measure the ability of a business to meet its short-term debts. – Solvency ratios – to measure the ability of a business to meet its long-term debts. – Market Prospects (Investment) ratios – to measure the investment worthiness of the business. E.g. earnings per share or returns on investment. 34 Profitability Ratio • Measure the income or operating profit of an enterprise for a given period of time. The profitability of a company may affects: its ability to obtain debt and equity financing; its liquidity position; and its ability to grow. 35 Profitability Ratio • In the income statement, there are four levels of profit for analysis: – Gross profit – Net profit before interest and tax (or called operating profit) – Net profit before tax – Net profit after tax • Profitability ratio provides a comprehensive measure of a company’s profitability and enables comparison with its competitors and the industry average by using percentage. 36 Profitability Ratio Key Profitability Ratios •Gross Profit Ratio/Margin •Net Profit Ratio/Margin •Return on Capital Employed (ROCE) 37 Gross Profit Margin • Gross profit = Total sale revenue – COGS • The cost of goods sold is the cost of merchandise or the cost of services. • Gross profit margin shows the profitability of a company after considering its cost of sales and the ability to cover its operating expenses. • The formula: Gross profit margin Gross profit 100% Sales 38 Gross Profit Margin • The gross profit margin provides important information to management. • If it declines, the management may consider: – to increase selling price if possible – to reduce cost of sales e.g. find another supplier who can provide materials at lower cost. 39 Financial Statements of ABC Ltd ABC Ltd Income Statement For the year ended 31 December 20X5 $'000 1,850 (935) 915 Sales Cost of sales Gross profit Expenses Distribution Selling and marketing General and administrative Operating profit Interest expenses Profit before tax Income tax expenses Profit after tax (135) (182) (174) 424 (26) 398 (66) 332 20X4 $'000 1,560 (753) 807 (108) (161) (155) 383 (24) 359 (56) 303 ABC Ltd Statement of Financial Position As at 31 December 20X5 $'000 Non-current assets Equipments Current assets Inventories Trade receivables Cash and bank Current liabilities Trade payables Tax payable Total assets less current liabilities Financed by: Share capital Retained earnings Non-current liabilities Long-term loan 20X4 $'000 3,200 3,000 212 304 118 634 189 286 225 700 285 66 351 250 56 306 3,483 3,394 2,200 786 2,986 2,200 454 2,654 497 3,483 740 3,394 40 Activity 1 – Calculation of Gross Profit Margin • Given the following information, calculate and comment the gross profit margin for the years of 20X4 and 20X5. 20X4 20X5 Sales $100,000 $120,000 Cost of goods sold $54,000 $62,000 Gross profit ? ? Gross profit margin ? ? 41 Activity 1 – Solution 20X4 20X5 Sales $100,000 $120,000 Cost of goods sold $54,000 $62,000 Gross profit $46,000 $58,000 46% 48.3% Gross profit margin • Comment: The GP margin is better in 20X5 which indicates that there is a better control in purchase cost. 42 Net Profit Margin • Net profit = Total revenue – Total costs • This ratio shows a company’s ability to earn a net income from sales after deducting operating expenses. • This ratio serves as an overall measure of the company’s operating effectiveness. • The formula: Net profit before tax Net profit margin 100% Sales 43 Net Profit Margin • Management concerns net profit margin as it provides information about the ability of the company to manage costs and expenses and generate profits. • A lower net profit margin may indicate poor control on operating expense. 44 Financial Statements of ABC Ltd ABC Ltd Income Statement For the year ended 31 December 20X5 $'000 1,850 (935) 915 Sales Cost of sales Gross profit Expenses Distribution Selling and marketing General and administrative Operating profit Interest expenses Profit before tax Income tax expenses Profit after tax (135) (182) (174) 424 (26) 398 (66) 332 20X4 $'000 1,560 (753) 807 (108) (161) (155) 383 (24) 359 (56) 303 ABC Ltd Statement of Financial Position As at 31 December 20X5 $'000 Non-current assets Equipments Current assets Inventories Trade receivables Cash and bank Current liabilities Trade payables Tax payable Total assets less current liabilities Financed by: Share capital Retained earnings Non-current liabilities Long-term loan 20X4 $'000 3,200 3,000 212 304 118 634 189 286 225 700 285 66 351 250 56 306 3,483 3,394 2,200 786 2,986 2,200 454 2,654 497 3,483 740 3,394 45 Activity 2 – Calculation of Net Profit Margin • Given the following information, calculate and comment the net profit margin for the years of 20X4 and 20X5. 20X4 20X5 Sales $100,000 $120,000 Cost of goods sold $54,000 $62,000 Gross profit $46,000 $58,000 Operating expenses $33,000 $44,000 Net profit ? ? Net profit margin ? ? 46 Activity 2 – Solution 20X4 20X5 Sales $100,000 $120,000 Cost of goods sold $54,000 $62,000 Gross profit $46,000 $58,000 Operating expenses $33,000 $44,000 Net profit $13,000 $14,000 13% 11.7% Net profit margin • Comment: The NP margin has declined in 20X5 which indicates that the company’s control in operating expense is poorer, making the % increase in operating expense exceeded the % increase in GP margin. 47 The End 48 Basic Ratio Analysis Part 4 – Calculation and Interpretation of Profitability Ratios (Return on Capital Employed) 49 Class Activity 1 – Class Discussion How are gross profit margin and net profit margin different from each? 50 Activity 1 – Solution • Gross profit margin: a ratio that indicates the gross profit earned by a company as a percentage of its sales. The focus of it is to analyse the efficiency of using cost of merchandise/services to generate profits. • Net profit margin: a ratio that measures the net income of the firm as a percentage of sales. The focus of it is to analyse the overall control on operating expenses such as administrative, sales and marketing, and logistic expenses to generate profits. 51 Return on capital employed (ROCE) • Return = Net profit before interest and tax • It is a measure of the efficiency of the company in using its capital to generate profit. • Generally – the higher the ratio, the more effective the company is in using its capital • The Formula: Profit before interest and tax Return on capital employed 100% Average capital employed Capital employed = Sole proprietorships: capital account balance Partnerships: capital account balances + current account balances (if any) Limited companies: non-current liabilities + shareholders’ fund 52 Financial Statements of ABC Ltd ABC Ltd Income Statement For the year ended 31 December 20X5 $'000 1,850 (935) 915 Sales Cost of sales Gross profit Expenses Distribution Selling and marketing General and administrative Operating profit Interest expenses Profit before tax Income tax expenses Profit after tax (135) (182) (174) 424 (26) 398 (66) 332 20X4 $'000 1,560 (753) 807 (108) (161) (155) 383 (24) 359 (56) 303 ABC Ltd Statement of Financial Position As at 31 December 20X5 $'000 Non-current assets Equipments Current assets Inventories Trade receivables Cash and bank Current liabilities Trade payables Tax payable Total assets less current liabilities Financed by: Share capital Retained earnings Non-current liabilities Long-term loan 20X4 $'000 3,200 3,000 212 304 118 634 189 286 225 700 285 66 351 250 56 306 3,483 3,394 2,200 786 2,986 2,200 454 2,654 497 3,483 740 3,394 53 Can the Company Produce Adequate Profits from its Capital? • One of the most important issues that management of a company to consider is whether the company can provide adequate return to its resources providers/investors (i.e. shareholders) whose purpose of making investments is to earn profits. • The reason of using net profit before interest and tax in calculating ROCE is that such profit is the income generated from the company’s assets regardless of how the company’s funds come from. • If the company relies heavily on borrowing, the net profit before tax will be adversely affected because of high interest expense and hence affect the comparison with companies with different capital structure. 54 Class Activity 2 – Calculation of Profitability Ratios Refer to the financial statements of XYZ Ltd, calculate and comment its profitability ratios. XYZ Ltd Income Statement For the year ended 31 December 20X5 20X4 $'000 $'000 Sales 3,310 2,952 Cost of sales (1,840) (1,632) Gross profit 1,470 1,320 Expenses Distribution (288) (225) Selling and marketing (349) (293) General and (227) (187) administrative Operating profit 606 615 Interest expenses (105) (87) Profit before tax 501 528 Income tax expenses (92) (96) Profit after tax 409 432 XYZ Ltd Statement of Financial Position As at 31 December 20X5 $'000 Non-current assets Equipments 20X4 $'000 5,500 5,220 Current assets Inventories Trade receivables 331 504 292 463 Cash and bank 222 108 1,057 863 396 92 488 367 96 463 6,069 5,620 4,000 1,022 5,022 4,000 855 4,855 1,047 6,069 765 55 5,620 Current liabilities Trade payables Tax payable Total assets less current liabilities Financed by: Share capital Retained earnings Non-current liabilities Long-term loan Class Activity 2 – Calculation of Profitability Ratios Calculations The Gross Profit Margin for XYZ Ltd: 20X5: $1,470/$3,310 x 100% = 44.41% 20X4: $1,320/$2,952 x 100% = 44.72% The Net Profit Margin for XYZ Ltd: 20X5: $501/$3,310 x 100% = 15.14% 20X4: $528/$2,952 x 100% = 17.89% The Return on Capital Employed for XYZ Ltd: 20X5: $606/$6,069 x 100% = 9.99% 20X4: $615/$5,620 x 100% = 10.94% Comments The GP margin for the two years are more or less the same which indicates a consistency in pricing products and sourcing materials. The NP margin of 20X5 is lower than 20X4 by 2.75% which indicates a poorer control on operating expenses. The ROCE of 20X5 is lower than 2014 by 0.95% which indicates the company is less effectively in using its capital to generate returns. 56 Purposes of Using Profitability Ratios • The use of profitability ratios can help to evaluate historical performance of a company and to serve as the basis for making projections about and improving the future financial performance. • The analysis helps users to identify critical relationships between different items in income statement. • The use of ratios can provide a standardised financial information for users to make comparisons between companies with different sizes or within the same company at different times. 57 The End 58 Basic Ratio Analysis Part 5 – Working Capital and its Management 59 Working Capital • Working capital = the difference between current assets and current liabilities • It provides information to access whether the company has sufficient funds to settle its liabilities at the right time . Working capital = CA - CL 60 Activity 1 – Class Discussion • Companies should have a positive amount of working capital, i.e. current assets are greater than current liabilities. • What happens if there were a negative working capital (i.e. current assets < current liabilities)? 61 Activity 1 – Solution • The working capital compares the amount of current assets to the current liabilities, it helps to see if the company is able to settle the short-term obligations at the right time. • Therefore, the larger the working capital a company has, the more able it will be to pay its debt as it comes due. • A negative working capital may indicate the company is unable to pay its short-term debts and may raise the concern from its lenders. • The company may need to source additional fund for its operation e.g. by additional long-term borrowing 62 Activity 2 – Calculation of Working Capital Refer to the financial statements of XYZ Ltd, calculate its working capital for the two years. XYZ Ltd Income Statement For the year ended 31 December 20X5 20X4 $'000 $'000 Sales 3,310 2,952 Cost of sales (1,840) (1,632) Gross profit 1,470 1,320 Expenses Distribution (288) (225) Selling and marketing (349) (293) General and (227) (187) administrative Operating profit 606 615 Interest expenses (105) (87) Profit before tax 501 528 Income tax expenses (92) (96) Profit after tax 409 432 XYZ Ltd Statement of Financial Position As at 31 December 20X5 $'000 Non-current assets Equipments 20X4 $'000 5,500 5,220 Current assets Inventories Trade receivables 331 504 292 463 Cash and bank 222 108 1,057 863 396 92 488 367 96 463 6,069 5,620 4,000 1,022 5,022 4,000 855 4,855 1,047 6,069 765 63 5,620 Current liabilities Trade payables Tax payable Total assets less current liabilities Financed by: Share capital Retained earnings Non-current liabilities Long-term loan Activity 2 –Working Capital of XYZ Ltd 20X5 Working Capital 20X4 Working Capital = Current Assets – = $1,057 = $569 = = = – Current Assets – $863 – $400 Current Liabilities $488 Current Liabilities $463 64 Changes in Working Capital • Increase in total working capital is caused by any transactions that: – ↑ total current assets by more than the ↑ in total current liabilities – ↓ total current assets by less than the ↓ in total current liabilities 65 Changes in Working Capital • Reasons for an increase in total working capital: – Issue of new shares for cash. (cash ↑ and share capital↑, working capital ↑) – Acquire new long-term loan or issue of bonds. (cash ↑ and non-current liabilities↑, working capital ↑) – Sale of non-current asset (cash ↑ and non-current asset ↓, working capital ↑)(Purchase of non-current asset → working capital ↓). – Increase in trading profit – selling goods/services at a profit brings cash into the business. (cash ↑ and retained earnings ↑, working capital ↑) 66 Changes in Working Capital • Total working capital will not change when: – Buy goods on credit - inventory ↑ (current asset) and trade payable ↑ (current liability) by the same amount. – Goods sold at cost on credit - inventory ↓ and trade receivable ↑ by the same amount. – Payment to suppliers - trade payables ↓ and cash ↓ by the same amount. – Payment from customers - trade receivables ↓ and cash ↑ by the same amount. 67 Discussion Question Which of the following would lead to an immediate increase in cash inflow for a particular period? A. B. C. D. Sale of goods on credit. Sale of a non-current asset at loss. Payment of dividend to shareholders. Settlement to suppliers. 68 Working Capital Management • Working capital management is the emphasis in managing all aspects of both the current assets and the current liabilities in order to minimize the risk of insolvency while maximizing the return on assets. • Its objective is to maintain the optimum balance of each of the working capital components. 69 Working Capital Management • A good working capital management can help a company to consider the following: • • • • What types and amounts of current assets should it hold? What types and amounts of short-term financing should it employ? How does it ensure there is sufficient cash to meet on-going obligations? How does it forecast its cash needs? 70 The Relationship of Working Capital Management and Business Solvency • A major responsibility of the financial manager is to ensure that adequate flow of cash is available for the business to operate efficiently. • E.g. some payments can be delayed without endangering the company’s financial position, but others must be paid on time such as the repayment of loan. If the company does not have sufficient cash settle the ‘must pay’ amount on time, it will have the risk of liquidation when it is sued by the creditors. 71 Working Capital Policies Working Capital Policy Levels of Current Assets How Current Assets are Financed Current Ratio Trade-off Between Profitability and Risk Conservative High With Longterm Debt and Equity Higher than Industry Average Lower Profits / Lower Risk Aggressive Low With Shortterm Debt Lower than Industry Average Higher Profits / Higher Risk 72 Class Activity 3 – Group Discussion • How a conservative working capital policy lowers profitability and risk? 73 Class Activity 3 – Solution Characteristics of a Conservative Working Capital Policy Higher Level of Cash Higher Level of Accounts Receivable Reduce Greater cost of investment financing and opportunity possibly more write-offs Reduce risk Won’t miss a because cash is potentially readily profitable sale available Higher Level of Inventory Less Short-term Debt /Greater Long-term Liabilities Higher Interest expenses are carrying costs higher for long-term and higher debt obsolescence Fewer stock- Less short-term debt outs payments to meet Impact Lower Return Less Risk 74 The End 75 Basic Ratio Analysis Part 6 –Liquidity Position and Liquidity Problems 76 Liquidity • Liquidity is defined as the ability to pay debts when they come due. • The optimum level of liquidity for a business varies from industry to industry. • Short-term creditors such as bankers and suppliers concern about the liquidity of a company as it may affect their decision to provide funds/credit. 77 How Liquid Is the Company? Liquidity is measured by two approaches: • Comparing the company’s current assets and current liabilities. • Examining the company’s ability to convert accounts receivables and inventory into cash on a timely basis. 78 Liquid Assets • The information from financial statements can provide an understanding of the liquid asset of the company and its liquidity. • A liquid asset is one that can be converted quickly into cash at the market price. E.g. trade receivable. This provides information about how liquid is the company. A company holding too many inventories may indicate a relatively low liquidity than a company holding more cash. 79 Class Activity 1 – Class Discussion Can you give some other examples of liquid assets? 80 Class Activity 1 – Solution • Cash • Marketable securities e.g. investment in stocks 81 Risks Associated with Cash Flows & Liquidity • Cash receipts will be lower than expected or cash payments will be higher than expected. • The company will face a cash shortage if it is unable to borrow the money it needs or unable to raise more cash by selling off its assets in due course. • The interest earned from bank deposit turns out to be much lower than the borrowing cost to settle immediate debts when the company is facing a cash shortage. 82 Activity 2 – Group Discussion • How can we know if a company has a liquidity problem? 83 Activity 2 – Signs of Liquidity Problems • Decline in daily or weekly cash inflows. • Decline in operating profit which indicates the company is unable to pass the cost on to customers. • Unexpected build-up of accounts receivable or inventory which indicates the company may not be able to collect money from customers or is unable to sell goods. • Unexpected build-up of accounts payable indicates the company is unable to pay to its suppliers. • Decline in company’s working capital. 84 How to Cope with Liquidity Problems • A company might consider the following methods to cope with the liquidity problems: • Offering an early settlement discount to its customers. This is a reduction in the amount of the payment required from the customer provided that the customer pays within a specified time limit. • Keep less inventory – e.g. applying Just-in-time inventory system to reduce the carrying cost and increase the cash balance. • When there is no harm to the relationship with suppliers, defer payment to suppliers as possible as it can. The End 86 Basic Ratio Analysis Part 7 – Calculation and Interpretation of Liquidity Ratio (Current Ratio and Acid-test Ratio) 87 Liquidity Ratios • The calculation of liquidity ratios can show the company’s ability to convert its assets into cash for settlement of its the short-term liabilities within short period of time. • Even a profitable company can fail because of cash flow problems other than any other reason. 88 Measuring Liquidity: Compare a company’s current assets with its current liabilities using: Current Ratio Acid-test Ratio 89 Current Ratio • It represents the proportion of current assets to current liabilities. • It is used to assess the ability of a business to pay its short-term debts when they fall due, and gives an indication of the margin of safety to meet the fluctuations which may arise from time to time in the flow of funds. • The formula: Current assets Current ratio Current liabilities 90 Current Ratio • It compares a company’s current assets to its current liabilities. – A current ratio of 2:1 means the company has sufficient liquidity to cover its short-term liabilities twice over. – A current ratio of 0.8:1 would suggest that the company is unable to meet its short-term liabilities and could be in a weak financial position. • A ratio below 1 does not mean the company will be bankrupt but of a higher risk of being bankrupt. 91 Current Ratio – Too High/Too Low • If the ratio is too high (e.g. 5:1), the company may be holding too many idle short-term assets. (e.g. cash that earns little or no interest income). • If the ratio is too low (e.g. 0.5:1), it may indicate that the company may not be able to meet its debts when they fall due and face liquidity problems. 92 Financial Statements of ABC Ltd ABC Ltd Income Statement For the year ended 31 December 20X5 $'000 1,850 (935) 915 Sales Cost of sales Gross profit Expenses Distribution Selling and marketing General and administrative Operating profit Interest expenses Profit before tax Income tax expenses Profit after tax (135) (182) (174) 424 (26) 398 (66) 332 20X4 $'000 1,560 (753) 807 (108) (161) (155) 383 (24) 359 (56) 303 ABC Ltd Statement of Financial Position As at 31 December 20X5 $'000 Non-current assets Equipments Current assets Inventories Trade receivables Cash and bank Current liabilities Trade payables Tax payable Total assets less current liabilities Financed by: Share capital Retained earnings Non-current liabilities Long-term loan 20X4 $'000 3,200 3,000 212 304 118 634 189 286 225 700 285 66 351 250 56 306 3,483 3,394 2,200 786 2,986 2,200 454 2,654 497 3,483 740 3,394 93 Activity 1 – Calculation of Current Ratio • Given the following information, calculate and comment the current ratio for the years of 20X4 and 20X5. 20X4 20X5 Inventory $163,000 $116,000 Accounts receivable $146,000 $162,000 Cash and bank $23,000 $44,000 Accounts payable $155,000 $171,000 94 Activity 1 – Solution 20X4 20X5 Current Ratio ($163,000 + $146,000 +$ 23,000) ($116,000 + $162,000 +$44,000) / $155,000 = 2.14 / $171,000 = 1.88 • Comment: The current ratio has declined in 20X5 which means it is less liquid than 20X4. However, it is still satisfactory as the ratio is higher than 1 which means it has sufficient current assets to cover its current liabilities. 95 Limitation of Using Current Ratio • Disadvantage of using current ratio – Misleading i.e. a high current ratio is not necessarily good. • When using current ratio, it is assumed that the accounts receivable will be collected on a timely basis and the inventories can be sold without any delay. • If the inventory by its nature is less liquid than its accounts receivable, i.e. it takes more time to sell than to receive cash from customers, the liquidity of the company will be decreased. • Therefore, a more stringent measure of liquidity may help to assess the liquidity of the company. 96 Acid Test/Quick/Liquid Ratio • Acid test ratio (or quick/liquid ratio) is a more conservative measure than the current ratio in measuring a company’s liquidity. The numerator consists of the most liquid current assets only. • In businesses with a slow inventory turnover, it is probably inappropriate to regard inventory as a ‘quick asset’ that will soon be converted into cash. • Quick assets are those can be converted into cash quickly. They consist of all the current assets except “INVENTORY”. 97 Acid Test/Quick/Liquid Ratio • The Acid Test Ratio indicates whether a company can meet its shortterm liabilities without having to dispose of its inventory. • The formula: Acid test ratio Current assets less inventory Current liabilitie s • Comparing the Current ratio and the Acid Test ratio therefore gives an indication of the relative size of the inventory holdings of a company. 98 Acid Test/Quick/Liquid Ratio – Too High/Too Low • If the ratio is too high, the company may be holding excessive liquid assets. • If the ratio is too low, it is probable that the company cannot settle it short-term debts and at a risk of liquidity problem. 99 Financial Statements of ABC Ltd ABC Ltd Income Statement For the year ended 31 December 20X5 $'000 1,850 (935) 915 Sales Cost of sales Gross profit Expenses Distribution Selling and marketing General and administrative Operating profit Interest expenses Profit before tax Income tax expenses Profit after tax (135) (182) (174) 424 (26) 398 (66) 332 20X4 $'000 1,560 (753) 807 (108) (161) (155) 383 (24) 359 (56) 303 ABC Ltd Statement of Financial Position As at 31 December 20X5 $'000 Non-current assets Equipments Current assets Inventories Trade receivables Cash and bank Current liabilities Trade payables Tax payable Total assets less current liabilities Financed by: Share capital Retained earnings Non-current liabilities Long-term loan 20X4 $'000 3,200 3,000 212 304 118 634 189 286 225 700 285 66 351 250 56 306 3,483 3,394 2,200 786 2,986 2,200 454 2,654 497 3,483 740 3,394 100 Activity 2 – Calculation of Acid Test Ratio • Given the following information, calculate the acid test ratio for the year of 20X4 and 20X5 and comment the ratios by comparing with the current ratio calculated in activity 1. 20X4 20X5 Inventory $163,000 $116,000 Accounts receivable $146,000 $162,000 Cash and bank $23,000 $44,000 Accounts payable $155,000 $171,000 101 Activity 2 – Solution 20X4 20X5 Current Ratio ($163,000 + $146,000 +$ 23,000) ($116,000 + $162,000 +$44,000) / $155,000 = 2.14 / $171,000 = 1.88 Acid Test Ratio ($146,000 +$ 23,000) / $155,000 ($162,000 +$44,000) / $171,000 = 1.09 = 1.20 • Comment: The current ratio suggests that 20X4 is more liquid while the acid test ratio indicates the contrast. The difference must come from the amount of inventories relative to its respective current liabilities of the two years . i.e. higher current ratio for 20X4 indicates that it has relatively more inventory than current liabilities then that in 20X5. • However, it is still satisfactory as the acid-test ratio is higher than 1, which means other than inventories, the company has sufficient current assets to 102 cover its current liabilities. Acid Test/Quick/Liquid Ratio • Advantages of using acid test ratio – A more conservative measure of liquidity than current ratio which the ratio focuses on the more-liquid assets of a company. – Can compare with the current ratio and see whether the company’s current assets are dependent on inventory or not. • Disadvantage of using acid test ratio – Same as the use of current ratio, misleading information can be provided i.e. a high acid test ratio is not necessarily good as the company may be holding too many idle short-term assets. 103 The End 104 Basic Ratio Analysis Part 8 – Evaluation on the Liquidity and Profitability of a Business Using Accounting Ratios and Its Limitation 105 How to Evaluate a Business? • Recall in Part 1 of the lesson, your uncle who is carrying a trade business knows you are studying business, accounting, and financial studies and asks if you could provide him with some ideas on the financial performance and position of his business. • After having learnt some basic ratios in the previous lessons, can you give him some advise now? 106 Can you give your uncle some advise? • Yes! • By the use of accounting ratios, we can evaluate the financial performance and financial position of a business so as to make a better business decision. Now, try to calculate the profitability and liquidity ratios for your uncle’s business, OPQ Limited, for the year 20X4 and 20X5 and provide basic analysis for the changes of ratios. 107 Evaluation of a Company Using Accounting Ratios Evaluate the financial performance and financial position of OPQ Ltd by using accounting ratios. OPQ Ltd Income Statement For the year ended 31 December 20X5 $'000 3,882 (2,323) 1,559 Sales Cost of sales Gross profit Expenses Distribution Selling and marketing General and administrative Operating profit Interest expenses Profit before tax Income tax expenses Profit after tax (382) (336) (224) 617 (102) 515 (85) 430 20X4 $'000 3,323 (1,905) 1,418 (371) (302) (216) 529 (101) 428 (72) 356 OPQ Ltd Statement of Financial Position As at 31 December 20X5 $'000 Non-current assets Equipments Current assets Inventories Trade receivables Cash and bank Current liabilities Trade payables Tax payable Total assets less current liabilities Financed by: Share capital Retained earnings Non-current liabilities Long-term loan 20X4 $'000 7,050 6,624 386 716 83 1,185 412 323 428 1,163 367 85 452 311 72 383 7,783 7,404 3,800 1,403 5,203 3,800 1,024 4,824 2,580 7,783 2,580 7,404 108 Evaluation of a Company Using Accounting Ratios Calculations The Gross Profit Margin for OPQ Ltd: 20X5: $1,559/$3,882 x 100% = 40.16% 20X4: $1,418/$3,323 x 100% = 42.67% The Net Profit Margin for OPQ Ltd: 20X5: $515/$3,882 x 100% = 13.27% 20X4: $428/$3,323 x 100% = 12.88% The Return on Capital Employed for OPQ Ltd: 20X5: $617/$7,783 x 100% = 7.93% 20X4: $529/$7,404 x 100% = 7.14% Comments The GP margin of 20X5 is lower than 20X4 by 2.51% which indicates a poorer control on purchase cost or reduction in pricing products to stimulate sales. The NP margin of 20X5 is slightly higher than 20X4 by 0.39% which indicates a better control of operating expenses. The ROCE of 20X5 is higher than 2014 by 0.79% which indicates the company is more effectively in using its capital to generate returns. 109 Evaluation of a Company Using Accounting Ratios Calculations The current ratio for OPQ Ltd: 20X5: $1,185/$452= 2.62 times 20X4: $1,163/$383 = 3.04 times Comments The current ratio for 20X5 is lower than 20X4 which indicates the ability to settle short-term debts is declined. It is still at an acceptable level (i.e. 2.62 times) but cash balance reduced significantly and the trade receivables are increased by 2.2 times may indicate a problem of bad debts. The acid test ratio for OPQLtd: The acid test ratio for 20X5 is lower than 20X5: ($1,185 - $386)/$452 = 1.76 times 20X4 but still at an acceptable level (i.e. 20X4: ($1,163 - $412)/$383 = 1.96 times 1.76 times) which indicates the ability of a company to meet its liabilities without having to dispose of its inventory is fine. 110 Activity 1 – Case Study Your uncle’s business is the supplier of DEF Ltd. Your uncle is now considering whether it is appropriate to sell goods to DEF Ltd on credit or COD (Cash on Delivery). (Demanding COD might cause DEF Ltd buy less from your uncle’s company.) Use accounting ratios to help your uncle to make decision. DEF Ltd Income Statement For the year ended 31 December 20X5 $'000 Sales 5,220 Cost of sales (3,380) Gross profit 1,840 Expenses 20X4 $'000 5,530 (3,410) 2,120 DEF Ltd Statement of Financial Position As at 31 December 20X5 $'000 Non-current assets Equipments 8,250 7,273 Current assets Distribution (522) (482) Inventories 338 284 Selling and marketing (414) (398) Trade receivables 536 406 General and administrative (331) (303) Cash and bank 34 128 573 (108) 465 (65) 400 937 (66) 871 (42) 829 908 818 782 65 847 434 42 476 8,311 7,615 5,500 1,688 7,188 5,500 1,288 6,788 1,123 8,311 827 7,615 Operating profit Interest expenses Profit before tax Income tax expenses Profit after tax Current liabilities Trade payables Tax payable Total assets less current liabilities Financed by: Share capital Retained earnings 111 20X4 $'000 Non-current liabilities Long-term loan Activity 1 – Solution 20X5 Ratio Calculation Result Gross Profit Margin $1,840 / $5,220 35.25% Net Profit Margin $465 / $5,220 8.91% ROCE $573 / $8,311 6.89% Current Ratio $908 / $847 1.07 Acid Test Ratio ($908 - $338) / $847 0.67 20X4 Ratio Calculation Result Gross Profit Margin $2,120 / $5,530 38.34% Net Profit Margin $871 / $5,530 15.75% ROCE $937 / $7,615 12.3% Current Ratio $818 / $476 1.72 Acid Test Ratio ($818 - $284) / $476 1.12 112 Activity 1 – Solution Ratio Gross Profit Margin Net Profit Margin Comments The GP margin of 20X5 is lower than 20X4 by 3.09% which indicates there may be keen competition on selling price or poor control on purchase cost. The NP margin of 20X5 is significantly dropped by 6.84% compared with 20X4. One of the reasons is the decline in sales. Besides, there seems a poorer control of operating expenses. ROCE The ROCE of 20X5 is significantly dropped by 5.41% compared with 20X4 which indicates the company is less effectively in using its capital assets to generate returns. Current Ratio The current ratio for 20X5 is lower than 20X4 which indicates the ability to settle short-term debts is worsen. Acid Test Ratio The acid test ratio for 20X5 is significantly dropped and below 1 which indicates the ability of a company to meet its liabilities without having to dispose of its inventory is deteriorated and there is a risk of insolvency. 113 Activity 1 – Solution • Suggested solution for your uncle: • While DEF Ltd’s ratios appear to be deteriorating, its profitability and liquidity ratios are low. It is suggested not to arrange credit to the DEF Ltd under its current situation as there is a risk that DEF Ltd is not able to settle the invoices. • Terms of COD might be hard and might push DEF Ltd into liquidity problem but it is safe for supplier to avoid the risk of bad debt. • Unless DEF Ltd can improve its profitability and especially liquidity ratios, e.g. by tightening its cost and infusion of equity capital into the company, it is suggested not to provide credit but ask for COD. 114 What other factors will you consider? • Despite the use of accounting ratios to make decision, there are some other factors that may affect business decision. • Examples: • Is your uncle’s revenues tied to one or few key customers (i.e. is DEF Ltd the major customer of your uncle’s business)? If so, the income will be declined significantly if the relationship with DEF Ltd is broken. • Is the legal and regulatory environment favourable to the DEF Ltd? If so, it will enhance the future financial performance and position of the business. 115 The Limitations of Accounting Ratio Analysis • The financial performance of a company may be affected by external environmental factors which beyond their control. E.g. economic downturn will lead to poor performance of the company. • It is sometimes difficult to identify other companies for comparison as there may not be any company running the same business as one another. • Financial statements use historic information. i.e. does not meant the trend will continue. • Accounting practices differ widely among companies. E.g. the inventory valuation or depreciation methods used may make the comparison distorted. • A high or low ratio does not automatically lead to a specific conclusion. Other factors (as discussed in previous slide) should also be considered. • Financial statements cover the financial information for one year and seasonal factors may not be reflected therein. 116 The End 117