Ratio Analysis

3.5 - 3.6

liquidity

the efficiency or ease with which an asset of security can be converted into ready cash without affecting its market price

ratio analysis

a business management tool for analyzing and judging the financial performance and liquidity of an organization

4 purposes of ratio analysis

• analyze short-term and long-term liquidity

• assess firm’s ability to control expenses

• compare actual figures with projections

• decision-making

two methods of comparing ratios

• historical comparison

• inter-firm comparison

types of profitability ratios

• gross profit margin

• net profit margin

• return on capital employed

gross profit margin

a profitability ratio that shows a firm’s gross profit expressed as a percentage of its sales revenue; the higher the better

methods to improve GPM (5)

• marketing to improve sales

• new products with higher GPM

• cutting prices for competitiveness (increase sales)

• cheaper raw materials

• reduce labor costs by ensuring productivity

net profit margin

a profitability ratio that measures a firm’s overall profit (profit before interest and tax), expressed as a percentage of its sales revenue

• the higher the better; also shows the ability to control/manage expenses

methods to improve the profit margin

• reduce unnecessary day-to-day expenses

• consider relocating to cheaper rents

return on capital employed

measures a firm’s profitability and efficiency in relation to its size (the size is measured by its capital employed)

• anything below 20% is BAD

capital employed

the sum of all funds invested in a business

• share capital + loan capital + retained profit

• non-current liabilities + equity

• equity + long-term borrowing

methods of improving ROCE

• increasing sales revenue

  • promotional offers

  • lower prices for competitiveness

  • wider distribution networks

  • improved quality of products

• reducing costs

  • economies of scale

  • quality management system

  • better stock control

liquidity ratios

the financial ratios that look at a firm’s ability to pay its short-term financial obligations (current liabilities)

types of liquidity ratios

• current ratio

• acid test ratio

current ratio

a liquidity ratio that calculates the ability of a business to meet its short-term debts (within 12 months)

current ratio analysis

• 1 :1 (CA:CL) → absolute minimum

• ideal → 1.2:1, 1.5:1 ~ 2.1

when current assets < current liabilities

• liquidity problem

• insolvency

• bankruptcy

methods to improve the current ratio

• encourage customers to pay by cash

• deposit cash that is not being used into higher-interest bank accounts

• use its cash balance to pay off short-term debts

• negotiate for longer trade credit periods

• find short-term debts with non-current liabilities

acid test (quick) ratio

a liquidity ratio that measures a firm’s ability to meet its short term debts, but ignoring stocks because some inventories are difficult to turn into cash in a short time

methods to improve the acid test ratio

• use the same methods as the current ratio

• improve stock management

• increase the level of current assets or lower current liabilities

insolvency

 financial state where person/firm cannot meet debt payments on time, take steps to resolution (file bankruptcy)

efficiency ratios

ratios that look how well a firm’s financial resources are being used

stock turnover

an efficiency ratio that measures the number of times a firm sells its stock within a year

methods of improving stock turnover

• hold lower levels of stock

• divestment; het rid of any slow selling stock

• reduce the range of products offered, by focusing on best sellers

gearing ratio

ratios used to assess a firm’s long-term liquidity position, looks at the firm’s capital employed that is financed by long-term debts

• the higher it is, the more dependent the firm is on long term borrowings

• more than 50% = highly geared

creditor days

an efficiency ratio that measures the average number of days it takes a company to pay its suppliers

bankruptcy

legal process when person/firm declares they can no longer pay back debt to creditors, liquidate assets to pay off debts

debtor days

an efficiency ratio that measures the average number of days it takes a company to collect payments from its customers