Project Appraisal

Ratio Analysis
Ratio Analysis
Key issues
1. Calculate a given Ratio
2. Determine whether it has improved (better) or deteriorated
(worse)
3. Explain the possible reason for the change in the ratio.
4. There are 3 main categories of ratios we are going to cover
• Profitability ratios
• Liquidity ratios
• Gearing ratios
 Profitability ratios
• These ratios measure the company's use of its assets
and control of its expenses to generate an acceptable
rate of return (Profit)
• There are 3 Profitability ratio we will consider
1. Gross profit margin (GPM)
2. Operating Profit Margin (OPM)
3. Return on Capital Employed (ROCE)
1. Gross profit margin (GPM)
• Meaning:
• Gross Profit = Sales – Cost of Sales
• The gross profit margin measures how well a company is running its core
operations.
• The gross profit percentage should be similar from year to year for the same
company.
• The higher the GPM the better i.e. the company is managing well its core
operations
• Calculation: GPM = (Gross profit ÷ Revenue (Sales) × 100%

What causes changes in GPM

• Significant change may be due to:
• A change in sales price – i.e. an increase will mean GPM will increase
• A change in product mix – i.e. now selling more goods on demand –
improvement
• An incorrect inventory valuation (will affect two years of results)
• A change in cost of sales due to efficiency or price movements

Example 1
You are given the following information for a business for the years 2020 and 2021
Sales 2020 P3,400,000
Sales 2021 P4,500,000
• Gross Profit: 2020 P650,000
• Gross Profit: 2021 P760,000
• COS 2020 = P2,750,000
• COS 2021 P3,740,000
• Finance Cost 2020: P170,000
• Finance Cost 2021: P186,000
Required Calculate the following ratios:
(a) Gross Profit Margin (GPM)

2. Operating profit margin (Net Profit Margin)

Meaning:
• Operating Profit = Gross Profit – Operating Expenses
• The operating profit margin is usually compared to the gross profit margin to
determine how well the company is controlling its overheads (operating cost)
• Operating profit is also called Net profit or Profit Before Interest and Tax
(PBIT) • Calculation:
• Operating Profit Margin= (Operating Profit ÷ Revenue) × 100%
 What causes changes in OPM
• Significant change may be due to:
• The reasons previously stated for the movement in gross profit margin
• Changes in control over administration and distribution costs
• One off expenses, for example advertising, Covid Expenses
 Example 2
• Continuing from Example 1 and given the following additional information
• Operating Profit (2020) P450,000
• Operating Profit (2021) P500,000
• Calculate Operating Profit Margin
3. Return on capital employed (ROCE)
• Meaning:
• The return on capital employed measures how efficiently a company uses its
capital to generate profits.
• The higher the better
• ROCE = Operating Profit ÷ Capital Employed x 100
• Capital Employed = Total Assets (Non-Current Assets + Current Assets) –
Current Liabilities)
 What causes changes in ROCE

• Significant change may be due to:

• Change in prices - Change in operating
• New assets acquired during the year which are not yet running at capacity
(result in a decrease in ROCE)
• Assets ageing and revaluations
Example 3
2020 2021
(P) (P)
• Non- Current assets 6,000,000 7,500,000
• Current Assets 870,000 980,000
• Current Liabilities 560,000 670,000
• Non-Current Liabilities 5,200,000 4,900,000
• Operating Profit 450,000 500,000
• Inventory 230,000 300,000
• Equity 7,500,000 8,600,000
(c) Using the above information calculate the ROCE and comment on your answer

Liquidity Ratios
• Liquidity ratios measure a company's ability to pay its short term debt
obligations through the calculation of ratios including the current ratio
and quick ratio.
• Hence measure the company's ability to meet its debts (obligations) in the
short-term.
• Liquidity is the ability to convert assets into cash quickly and cheaply.
Types of Liquidity Ratios

1. The Current Ratio

• The current ratio measures a company's ability to pay off its current liabilities
(payable within one year) with its total current assets such as cash, accounts
receivable, and inventories.
• An ideal Current ratio is 2 (CA):1 (CL)
• The higher the ratio, the better the company's liquidity position:
• Calculation:
• Current Ratio = Current assets ÷ Current liabilities
What causes changes in Current Ratio

• A change in the levels of inventories, receivables and payables held

• a decrease in current ratio means that there are problems with inventory
management, ineffective or lax standards for collecting receivables, or an
excessive cash burn rate.
• If a company’s current ratio falls below 1, the company likely won’t have
enough liquid assets to pay off its liabilities. • While a decreasing current ratio
indicates poor financial health, it doesn’t necessarily mean that the company
will fail.
Types of Liquidity Ratios
2. The Quick Ratio
• The quick ratio measures a company's ability to meet its short-term obligations with
its most liquid assets and therefore excludes inventories from its current assets.
• It is also known as the acid-test ratio:
• This is similar to the current ratio except that it omits the inventories figure from
current assets.
• This is because inventories are the least liquid current asset that a company has,
because they have to be sold, turned into receivables and then the cash has to be
collected.
• The ideal ratio is 1:1
• Calculation: (Current assets – inventories) ÷ Current liabilities
Types of Liquidity Ratios
3. Inventory turnover period (days)

• Meaning:
• This ratio measures the number of days inventories are held on average by
a company before they are sold.
• This figure will depend on the type of goods sold by the company.
• A company selling fresh fruit and vegetables should have a low inventory
holding period as these goods will quickly become inedible.
• Calculation: (Inventories ÷ Cost of sales) × 365 days
What causes change in Inventory Turnover

• Significant change may be due to:

• A change in the type of inventory held (Covid Related Stock demand
increase)
• Improved or worsened inventory controls
• Changes in the popularity of certain inventory items
• The decline of the inventory turnover (days) value during the year is a
positive trend for the company.
Types of Liquidity Ratios
• It means that less funds are being distracted to form the inventories
4. Receivables collection period (days) •
Meaning:
• This ratio shows, on average how long it takes for the trade receivables to
settle their account with the company.
• The average credit term granted to customers should be taken into account
as well as the efficiency of the credit control function within the company.
• Calculation: (Trade receivables ÷ Revenue) × 365 days
What causes changes in Receivables collection period (days)
• Significant change may be due to:
• Increased/decreased credit terms offered to customers • A change in the
mix between cash and credit transactions
• Better/worse credit control.
Types of Liquidity Ratios
5. Payables payment period (days)
• Meaning:
• This ratio measures the time it takes the company to settle its trade payable
balances.
• Trade payables provide the company with a valuable source of short term
finance, but delaying payment for too long a period of time can cause
operational problems as suppliers may stop providing goods and services
until payment is received.
• Calculation:
• Payables Payment Period = (Trade payables ÷ Purchases × 365 days)
What causes changes in Payables payment period (days)

• Significant change may be due to:

• Increased/decreased credit terms from suppliers
• Increase/decrease the cash the company has available to make payments
• Better/worse management of the payables ledger
Gearing Ratios

• Gearing is a measure of how much of a company's operations are funded

using debt versus the funding received from shareholders as equity.
• Gearing is the ability of a company to meet its long-term obligations.
• assess the company's amount of leverage and financial stability.
• A higher gearing ratio indicates that a company has a higher degree of
financial leverage and is more vulnerable to downturns in the economy and
the business cycle.
 • a company with a high gearing ratio has a riskier financing structure than a
company with a lower gearing ratio.

Gearing Ratios
1. Debt/equity ratio
• Meaning:
• This ratio measures a company's gearing and is concerned with the long-term financial
stability of the company.
• It looks at how much debt the company has in relation to its equity funding and gives a
percentage for gearing.
• Interest bearing debt describes the long-term debt on which a company is required to pay
interest.
• In some cases a persistent bank overdraft may be classified as long term debt.
• Calculation: (Interest bearing debt ÷ Equity) × 100%
• Interest Bearing Debt / Long term Debt (Non-Current Liabilities) and short term Overdraft
• Equity – Ordinary Share Capital (contributed by shareholders)

What causes changes in Debt/Equity Ratio

• Significant change may be due to:
• An issue of shares during the year
• Repayment or taking out of new debt financing
Gearing Ratios

2. Interest Cover
Meaning:
• This ratio considers the number of times a company could pay its interest
payments using its profit from operations.
• A company should always ensure that it does not have so much debt finance
that it risks not being able to settle the debt as it falls due. • Calculation
• Interest Cover =Operating Profit ÷ finance costs
• PBIT/operating Profit/ Net Profit
• Finance Cost – Interest Cost
What causes Changes in Interest Cover

• Significant change may be due to:

• Factors which have a significant impact on profit before interest and tax
• A change in interest bearing debt
• Repayment of loans
Limitations of ratio analysis

• Comparative information is not always available.

• They sometimes use out of date information.
• Interpretation requires thought and analysis. Ratios should not be considered
in isolation.
• The exercise is subjective, for example not all companies use the same
accounting policies.
• Ratios are not defined in standard form.
 Activity 1
TJF is a national supermarket chain selling food, clothes and household appliances with
a 31 December year end.
The finance director would like the management accountant to prepare some financial
data and analysis to present to the board. He has provided the management
accountant with extracts from the financial statements to assist him in his analysis.
Lecture Activity 1(Cont’d)
Extracts from statement of profit or loss for the year ended 31
December 20X5 (with comparatives)
2021 2021

$m $m

Revenue 20,510 17,835

Cost of sales 18,970 16,835
Gross profit 1,540 1,000
Operating profit 650 530
Finance costs 200 130
Lecture Activity 1 (cont’d)
Extracts from statement of financial position as at 31 August 2021 (with
comparatives)
2021 2020

$m $m

Non-current assets 9,100 8,390

Inventories 850 1,000
Total current assets 1,570 1,610
Trade payables 2,100 2,280
Total current liabilities 2,920 2,650
 Non-current liabilities 3,250 2,530
Equity 5,050 4,935

Lecture Activity 1 (cont’d))

2020
Gross profit margin 5.6%

Operating profit margin 3.0%

ROCE 7.1%
Current ratio 0.61

Inventory holding period 22 days

 Payables payment period 49 days
Interest cover 4.08

Lecture Activity 1 (cont’d)

The finance director has also supplied the following information regarding events in the
year ended 31 August 2021:
(1) Online food home delivery increased by 25% due to Covid
(2) The number of stores grew by 10% in the year. This was financed by long term
borrowings.
(3) In the year ended 31 August 2021, 40% of customers purchased at least one clothing
item during the year whereas in the year ended 31 August 2020, only 20% of
customers did.
 Activity 1 (cont’d)
(4) A strong marketing campaign took place during the year.
(5) The new strengthened Grocery Supplier Code of Practice came into force to
improve grocery retailers’ treatment of suppliers.
 Activity 1 (cont’d)
Required
(a) Calculate the ratios below for the year ended 31 August 2021, state whether it has improved or
deteriorated and provide one possible reason for the movement in each ratio:
• Gross profit margin
• Operating profit margin
• Return on capital employed
• Current ratio
• Inventory holding period
• Payables payment period
• Interest cover