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Accounting & Financial
Analysis 111
Lecture 8
Ratio Analysis, Break-even pointRatio Analysis, Break-even point
Ratio analysisRatio analysis
Ratio analysis provides the manager with the tools necessary to analyse the performance of the business.
The business can then compare its current performance with its past performance to establish whether it is doing better or worse than previous years.
It can also compare its performance with that of similar types of business by extracting the relevant ratios from business statistical publications.
Ratio analysis provides the manager with the tools necessary to analyse the performance of the business.
The business can then compare its current performance with its past performance to establish whether it is doing better or worse than previous years.
It can also compare its performance with that of similar types of business by extracting the relevant ratios from business statistical publications.
Ratio analysis 2Ratio analysis 2
Ratios are use to measure different aspects of the business namely: The trading performance - (P & L) The trading performance in relation to
assets, liabilities and shareholder's equity - (P & L / BS)
An analysis of the company's worth - (BS)
Ratios are use to measure different aspects of the business namely: The trading performance - (P & L) The trading performance in relation to
assets, liabilities and shareholder's equity - (P & L / BS)
An analysis of the company's worth - (BS)
Ratio analysis 3Ratio analysis 3
Ratios are viewed under the following headings:
1) Profitability 2) Activity 3) Liquidity 4) Leverage 5) Valuation
Ratios are viewed under the following headings:
1) Profitability 2) Activity 3) Liquidity 4) Leverage 5) Valuation
Ratio analysis e.g.Ratio analysis e.g.
In your notes are the Profit & Loss and Balance Sheet of Pizza Delight Ltd for the years 2003 & 2004.
We will use these figures in the ratios that follow.
In your notes are the Profit & Loss and Balance Sheet of Pizza Delight Ltd for the years 2003 & 2004.
We will use these figures in the ratios that follow.
Measuring ProfitabilityMeasuring Profitability
The ratios used to measure profitability are usually:
1. Gross profit margin % 2. Net profit margin % 3. Return on total assets % 4. Return on shareholder's funds %
5. Return per employee $
The ratios used to measure profitability are usually:
1. Gross profit margin % 2. Net profit margin % 3. Return on total assets % 4. Return on shareholder's funds %
5. Return per employee $
Gross profit margin Gross profit margin
= Gross profit * 100 Sales
$880,000 * 100 = 40% $2,200,000
= Gross profit * 100 Sales
$880,000 * 100 = 40% $2,200,000
Net profit margin Net profit margin
= Net profit * 100 Sales
$218,500 * 100 = 6.95% $2,200,000
= Net profit * 100 Sales
$218,500 * 100 = 6.95% $2,200,000
Return on net assetsReturn on net assets
= Net profit after tax * 100 Total assets - current liabilities
$152,950 . * 100 = 14.37% $1,064,300
= Net profit after tax * 100 Total assets - current liabilities
$152,950 . * 100 = 14.37% $1,064,300
Return on shareholder's funds Return on shareholder's funds
= Net profit after tax *100
Shareholder's equity
= $152,950 * 100 = 36.92%
$414,300
= Net profit after tax *100
Shareholder's equity
= $152,950 * 100 = 36.92%
$414,300
Return per employeeReturn per employee
Net profit after tax Number of employees
$152,950 = $7,648
20
Net profit after tax Number of employees
$152,950 = $7,648
20
Measuring ActivityMeasuring Activity
The ratios used to measure activity are:
1. Average inventory 2. Stock turnover 3. Average accounts receivable
turnover 4. Average daily credit sales 5. Average collection period 6. Asset / employee ratio
The ratios used to measure activity are:
1. Average inventory 2. Stock turnover 3. Average accounts receivable
turnover 4. Average daily credit sales 5. Average collection period 6. Asset / employee ratio
Average inventoryAverage inventory
Opening stock + closinq stock
2
$32,000+$29,000 = $30,500
2
Opening stock + closinq stock
2
$32,000+$29,000 = $30,500
2
Stock turnover Stock turnover
Cost of qoods sold
Average inventory
= $1,320,000 = 43.28 times $30,500
Cost of qoods sold
Average inventory
= $1,320,000 = 43.28 times $30,500
Average accounts receivable turnover
Average accounts receivable turnover
Annual Credit sales
Accounts receivable
= $2,200,000 = 28 times $78,200
Annual Credit sales
Accounts receivable
= $2,200,000 = 28 times $78,200
Average daily credit salesAverage daily credit sales
Annual credit sales
Number of working days
=$2,200,000 = $6,027 365
Annual credit sales
Number of working days
=$2,200,000 = $6,027 365
Average collection periodAverage collection period
Accounts receivable
Average daily credit sales
= $78,200= 13 days $6,027
Accounts receivable
Average daily credit sales
= $78,200= 13 days $6,027
Asset/ Employee ratioAsset/ Employee ratio
Total assets
Number of employees
= $1,182,650 = $59,133
20
Total assets
Number of employees
= $1,182,650 = $59,133
20
Measuring LiquidityMeasuring Liquidity
Liquidity ratios are a means of calculating the working capital available to meet the short term debts of the company.
It is an expression of how cash liquid the company is.
The higher the number the stronger the company position.
Liquidity ratios are a means of calculating the working capital available to meet the short term debts of the company.
It is an expression of how cash liquid the company is.
The higher the number the stronger the company position.
Current ratio Current ratio
Current assets
Current liabilities
$345,000 = 2.92 times $118,350
Current assets
Current liabilities
$345,000 = 2.92 times $118,350
Quick ratioQuick ratio
Current assets - inventory Current liabilities- bank overdraft
$316,000 = 2.67 times $118,350
Current assets - inventory Current liabilities- bank overdraft
$316,000 = 2.67 times $118,350
Measuring leverage - gearingMeasuring leverage - gearing
Debt to equity (Gearing)Debt to equity (Gearing)
Long-term debts
Shareholder's equity
= $650,000 = 1.57 times $414,300
Debt to equity (Gearing)Debt to equity (Gearing)
Long-term debts
Shareholder's equity
= $650,000 = 1.57 times $414,300
Total debt to total assets Total debt to total assets
Total debt
Total assets
= $768,350 = 0.65 times $1,182,650
Total debt
Total assets
= $768,350 = 0.65 times $1,182,650
Interest coverage Interest coverage
Profit before Interest** & Tax
Interest
= $218,500 + $68,000=4.21 times
$68,000
** Shown as “Finance Costs” in P&L
Profit before Interest** & Tax
Interest
= $218,500 + $68,000=4.21 times
$68,000
** Shown as “Finance Costs” in P&L
Fixed charge coverage Fixed charge coverage
PBIT* + Lease payments
Interest + lease payments
$286,500 + $130,000
$68,000 + $130,000 = 2.1 times
* Profit Before Interest & Tax
PBIT* + Lease payments
Interest + lease payments
$286,500 + $130,000
$68,000 + $130,000 = 2.1 times
* Profit Before Interest & Tax
Measuring valuation Measuring valuation
Earnings per shareEarnings per share
Profit after tax
No. of Ordinary shares issued
= $152,950 = $0.76 p.s.
200,000
Earnings per shareEarnings per share
Profit after tax
No. of Ordinary shares issued
= $152,950 = $0.76 p.s.
200,000
Dividend per shareDividend per share
Ordinary dividends paid
No. of Ordinary shares issued
= $50,000 = $0.25 p.s. 200,000
Ordinary dividends paid
No. of Ordinary shares issued
= $50,000 = $0.25 p.s. 200,000
Earnings yield % per share Earnings yield % per share
Earnings per share * 100
Market price per share
=$0.76 * 100 = 18.09% $4.20
Earnings per share * 100
Market price per share
=$0.76 * 100 = 18.09% $4.20
Dividend yield % per share Dividend yield % per share
Annual dividend paid per share * 100
Market price per share
$0.25 * 100 = 5.95%
$4.20
Annual dividend paid per share * 100
Market price per share
$0.25 * 100 = 5.95%
$4.20
Price / earnings ratioPrice / earnings ratio
Market price per share Earnings per share
= $4.20 = 5.5 times $0.76
Market price per share Earnings per share
= $4.20 = 5.5 times $0.76
Break-even PointBreak-even Point
Selling price - Variable costs = Contribution marginContribution margin
Contribution margin - Fixed costs = ProfitProfit
Selling price - Variable costs = Contribution marginContribution margin
Contribution margin - Fixed costs = ProfitProfit
Selling priceSelling price
is the price per unit sold. Total number of units sold * selling
price per unit = Total revenueTotal revenue
E.G. sale of 15,000 meals *$25 per meal =$375,000 revenue
is the price per unit sold. Total number of units sold * selling
price per unit = Total revenueTotal revenue
E.G. sale of 15,000 meals *$25 per meal =$375,000 revenue
Variable costsVariable costs
are costs that increase/decrease according to the level of activity. (Sales, production)
They relate to PER UNIT COST E.G. If each meal cost $9 to purchase the
ingredients. The cost of the meals will change depending on
the number of meals produced. 10,000 =$90,000 and 15,000 = $135,000.
If the kitchen staff are paid by the number of meals produced and sold, their wages would be variable costs otherwise they are fixed costs.
are costs that increase/decrease according to the level of activity. (Sales, production)
They relate to PER UNIT COST E.G. If each meal cost $9 to purchase the
ingredients. The cost of the meals will change depending on
the number of meals produced. 10,000 =$90,000 and 15,000 = $135,000.
If the kitchen staff are paid by the number of meals produced and sold, their wages would be variable costs otherwise they are fixed costs.
Semi-variable costsSemi-variable costs
are costs that change slightly as the level of production increases but not in proportion to the increase in production.
A semi-variable cost has an element of fixed costs in it. E.G. Telephone account has a fixed service charge, only the call
charge increases as the calls increase. Electricity/gas charges in a kitchen will not change too much as
the number of meals increase. Semi-variable costs are not normally classified within
small to medium sized industry. It is only the very large corporations that may apply
semi-variable costs in management applications. Most companies consider semi variable costs as part of the fixed costs.
are costs that change slightly as the level of production increases but not in proportion to the increase in production.
A semi-variable cost has an element of fixed costs in it. E.G. Telephone account has a fixed service charge, only the call
charge increases as the calls increase. Electricity/gas charges in a kitchen will not change too much as
the number of meals increase. Semi-variable costs are not normally classified within
small to medium sized industry. It is only the very large corporations that may apply
semi-variable costs in management applications. Most companies consider semi variable costs as part of the fixed costs.
Fixed costsFixed costs
are costs that remain the same irrespective of the level of sales or production.
E.g. Occupancy costs - (Rent, rates, electricity, telephone, insurance), long-term finance costs, Depreciation, Administration costs, Marketing costs.
are costs that remain the same irrespective of the level of sales or production.
E.g. Occupancy costs - (Rent, rates, electricity, telephone, insurance), long-term finance costs, Depreciation, Administration costs, Marketing costs.
Break-even pointBreak-even point
It is in the interest of every business to calculate the amount of sales required at a given profit margin that will equal the fixed costs.
That number of sales is the break-even point for the business.
If the business cannot finance its fixed costs within a short time of commencement and has no alternate funding its chances of success are limited.
It is in the interest of every business to calculate the amount of sales required at a given profit margin that will equal the fixed costs.
That number of sales is the break-even point for the business.
If the business cannot finance its fixed costs within a short time of commencement and has no alternate funding its chances of success are limited.
Break-even point 2Break-even point 2
The break-even point is influenced by three components.
An adjustment to any of the components will change the break-even number.
1. Change in the selling price per unit
2. Change in variable costs
3. Change in fixed costs
The break-even point is influenced by three components.
An adjustment to any of the components will change the break-even number.
1. Change in the selling price per unit
2. Change in variable costs
3. Change in fixed costs
Break-even point e.g.Break-even point e.g.
A manufacturing company producing one product has the following data:
Sale price $52 Variable costs $31 Fixed costs $325,500 Before the company starts to make any
profit it must produce enough contribution equal to the fixed costs ($325,000).
Therefore it must sell 15,500 units.
A manufacturing company producing one product has the following data:
Sale price $52 Variable costs $31 Fixed costs $325,500 Before the company starts to make any
profit it must produce enough contribution equal to the fixed costs ($325,000).
Therefore it must sell 15,500 units.
Break-even point e.g. ctd.Break-even point e.g. ctd.
$52 - $31 = $21 contribution $325,500 / $21 = 15,500 units
At this stage the company has not made any profits it has only made sufficient contribution to cover its costs.
Every unit sold in excess of 15,500 will produce a profit of $21.
Therefore if the company sells 18,000 units it should make a profit of $52,500. (18,000 - 15,500) * $21
$52 - $31 = $21 contribution $325,500 / $21 = 15,500 units
At this stage the company has not made any profits it has only made sufficient contribution to cover its costs.
Every unit sold in excess of 15,500 will produce a profit of $21.
Therefore if the company sells 18,000 units it should make a profit of $52,500. (18,000 - 15,500) * $21
Break-even point e.g. ctdBreak-even point e.g. ctd
The company may decide that $52,500 is not sufficient return on assets employed and it is not likely to increase sales beyond 18,000 units.
Therefore an adjustment to any of the three components could improve the profit margin.
The company may decide that $52,500 is not sufficient return on assets employed and it is not likely to increase sales beyond 18,000 units.
Therefore an adjustment to any of the three components could improve the profit margin.
Break-even point e.g. ctdBreak-even point e.g. ctd
E.g. If selling price was to be increased to $54 the break-even point would be reduced to 14,152 units.
The outcome will be a profit of $88,504. (18,000 - 14,152) * $23 = 88,504 OR:((18,000 * $54) - (18,000 * $31)) -
$325,500 = $88,500
E.g. If selling price was to be increased to $54 the break-even point would be reduced to 14,152 units.
The outcome will be a profit of $88,504. (18,000 - 14,152) * $23 = 88,504 OR:((18,000 * $54) - (18,000 * $31)) -
$325,500 = $88,500
Break-even equationBreak-even equation
The equation to calculate the break-even point is:
Break-even point =Fixed costs Contribution
The equation to calculate the break-even point is:
Break-even point =Fixed costs Contribution
PRACTICE ACTIVITY!PRACTICE ACTIVITY!
Class Exercise 8A & 8B Do it manually or use Excel
Class Exercise 8A & 8B Do it manually or use Excel
