3.5 Profitability and ratio analysis Comprehensive Study Guide

Fundamentals of Ratio Analysis

• Definition of Ratios: Ratios are described as a "collection of doctors' instruments" used by accountants to analyze the health and performance of a business.

• Initial Concepts for Analysis:     * Current Assets vs. Fixed Assets: Understanding the difference between assets that can be converted to cash within a year and long-term assets.     * Gross Profit vs. Net Profit: Understanding the difference between profit after direct costs (COGS) and profit after all expenses (overheads).

• Core Learning Objectives:     * Calculate profitability and liquidity ratios.     * Interpret the results of financial calculations.     * Assess the inherent value and limitations of ratio analysis.

Profitability Ratios: Gross Profit Margin (GPM)

• Gross Profit Margin Purpose: Measures the percentage of sales revenue that remains after substracting the cost of goods sold (direct costs).

• Strategies to Improve GPM:     * Raising Sales Revenue:         * Reduce selling price: Effective if there are many available substitutes ($Price \, Elasticity$).         * Raise selling price: Effective if there are few substitutes ($Brand \, Loyalty$).         * Improve marketing strategies.         * Seek alternative revenue streams.     * Reducing Direct Costs:         * Sourcing cheaper suppliers.         * Cutting direct labor costs, such as through redundancies.

• Assessment Criteria: GPM figures must be compared to results from previous years and to the company's competitors to be meaningful.

Profitability Ratios: Net Profit Margin (NPM)

• Net Profit Margin Purpose: Measures the percentage of sales revenue remaining after all costs and expenses (indirect costs) have been deducted.

• Preferred Metric: In ratio analysis, "Net profit before interest and tax" is typically used.

• Strategies to Improve NPM:     * Increasing Sales Revenue: As discussed with GPM.     * Reducing Indirect Costs (Overheads):         * Negotiating cheaper rent for facilities.         * Reducing wages of non-direct staff.         * Cutting advertising budgets.         * Reducing insurance premiums.         * Reducing utility bills, such as light and heating.

• Assessment Criteria: Similar to GPM, NPM should be compared against previous years and competitor performance.

Liquidity Ratios: Analysis of Short-term Health

• Definition: Liquidity ratios measure a company’s ability to pay its short-term debts sustainably.

• Hierarchy of Asset Liquidity (from most to least liquid):     1. Cash     2. Bank     3. Debtors (Accounts Receivable)     4. Stock (Inventory)

• Current Ratio:     * Ideal Range: Between $1.5 : 1$ and $2 : 1$.     * Example Calculation: A ratio of $2 : 1$ means the business has $\$2.00$ available in liquid assets for every $\$1.00$ of current liabilities. This provided a "margin of safety" for assets that may lose value if sold quickly.     * Ratio Below $1.5 : 1$: Indicates the business may struggle to cover short-term debts, potentially jeopardizing its future or forcing a reliance on short-term finance. Improvement involves increasing current assets or decreasing current liabilities.     * Ratio Above $2 : 1$: Indicates the business is holding too many current assets, presenting an opportunity cost. Excess cash could be used for Research and Development (R&D), training, or advertising. Too many debtors increase the risk of bad debt, and too much stock increases storage and insurance costs.

• Acid Test (Quick) Ratio:     * Definition: A more stringent measure of liquidity that excludes stock ($Stock$) because inventory is the least liquid current asset and requires market demand to be converted to cash.     * Formula Logic: Excludes items like work-in-progress (which has little added value) and highly expensive stock (named example: $Boeing$ aircraft) which is difficult to sell quickly.     * Standard Target: At least $1 : 1$.

Efficiency Ratios: Return on Capital Employed (ROCE)

• Definition of ROCE: Measures financial performance relative to the total capital invested in the firm.

• Significance: Widely regarded as the "key ratio" because it allows for the comparison of businesses of vastly different sizes.

• Performance Benchmarking: The ROCE should ideally exceed current interest rates offered by banks to incentivize investors to take the associated business risk.

• Improving ROCE:     * Improve Net Profit figures.     * Reduce the capital employed while keeping profits constant (though this is noted as generally not desirable).

Stakeholders and the Utility of Ratio Analysis

• Employees and Trade Unions: Assess the likelihood of pay rises and the security of jobs.

• Managers and Directors: Identify specific areas for operational improvement and assess the likelihood of receiving performance bonuses.

• Trade Creditors: Determine if the business has the liquidity to repay short-term trade debts.

• Shareholders: Evaluate the potential Return on Investment (ROI).

• Financiers (Bank Managers): Confirm the business can repay loans.

• Local Community: Gauge potential job opportunities for residents and potential for the business to sponsor local events.

Limitations of Ratio Analysis

• Historical Data: Ratios only provide an account of past performance and do not guarantee future success.

• External Environment: Changes in interest rates or the economy can shift ratios even if business performance remains steady.

• Accounting Inconsistencies: Different depreciation methods or accounting policies make cross-company comparisons difficult.

• Qualitative Omissions: Ratios do not account for staff motivation, brand awareness, or brand loyalty.

• Varying Objectives: Different organizations prioritize different things (e.g., growth vs. profit maximization, private vs. state-owned structures).

• Context Requirement: For a complete picture, ratios must be analyzed alongside historical performance, competitive landscape, the nature of the business, and the current state of the economy.

Case Study: Lego ($1932$ - $2010$)

• Ownership: Owned and managed by the $Christiansen$ family in $Denmark$.

• Market Position: Quality products, strong global brand, and "Toy of the 20th Century" accolades. Objectives historically did not prioritize profit maximization.

• Financial Crisis ($2004$): Move into diversified markets like clothing, theme parks, and watches resulted in significant losses (Net \, loss \, before \, interest \, and \, tax = -332 \, million \, US\). Rumors of a takeover by $Mattel$ circulated.

• Recovery and Growth ($2009$-$2010$): By $2009$, profit reached 1513 \, million \, US\ on revenue of 2010 \, million \, US\.

• Strategic Insights from Charlotte Simonsen (Spokesperson):     * Acknowledged mistakes in over-diversification.     * Identified shift in consumer tastes toward computer games.     * Utilized technology: A 3D website for custom toy design and a computer-generated $Lego$ film planned for release in $2012$.     * Economic Perspective: The recession of $2008$-$2009$ helped because parents returned to "trusted global brands" for durable, familiar toys.

Case Study: Cool Meals (CM)

• Operations: Produces frozen organic ready-made meals sold to retailers.

• Strategy: Uses "Just-In-Case" ($JIC$) stock control and "Cost-Plus (mark-up)" pricing.

• Corporate Social Responsibility (CSR): Committed to buying large quantities from local farmers every $4 \, months$ at a fair price.

• Financial Status:     * 2017: Revenue $\$6000000$, GPM $16\%$, NPM $6\%$, Current Ratio $2.1$, Acid Test $0.8$.     * 2018: Revenue $\$3500000$, GPM $14\%$, NPM $3\%$, Current Ratio $2.4$, Acid Test $0.6$.

• Liquidity Observation: While the Current Ratio is high ($2.4$), the Acid Test is low ($0.6$), indicating a massive reliance on unsold stock during an economic downturn.

Case Study: BBT (Online Education)

• Context: Small private limited company in the $United \, States$ founded by $Mark \, Davis$.

• Competitive Edge: Patented software provides a Unique Selling Point ($USP$), but the copyright is expiring.

• Current Problem: Bank manager refused R&D funding due to the short product life cycle of software and a deteriorated balance sheet.

• Financial Snapshot (as of 31 October 2010):     * Fixed Assets (Net): $US\$28500$.     * Current Assets: Debtors ($US\$28000$) and Cash ($US\$2000$); Total $US\$30000$.     * Current Liabilities: Creditors ($US\$48000$).     * Net Profit (BIT): $US\$27695$.     * Capital Employed: $US\$10500$.

• Profitability Indicator: ROCE is calculated based on profit ($US\$27695$) against capital employed ($US\$10500$).

Numerical Data: JKL Ltd. Financials

• Profit & Loss Account Trends:     * Year 2: Sales revenue $1000$, Cost of goods sold $500$, Net Profit (BIT) $400$, Tax $100$, Dividends $50$, Retained Profits $250$.     * Year 1: Sales revenue $850$, Cost of goods sold $450$, Net Profit (BIT) $360$, Tax $90$, Dividends $220$, Retained Profits $50$.

• Balance Sheet Comparison:     * Fixed Assets: Year 2 ($600$) vs Year 1 ($500$).     * Total Current Assets: Year 2 ($700$) vs Year 1 ($500$).     * Current Liabilities: Year 2 ($300$) vs Year 1 ($200$).     * Working Capital: Year 2 ($400$) vs Year 1 ($300$).     * Net Assets: Year 2 ($750$) vs Year 1 ($550$).     * Current Ratio Calculation: Year 2 = $\frac{700}{300} = 2.33$; Year 1 = $\frac{500}{200} = 2.5$.