Business 3.5 - Ratio Analysis

Efficiency Ratio Calculation - Stock turnover

-Measures the number of times a firm sells its stock within a year - Stock turnover = cost of goods sold/average stock OR Stock turnover = average stock/cost of goods sold * 365 - Higher the ratio the better - Can improve by: Holding lower levels of stock, Divestment; getting rid of any slow selling stock, Reducing the range of products offered, by only keeping the ones that sell.

Liquidity Ratio Calculations

- A ratio of 1.5 to 2.0 is good for short term ratios (So for every $1 of current liability, the firm has $1.5 or $2 of current (liquid) assets) - Ratio of 1:1 is good for acid test ratio (Ratio less than 1:1 could mean firm has liquidity crisis where the firm is unable to pay its short term debts) - Can be improved by increasing assets and decreasing liabilities Current ratio = current assets/current liabilities Acid test (quick) ratio = current assets - stock/current liabilities

Profitability ratios

- Assess the financial performance of a business. - Will show how well a firm has performed. - These ratios measure profit in relation to other variables such as sales turnover or capital employed.

Gearing Ratio Calculation

- Looks at the firm's capital employed that is financed by long term debt. - Gearing ratio = long term liabilities/capital employed * 100 OR Gearing ratio = loan capital/capital employed * 100 - Higher the gearing ratio the larger the firm's dependence on long term sources of borrowing (firm will incur higher costs due to debt financing) - If firm has gearing ratio of 50% or more = highly geared (Banks will be less willing to loan you more money, investors will see you as a huge investment risk)

Efficiency Ratio Calculation - Return on capital employed (ROCE)

- Measures the financial performance of a company compared with the amount of capital invested - ROCE = Net profit before interest and tax/capital invested * 100 - Capital Invested (also called capital employed) = shareholder's funds + reserves + long-term liabilities - Higher the ratio the better (Some believe that 20% ROCE is a good target to achieve)

Profitability Ratios Calculation - NPM

- This ratio will show the % of sales turnover that is turned into net profit. - Net profit = Profit that is left after all the costs of production have been accounted for. - Good indicator of firm's probability because it takes into account both cost of sales and expenses. - Can be improved by reducing costs (e.g. better payment terms with creditors and suppliers) Net Profit margin = net profit before interest and tax/sales revenue * 100

Profitability Ratios Calculation - GPM

-Gross Profit = sales revenue - COGS -The higher the GPM ratio, the better it is for a business. - Gross profit goes towards paying overheads and expenses of the business. - Can raise via raising revenue or reducing costs Gross profit margin = gross profit/sales revenue * 100

Liquidity ratios

-Looks at the ability of a firm to pay its short-term liabilities. -The firm's ability to repay its debts. -Short term liquidity ratios calculate how easily a firm can pay its short-term financial obligation from its current assets. (financial ratios that measure the ability of a firm to obtain the cash it needs to pay its short-term debt obligations as they come due)

Gearing ratio

-Looks at the long-term liquidity position of a firm; A high degree of gearing could mean a inadequate long-term liquidity because the firm must repay its loans. If a firm is highly geared it will be considered a risky business. (A measure of the percentage of capital employed that is financed by debt and long term finance.)

Shareholder ratios

-Measures the returns to shareholders in a company. -Shareholders will be interested in earnings per share.

Efficiency ratios

-Shows how well a firm's resources are being used. (indicate how well a firm's resources have been used, such as the amount of profit generated from the available capital used in the business)

Two ways ratios can be compared

1. Historical comparisons 2. Inter-firm comparisons (In the same industry; McDonald's should compare their ratios with rivals of similar size, like Burger King)

The Purpose of Ratio Analysis

a tool for analyzing and judging the financial performance of a business; -To analyze short and long term liquidity. -To asses a firm's ability to control expenses. -To compare actual figures with projected ones. -To help in the decision making process (e.g. Should investors risk their money in the business)