FINANCIAL RATIOS

* LIQUIDITY

* SOLVENCY
* PROFITABILITY
* EFFICIENCY
© The Corporate Classroom 2009 1
 LIQUIDITY
* The ability of a business to meet its short
term debts
* Use the Current Ratio (sometimes called the
Working Capital Ratio)
* Information found on the Balance Sheet
* Current Ratio = CURRENT ASSETS

CURRENT LIABILITIES
* Expressed as a ratio NOT a percentage
© The Corporate Classroom 2009 2
 AN EXAMPLE
ICE CREAM PALACE PTY. LTD.
BALANCE SHEET AS AT 30 JUNE 2009
 
ASSETS LIABILITIES
Cash 50,000 Creditors Current Assets
30,000
Debtors 130,000 Overdraft
Current Liabilities
90,000
Premises 220,000 Mortgage 50,000
Equipment 110,000
= 180,000
Goodwill 10,000 120,000
OWNER’S EQUITY
Capital 330,000
Net Profit 20,000 = 1.5 : 1
520,000 520,000

© The Corporate Classroom 2009 3

 WHAT DO I DO WITH A
CURRENT RATIO?
1. PUT IT IN PLAIN
ENGLISH
E.g. “A current ratio of 1.5:1
means that the business has
$1.50 in short term (liquid)
assets to cover each $1 of
short term debt
This tells an examiner that you
understand what you have
calculated
© The Corporate Classroom 2009 4
 2. COMMENT ON THE RATIO
• Generally a ratio of 2:1 is
considered acceptable. However,
some businesses with a high cash
flow (e.g. a supermarket) may
survive with a lower ratio of
almost 1:1
• Ratio too high – money that could
be invested is instead held in
cash or tied up in stock

• Ratio too low – does not pay bills as rapidly as it

could. Unable to take advantage of cash discounts
or other favourable terms
© The Corporate Classroom 2009
5
 3. COMPARE THE RATIO
• Can you compare the business’s ratio
with:-

• The industry norm ? (sometimes this is

given at the bottom of the balance
sheet)

• Past performance ? (if more than one

year’s information is provided)

© The Corporate Classroom 2009 6

 SOLVENCY (GEARING)
• Indicates the long term stability of the
business and the degree to which the business
relies on debt finance (BORROWING)
• Shows the relationship between debt funding
and equity funding
• Use the gearing ratio (Debt/Equity Ratio)
• Gearing Ratio = Total Liabilities
Owner’s Equity
• Information found on a balance sheet
• Expressed as a PERCENTAGE

© The Corporate Classroom 2009 7

 A GEARING EXAMPLE
ACE
ACESPORTS
SPORTSPTY.
PTY.LTD.
LTD.
BALANCE
BALANCESHEET
SHEETAS
ASAT
AT30
30JUNE
JUNE2009
2009
  

ASSETS
ASSETS CURRENT
CURRENTLIABILITIES
LIABILITIES
Cash
Cash 30,000
30,000 A/Cs
A/CsPayable
Payable 10,000
10,000
A/Cs
A/CsReceivable
Receivable 10,000
10,000 Bank
Bank 20,000
20,000
Stock
Stock 70,000
70,000
NON
NONCURRENT
CURRENTLIABILITIES
LIABILITIES Total Liabilities
Mortgage
Mortgage 25,000
25,000 Owner’s Equity
OWNER’S
OWNER’SEQUITY
EQUITY
Capital
Capital 40,000
40,000
Retained
RetainedProfit
Profit 15,000
15,000
55,000 X 100

110,000
110,000 110,000
110,000 55,000

= 100%
8
© The Corporate Classroom 2009
 HOW DO I USE A GEARING
RATIO?
• Put it in ‘plain English’
• E.g. A result of 100% shows
the business finances it’s
activities equally by debt and
equity
• For every $2 the firm uses,
$1 is borrowed (debt) and $1
comes from owners (equity)
© The Corporate Classroom 2009 9
 ANOTHER EXAMPLE
400,000 (Total Liabilities)
500,000 (Owner’s Equity)
= 80%
For every $1.80 of funding, 80 cents
comes from borrowing (debt) and $1
comes from the owners (equity)
OR
For every $9 of funding, $4 comes from
debt and $5 comes from equity
© The Corporate Classroom 2009 10
 ONE MORE TO MAKE SURE

400,000 (Total Liabilities)

200,000 (Owner’s Equity)
= 200%
For every $3 of funding, $2 comes from
borrowing (debt) and $1 comes from the
owners (equity)
OR
For every $6 of funding, $4 comes from debt
and $2 comes from equity

© The Corporate Classroom 2009 11

 WHAT DOES IT MEAN?
• The higher the percentage the
more highly geared the firm

• The higher the percentage the

greater the reliance on
borrowed funds

• A combination of debt AND

equity is preferable

• Generally gearing up to 100% is

acceptable

© The Corporate Classroom 2009 12

 A HIGH GEARING/SOLVENCY RATIO
• A highly geared business is one that has a
gearing ratio above 100%

• Excessive gearing (e.g. 200%) often leads to

INSOLVENCY and has contributed to many
corporate collapses

• A highly geared firm relies too

much on borrowed funds - a
concern to creditors

• Highly geared businesses are

particularly vulnerable to insolvency
in recession and economic downturns
13
© The Corporate Classroom 2009
 A LOW GEARING/SOLVENCY
RATIO
• A relatively low gearing (debt/equity) ratio is one
below 100%

• Generally any gearing ratio less than 100% is

considered acceptable

• However, a firm geared too low may be

missing out on investment opportunities

• Lower gearing ratios means lower risk-

• creditors are happy
14
© The Corporate Classroom 2009
 PROFITABILITY

• Measures the earnings of the business

• The higher the better
• Gross Profit Ratio - Profit/Loss Statement
• Net Profit Ratio - Profit/Loss Statement
• Return on Owner’s Equity Ratio - Balance Sheet

• Profitability ratios (margins) generally expressed

as a PERCENTAGES

© The Corporate Classroom 2009 15

 PROFITABILITY RATIOS
• Gross Profit = Gross Profit x 100

Sales

• Net Profit Ratio = Net Profit x 100

Sales

• Return on Owner’s Equity = Net Profit x 100

© The Corporate Classroom 2009 16
 A GROSS PROFIT EXAMPLE

Revenue
Revenue Statement
Statement
Fab
Fab Flowers
Flowers Pty
Pty Ltd
Ltd

Sales
Sales 450,000
450,000
Cost
Gross Profit x 100
Cost of
of Sales
Sales 270,000
270,000

Gross
Gross Profit
Profit 180,000
180,000

Operating
Operating Expenses
Expenses 153,000
153,000

Net
Net Profit
Profit 27,000
27,000
 
 

Sales
© The Corporate Classroom 2009 17
 SO WHAT DO I DO WITH A
GROSS PROFIT RATIO ?
1. PUT IT IN PLAIN ENGLISH
E.g. “A gross profit margin of 40%
means that every dollar of sales
generates 40cents of gross profit”

2. IDENTIFY ANY TRENDS

3. COMPARE IT TO THE INDUSTRY

NORM

© The Corporate Classroom 2009 18

 WHAT DOES A GROSS
PROFIT RATIO SHOW?
• The GP margin reflects the
margin or mark up between the
business’s purchasing costs and
its selling prices
• A low GP margin suggests high
supply costs and/or products
priced too low
• A high GP margin suggests low
supply costs and/or products
more highly priced
© The Corporate Classroom 2009 19
 A NET PROFIT EXAMPLE

Revenue
Revenue Statement
Statement NET PROFIT X 100
Fabulous
Fabulous Flowers
Flowers Pty
Pty Ltd
Ltd SALES
Sales
Sales 450,000
450,000
Cost
Cost of
of Sales
Sales 270,000
270,000 = 27,000 X 100
Gross
Gross Profit
Profit 180,000
180,000
450,000

Operating
Operating Expenses
Expenses 153,000
153,000 =6%

Net
Net Profit
Profit 27,000
27,000
 
 

© The Corporate Classroom 2009 20

 SO WHAT DO I DO WITH A
NET PROFIT RATIO ?
1. PUT IT IN PLAIN ENGLISH
E.g. “A net profit margin of
6% means that every dollar
of sales generates 6 cents of
net profit”

2. IDENTIFY ANY TRENDS

3. COMPARE IT TO THE
INDUSTRY NORM
© The Corporate Classroom 2009 21
 WHAT DOES A NET PROFIT
RATIO SHOW?
• The NP margin reflects the
operating costs or expenses of
the business

• A low NP margin (especially

when the GP is relatively high)
suggests excessive costs

• A high NP margin suggests low

costs/ expenses and sound
financial management

© The Corporate Classroom 2009 22

 RETURN ON OWNER’S
EQUITY
 This ratio indicates how much
the owner’s investment in the
business is earning

 The higher the better

 Expressed as a percentage
© The Corporate Classroom 2009 23
 RETURN ON OWNER’S EQUITY
EXAMPLE
THE
THEBOOK
BOOKBARN
BARNPTY.
PTY.LTD.
LTD.
BALANCE
BALANCESHEET
SHEETAS
ASAT
AT30
30JUNE
JUNE2009
2009
  
ASSETS
ASSETS LIABILITIES
LIABILITIES
Cash
Cash 15,000
15,000 A/Cs
A/CsPayable
Payable 9,000
9,000
Stock
Stock 80,000
80,000 Bank
Bank 15,000
15,000
Premises
Premises 34,000
34,000 Mortgage
Mortgage 25,000
25,000
NET PROFIT X 100
OWNER’S
OWNER’SEQUITY
EQUITY OWNER’S EQUITY
Capital
Capital 70,000
70,000
Retained = 10,000 X 100
RetainedProfit
Profit 10,000
10,000
80,000
129,000
129,000 129,000
129,000
= 12.5%
24
© The Corporate Classroom 2009
 SO WHAT DO I DO WITH A
ROE RATIO ?
1. PUT IT IN PLAIN ENGLISH
E.g. “A ROE ratio of 12.5% means that
every dollar contributed by the owner
generates 12.5 cents return”

2. IDENTIFY ANY TRENDS

3. COMPARE IT TO THE INDUSTRY

NORM

4. COMPARE THE RESULT TO

ALTERNATIVE INVESTMENTS

© The Corporate Classroom 2009 25

 EFFICIENCY RATIOS
 A business improves efficiency when more output results
from given inputs

 Greater efficiency contributes to a comparative

advantage

 Expenses Ratio = Operating Expenses x 100

Sales

 Accounts Receivable Turnover Ratio = A/Cs Receivable

Sales / 365
© The Corporate Classroom 2009 26
 AN OPERATING EXPENSES
EXAMPLE
Operating Expenses x 100 Revenue
Revenue Statement
Statement
Sales Fabulous
Fabulous Flowers
Flowers Pty
Pty Ltd
Ltd

Sales
Sales 450,000
450,000
= 153,000 x 100 Cost
Cost of
of Sales
Sales 270,000
270,000
450,000
Gross
Gross Profit
Profit 180,000
180,000
= 34%
Operating
Operating Expenses
Expenses 153,000
153,000

Net
Net Profit
Profit 27,000
27,000

© The Corporate Classroom 2009 27

 WHAT DOES AN
EXPENSES RATIO SHOW?
• AN EXPENSES RATIO SHOWS HOW MUCH OF
EACH $ OF SALES IS TAKEN UP IN
EXPENSES

• A RESULT OF 34% MEANS THAT THE

BUSINESS HAD EXPENSES OF 34 CENTS TO
EARN EVERY DOLLAR OF SALES

• THE LOWER THE PERCENTAGE

THE BETTER
© The Corporate Classroom 2009 28
 WHAT DOES AN A/Cs RECEIVABLE
TURNOVER RATIO MEAN ?
• EXPRESSED AS A NUMBER OF DAYS NOT A PERCENTAGE
OR RATIO

• AN ANSWER OF 61.2 MEANS THAT IT GENERALLY TAKES

61.2 DAYS TO COLLECT ACCOUNTS RECEIVABLE

• ACCOUNTS RECEIVABLE ARE CREDIT SALES

• USED TO EVALUATE EFFICIENCY OF CREDIT

COLLECTION EFFICIENCY

• RESULT SHOULD NOT BE HIGHER THAN THE CREDIT

POLICY

29
© The Corporate Classroom 2009
 CASH FLOW
STATEMENTS
Umbrella Universe Pty Ltd.

J F M A M J J A S O N D
Opening - 20 10 30 50 80 160 170 70 -30 -70 -10
Cash
Balance

Receipts 140 100 150 130 120 180 150 100 80 110 270 260
Outlays 120 110 130 110 90 100 140 200 180 150 210 250
Closing 20 10 30 50 80 160 170 70 -30 -70 -10 0
Cash
Balance

© The Corporate Classroom 2009 30

©The Corporate Classroom 2009 31