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Ratio Analysis
Mini Lesson for IA
Two main types of financial statements (or
final accounts)
• Profit and Loss Account
• Also known as the income statement
• Shows records of income and expenditure flows for a business over a given
period of time
• Establishes whether a business has made a profit or loss and how it was
distributed at the end of that period
• Balance Sheet
• Also known as the statement of financial position
• Lists the assets, liabilities, and equity of a company at a specific point in time
• It tells us what the company owns (total assets) and owes (total liabilities),
including how much shareholders have invested in the company (equity)
Example: Profit and Loss Account for
McDonald’s
Sales
Cost of Goods Sold
Gross Profit = Sales – Cost of Goods Sold Gross Profit
Expenses
Net Profit before interest and tax = Gross Profit - Expenses Net Profit before interest and tax
Interest Expense
Net Profit before tax = net profit before interest and tax - interest Net Profit before tax
Tax Expense
Net Profit after interest and tax = net profit before tax – tax expense Net Profit after interest and tax
Dividends
Retained earnings or profit = net profit after interest and tax – dividends Retained Earnings
In Thousands $
For Year Ending
12/31/2014
27,441,300
16,250,000
11,191,300
3,083,700
8,107,600
8,107,600
3,450,000
4,657,600
-
4,657,600
Example: Balance Sheet for McDonald’s
Fixed assets are long term assets that last a business more
than 12 months. For e.g. buildings, equipment, machinery, etc.
Current assets are short term assets that last a business for up
to 12 months. For e.g. cash, accounts receivable (debt that is
yet to be paid to the business), inventory, etc.
As of 12/31/14
Fixed Assets
Intangible Assets
26,557,500
2,846,900
Current Assets:
Cash
A/R
Inventory
Other
Total Current Assets
3,082,400
1,214,400
110,000
783,200
5,190,000
Current Liabilities:
A/P
Other
Total Current Liabilities
2,747,900
2,747,900
Working capital = total current assets – total current liabilities
Working Capital
2,442,100
Long term liabilities are long term debts payable after 12 months
LT Loans
12,881,500
Net assets = fixed assets + working capital – long term liabilities
Net Assets
18,965,000
Total Equity = share capital + retained earnings
Equity:
Current liabilities are short term debts payable within 12
months
Bottom line: Net assets = Equity!!!
Share Capital
Retained earnings
Total Equity
4,736,000
14,229,000
18,965,000
Ratio Analysis
• Profitability ratios: assess the performance of a firm in terms of its
profit-generating ability
• Gross Profit Ratio
• Net Profit Ratio
• Efficiency ratios: assess how well a firm internally utilizes its assets
and liabilities
• Return on Capital Employed
• Liquidity ratios: measure the ability of a firm to pay off its short term
debt obligations
• Current Ratio
• Acid Test (Quick) Ratio
Gross Profit Ratio
Gross profit ratio =
Gross Profit
x 100
Sales Revenue
• Result is a percentage %
• Indication of profit available to pay for expenses
• Solution for low ratio: Increase sales without increasing COGS, by
increasing the sale price or finding ways to cut COGS (new suppliers).
May impact quality.
• Things to consider: Is the business labor or capital intensive? This may
impact the amount of cost of goods sold
Net Profit Ratio
Net Profit Ratio = Net profit before Interest & Tax x 100
Sales Revenue
• Result is a percentage %
• Measures how much of each dollar of sales represents net profit
• Rule of Thumb: 10% is usually a minimum
• Solution for low ratio: Generate higher levels of Gross profit, or cut
other costs such as salaries or energy costs without reducing sales. An
investment in advertising may also lead to higher sales. May impact
quality.
• Things to consider: Increased expenses may be due to growth plans
Return on Capital Employed (ROCE)
ROCE = Net Profit Before Interest & Tax x 100
Capital Employed
• Result is a percentage %
• Capital employed = Loan capital (or long-term liabilities) + share capital + retained profit
• Measures how much profit the business is generating as a percentage from its main
sources of finance
• Rule of Thumb: Should be greater than current interest rates if an investor was to put
money into the bank (for example, 5%). Bank investment significantly less risk, so ROCE
should be several percent more.
• Solutions for low ratio: Same as net profit solutions. Could also reduce amounts payable
to lenders by repaying loans, returning share capital to investors or pay dividends to
reduce the retained profits. Need cash to be able to do these.
• Things to consider: If the business has recently received a large amount of finance, it may
not have had time to generate profit from it yet.
Current Ratio
Current Ratio =
•
•
•
•
•
Current assets _
Current liabilities
Result is a ratio X:1
Measures the ability of the business to cover (pay) its debts in the next 12
months.
Rule of thumb: Should be about 2:1. Anywhere between 1.5:1 - 3.5:1
acceptable. If too low business unable to pay liabilities. Too high, current
assets not used adequately to increase profits
Solution: Increase current assets such as cash at bank or debtors by
increasing sales or taking a loan; or decrease liabilities by reducing
creditors (however this will require cash)
Things to consider: Business may not be able to get more cash through
borrowing if already highly geared
Acid Test (Quick) Ratio
Acid Test (Quick) Ratio = Current assets – stock
Current liabilities
• Result is a ratio X:1
• Measures the ability of the firm to cover (pay) immediate debt obligations
(next month)
• Rule of Thumb: Should be above 1:1. below 1:1 business at high risk (not
able to cover current liabilities)
• Solution: Increase cash held by holding lower levels of stock when possible.
Decrease current liabilities by reducing creditors.
• Things to consider: Nature of business may require higher levels of stock to
meet fluctuating demand.