Ratio Analysis

What is the company’s net return on assets and sales?

These ratios measure how profitable a company is; they are a measure of the company’s overall performance. Profitability ratios measure the company’s use of its assets and control of its expenses to generate an acceptable rate of return.

Different types of businesses will have different gross and net profit margins depending on the industry and environment they operate in.

Here are some examples:

Business Type	Gross Profit	Net Profit
Hotel	9.64%	7.36%
International Airline	5.62%	4.05%
Discount Airline	27.46%	10.87%
Manufacturer	35.14%	-10.48%
Retailer	11.41%	1.63%
Pizza Restaurant	47.52%	7.55%
Computer Software	89.55%	27.15%

(Adapted from http://www.bized.co.uk)

From the above examples, we can point out that:

• The international airline has a gross profit margin of only 5.62% (the lowest) whereas the computer software business has a gross profit margin of 89.55% (the highest). These two companies are obviously operating in very different environments.
• However, when looking at the net profit margin, the international airline’s net profit margin is only a little bit lower than its gross profit margin. Whereas the discount airline's gross profit margin is 27.46% its net profit margin is a lot less than that at 10.87%.

Gross Profit Percentage

Explanation	Gross profit in relation to sales revenue. It tells us the percentage of sales that are available to cover general expenses and operating costs.
Formula	Gross profit divided by sales x 100 (gross profit is sales - the cost of sales).
Result Format	Percentage, e.g. 20%. This represents the average gross profit earned on every dollar of sales before we consider operating expenses (and profit).
Comment	The higher the percentage the better. An increase in this ratio over the years implies increased profits; due to an increase in sales or a decrease in the cost of sales and vice versa. We need to look at the statement of financial performance to find out exactly why gross profit is high or low.

Net Profit Percentage

Explanation	Tells us the percentage of profit earned on sales, after you subtract the operating expenses.
Formula	EBIT divided by Sales × 100 (EBIT means earning before interest and tax. It is the gross profit expenses; before interest and tax).
Result Format	Percentage, e.g. 20%. This represents the average profit earned on every dollar of sales after we consider operating costs (excluding interest and tax).
Comment	An increase in this ratio over the years implies increased profits; perhaps due to an increase in gross profit or a decrease in operating expenses and vice versa. Again, we need to look at the statement of financial performance to find out exactly why the net profit is high or low.

Time Out: Comparing Results

As we have already learned, one ratio by itself is not useful. We need to make comparisons to get more information and make sound business decisions. There are two methods we can use for making comparisons. We will briefly look at them now, but you will be using them later when writing your financial reports.

Here is the Statement of Financial Performance (Profit and Loss Account) for the Carphone Warehouse (a telecommunications company in the UK).

Carphone Warehouse Profit and Loss Account for the years ended
	31 March 2001	25 March 2000
	£'000	£'000
Sales	1,110,678	697,720
Cost of sales	830,126	505,738
Gross profit	280,552	191,982
Operating expenses	176,960	129,359
Operating profit	66,016	41,389
Other costs/income	6,555	-5,132
Net profit	45,012	25,300

Let's calculate the gross and net profit margins for the years ended 31 March 2000 and 2001:

Ratio	2001	2000
Gross Profit	280,552 ÷ 1,110,678 x 100 25.26%	191,982 ÷ 697,720 x 100 27.52%
Net Profit	45,012 ÷ 1,110,678 x 100 4.05%	25,300 ÷ 697,720 x 100 3.63%

1. Comparing the same business over a number of years.

   Looking at the results, we can see that the Carphone Warehouse had almost the same profitability results for the two years. This suggests the business is being managed in a stable way. From what we know about the mobile phone industry, i.e. it is constantly changing and growing, we could say this is a good sign as it implies the Carphone Warehouse is stable.

   Are the Carphone Warehouse’s ratio results actually good or bad?

   We don’t know! We need even more information.

2. Comparing one business with a similar business in the same industry

   One way to find out how good or bad the Carphone Warehouse is doing is to compare its ratios with that of another company in the same industry, such as Vodafone.

Ratio	Vodafone 2001
Gross Profit	41.4%
Net Profit	-55.57%

In comparison to the Carphone Warehouse, Vodafone has a higher gross profit margin.

However, when we look at the net profit margin we can see something unusual; Vodafone has made a net loss. To help us find out why this is the case we can look at Vodafone’s Statement of Financial performance.

Vodafone Profit and Loss Account for the year ended 31 March 2001
	£'000
Sales	15,004.0
Cost of sales	-8,702.0
Gross profit	6,302.0
Operating expenses	-13,291.0
Operating profit	-6,989.0
Other costs/income	80.0
Net Profit	-6,909.0

Vodafone's operating expenses were very high, and this caused a huge net loss.

So, even though the businesses are in the same industry, they have very different results. At first glance, we may have said that Vodafone was more profitable than the Carphone warehouse but on closer analysis, we can see that the Carphone Warehouse is actually more profitable.

Return on Total Assets and Inventory Turnover

Explanation	Also called ‘return on investment'. Measures the net profit after tax as a percentage of the assets employed. It tells us the overall effectiveness of management in using the resources available to the company.
Formula	EBIT Total Assets × 100 (the total assets are simply current assets + noncurrent assets).
Result Format	Percentage, e.g. 20%. This represents the average profit earned on every dollar of assets the company owns.
Comment	A high ratio implies a higher return on assets. We need to compare this figure to previous years or similar companies to get a meaningful conclusion on whether the result was good or not. We can also compare it to the return on bank deposits (savings) so that we can see where it would be best to invest the money.

Now, let's calculate the return on total assets percentage ratio for The Warehouse Group in 2010. It is:

EBIT

Total Assets × 100 = 126,575

126,575 ÷ 372,928 + 302,104 × 100

Which is: 126,575 ÷ 675,032 x 100 = 18.75%

Inventory Affects the Ratio Calculations (After 88 days in 2010)

However, how quickly inventory is usually sold depends on the type of business;

• Steel companies can have their materials in stock for as much as 9 months to a year.
• Vegetable shops should have stocks for no longer than 4 or 5 days.

Calculate the Inventory Turnover ratio for The Warehouse Group in 2010. (Note the closing stock for one year is the opening stock for the next year; closing stock for 2008 was $275,581, therefore this is the 2009 opening stock figure).

Cost of Good Sold ÷ Average Inventory × 100

Which is 1,046,012 ÷ (257,943 + 254,606) ÷ 2 × 100 = 1,046,012 ÷ 256,274.50

The result is 4.15 times or every 88 days.

Calculate the Inventory Turnover ratio for The Warehouse Group in 2009.

Cost of Goods Sold ÷ Average Inventory

Which is 1,087,375 ÷ (257,581 + 257,943) ÷ 2

The result is 4.08 times or every 89.5 days.

When comparing the results of both years, turnover decreased slightly in 2010 from 4.08 to 4.15 times. When converted to days the stock turnover decreased by one from 89.5 in 2009 to 88 days in 2010.

How effectively is the company using its assets?

These ratios show how much use the company makes of its assets in generating sales. They show whether the company’s investments in assets are too big or too small.

If the company has invested too much in assets, it means money is tied up in the assets and not being used as productively as it could be. The company may be making a mistake; it could invest the money more wisely somewhere else.

On the other hand, if the company has not invested enough in assets, then it may be over-using is resources and may not be able to continue meeting customer need. The company may be producing a poor-quality product or providing poor customer service.

Inventory Turnover

Explanation	Measures the number of times inventory (stock) is turned over during the year, i.e. sold and replaced; this measures the efficiency of inventory management.
Formula	Cost of Goods Sold divided by Average Inventory (Opening and Closing Inventory / 2).	Number of Days in the Year Inventory Turnover
Result Format	Times per year	Days
Comment	A high turnover indicates better liquidity. This means less money is tied up in stock and is now free to be spent somewhere else. However, it may also suggest a shortage of inventory needed for sales, which could mean unhappy customers. A low turnover indicates poor liquidity or possible overstocking or obsolete stock.

Inventory Affects the Ratio Calculations

Sometimes inventory causes problems because it can be difficult to sell or use. For example, even though a supermarket has thousands of people walking through its doors every day, there are still items on its shelves that don't sell as quickly as the supermarket would like. Similarly, there are some items that will sell very well if a business needed to sell some of its inventory to try to cover an emergency, they would be disappointed if it took a long time.

However, how quickly inventory is usually sold depends on the type of business:

• Steel companies can have their materials in stock for as much as 9 months to a year.
• Vegetable shops should have stocks for no longer than 4 or 5 days.

Accounts Receivable Turnover

Explanation	Tells us the average time a firm has to wait before it receives cash after making a sale; and how long it takes the customers to pay. It measures how good the business’s credit, billing, and collection procedures are.
Formula	Annual Sales Average Accounts Receivable                    →	Number of Days in the Year Accounts Receivable Turnover
Result Format	Times per year	Days
Comment	A high turnover (fewer days) the more successful the company is in collecting cash from customers. A low turnover (more days) means customers are taking longer to settle their accounts and it is a sign to the company to reconsider its credit policy because the sooner it can receive the cash the sooner it can use it elsewhere.

Is the company able to meet its short-term (next 2 months) obligations?

Working capital is used to measure the company’s short-term liquidity. It tells us how much cash is available to the company to pay its short-term debt, i.e. does it have enough cash resources to pay bills?

Working Capital = Current Assets - Current Liabilities

The liquidity of a business is a measure of how it can meet its short-term obligations, i.e. pay loans and creditors. An asset is said to be “liquid” if it can be quickly turned into cash. Liquid assets are current assets, such as cash and accounts receivable.

Current Ratio

Explanation	Tells us how well the business can pay its creditors and loans in the next accounting period using its current assets
Formula	Current Assets Current Liability  x100
Result Format	x:y
Comment	A ratio of 2:1 means that for every $1 of liabilities, the firm has $2 in assets, i.e. the firm has two times as many assets as liabilities. A ratio at this level (or above) is considered ideal. A really high ratio would suggest that there are too many assets; they are not being used efficiently. The ratio should be at least 1:1 because if the company cannot pay its bills it could become bankrupt. If the ratio result is less than 1:1 the business needs to take action to make an improvement. It could: Increase current assets without increasing current liabilities: The owner could invest more money into the business. A long-term loan could be borrowed from the bank to pay off short-term liabilities. Decrease current liabilities: The business could sell some non-current assets to pay off current liabilities. If the current ratio increases over the years, it means the company has improved, it had an increase in assets, and it is now in a better position to pay off its debts.

How to Improve Working Capital

There are two options;

1. The business must increase current assets
   or
2. The business must decrease current liabilities.

Some actions that can be taken include:

• Increase the gross profit percentage.
• Increase the rate of inventory turnover (in the short term the business could have a sale to convert inventories into cash or accounts receivable; in the long term the business could make changes to its product mix).
• Improve the debt collection period (encourage customers to pay quicker).
• Introduce more capital (cash) into the business.
• Reduce drawings.
• Sell any non-current assets that are not in use.
• Sell some non-current assets and then lease them back (a building for example).
• Borrow long-term funds.

Long-Term Financial Stability Ratios

Is the company able to meet its long-term obligations?

Also known as leverage or debt ratios, they measure the company’s long-term solvency, i.e. the ability of the company to meet all its liabilities. They tell us if the company is likely to survive in the long run. This analysis is used to give a warning of future failure.

Debt to Total Assets

Explanation	Measures the percentage of funds provided by creditors and shows the protection provided by the shareholders for the creditors.
Formula	Total Debt (all liabilities) x 100 Total Assets
Result Format	%
Comment	A low ratio implies financial stability and, therefore, more flexibility to borrow funds in the future. A higher ratio would not be welcomed by creditors as they would think there is more risk involved.

Debt to Equity Ratio

Explanation	A measure of a company's financial leverage.
Formula	Long-Term Debt Equity (or shareholders’ funds)
Result Format	%
Comment	A high ratio implies that a large proportion of long-term assets are financed by debt. Long-term creditors prefer to see a low ratio because this implies there is greater protection for them.

Is it worth investing in the company?

The results of these ratios are of interest to investors. They give information on the potential risks and returns involved in owning shares in the company.

Earnings Per Share

Explanation	Shows the amount of earnings for each share. This is one of the most important ratios used by investors because they are more interested in their own share of the profit rather than the company as a whole
Formula	Net Profit Number of ordinary shares
Result Format	Price, e.g. $0.50 per share
Comment	If the earnings per share ratio increase over time, investors will be happy as there are more profits available for them. If profits drop you will notice that the EPS will also drop (unless the number of shares changes).

Now, let's calculate the EPS ratio for The Warehouse Group in 2010, using ordinary shares.

"Ordinary shares are the total number of voting securities of the company on the issue on 10 September 2010 was 311,195,868 fully paid ordinary shares". This figure has been adjusted to 311,196 to make calculations easier. The Warehouse calculates its EPS (it made a slight adjustment to the ordinary share figure; therefore, our results are not the same).

The calculation is:

Price Earnings

Explanation	Measures the ratio of the current market price of the ordinary shares to the earnings per share of the ordinary shares. It is a useful ratio for comparing companies.
Formula	Market Price Per Share Earnings Per Share
Result Format	Times, e.g. 5 years
Comment	Because the market price changes from day to day this ratio will also change. For example, if the ratio result is 5 years this means that the investor who wants to buy shares is willing to pay 5 times the price of the earnings per share; prepared to wait 5 years to recover the price of the share. If a company's ratio is higher than its competitors it indicates that investors are expecting profits, dividends and the share price to grow more quickly than the other companies.

We have just covered a lot of information. Let's now recap and check your knowledge.

Now we are going to calculate the ratios for Autumn Mists Trading Company LTD (AMT).

Download the Word document here containing the following financial performance of AMT Company Ltd, which contains resourceful information for your assessment.

AMT Company Ltd Statement of Financial Performance for the year ending 31 Dec 2009.

Sales			2,000,000
Less Cost of Goods Sold:
Opening Inventory	150,000
Purchases	1,450,000	1,600,000
Less Closing Inventory		200,000
Cost of Goods Sold			1,400,000
Gross Profit			600,000
Less Expenses:
Selling		80,000
Administration		220,000	300,000
Net Profit Before Interest and Tax			300,000
Interest Expense			100,000
Net Profit Before Tax			200,000
Tax			66,000
Net Profit After Tax			134,000

AMT Company Ltd Statement of Movements in Equity for the year ending 31 Dec 2009.

Equity:
Share Capital	300,000
Retained Earnings	200,000
Total Equity	500,000

AMT Company Ltd Statement of Financial Position for the year ending 31 Dec 2009.

Total Equity (Owners Equity)			500,000
Represented By:
Current Assets
Bank		240,000
Accounts receivable	120,000
Prepayments	40,000
Inventories		200,000	600,000
Current Liabilities
Accounts Payable		140,000
Taxes Payable		20,000
Accrued Expenses		120,000	280,000
Working Capital			320,000
Non-Current Assets
Plant and Equipment	550,000
Accumulated Depreciation	150,000	400,000
Less Non-Current Liabilities		220,000	180,000
Total Net Assets			500,000

Market price per share $2.25: The share capital is made up of $1 ordinary shares.

Profitability

Ratio	Calculation
Gross Profit	Gross Profit 600 = 0.3 x 100 = 30% (Note: all the figures are in 000 but to make calculations easier we ignore the 000s). Sales 2000
Net Profit	EBIT 300 = 0.15 x 100 = 15% Sales 2000
Return on Total Assets	EBIT 300 = 300 = 0.3 x 100 = 30% Total Sales (600 + 400) 1000

Asset Utilisation

Ratio	Calculation
Inventory Turnover	Cost of Goods Sold 1400 = 1400 = 8 times per year Average Inventory (150 + 200) / 2 175 = Number of Days in Year 365 = 45.6 days ACC Inv Turnover 8
Accounts Receivable Turnover	Sales 2000 = 16.7 times per year Accounts Receivable 120 Number of Days in Year 365 = 21.9 days ACC Rec Turnover 16.7

Working Capital Management

Ratio	Calculation
Current Ratio	Current Assets 600 - 2.14:1 Current Liabilities 280

Long-Term Financial Stability

Ratio	Calculation
Debt to Total Assets	Total Debt 280 + 220 = 500 = 0.5 x 100 = 50% Total Assets 1000
Debt to Equity Ratio	Long-term Debt 220 = 0.44 x 100 = 44% Equity 500

Financial Markets

Ratio	Calculation
Earnings Per Share	Net Profit after Tax 134 = $0.45 per share Number of Ordinary Shares 300 The share capital is $300,000 which is made up to $1 shares so there are 300,000 shares.
Price Earnings	Market Price Per Share 2.25 = 5 years Earnings Per Share 0.45

Now it is your turn to give it a go!