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# You owe HWK

## Ratios you MUST know

Profitability (ROCE). Gearing Liquidity (current and acid test ratios), Financial efficiency (asset turnover, stock turnover, creditor and debtor days), Shareholder ratios (dividend per share and dividend yield)

Which is better?
Company A has 100,000 profit Company B has 1m profit

## Which is the more successful company?

Which is better?
Company A has 100,000 profit, where 200,000 was the capital invested Company B has 1m profit, where 10m was the capital invested

## Which is the more successful company?

Which is better?
Company A has 100,000 profit, where 200,000 was the capital invested
100,000/200,000 x100

= 50%

1m / 10m x100

## How can you use % calculation= to see 10% the differences?

Profitability ratios
Gross Profit Margin *
Operating Margin * ROCE
* Covered in AS BUSS2

## This is one type of ratio!

Known as ROCE Return on Capital Employed

Profitability Ratios
The primary ratio. ROCE return on capital employed This tells us how efficient the company is by looking at their profits & comparing it to the funds invested in the business.

ROCE =

## Examples of ROCE (2007)

Company Annual operating profit 157m \$32,352m Capital employed ROCE

Burberry B.P.

Tesco

2,648m
796m

Which company do you Which company think might be the looks the more most efficient at impressive just generating profits? on raw profit figure? Remember to consider the reasons why?

## Examples of ROCE (2007)

Company Annual operating profit 157m \$32,352m Capital employed 419.3m \$158,845m ROCE Which company looks the more impressive now?

Burberry B.P.

Tesco

2,648m
796m

16,655m
6,706m

Capital employed

Company

Burberry B.P.

ROCE

Tesco

2,648m
796m

16,655m
6,706m

## Examples of ROCE (2007)

Company Annual operating profit 157m \$32,352m Capital employed For every 1
invested in the company, 419.3m Burberry make 37p back in profits

ROCE

Burberry B.P.

37.44% 20.37%

\$158,845m

Tesco

2,648m
796m

16,655m
6,706m

15.90%
11.87%

Evaluating ROCE
Higher % is better

ROCE %

Watch for trend over time Watch out for low quality profit which boosts ROCE
Leased equipment will not be included in capital employed

## Other profitability ratios

At AS you looked at
Gross profit margin & Net profit margin,

and in A2 you will be given credit for looking at this profitability ratio again!

## Gross Profit Margin

Gross Profit Margin = Gross Profit Turnover Remember: Turnover = sales Gross Profit = Turnover Cost of Sales x 100 = %

The Gross Profit margin ratio tells us the profit a business makes on its cost of sales or cost of goods sold. It is a very simple idea and it tells us how much gross profit per 1 of turnover the business is earning.

For example,
A 40% GPM means for every 1 sold 40p equates to gross profit A 14% GPM means for every 1 sold 14p equates to gross profit Gross Profit is the profit we earn before we take off any administration costs, selling costs and so on. So we should have a much higher gross profit margin than net profit margin.

## Gross Profit Margin

Here are a few examples of the gross profit margins from different businesses.
Leisure & Hotel International Airline Manufacturer Retailer Discount Airline Refining Pizza Restaurants Accounting Software

Gross Profit

9.64%

5.62%

35.14%

11.41%

27.46%

12.63%

47.52%

89.55%

The Gross Profit Margins may vary from business to business and industry to industry. What does the

Gross Profit For example, the International Airline has a gross profit of 5.62% yet the Accounting Software business has 89.55% Margin also tell us
If a companys raw materials and factory wages go up a lot, the gross profit margin will sales? go down unless the business increases its selling prices at the same time.

## Net Profit Margin

Net Profit Margin =
Remember

x 100 =

## Net Profit = Gross Profit overheads + income earnt

The Net profit margin ratio tells us of net profit per 1 of turnover. That is, after taking into account the cost of sales, administration costs, the selling and distribution costs, the net profit is the profit that is left, out of which they will pay interest, tax, dividends and so on.
Leisure & Hotel International Airline Manufacturer Retailer Discount Airline Refining Pizza Restaurants Accounting Software

Net Profit

7.36%

4.05%

-10.48%

1.63%

10.87%

11.99%

7.55%

27.15%

Just like the gross profit margins, the net profit margins also vary from business to business and industry to industry. When we compare the gross and net margins we can gain a good impression of their non-production and non-direct costs such as administration, marketing and finance costs. We saw that the International airlines gross profit margin was the lowest of the 8 industries at 5.62% but its net profit margin is 4.05%, only a little bit lower. On the other hand, the discount airline gross profit margin is 27.46% but its net profit margin is 10.87% These comparisons give us a great insight into the cost structure of these businesses.

## Comparing Gross to Net Profit Margins

Leisure & Hotel International Airline Manufacturer Retailer Discount Airline Refining Pizza Restaurants Accounting Software

Gross Profit

9.64%

5.62%

35.14%

11.41%

27.46%

12.63%

47.52%

89.55%

## Leisure & Hotel

International Airline

Manufacturer

Retailer

Discount Airline

Refining

Pizza Restaurants

Accounting Software

Net Profit

7.36%

4.05%

-10.48%

1.63%

10.87%

11.99%

7.55%

27.15%
So whats happened to Manufacturing?

Look at the software business a very high GPM of 89.55% but a NPM of 27.15% . This is still high, but we can see that the administrations costs are very high while the costs of sales are very low.

## Recap profitability ratios

There are THREE profitability ratios..

## Operating Margin * ROCE

Ratio name Fill in the profitability ratio info for ROCE

Ratio formula

## Gearing another ratio

A Liquidity ratio

Gearing
This tells us how much of the companys finance is through debt! A highly geared business is funded heavily through long term debts

## A low geared business is funded mainly through its owners/shareholders.

Gearing
A company with 80% gearing. has 80% of funds through long term debts and 20% through owners/shareholders. A company with 35% gearing has 35% of funds through long term debts and 75% through owners/shareholders.

## Which is in the better position?

Calculating Gearing
Gearing = non current liabilities x 100 total equity & non current liabilities* Aka capital employed So if a company has 280 in non current liabilities and 1,000 in capital employed

Gearing =

## Examples of Gearing (2007)

Company Date of balance sheet Non current Capital Gearing liabilities employed Which company

BA
Tesco Morrisons

31/3/08
23/2/08 29/7/08

4,646m
7,999m 1,356m

## looks the more 7,679m impressive 60.50% just on the figures?

19,901m 5,773m 40.20% 23.49%

## Benefits of high gearing

With low interest rates highly geared companies benefit from cheap finance. But when Interest rates go back up Relatively few shareholders easier to keep control of the company. Fewer shareholders could mean that the business has less dividend pressure, and could retain profit for future investments.

## Benefits of low gearing

Most of the capital is permanent and does not have to be repaid with interest! Less risky where creditors can not force the business into liquidation (think Woolies!)

Ratio name

## Fill in the gearing ratio info

Ratio formula

Liquidity ratios
Assess whether a business has sufficient cash or equivalent current assets to be able to pay its debts as they fall due

Liquidity ratios.
What is liquidity? Liquidity is an asset's ability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value.

## Money in the bank or cash on hand, is the most liquid asset.

Liquidity Ratio
These tell us how healthy the business is in the SHORT TERM It tells us whether the working capital is sufficient to cover the immediate debts!
Current Ratio Acid Test Ratio

Quick recap
What is the money owed to a business from customers called on the balance sheet?
Receivables (from debtors)

## What are the other current assets?

Cash Inventories (stock)

Current Ratio
A liquidity ratio

Current Ratio
Current Ratio = current assets : current liabilities or Current Ratio = Current assets
Current liabilities

So what do you think a current ratio of 2:1 means? The company has 2 of assets for every 1 of debt

## Examples of Current ratios

Company Balance Current sheet date assets

Which company looks the more impressive just the figures? Current on Current liabilities ratio

BA
Tesco Tate & Lyle Burberry

31/3/08
23/2/08 31/3/08 31/3/08

3,148m
6,300m 1,695m 588.4m

3,244m
10,263m 1,204m 436.2m

Calculate their Current Assets ratio = current assets / current liabilities Written as ? : 1

Company

## Balance Current sheet date assets

Current liabilities

## a liquidity of <1? Current

ratio 0.97:1

BA
Tesco Tate & Lyle Burberry

31/3/08
23/2/08 31/3/08 31/3/08

3,148m
6,300m 1,695m 588.4m

3,244m

## What can they do to improve Current ratio?

Sell under used non current assets but is this really wise?) BA is grounding 22 planes this winter!
Raising more share capital (what the banks have done!) Increase long term borrowing! (OK when IRs are soo low!) Postpone planned investments eg Stelios disagreement over Easyjet!

http://news.bbc.co.uk/1/hi/uk/8178474.stm About BA & how well its positioned to survive the current crisis looks at reducing CA, increasing N-CL & gearing all in one clip!

## Acid Test Ratio

A liquidity ratio

## Acid Test Ratio

This ratio looks at comparing assets with liabilities BUT with removing stock figures

ACID TEST RATIO =(current assets inventories) : Current liabilities Or ACID TEST RATIO = Current assets inventories Current liabilities

## Why remove the inventories?

Stock is THE MOST illiquid asset of the business It can take a long time to convert inventories (stock) into cash

It can depreciate if sold as 2nd hand rather than produced into final product.

## Acid Test Ratio

So another way of calculating the Acid Test Ratio = Cash & receivable (debtors) Current liabilities

## So what would an Acid Test Ratio of 1.5:1 mean?

The company has 1.50 worth of liquid assets to every 1 of debt! The ideal situation is an Acid Test ratio of 1:1

Quick Q
If Tesco has a current ratio of 0.61:1, what do you think their Acid Test Ratio will be? Will it be higher or lower than this?

## Examples of Acid Test ratios

Company Balance Current sheet date assets Current liabilities Current ratio

BA
Tesco Tate & Lyle Burberry

31/3/08
23/2/08 31/3/08 31/3/08

3,148m
3,870m 1,133m 318.4m

3,132m
10,263m 1,204m 436.2m

Company

## Balance Current sheet date assets

Current liabilities

## to having so much Current stock!

ratio

BA
Tesco Tate & Lyle Burberry

31/3/08
23/2/08 31/3/08 31/3/08

3,148m
3,870m 1,133m 318.4m

3,132m

1.01 :1

## Why is 1:1 ideal?

Why is the acid test ideal 1:1? If a company has a ratio of 2:1 what does this mean? Why is that not the most efficient use of its liquidity? If a company has a ratio of 0.1 : 1 what does this mean? What does this suggest about the companys financial strength?

## So use your colour sheet

Ratio name Ratio formula

## Financial efficiency ratios

Asset turnover

Stock turnover
Debtor days

Creditor days

Asset Turnover
This tells us how well the company uses all its assets to generate its sales

Asset turnover =

## Revenue (sales turnover) Net assets*

* where net assets are Total Assets -Total liabilities * this is also the total equity figure at the bottom of the balance sheet.

## Examples of Asset turnover

Its very difficult to compare different industries This is a ratio that definitely to be used benchmarking inter-firm comparison or over a period of time with the same firm. For example, Tesco will have a high asset turnover pile them high & sell them cheap. Meanwhile, Harrods would have a low asset turnover of lower quantity sales but with a high profit margin!

Stock Turnover

Stock Turnover
This tells us the number of times a business will sell & replace its stock. A fishmonger should have a HIGH stock turnover of 365 times as it gets fresh fish delivered every day of the year! Where as a second hand car dealer may have a stock turnover of 12 times which is selling & replacing its cars on the forecourt once a month!

## Calculating Stock Turnover

Stock Turnover = Cost of goods sold Average stock held

1. List three business that would have a high stock turnover and three that would have a low figure for stock turnover. 2. A bread shop has an opening stock of 5 000 at the start of the financial year and at the end of the year its stock is 6 000. The cost of sales for the shop is 55 000. Calculate its stock turnover.

## Factors that influence rate of stock turnover

Nature of the product perishable, antiques Importance of holding stock in large or smaller quantities imagine going into M&S with empty shelves! High street stores need large quantities of stock. The length of the product life cycle Stock management systems Variety of products being held.

## Debtor & Creditor days

Debtor Days
Debtors are known as receivables Debtor days = receivables x 365 revenue

This tells us how much credit the company gives to its customers.

Sofa companies often give buy now pay later options whereas at the local petrol station I have to pay immediately!

Creditor Days
Creditors are known as payables Creditor days = payables x 365 revenue

This tells us how long the company takes to pay back the money it owes to its suppliers. Delaying payment for as long as possible can help the business! BUT can cause problems with suppliers in future! BUT can incur interest charges (Late Payment Act 1998!)

Ratio formula

## Fill in the financial efficiency ratios info Ratio name

Shareholder ratios
Dividend per share Dividend yield

## Dividend per share

DPS = Total dividends Number of shares issued

## Answer is expressed as number of pence per share

In 2008 M&S anounced dividends of 343.6m for 1,586.48m shares 21.65p per share.
Obviously the higher the dividend the better for shareholders! The lower the dividend per share might mean that the company is retaining profit for investments!

Dividend Yield
Dividend Yield = Dividend per share x 100 Market price of share

So using the M&S calculation previously, if the share price was 220p on one day the Dividend yield would be 21.65/220 x 100 = 9.48% You would need to compare this figure with past figures & can vary greatly with fluctuations in the stock market!

Ratio name

## What do these ratios mean?

NPM of 24% ROCE of 15% Debtor days of 20 and Creditor days of 10. Stock turnover of 12 times? Acid test ratio of 1.8 : 1 ? Acid test ratio of 0.78 : 1 ? Gearing of 12% or Gearing of 66% - which is better for the business?

Why is it a bad situation for a company to have a gearing of 90%? Dividend per share 80p Dividend yield 5%

Interpreting Ratios
Textbook p169 B1 .. Do Q3 Which business would you buy based on the quantitative factors?

## Not too sure about the wobble!

You will need your ratio colour sheet & a calulator

Income Statement Revenue Cost of sales Gross profit Expenses Operating profit Finance income Finance cost Profit before tax Taxation Profit for the year m 35400 (30100) 5300 (720) 4580 300 (260) 4620 (1109) 3511 Balance Sheet Non-current assets Inventories Receivables Cash & cash equivalents Total current assets Current liabilities Net current liabilities Non-current liabilities Net assets Share capital Reserves & retained earnings Total equity m 19550 2375 1170 2300 5845 (8160) (2315) (6000) 11235 6000 5235 11235

## ROCE Gearing Current Ratio Acid Test Ratio

Asset Turnover Inventory / Stock Turnover Payable days (assume payables are
50% of current liabilities for your calculation)

Receivable days

Profitability ratio
Income Statement Revenue Cost of sales Gross profit Expenses Operating profit Finance income Finance cost Profit before tax Taxation Profit for the year m 35400 (30100) 5300 (720) 4580 300 (260) 4620 (1109) 3511 Balance Sheet Non-current assets Inventories Receivables Cash & cash equivalents Total current assets Current liabilities Net current liabilities Non-current liabilities Net assets Share capital Reserves & retained earnings Total equity ROCE Operating profit x 100 total equity + non-current liabilities 4580 11235 + 6000 x 100 m 19550 2375 1170 2300 5845 (8160) (2315) (6000) 11235 6000 5235 11235

For every 1 of capital employed in the business how much is being generated in profit? Why would it be meaningful to compare this to the current rate of interest? Why might a high street retailer compare ROCE between individual stores?

4580 17235

x 100 = 27%

Gearing ratio
Income Statement Revenue Cost of sales Gross profit Expenses Operating profit Finance income Finance cost Profit before tax Taxation Profit for the year m 35400 (30100) 5300 (720) 4580 300 (260) 4620 (1109) 3511 Balance Sheet Non-current assets Inventories Receivables Cash & cash equivalents Total current assets Current liabilities Net current liabilities Non-current liabilities Net assets m 19550 2375 1170 2300 5845 (8160) (2315) (6000) 11235

Gearing Non-Current Liabilities x 100 total equity + non-current liabilities 6000 (11235 + 6000) = 6000 x 100 17235 =35% x 100

## 6000 5235 11235

For every 1000 invested in this business how much of it is from long term loans? Why might a high gearing be more of a concern to a business with small profit margins?

Liquidity ratios
Current Ratio Current Assets : Current Liabilities 5845 : 8160 = 0.716 : 1 For every 1 of CL the firm owes it owns 0.716 in CA
Balance Sheet Non-current assets Inventories Receivables Cash & cash equivalents Total current assets Current liabilities Net current liabilities Non-current liabilities Net assets Share capital Reserves & retained earnings Total equity m 19550 2375 1170 2300 5845 (8160) (2315) (6000) 11235 6000 5235 11235

Acid Test Liquid Assets : Current Liabilities 1170 + 2300 : 8160 = 3470 : 8160 = 0.425 : 1 For every 1 of CL the firm owes it owns 0.425 in CA

## Financial Efficiency ratio

Income Statement Revenue Cost of sales Gross profit Expenses Operating profit Finance income Finance cost Profit before tax Taxation Profit for the year m 35400 (30100) 5300 (720) 4580 300 (260) 4620 (1109) 3511 Balance Sheet Non-current assets Inventories Receivables Cash & cash equivalents Total current assets Current liabilities Net current liabilities Non-current liabilities Net assets Share capital Reserves & retained earnings Total equity Asset Turnover Revenue Net assets 35400 11235 For every 1 of net assets in the business how much is being generated in revenue? What is meant by the term sweating your assets? Why might asset turnover help a business assess operational efficiency between factories? m 19550 2375 1170 2300 5845 (8160) (2315) (6000) 11235 6000 5235 11235

= 3.15 times

## Financial Efficiency ratio

Income Statement Revenue Cost of sales Gross profit Expenses Operating profit Finance income Finance cost Profit before tax Taxation Profit for the year m 35400 (30100) 5300 (720) 4580 300 (260) 4620 (1109) 3511 Balance Sheet Non-current assets Inventories Receivables Cash & cash equivalents Total current assets Current liabilities Net current liabilities Non-current liabilities Net assets Share capital Reserves & retained earnings Total equity m 19550 2375 1170 2300 5845 (8160) (2315) (6000) 11235 6000 5235 11235

Inventory/ Stock Turnover Cost of sales Inventory 30100 2375 =12.67 times

On average for how long does this business hold stock? What type of business might have this level of inventory turnover? Justify your answer

Why might it be more accurate to divide by average inventory held rather than just inventory?

## Financial Efficiency ratio

Income Statement Revenue Cost of sales Gross profit Expenses Operating profit Finance income Finance cost Profit before tax Taxation Profit for the year m 35400 (30100) 5300 (720) 4580 300 (260) 4620 (1109) 3511 Balance Sheet Non-current assets Inventories Receivables Cash & cash equivalents Total current assets Current liabilities Net current liabilities Non-current liabilities Net assets Share capital Reserves & retained earnings Total equity Receivables (Debtors) days
Assumed payables are 50% of current liabilities

m 19550 2375 1170 2300 5845 (8160) (2315) (6000) 11235 6000 5235 11235

## 4080 x 365 30100

= 49 days

Receivables Revenue
1170 x 365 35400 = 12 days

x 365

Interpreting Ratios
Dodgy scanning

## Capital Employed = Share capital + reserves

Interpreting Ratios

## 180/1460 x 365 = 45 days

HOMEWORK 2
Yellow Work booklet 5 pages