Ratio analysis

• Ratio analysis is a quantitative management tool for analysing and judging the financial performance of a business.

• How ratios are compared (two main approaches):

  • Historical comparisons: compare the same ratio in two time periods for the same firm.

  • Inter-firm comparisons: compare the ratios of businesses in the same industry.

• The material notes that some ratios in the video are not on the syllabus; focus on the ratios studied in this course: profitability ratios and liquidity ratios.

• Toolkit reference: Boston Consulting Group (BCG) matrix is mentioned as part of the Business Management Toolkit.

Profitability ratio

• Profitability ratios examine profit in relation to other figures (e.g., profit to sales revenue).

• Relevant to profit-seeking businesses (not-for-profit organizations are generally less central for these ratios).

• Ratios studied in this course:

  • Gross profit margin (GPM)

  • Profit margin (PM)

  • Return on capital employed (ROCE)

• There are many profitability ratios, but these three are the focus here.

Gross profit margin (GPM)

• Formula: GPM = rac{Gross\ profit}{Sales\ revenue} \times 100

• What it shows: the value of gross profit as a percentage of sales revenue.

• Interpretation: GPM measures profitability after deducting direct costs associated with producing and selling goods/services.

• Example interpretation:

  • Yoga studio: GPM = 46%

  • Restaurant: GPM = 65%

  • For every $100 of sales, yoga studio has $46 gross profit; restaurant has $65 gross profit.

• Importance: Higher GPM means more gross profit available to cover expenses beyond direct costs.

Interpreting GPM (in more detail)

• Higher GPM is generally better because it leaves more gross profit to pay for expenses such as operating costs, overhead, and profit after tax.

• Decision example (from slides): restaurant performs better on GPM than yoga studio due to higher gross profit retention.

Strategies to improve gross profit margin (GPM)

• Increase revenue (raise selling price for products with few substitutes; decrease price for products with many substitutes):

  • Use marketing to raise sales revenue.

  • Produce or sell products with a higher gross profit margin.

  • Seek alternative revenue streams.

• Reduce cost of sales (direct costs):

  • Reduce direct material costs by sourcing alternative raw materials or suppliers.

  • Reduce direct labour costs.

• Assessment prompt (from slides):

  • A studio (e.g., yoga) to improve its GPM: Recommend three strategies (this is an assessment task for students).

Profit margin (PM)

• Note on terminology in the slides:

  • The term PM is described as the value of net profit as a percentage of sales revenue, but the formula shown is for profit before interest and tax (PBIT).

  • Practical interpretation in the slides uses profitability after indirect costs but before interest and tax (PBIT) for PM values.

• Formula (as shown): PM = rac{Profit\ before\ I\&T}{Sales\ revenue} \times 100

• What it shows: PM indicates the profitability after deducting indirect costs from gross profit (i.e., how much of each sales dollar remains as profit after overheads and other indirect costs).

• Important note: The slide examples treat PM values as the portion of revenue converted into profit before interest and tax (PBIT), with the following example values:

  • Yoga studio: PM = 25%

  • Restaurant: PM = 18%

  • Interpretation: For every $100 of sales, yoga studio yields $25 of profit before interest and tax; restaurant yields $18.

• The PM interpretation emphasizes how PM affects dividends and reinvestment potential.

Interpreting PM (NPM context)

• Higher PM is better because it implies more profit available for dividends and reinvestment.

• Example comparison (from slides): yoga studio has PM = 25% vs restaurant PM = 18% (per $100 of revenue, $25 vs $18 of PBIT).

Return on capital employed (ROCE)

• Formula: ROCE = \frac{Profit\ before\ I\&T}{Capital\ employed} \times 100

• Capital employed definition (as per slides):

  • Capital\ employed=Noncurrent\ liabilities+Equity

• Purpose: ROCE measures the profitability of a firm relative to the amount of capital invested (sources of funds).

• Interpretation: The higher the ROCE, the more efficiently the firm generates profit from the funds invested.

• Example interpretation (from slides):

  • Yoga studio: ROCE = 10%

  • Restaurant: ROCE = 8%

  • For every $100 invested, yoga studio generates $10 of profit; restaurant generates $8.

Strategies to improve profitability ratios (PM and ROCE)

• Core idea: both PM and ROCE can be improved by controlling expenses.

• Examples of expense-control strategies (illustrative):

  • Reduce indirect labour costs

  • Seek cheaper rental premises

  • Install energy-efficient machinery and equipment

  • Find alternative suppliers for insurance policies

  • Use cheaper forms of advertising

  • Take advantage of cash payment discounts

  • Use the services of a tax accountant to advise on reducing tax liabilities

Drawbacks and limitations of profitability strategies (from the draw-up table)

• A firm decides to improve its GPM by spending more on advertising their products.

  • Drawback: Increases expenses, which can erode profits if not offset by higher revenue.

• A firm decides to improve its PM and ROCE by making 20% of its employees redundant.

  • Drawback: Creates a climate of fear and demotivation among staff; potential long-term productivity and reputational harm.

• A firm decides to relocate its business to a cheaper location.

  • Drawback: Time and money spent locating new premises, real estate fees, moving costs, and informing customers; potential loss of customers and brand strength.

Liquidity ratios (overview)

• Liquidity ratios look at the ability of a firm to pay its short-term liabilities.

• They reveal the level of working capital available to meet everyday financial obligations.

• Ratios studied in this course:

  • Current ratio

  • Quick (acid-test) ratio

• These are part of the business toolkit alongside profitability ratios.

Current ratio

• Formula: CR = \frac{Current\ assets}{Current\ liabilities}

• What it covers: liquid assets (cash or assets that can be turned into cash quickly) vs short-term liabilities; assesses whether liquid assets can cover short-term debts.

• Benchmark: Ideal current ratio benchmark is between 1.5 and 2:1.

• Example interpretations (from slides):

  • Yoga studio: CR = 0.9:1 (For every $1 of current liabilities, $0.90 of current assets)

  • Restaurant: CR = 1.9:1 (For every $1 of current liabilities, $1.90 of current assets)

• Overall interpretation: A ratio below the benchmark may indicate liquidity risk; a ratio above the benchmark may indicate underutilized liquidity.

Interpreting the current ratio (examples from the slides)

• Yoga studio: Current ratio = 0.9:1 → liquidity concerns; not enough working capital to cover current liabilities.

• Restaurant: Current ratio = 1.9:1 → within the benchmark; appears more favorable.

Quick (acid-test) ratio

• Formula: QR = \frac{Current\ assets - Stock}{Current\ liabilities}

• Concept: Similar to current ratio but excludes stock (inventory) which may not be easily converted to cash.

• Why stock exclusion matters: Some stock is illiquid; e.g., unsold oil heaters may not convert to cash quickly.

• Benchmark: Ideal quick ratio benchmark is 1:1.

• Example interpretations (from slides):

  • Yoga studio: Quick ratio = 0.3:1 → very weak liquidity; insufficient cash/debtors to cover liabilities.

  • Restaurant: Quick ratio = 1.05:1 → within the benchmark; indicates enough liquid assets (cash/debtors) to cover liabilities.

Exceeding liquidity benchmarks

• If liquidity ratios exceed common benchmarks, it may seem good (lots of current assets).

• However, surpassing benchmarks is not necessarily favorable:

  • Current ratio benchmark 1.5 to 2:1: Excess cash tied up in current assets.

  • Quick ratio benchmark 1:1: Excess cash or debtors may indicate idle funds or slow-paying customers.

• Consequences of exceeding benchmarks:

  • Excess cash may be wasted; missed opportunities to invest in growth.

  • A high debtor balance increases risk of bad debts if collection worsens.

  • Excess stock can be perishable or obsolete and may not convert to cash easily.

Strategies to improve liquidity ratios

• Increase current assets (grow liquid resources):

  • Encourage cash purchases by offering discounts for immediate cash payments or early repayments on trade credit.

  • Invest in stock control systems to reduce the amount of stock held (thus increasing cash balance).

• Increase current assets by other means (if appropriate), or reduce current liabilities as needed:

  • Cut overdrafts and use long-term loans with lower interest rates (to manage funding costs).

  • Avoid late payment penalties by paying on time.

  • Take advantage of cash payment discounts.

  • Use tax planning services to reduce tax liabilities (affects cash flows).

Limitations of strategies used to improve liquidity ratios

• A firm deciding to increase the value of current assets by investing in a stock control system:

  • Drawback: Paying for the system ties up cash, which can reduce liquidity in the short term.

  • There may be a reduction in the number of creditors; yet it lowers cash on hand.

• A firm deciding to reduce current liabilities by taking advantage of immediate cash settlement discounts:

  • Drawback: Paying suppliers early reduces cash but may reduce liquidity in the short term; the benefit may be offset by reduced cash reserves.

Summary of ratios (from the formula sheet)

• These ratios appear on the formulae sheet provided in the examination.

Profitability ratios

• Gross profit margin (GPM)

  • Formula: GPM = \frac{Gross\ profit}{Sales\ revenue} \times 100

  • Benchmark: The higher the better

  • Category: Profitability

• Profit margin (PM)

  • Formula: PM = \frac{Profit\ before\ I\&T}{Sales\ revenue} \times 100

  • Benchmark: The higher the better

  • Category: Profitability

• Return on capital employed (ROCE)

  • Formula: ROCE = \frac{Profit\ before\ I\&T}{Capital\ employed} \times 100

  • Benchmark: The higher the better

  • Category: Profitability

• Capital employed definition (for ROCE):Capital\ employed = Non-current\ liabilities + Equity

Liquidity ratios

• Current ratio

  • Formula: CR = \frac{Current\ assets}{Current\ liabilities}

  • Benchmark: 1.5 to 2:1

  • Category: Liquidity

• Quick/Acid-test ratio

  • Formula: QR = \frac{Current\ assets - Stock}{Current\ liabilities}

  • Benchmark: 1:1

  • Category: Liquidity

"Note": This notes bundle the key concepts, formulas, and practical interpretations from the provided transcript. It is structured to serve as a comprehensive study guide that can substitute for the original source for exam preparation.