34: Analysis of published accounts

Liquidity ratio

Profitability ratio

Financial efficiency ratio

Gearing ratio

Investor ratio

Methods to improve each of them

Liquidity ratio

2 main liquidity ratio: current ratio + acid test ratio

Current ratio

Current assets ÷ current liabilities = … : …

Definition: compares current assets with current liabilities

Ratio of 2:1 means that the business has enough money to pay for short term debts twice

Acid test ratio (a better way)

Definition: compares liquid assets to current liabilities

Liquid assets ÷ current liabilities

(Liquid assets = current assets - inventories)

This is more accurate because inventories can not be sold right away, so remove this removes the risks of not selling inventories in time to pay debt

Different businesses hold different inventory level, furniture company needs high inventory, so its low acid test ratio 0.75:1 is normal. But computer company needs low inventory as stuff outdated, so 1.5:1 is good

Should compare ratio throughout the years, if ratio increased slightly like 0.5:1 to 0.75:1, it’s still a good sign

Way to improve liquidity ratio

1. Sell off fixed assets (land)
   Selling too quickly will reduce land’s value

   If business still needs that land, then leasing it will add to overheads, reduce profit margin

2. Sell off inventories for low price
   Brand image affected

3. JIT to lower inventory holding

4. Get loans
   Gearing ratio will increase

Profitability ratio

3 main methods: Gross profit margin ratio, Operation profit margin ratio, Return on capital employed ratio

Reminder

Revenue - Cost of good sold = Gross profit

Gross profit - overhead expenses (HRM,… that do not directly make product) = Operating profit

Gross profit margin ratio

Ratio compares gross profit (revenue - cost of good sold) with revenue

(Gross profit ÷ revenue) x 100 = …%

Indicator of how effective manager at adding value to goods

If ratio is low, then either the product is sold at low price or high COGS

Operating profit margin ratio

Ratio compare operating profit with revenue

Operating profit = Gross profit - overhead expenses

(Operating profit ÷ revenue) x 100 = …%

Return on capital employed ratio (RoCE) (Primary efficiency ratio)

Compare operating profit with capital employed (invested) in business

(Operating profit ÷ capital employed) x 100 = …%

Capital employed (long term finance invested) = total assets - current liabilities = equity + non-current liabilities

(We use non-current liabilities like loans to buy fixed assets like land, when we pay off that loan then the land becomes an assets, so equity + non-current liabilities)

Way to improve profitability ratio

1. Reduce direct (COGS) and overhead (HRM,…) cost

2. Increase price

Financial efficiency ratio

How effective business uses resources

3 main way: Rate of inventory turnover, trade receivable turnover, trade payable turnover

Inventory turnover

Record number of inventory that is bought and sold

Formula: COGS ÷ average inventory = …

(average inventory = [value of inventory at start of year + end of year] ÷ 2)

The higher the number, the better. This is because the value of cost bought in is higher than the value of unsold inventory. This means you sell most of the stuff out already, ít hàng tồn kho

This doesn’t matter for service sector firm, like insurance company, cause they not holding inventory

Trade receiveable turnover (days)

Measure how many days it takes customer to pay on credit

(Trade receivables ÷ credit sales) x 365 = … days

Credit sales is the total value of goods that are sold on credit

Trade receivables are the credits that customer has not paid yet

E.g: We have sold $100M on credit, but the customer only paid $60M. So we have $40M trade receivables

Low value means the business force customer to pay early

Marketing department want high credit term to sell more. But finance department want shorter so customer pay faster.

Trade payable turnover (days)

How many days it take to pay supplier on credit purchase

(Trade payables ÷ credit purchase) x 365 = …days

You should wait for customer to pay you before you pay suppliers. So trade receiveable turnover should be lower than trade payable turnover. If you pay supplier too fast than customer pay you then there will be cash flow problem.

Way to improve financial efficiency

1. Increase inventory turnover by JIT

2. Reduce credit term and pay supplier slower

Gearing ratio

How much capital employed is finance from long term debt.

The more debt, the higher the gearing ratio

(Long term debt ÷ capital employed) x 100 = …%

High gear = high loan to invest = expansion = higher profit = more dividends & attract shareholder

Low gear = the business is playing it safe = share dividends are not attractive

Way to improve gearing

1. Reduce dividends or sell more shares to cover loan

   Poor economy = sell shares at low price

2. Sell assets

Investment ratio

Chance of financial gain from buying shares of a business

Dividend yield ratio

% of dividend compared to share price

(Dividend per share ÷ share price) x 100 = …%

Divided per share = total dividend ÷ total shares

The higher the percentage, the more return shareholders can get

Reduce dividend = low dividend yield ratio = but increase retained earnings and lower gearing

High dividend yield does not mean the business is making good investment, maybe share price is falling.

Dividend cover ratio

how many times profit can cover dividends for a year

Profit for a year ÷ Annual dividends =…

High level mean business has more profit to cover dividend.

Low result might mean business save profit for future expansion or increase dividend

Price/earning ratio (P/E ratio)

Share price to earnings per share

Or

How much dollar investor would pay to get $1 return

Or

How many years will the current dividend add up to buy 1 real share

Or

How many years does it take for business to pay back all shares

Or

How confident shareholder will get high dividend

market share price ÷ earnings per share = …

(Earnings per share = profit ÷ number of shares)

Tells us if the share price is cheap or expensive

E.g: Ratio of 50 shows us that we are paying too much for share price and the company is not growing much. But this is a form of investment, and high PE ratio means investor is anticipating company growth

High ratio = share price might fall

Low ratio = share price might increase

The higher the result, the more confident shareholders. Because even though the profit increase (denominator), shareholders buy in more (numerator), hence the rate of buying share outweigh the increasing profit. So high result

However, low results mean it take less time to gain dividend to pay back the original stock price.