3.6 Ratio Analysis

Topic 3– 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 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

Stock Turnover Ratio

Sales Revenue

Cost of Goods Sold

Current Assets

Current Liabilities

Stocks(Inventory)

AccountsRecvble

Net Profit

Gross Profit

ABC, Inc. 125 25

XYZ Corp.

2400 600

Cost of Goods Sold / Value of Stock (average for the year)

ABC Inc: 125/25 = 5

XYZ Corp: 2400/600 = 4

Which purchased inventory more frequently throughout the year?

ABC bought inventory 5 times XYZ bought inventory 4 times

Purpose: How many times do we buy our inventory in a year?

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)

AccountsRecvble

Net Profit

Gross Profit

ABC, Inc. 250 75

XYZ Corp.

3200 600

Accounts Receivable / Sales Turnover (Sales)

ABC Inc: (75/250) X 365 = 109.5 days

XYZ Corp: (600/3200) X 365 = 68.62 days

Which company takes the longest time to receive money from customers?

What does this do to cash flow?

Purpose: How many days does it take for our customers to pay us?

Can also be calculated using only credit sales – eliminating cash sales – since cash sales will never lead to debtors.

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

AccountsPayable

Stocks(Inventory)

AccountsRecvble

Net Profit

Gross Profit

ABC, Inc. 100 20

XYZ Corp.

1125 250

Accounts Payable / Credit Purchases

ABC Inc: (20/100) X 365 = 73 days

XYZ Corp: (250/1125) X 365 = 81.395 daysWhich company takes the longest time to pay their vendors?

What does this do to cash flow?

Purpose: How many days does it take for us to pay our suppliers?

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 ProfitAfter Tax

Gross Profit

ABC, Inc. 21 140 .15 1.50 50

XYZ Corp.

140 200 .70 10.00 500

(Dividend Per Share / Current Share Price) X 100 (Market Share Price)

ABC Inc: .15/1.50 X 100 = 10%

XYZ Corp: .70/10.00 X 100 = 7% Which company produces more return per share?

Purpose: How much is my return on the investment at the current 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 ProfitAfter Tax

Gross Profit

ABC, Inc. 21 140 .15 1.50 50

XYZ Corp.

140 200 .70 10.00 500

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?

Purpose: How much is each share earning?

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 RatioSales Revenue

Cost ofGoods Sold

Current Assets

Current Liabilities

Long TermLoans

*CapitalEmployed

Net Profit

Gross Profit

ABC, Inc. 40 400

XYZ Corp.

2000 5000

Long-Term Loans / Capital Employed X 100

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?

Purpose: How much is the company relying on long-term loans vs other capital?

*capital employed = non-current liabilities + shareholders equity

A rate above 50% indicates a “highly” geared company.

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.