Classification: 1. Profitability. 2. Efficiency. 3. Liquidity

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1 BUSS1030 Semester Simple means of examining the health of a business - Help highlight the financial strengths and weaknesses of a business o Cannot, however, explain why certain strengths/weaknesses exist or why certain changes have occurred - Ratio derived can be used as a basis for comparison (proportionate) o Only when you compare ratios with some benchmark that the information can be interpreted and evaluated Classification: 1. Profitability 2. Efficiency 3. Liquidity 4. Gearing: Relationship between the amount financed by the owners and the amount contributed by outsiders reflects the degree of risk associated with the businessalso referred to solvency, leverage or financial stability 5. Investment Key steps in financial ratio analysis: 1. Shareholders: interested in return and risk of investments à profitability, investment and gearing ratios are of interest 2. Long-term lenders: concerned with long-term viability of business à profitability and gearing ratios will be useful 3. Short-term lenders: such as suppliers- interested in how readily the business can repay the amounts owing in the short-term- interested in liquidity ratios Calculating the ratios When a ratio involves a comparison between 2 statements of financial position, we use year-end figures If the ratio involves both position and performance, we use the AVERAGE of the two figures from the statement of financial position rather than the year-end figures Why do we use the average figure for the statement of financial position? The statement of financial performance includes income and expense figures related to transactions for the year. It is a flow statement. The statement of financial position (balance sheet) includes assets, liabilities and equity expressed as financial amounts at the end of the period. It is a static statement. To ensure the validity in comparing a financial magnitude from the statement of financial position (at end of the period) with a financial magnitude from the statement of comprehensive income (for the period) it is necessary to adjust the balance sheet figure from a year end amount to an amount for the period (average for the period).

2 BUSS1030 Semester ***Need to focus on interpretation and analysis of the ratios in the exam Profitability Return on ordinary shareholders funds/return on equity ROSF / ROE = Net profit after taxation and preference dividend (if any) Average ordinary share capital plus reserves Return on total assets ROA = Average total assets à Measures both efficiency and effectiveness with which assets are used à Use before tax/interest figure because those are prone to fluctuations Return on capital employed ROCE = Share capital + long-term loans à Vital in assessing how effectively funds have been deployed Net profit margin Net profit margin= à Often regarded, as the most appropriate measure of operational performance for comparison purposes, as differences arising from the way a particular business is financed will not influence this measure. à Vary between types of businesses: supermarket may operate at a low net profit margin but a jeweler may have lower sales but still operate at a higher margin à Things to consider: economic climate, degree of competition, type of customer and industry characteristics (level of risk) Gross profit margin Gross profit margin= Gross profit à A measure of profitability in buying/producing and selling goods before other expenses are taken into account à Since COGS represents a significant expense, a change can affect the bottom line (net profit) à Inadequate GP margin will usually mean a business has little chance of success

3 BUSS1030 Semester à GP must cover other expenses and give owner satisfactory return. Adequacy of this margin depends on the buying price (or manufactured cost) and the selling price The gross profit margin for Inca Ltd falls for the year from 31% to 29%. (a) What is the gross profit margin? Gross profit margin equals gross profit (sales minus cost of goods sold) divided by sales. (b) Why is it an important financial measure? It is an important measure because without an adequate gross profit margin business is doomed to struggle and or fail. (c) What may have given rise to the fall identified? The gross margin falls because the relationship between selling price and cost price changes. The margin may have fallen because: Selling price has dropped (i.e. greater competition; lower demand). The buying price has risen (i.e. less competition; changes in exchange rates; increased inwards freight costs; increased government charges). A change in the mix of products sold (i.e. selling more with a lower margin). (d) Under what circumstances would such a fall be of limited concern? The fall in gross margin would not be a great concern where: It is a short-term phenomenon. The level of sales increases more then compensates for the declining gross profit margin. Reductions in other expenses compensate for the decline in gross profit margin (i.e. reduced staff costs). Reduction in the level of assets required to generate the sales (e.g. greater cash sales; reduced equipment levels; reduced inventory levels). Efficiency Average inventory turnover period o Business prefers a low number because funds tied up in inventory cannot be used for other purposes (however, low number may also indicate an issue with ordering insufficient inventory- may not be meeting orders) Inventory turnover period= Average inventory held COGS à For seasonal businesses, monthly average may be more appropriate à Normally prefers a LOW inventory turnover period as funds tied up in inventory cannot be used for other purposes à Things to consider: future demand, future prices, future shortage, cost advantages of buying in bulk and then storing excess, storage space available and perishability of the product Average settlement period for accounts receivable o Usually prefers a shorter average settlement period than a longer one because funds that are not tied up may be used for more profitable purposesà average can be badly distorted (few large customers are slow) Average settlement period= Average accounts receivable Credit Average settlement period for accounts payable

4 BUSS1030 Semester o Can be easily distorted by one or two payment periods by large suppliers Average settlement period= Average accounts payable Credit purchases à Since AP provide a free source of finance for the business, it is not surprising that some businesses attempt to increase their average settlement periods à However, this can be taken too far and business could lose supplier s goodwill Asset turnover period o Examines how effectively the assets of the business are being employed in generating sales revenue Average asset turnover period= Average total assets employed Lower number is preferred to a higher periodà lower period means that assets are being used more productively in the generation of revenue However, very low period may suggest that the business is overtrading on its assets - that is, has insufficient assets to match level of sales achieved o When comparing between businesses- age and condition of assets outright and whether assets are rented/purchased may complicate interpretation ****Remember if you have the turnover figure (3.2 times), you can get the turnover period by dividing 365 by 3.2. Similarly, if you have the turnover period, you can get the turnover figure by dividing 365 by the number of days. The relationship between profitability and efficiency Return on total assets is regarded as a key ration in many businesses Two ratios combined: o Net profit margin ratio o Asset turnover ratio Overall return on funds employed in the business will be determined both by profitability of sales and efficiency in use of assets: Return on average total assets =! Average total assets Liquidity Measures how well the business can meet short-term commitments or claims against the assets when they fall due Current ratio o Compares liquid assets with short-term liabilities o Some suggest that ideal current ratio is at least 2 o However, different types of businesses require different ratios o The higher the ratio, the more liquid the business However, a very high CR may mean a business has too many funds tied up in cash/other liquid assets and so are not being used as productively as they might be

5 BUSS1030 Semester Current assets Current ratio= Current liabilities Acid test (liquid/quick ratio) o More stringent test of liquidity (argued that inventory on hand cannot be converted into cash quickly o However, in a business where cash flows are strong, it is not unusual for the acid test ratio to be below 1 without causing liquidity problems o Derive figures from Balance Sheet- may not truly represent liquiditysnapshot of business at particular point in time (maybe business is seasonal in nature? Acid test ratio= Current assets (excluding inventory and prepayments) Current liabilities Cash flows from operations o Provides further insight of how well a business can meet its maturing obligations o Higher the ratio, the better the liquidity o This ratio has the advantage that the operating cash flows for a period usually provide a more reliable guide to liquidity than the current assets held at the reporting date Cash flows from operations ratio= Operating cash flows Current liabilities Financial gearing (leverage) Evaluate gearing or long-term financial stability (solvency) of a business Financial gearing occurs when a business is financed by part by contributions from outside parties Level of gearing is often important in assessing risk o A business that borrows heavily is committed to pay interest charges and make capital repayments- financial burden that can increase its risk of becoming insolvent Gearing can be good though! If owners have insufficient funds and gearing can also be used to increase the returns to owners as long as the returns from borrowed funds exceed the cost of paying interest Effect of gearing: returns to equity become more sensitive to changes in profits: for a highly geared company, a change in profits can lad to a proportionately greater change in the returns to equity Gearing ratio o Measures the contributions of long-term lenders

6 BUSS1030 Semester Long-term liabilities Gearing ratio= Share capital + reserves + long-term liabilities What are the potential advantages of debt finance (borrowing) over owners equity finance (contributions)? The potential advantages of debt finance over owner s equity finance from the viewpoint of the business (and owners) being: 1. Debt finance is normally short-term and when repaid will not affect the current owners share of the business profits or assets. It is temporary and does not dilute ownership interests. 2. Interest paid on debt finance is tax deductible, whereas dividend paid on owners equity finance (shares) is not. 3. The cost of debt (e.g. interest rate) is often lower than the cost of owners equity. 4. Debt holders do not have voting rights. 5. Where the return on assets is higher than the cost of debt finance, a business can improve the return to equity holders by the use of debt finance to improve returns (called leverage or gearing). Other variations of the gearing ratio focus on the proportion of outside debt to OE: Total liabilities to total assets Total liabilities to total OE Long-term liabilities to total OE Financial leverage facilitates gearing up or multiplying the return to assets where the return on assets is greater then the interest on debt, e.g.: *1 =10%+[50/50x(10%-8%)] *2 =10%+[90/10x(10%-8%)] However, the greater the borrowing the higher the interest rate, and at the same time the greater the investment the lower the returns. Taking the last example: *3 8.5% + [90/10 x (8% - 9%)] Interest cover ratio o Measures amount of profit available to cover interest expense o The lower the level of profit coverage, the greater the risk to lenders that interest payments will not be met Profit before interest and taxation Interest cover ratio= Interest expense