Accounting & Financial
Analysis 111
Lecture 8
Ratio Analysis, Break-even point
Ratio analysis



Ratio analysis provides the manager with
the tools necessary to analyse the
performance of the business.
The business can then compare its
current performance with its past
performance to establish whether it is
doing better or worse than previous
years.
It can also compare its performance with
that of similar types of business by
extracting the relevant ratios from
business statistical publications.
Ratio analysis 2

Ratios are use to measure different
aspects of the business namely:
The trading performance - (P & L)
 The trading performance in relation to
assets, liabilities and shareholder's
equity - (P & L / BS)
 An analysis of the company's worth (BS)

Ratio analysis 3
Ratios are viewed under the
following headings:
 1) Profitability
 2) Activity
 3) Liquidity
 4) Leverage
 5) Valuation

Ratio analysis e.g.
In your notes are the Profit & Loss
and Balance Sheet of Pizza Delight
Ltd for the years 2003 & 2004.
 We will use these figures in the
ratios that follow.

Measuring Profitability
The ratios used to measure
profitability are usually:
 1. Gross profit margin %
 2. Net profit margin %
 3. Return on total assets %
 4. Return on shareholder's funds %
5. Return per employee $

Gross profit margin
= Gross profit * 100

Sales

$880,000 * 100
 $2,200,000

= 40%
Net profit margin
= Net profit * 100

Sales

$218,500 * 100 =
$2,200,000
6.95%
Return on net assets
= Net profit after tax
* 100
 Total assets - current liabilities

$152,950 . * 100
$1,064,300
=
14.37%
Return on shareholder's funds
= Net profit after tax
Shareholder's equity
*100
= $152,950 * 100 = 36.92%
$414,300
Return per employee
Net profit after tax
 Number of employees


$152,950
20
=
$7,648
Measuring Activity
The ratios used to measure activity
are:
 1. Average inventory
 2. Stock turnover
 3. Average accounts receivable
turnover
 4. Average daily credit sales
 5. Average collection period
 6. Asset / employee ratio

Average inventory

Opening stock + closinq stock
2

$32,000+$29,000 =
2
$30,500
Stock turnover

Cost of qoods sold
Average inventory

= $1,320,000
$30,500
=
43.28 times
Average accounts receivable
turnover

Annual Credit sales
Accounts receivable

= $2,200,000
$78,200
= 28 times
Average daily credit sales

Annual credit sales
Number of working days
=$2,200,000 = $6,027

365

Average collection period
Accounts receivable
Average daily credit sales

= $78,200

$6,027

= 13 days
Asset/ Employee ratio

Total assets
Number of employees
= $1,182,650 = $59,133
20
Measuring Liquidity
Liquidity ratios are a means of
calculating the working capital
available to meet the short term
debts of the company.
 It is an expression of how cash
liquid the company is.
 The higher the number the stronger
the company position.

Current ratio
Current assets
Current liabilities


$345,000 =
$118,350
2.92 times
Quick ratio
Current assets - inventory
 Current liabilities- bank overdraft

$316,000
 $118,350

= 2.67 times
Measuring leverage - gearing
 Debt
to equity (Gearing)
Long-term debts
Shareholder's equity

= $650,000 = 1.57 times

$414,300

Total debt to total assets
Total debt
Total assets
=
$768,350
$1,182,650
= 0.65 times
Interest coverage

Profit before Interest* & Tax
Interest
= $218,500 + $68,000
$68,000
=4.21 times
* Shown as “Finance Costs” in P&L
Fixed charge coverage
PBIT* + Lease payments
Interest + lease payments
$286,500 + $130,000
$68,000 + $130,000
= 2.1 times
* Profit Before Interest & Tax
Measuring valuation
Earnings per share
Profit after tax
No. of Ordinary shares issued
= $152,950
200,000
= $0.76 p.s.
Dividend per share
Ordinary dividends paid
No. of Ordinary shares issued



= $50,000
200,000
= $0.25 p.s.
Earnings yield % per share
Earnings per share * 100
Market price per share

=$0.76 * 100 = 18.09%
 $4.20

Dividend yield % per share

Annual dividend paid per share * 100
Market price per share
$0.25 * 100
$4.20
=
5.95%
Price / earnings ratio
Market price per share
 Earnings per share

= $4.20

$0.76

=
5.5 times
Break-even Point

Selling price - Variable costs =
Contribution margin

Contribution margin - Fixed costs = Profit
Selling price
is the price per unit sold.
 Total number of units sold * selling
price per unit = Total revenue


E.G. sale of 15,000 meals *$25 per
meal =$375,000 revenue
Variable costs





are costs that increase/decrease according to
the level of activity. (Sales, production)
They relate to PER UNIT COST
E.G. If each meal cost $9 to purchase the
ingredients.
The cost of the meals will change depending on
the number of meals produced. 10,000 =$90,000
and 15,000 = $135,000.
If the kitchen staff are paid by the number of
meals produced and sold, their wages would be
variable costs otherwise they are fixed costs.
Semi-variable costs


are costs that change slightly as the level of production
increases but not in proportion to the increase in
production.
A semi-variable cost has an element of fixed costs in it.




E.G. Telephone account has a fixed service charge, only the call
charge increases as the calls increase.
Electricity/gas charges in a kitchen will not change too much as
the number of meals increase.
Semi-variable costs are not normally classified within
small to medium sized industry.
It is only the very large corporations that may apply
semi-variable costs in management applications.
Most companies consider semivariable costs as part
of the fixed costs.
Fixed costs
are costs that remain the same
irrespective of the level of sales or
production.
 E.g. Occupancy costs - (Rent, rates,
electricity, telephone, insurance),
long-term finance costs,
Depreciation, Administration costs,
Marketing costs.

Break-even point



It is in the interest of every business to
calculate the amount of sales required at
a given profit margin that will equal the
fixed costs.
That number of sales is the break-even
point for the business.
If the business cannot finance its fixed
costs within a short time of
commencement and has no alternate
funding its chances of success are
limited.
Break-even point 2


1.
2.
3.
The break-even point is influenced
by three components.
An adjustment to any of the
components will change the breakeven number.
Change in the selling price per unit
Change in variable costs
Change in fixed costs
Break-even point e.g.






A manufacturing company producing one
product has the following data:
Sale price $52
Variable costs $31
Fixed costs $325,500
Before the company starts to make any
profit it must produce enough
contribution equal to the fixed costs
($325,000).
Therefore it must sell 15,500 units.
Break-even point e.g. ctd.




$52 - $31 = $21 contribution $325,500 /
$21 = 15,500 units
At this stage the company has not made
any profits it has only made sufficient
contribution to cover its costs.
Every unit sold in excess of 15,500 will
produce a profit of $21.
Therefore if the company sells 18,000
units it should make a profit of $52,500.
(18,000 - 15,500) * $21
Break-even point e.g. ctd
The company may decide that
$52,500 is not sufficient return on
assets employed and it is not likely
to increase sales beyond 18,000
units.
 Therefore an adjustment to any of
the three components could
improve the profit margin.

Break-even point e.g. ctd
E.g. If selling price was to be increased
to $54 the break-even point would be
reduced to 14,152 units.
 The outcome will be a profit of $88,504.
 (18,000 - 14,152) * $23 = 88,504
 OR:((18,000 * $54) - (18,000 * $31)) $325,500 = $88,500

Break-even equation
The equation to calculate the breakeven point is:
 Break-even point =
Fixed costs

Contribution
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PRACTICE ACTIVITY!
Class Exercise 8A & 8B
 Do it manually or use Excel
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