Chapter 34, Analysis of Published Accounts
Learning Objective: To understand how to further analyze the published accounts previously learned (profitability and liquidity ratios)
After understanding the different Accounting Reports, their uses and importance it is time to start looking at other measures of business performance and financial health - ratios. These ratios are to be used in combination with the accounting reports.
There are two main categories of ratios:
Profitability Ratios - Focus on measuring business performance:
- Gross Profit Margin
- Operating Profit Margin (Net Profit Margin)
- Return on Capital Employed
Liquidity Ratios - Focus on the management of cash as well as performance:
- Quick Ratio
- Acid-Test Ratio
Liquidity:
Liquidity is a business access to cash - ability to pay its short-term debts. It is an important measure as it relates to business survival and therefore liquidity ratios should be monitored constantly:
Current Ratio
Acid-Test Ratio
Liquidity ratios are used by companies to assess its ability to pay its short-term debts. These ratios are not concerned with profit, but with working capital:
A very low liquidity ratio shows the firm's inability of paying its short-term debts;
A very high liquidity ratio shows that the business could be using its cash more profitably by investing in other assets.
To understand Liquidity Ratios we will be making use of the following information:
The Current Ratio shows the ratio between Current Assets and Current Liabilities:
Current Assets are assets owned by the business that can easily and quickly be converted into cash if it needs to (<12 months);
Current Liabilities are the short-term debts to be paid in the near future (<12 months).
A healthy business needs to have a higher ratio of current assets compared to its current liabilities. If not, it will run in to liquidity problems: not enough cash to pay short-term debts.
What is a good Current Ratio then? A current ratio between 1.5 and 2 is the best:
Lower than 1.5 may be dangerous (insolvency) in case of unexpected expenses;
Higher than 2 is not advisable because the business might have too much cash tied to current assets (non-profitable assets), which is an opportunity cost.
Example:
- Nairobi has $2 of current assets for every $1 of short-term debt;
- Port Louis, on the other hand, would be in troubles if all creditors request payment of the firm's debt at the same time since it has only $1 of current assets for each $1 of short-term debts.
Example 2:
Calculate the Current Ratio using the table:
The Acid-Test Ratio is slightly different from the Current Ratio:
This calculation only considers assets that are liquid - it excludes inventories because:
- They might or might not be sold within 12 months;
- Inventory sold on credit will take long to materialize into cash.
As it only considers liquid assets on its calculation, the Acid-Test Ratio is a 'better' and more accurate liquidity ratio. It gives a clearer picture of the firm's ability to pay short-term debts.
Therefore, Acid-Test Ratio formula is:
How to look at the Acid-Test Ratio results?
Results of 1 are satisfactory;
Results lower than 1 is risky since the business might not be able to bare its short-term debts;
Results higher than 1 represent that cash is tied up to unprofitable assets.
Some businesses which carry high inventories will have very different current ratio and acid-test ratio, which is acceptable. For example: a furniture shop will probably have high inventories whereas a computer manufacturing company might not have as much.
Example:
Ways for businesses such as Port Louis can take to improve their acid-test ratio:
Reduce inventories to decrease the amount of cash tied up to it by:
- Selling it off at a reduced price (watch for brand reputation and profit margins).
Increase cash / working capital through:
- Recovering receivables quicker;
- External finance (e.g. loans, overdraft) which will increase business debt.
It is important to know that there are options out there for improving liquidity and avoid bankruptcy. Keep in mind that there are always consequences when making such decisions.
- The ratios are complimentary to the accounting reports;
- They should be used simultaneously for a full picture of a business health;
- Ratios are only useful if comparisons take place: with other businesses' in the industry as well as previous years.
The Problem?
- The ratios highlight potential problems but they do not show their causes or offer a solution.
- They are simple visualization and identification tools.
Activity 34.1
+ Reflection
Let's now jump in to performance / profitability ratios
- Gross Profit Margin
- Operating Profit Margin (Net Profit Margin)
- Return on Capital Employed
Gross Profit, as we know, is the simple difference between revenue and the cost of making/selling a product:
The Gross Profit Margin, therefore, measures how much gross profit is earned for each $1 of revenue made:
The results of the Gross Profit Margin are influenced by revenue and COGS. Therefore, in order to improve Gross Profit Margin, companies can:
Increase Revenues:
- Increase revenues without increasing COGS (e.g. increase prices);
- Needs to be done carefully as sometimes increase in prices may lead to loss of sales;
Reduce Cost of Sales:
- Trying to use cheaper supplies;
- More efficient production methods;
- While still keeping the same revenue.
Example:
Why do you think that the gross profit margin of Port Louis Press Ltd. is lower than the one of Nairobi Press Ltd. even though it has higher gross profit and higher revenue?
Causes of low Gross Profit Margin:
When a businesses charges low prices to try to enter a new market;
High cost of sales such as costly materials or labor;
Ineffective management and control of costs.
Summary:
As you can see from the formula and the examples, the gross profit margin compares gross profit (before deduction of overheads) with revenue and so it is a good indicator on how a business manages to add value to the cost of sales (materials, labor, etc.)
The calculation of Net Profit is a little different as it considers Total Costs:
Therefore, the Net Profit Margin will show profit as a percentage of revenue:
This result tells us that for every $1 of revenue/sales we earned $0.06 of profit.
Example:
Although Nairobi has a much higher gross profit margin than Port Louis, it has a somewhat similar operating profit margin. We can conclude, therefore, that Nairobi's has high overheads which impacts on its operating profits.
This is a specially important ratio as it shows the business efficiency of turning revenues into profits. Businesses should also aim to improve Net Profit Margin:
Improving Gross Profit Margin will positively impact on the Net Profit Margin:
- COGS are a part of total costs;
Reducing total costs and expenses:
- Using cheaper materials without compromising quality;
- Reducing labor costs watching for reduction in productivity (demotivation);
Increase prices carefully so that sale revenue won't decrease (watch for price elasticity of demand);
Reducing overheads:
- Moving to a cheaper location which depending on the business can be done without major consequences;
- Reducing promotion costs can be a way but may also impact sales negatively;
- Performing delayering so that the number of middle level managers can be reduced - watching for efficiency and productivity.
There are, therefore, a variety of strategies to reduce total costs. Each of them, however, may have different impacts on the business.
In summary:
Gross Profit Margin and Profit Margin are used to measure how well a business adds value to its products/services as well as how efficiently it controls its costs.
Based on what you just learned then, can we say that PLS performs better than BSK?
Not necessarily:
Although BSK has 10x higher operating profits than PLS, its revenues are almost 13x higher!
Along the same lines, we have no information on how much capital has been invested into each business and therefore it's hard to name a better performing one straight away.
This is where ROCE comes in - a much better measure of business profitability;
A.K.A. primary efficiency ratio as it compares operating profits with the long term capital invested in the business:
ROCE = (Operating Profit / Capital Employed) * 100
Where...
Capital Employed can be calculated in two different ways:
C.E = Non-Current Liabilities + Shareholders Equity
Or...
CE = Total Assets - Current Liabilities
Going back to the previous example:
Understanding the results:
The higher the ROCE the better;
Used for benchmarking and time-record (year-on-year) comparisons;
It can also be compared to the return on interest accounts as an alternative (low-risk) investment;
It should also be compared to the cost of borrowing (interest) as it will indicate whether or not the investment should be carried on;
To increase ROCE the use o of assets purchased with the CE should be more efficient and profitable, or...
Activity 34.2 Q1 (3 Profitability Ratios)
Activity 34.3 Q1, Q4
Chapter 34, Analysis of Published Accounts
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