Financial Ratios and Ratio Analysis
- Financial ratios are essential for assessing business performance.
- They provide a structured way to analyze profitability, liquidity, and efficiency by comparing key financial data.
- Stakeholders, including managers, investors, and creditors, use these ratios to make informed decisions based on facts rather than assumptions.
Ratio Analysis
Ratio Analysis is a financial analysis tool that evaluates a company's financial performance using various ratios. It helps in assessing profitability, liquidity, efficiency, and solvency.
Why Ratio Analysis Matters
- Raw financial numbers can be misleading without context.
- Ratio analysis helps businesses compare performance over time and against competitors.
- Consider this:
| Company A | Company B | |
|---|---|---|
| Profit | €15 Million | €3 Million |
| Sales | €180 million | €12 million |
- At first glance, Company A appears more successful because it earns five times more profit than Company B.
- However, using profitability ratios tells a different story:
- Company A: $(15 \text{ million} / 180 \text{ million}) \times 100 = 8.3\%$
- Company B: $(3 \text{ million}/ 12 \text{ million}) \times 100 = 25.0\%$
- Always calculate ratios before making conclusions.
- Looking at just profit figures can give a distorted view of success.
Types Of Financial Ratios
- There are four main categories of financial ratios:
- Profitability Ratios: Measure how well a business generates profit.
- Liquidity Ratios: Assess whether a company can pay short-term debts.
- Financial Efficiency Ratios (HL Only): Evaluate how effectively a business uses resources.
- Gearing Ratios (HL Only): Examine the balance between internal and external financing.
Overview of Different Profitability and Liquidity Ratios
| Type of Ratio | Profitability Ratios | Liquidity Ratios |
|---|---|---|
| Ratios Used | Gross Profit Margin, Profit Margin, Return on Capital Employed (ROCE) | Current Ratio, Acid-Test Ratio |
| Purpose | Measures profitability relative to revenue or capital | Assesses ability to meet short-term debts |
| Key Stakeholders | Shareholders, Creditors, Managers, Investors | Suppliers, Lenders, Managers |
Investors focus on profitability, while creditors care more about liquidity.
Getting The Right Data
- Ratios are only as good as the data used.
- The most useful sources include:
- Business Financial Records
- Profit and Loss Statements and Balance Sheets provide the raw data needed.
- Industry Benchmarks, ratios should be compared to industry norms to make sense.
- Economic Conditions, a drop in profitability could be due to external factors like inflation, not poor management.
- A ratio by itself means nothing.
- Always compare it over time or against competitors.
How Ratios Are Expressed
- Ratios appear in two main formats:
- As a percentage: ROCE (Return on Capital Employed) is written as a percentage of capital invested.
- As a ratio: The acid-test ratio may be 0.9:1, meaning the business has \$0.90 in liquid assets for every \$1 of short-term liabilities.
Be specific in exams. If a question asks about profitability, don’t just discuss profits, they’re not the same thing.
Profitability Ratios: Gross Profit Margin, Profit Margin, and ROCE
- Profitability ratios assess whether a business is making enough money relative to its sales, assets, or capital investment.
Profitability
A measure of how well a business turns revenue into profit.
Profitability ratios compare profits to other key variables, such as sales revenue or capital employed.
Gross Profit Margin: Measuring Operational Efficiency
Gross Profit Margin
The Gross Profit Ratio is a profitability ratio that measures the percentage of gross profit to net sales. It indicates how efficiently a company produces and sells its goods.
A higher ratio suggests better profitability from core business operations.
Gross Profit Margin Formula
$$\text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100$$
- A retail company reports gross profit of USD 4,500 million on sales of USD 20,500 million.
- Gross Profit Margin = (USD 4,500M / USD 20,500M) × 100 = 21.95%
Why It Matters
- Operational Efficiency: Shows how well a business controls its direct costs.
- Pricing Strategy: Reflects the effectiveness of pricing decisions.
Profit Margin: Reflecting Overall Profitability
Profit Margin
The Profit Margin measures the percentage of net profit relative to net sales. It reflects a company's ability to generate profit after accounting for all expenses, including taxes and interest.
A higher ratio indicates better profitability and financial efficiency.
Profit Margin Formula
$$\text{Profit Margin} = \frac{\text{Profit before Interest and Tax}}{\text{Revenue}} \times 100$$
Why It Matters
- Comprehensive View: Includes all operating expenses, providing a fuller picture of profitability.
- Performance Indicator: Helps compare businesses with different cost structures.
Return on Capital Employed (ROCE): Evaluating Resource Efficiency
Capital Employed
Capital Employed represents the total capital investment used to generate profits. It reflects the long-term funds deployed in the business.
Return on Capital Employed
ROCE is a key profitability ratio that measures how efficiently a company generates profit from its capital employed.
$$\text{ROCE} = \frac{\text{Profit before interest and tax}}{\text{Capital employed}} \times 100$$
A higher ROCE indicates efficient use of capital in generating profits.
Return on Capital Employed (ROCE) Formula
$$\text{ROCE} = \frac{\text{Profit before interest and tax}}{\text{Capital employed}} \times 100$$
$$\text{Capital employed} = \text{Non-current liabilities + Equity}$$
Why It Matters
- Primary Efficiency Ratio: Shows how well a business uses its capital to generate profit.
- Investment Attractiveness: Higher ROCE indicates better returns for investors.
ROCE should be compared to industry benchmarks and past performance to provide meaningful insights.
Why Profitability Ratios Matter
- Stakeholder Insights:
- Shareholders: Assess dividend potential and investment returns.
- Managers: Identify areas for improvement and set performance targets.
- Competitive Analysis: Compare performance against industry peers.
- Strategic Decision-Making: Guide pricing, cost management, and investment strategies.
- How do cultural differences influence the way businesses prioritize profitability?
- Consider culture within the company itself, and also its physical location.
