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RATIOS TO EVALUATE PROFITABILITYPROFITABILITY RATIOS Gross Profit Margin Operating Profit Margin Net Profit Margin Return on Total Assets (ROTA) Return on Net Assets (RONA) Return on Equity (ROE)Additional ratios can include any growth ratios (year on year movements)GROSS PROFIT MARGINPROFITAB...

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RATIOS TO EVALUATE PROFITABILITY PROFITABILITY RATIOS      

Gross Profit Margin Operating Profit Margin Net Profit Margin Return on Total Assets (ROTA) Return on Net Assets (RONA) Return on Equity (ROE)

Additional ratios can include any growth ratios (year on year movements)

GROSS PROFIT MARGIN Formula (How)

PROFITABILITY

Information (Why) Rules (Remember)

Interpret (See as)

Manage (Improve)

Careful (Manipulation) Ideal (Optimum) Other

𝟏 𝟓𝟑𝟕 𝐆𝐫𝐨𝐬𝐬 𝐏𝐫𝐨𝐟𝐢𝐭 = = 𝟒𝟑. 𝟎𝟐% 𝐒𝐚𝐥𝐞𝐬 𝟑 𝟓𝟕𝟑 Indication of percentage of sales that are converted to gross profit after the cost of sales has been covered. Gross profit are calculated after cost of sales is deducted, no other expenses are deducted to arrive at gross profit. Sales include both credit sales and cash sales. Higher gross profit percentage indicates that a greater percentage of sales are converted into gross profit, to convert further into net profit after other expenses. Decline can indicate a planned decline in gross profit percentage to stimulate sales. Increase sales while carefully managing cost of sales. Sales can be increased by advertising or promotions. Management should just be careful, as sales can be increased if mark-ups are decreased, but that might negatively affect the gross profit margin. Expenses can be falsely classified, and not included in cost of sales as it should. This would result in a lower cost of sales figure. A higher gross profit margin would be preferable, but customers that buy the products need to be satisfied with the selling price. Profit mark-up can also be calculated (1 537 / 2 036 = 75.49%)

OPERATING PROFIT MARGIN Formula (How)

PROFITABILITY

Information (Why)

Rules (Remember) Interpret (See as)

Manage (Improve)

Careful (Manipulation) Ideal (Optimum) Other

𝐄𝐁𝐈𝐓 𝟐𝟖𝟐 = 𝟕. 𝟖𝟗% = 𝟑 𝟓𝟕𝟑 𝐒𝐚𝐥𝐞𝐬 Indication of percentage of sales that are converted to earnings before interest and tax after the operating costs have been covered. Indicates how much is spent to get services or finished products to clients. EBIT stands for earnings before interest and tax. Sales include both credit sales and cash sales. Higher operating profit percentage indicates that a greater percentage of sales are converted into earnings before interest and tax, to convert further into net profit after all other expenses. Increase sales while carefully managing other costs. Sales can be increased by advertising or promotions. Management should just be careful, as sales can be increased if mark-ups are decreased, but that might negatively affect the earnings before interest and tax. Expenses can be falsely classified, and included in the wrong accounts. This would affect the calculations depending on where the costs were classified. A higher net operating profit margin would be preferable. Net profit margin can also be calculated (128 / 3 573 = 3.58%). Net profit margin is included in the Du Pont analysis.

PROFITABILITY

NET PROFIT MARGIN Formula (How) Information (Why) Rules (Remember) Interpret (See as) Manage (Improve) Careful (Manipulation) Ideal (Optimum) Other

𝟏𝟐𝟖 𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭 𝐚𝐟𝐭𝐞𝐫 𝐓𝐚𝐱 = = 𝟑. 𝟓𝟖% 𝐒𝐚𝐥𝐞𝐬 𝟑 𝟓𝟕𝟑 Indication of % of profit retained after all costs are considered. After preference dividend. For every R1 obtained from sales, 3.58c goes to the owner. When measured against the operating profit margin, it gives an indication of how much is spent on financing costs and tax. Focuses attention on management of overall cost. Manipulation to increase sales and / or decrease all costs. Aim for as high as possible – highest nominal profit. Second Du Pont factor – also called earnings.

ROTA 1 – PROFIT BEFORE INTEREST AND TAX

PROFITABILITY

Formula (How)

Information (Why) Rules (Remember) Interpret (See as) Manage (Improve) Careful (Manipulation)

Ideal (Optimum)

𝐏𝐫𝐨𝐟𝐢𝐭 𝐛𝐞𝐟𝐨𝐫𝐞 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐚𝐧𝐝 𝐓𝐚𝐱 𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬

=

𝟐𝟖𝟐 = 𝟏𝟗. 𝟔𝟓% 𝟏 𝟒𝟑𝟓

Measures the return rendered by using the assets in the operations of the company. It gives an indication of the profitability of the firm in terms of assets employed. Ignores tax and finance costs – comparable to other entities with different tax and gearing characteristics. A higher return on assets will be desirable as it will mean that the assets are used efficiently to generate the highest possible return. Assets should be used productively in order to generate a return. Managers could decide not to invest in new assets in order to keep the asset base as low as possible. That would result in a higher return on asset percentage, as the returns would be divided by a lower asset value. Provided that returns or values of assets are not manipulated, a higher return on assets would be preferable.

Other

ROTA 2 – PROFIT BEFORE INTEREST AFTER TAX PROFITABILITY

Formula (How)

Information (Why) Rules (Remember) Interpret (See as) Manage (Improve) Careful (Manipulation) Ideal (Optimum) Other

𝐏𝐫𝐨𝐟𝐢𝐭 𝐛𝐞𝐟𝐨𝐫𝐞 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐚𝐟𝐭𝐞𝐫 𝐓𝐚𝐱 𝟏𝟐𝟖 + 𝟎. 𝟕(𝟏𝟎𝟎) = 𝟏𝟑. 𝟖% = 𝟏 𝟒𝟑𝟓 𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬 Measures the return rendered by using the assets in the operations of the company. It gives an indication of the profitability of the firm in terms of assets employed. Ignores finance costs – conceptually most correct as tax is also an ‘operating expense’. A higher return on assets will be desirable as it will mean that the assets are used efficiently to generate the highest possible return. See ROTA 1. See ROTA 1. Provided that returns or values of assets are not manipulated, a higher return on assets would be preferable. Ignores interest paid – a cost of financing.

ROTA 3 – NET PROFIT

PROFITABILITY

Formula (How)

Information (Why) Rules (Remember) Interpret (See as) Manage (Improve) Careful (Manipulation) Ideal (Optimum) Other

𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭 𝟏𝟐𝟖 = 𝟖. 𝟗𝟐% = 𝟏 𝟒𝟑𝟓 𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬 Measures the return rendered by using the assets in the operations of the company. It gives an indication of the profitability of the firm in terms of assets employed. Use net profit after interest and tax. A higher return on assets will be desirable as it will mean that the assets are used efficiently to generate the highest possible return. See ROTA 1. See ROTA 1. Provided that returns or values of assets are not manipulated, a higher return on assets would be preferable. Shortcoming – does not ignore the cost of financing. Possibility to overstate profit therefore increases. The product of the first two Du Pont factors.

RONA 1 – PROFIT BEFORE INTEREST AND TAX Formula (How)

PROFITABILITY

Information (Why) Rules (Remember)

Interpret (See as)

Manage (Improve)

Careful (Manipulation)

Ideal (Optimum) Other

𝐏𝐫𝐨𝐟𝐢𝐭 𝐛𝐞𝐟𝐨𝐫𝐞 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐚𝐧𝐝 𝐓𝐚𝐱 𝐍𝐞𝐭 𝐀𝐬𝐬𝐞𝐭𝐬

=

𝟐𝟖𝟐 = 𝟐𝟏. 𝟒𝟒% 𝟗𝟏𝟓 + 𝟒𝟎𝟎

Measures the profitability of the company in relation to the total assets, BUT as financed with long term financing. Ignores creditors. Basis of ratio includes short term loans, if there is an associated cost. Excludes non-operating financial assets and excess cash. A higher return on assets will be desirable as it will mean that the assets are used efficiently to generate the highest possible return. Return on capital that was invested for the long term – compare to CoC. Assets should be used productively in order to generate a return. Depends on the amount of long term financing. Managers could decide not to invest in new assets in order to keep the asset base as low as possible. That would result in a higher return on asset percentage, as the returns would be divided by a lower asset value. Depends on the amount of long term financing Provided that returns or values of assets are not manipulated, a higher return on assets would be preferable. 1 315 = 1 435 (total assets) – 98 (creditors) – 22 (short term borrowings.

RONA 2 – PROFIT BEFORE INTEREST AFTER TAX Formula (How)

PROFITABILITY

Information (Why) Rules (Remember)

Interpret (See as)

Manage (Improve) Careful (Manipulation)

Ideal (Optimum) Other

𝐏𝐫𝐨𝐟𝐢𝐭 𝐛𝐞𝐟𝐨𝐫𝐞 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐚𝐟𝐭𝐞𝐫 𝐓𝐚𝐱 𝟏𝟐𝟖 + 𝟎. 𝟕(𝟏𝟎𝟎) = 𝟏𝟓. 𝟎𝟔% = 𝟗𝟏𝟓 + 𝟒𝟎𝟎 𝐍𝐞𝐭 𝐀𝐬𝐬𝐞𝐭𝐬 Measures the profitability of the company in relation to the total assets, BUT as financed with long term financing. Ignores creditors. Basis of ratio includes short term loans, if there is an associated cost. Excludes non-operating financial assets and excess cash. A higher return on assets will be desirable as it will mean that the assets are used efficiently to generate the highest possible return. Return on capital that was invested for the long term – compare to CoC. Used for comparison to the company’s CoC, as not all liabilities are used for the CoC. Managers could decide not to invest in new assets in order to keep the asset base as low as possible. That would result in a higher return on asset percentage, as the returns would be divided by a lower asset value. Depends on the amount of long term financing Provided that returns or values of assets are not manipulated, a higher return on assets would be preferable. If RONA 2 > WACC, assets create value.

RETURN ON EQUITY

PROFITABILITY

Formula (How)

Information (Why)

Rules (Remember) Interpret (See as) Manage (Improve)

Careful (Manipulation)

Ideal (Optimum) Other

𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐓𝐨𝐭𝐚𝐥 𝐄𝐪𝐮𝐢𝐭𝐲

=

𝟏𝟐𝟖 = 𝟏𝟑. 𝟗𝟗% 𝟗𝟏𝟓

Gives the percentage net income that is returned on the funds that shareholders invested in the company. Shareholders want a return on their investment, and that return can either be paid out as dividends or reinvested in the company to facilitate growth in future years. Total shareholder funds includes retained earnings. A higher return on equity will mean that the shareholders are earning a higher return in money invested. Income generated should be increased and costs carefully managed. Misstatements in income and expense items. A company can choose not to obtain funding by means of equity in order to keep the equity-base as low as possible, which could be detrimental for the company in the long run. Provided that returns or values of equity are not manipulated, a higher return on equity would be preferable. Du Pont analysis calculates and analyses Return on Equity.

RATIOS TO EVALUATE ASSET MANAGEMENT ASSET MANAGEMENT RATIOS     

Inventory Turnover Debtors’ Collection Period Fixed Asset Turnover Operational Asset Turnover Total Asset Turnover

These ratios can also be used to assess liquidity

ASSET MANAGEMENT

INVENTORY TURNOVER Formula (How) Information (Why) Rules (Remember) Interpret (See as) Manage (Improve) Careful (Manipulation) Ideal (Optimum) Other

𝐂𝐨𝐬𝐭 𝐨𝐟 𝐒𝐚𝐥𝐞𝐬 𝟐 𝟎𝟑𝟔 = 𝟑𝟏. 𝟑 𝐭𝐢𝐦𝐞𝐬 = 𝟔𝟓 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 How many times inventory on hand is sold during period. Excessive inventory yields a low or zero return. Do not use turnover figure above the line, as it is not stated at cost price. If available use average inventory level below the line. If inventory turnover is 12 times, it means that everything in terms of inventory will be sold a month later. Manufacturers / Retailers – Improved scheduling of production or purchases. Sales / advertise to lower inventory levels. Managers can consciously reduce production drastically just before year-end. Stock takes can be wrong (too low) Depends on company, e.g. storing cost, availability of inventory, lifespan to obsolescence, etc. Inverse of ratio is called “number of days in inventory”

DEBTORS’ COLLECTION PERIOD

ASSET MANAGEMENT

Formula (How)

Information (Why)

Rules (Remember)

Interpret (See as)

Manage (Improve)

Careful (Manipulation) Ideal (Optimum) Other

𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐬 𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞 𝟏𝟐𝟐 = = 𝟏𝟐. 𝟒𝟔 𝐝𝐚𝐲𝐬 𝐒𝐚𝐥𝐞𝐬⁄ 𝟑 𝟓𝟕𝟑⁄ 𝟑𝟔𝟓 𝟑𝟔𝟓 Average number of days that a firm must wait to collect the cash after making a sale. Do not want to wait for cash, but also do not want a policy that is too strict. Use average accounts receivable above the line if available. If split is available between cash sales and credit sales, use credit sales below the line. If firm only sells on credit and terms are 30 days, anything more than that indicates customers are not keeping to terms. If days are too low, it can indicate that credit policy is too strict. Give incentives to customers for paying faster. Stricter credit terms (disadvantage: might lose customers). Creditworthiness check before selling to customers, and manage debtors with an age analysis. Managers can record sales expected for next year at the end of this year. Managers can offer incentives close to year-end for debtors to pay faster than usual. Write off recoverable debts as bad debts. Depends on company, e.g. credit policies, risk appetite, etc. N/A

FIXED ASSET TURNOVER

ASSET MANAGEMENT

Formula (How) Information (Why) Rules (Remember)

Interpret (See as)

Manage (Improve)

Careful (Manipulation)

Ideal (Optimum) Other

𝐒𝐚𝐥𝐞𝐬 𝐅𝐢𝐱𝐞𝐝 𝐀𝐬𝐬𝐞𝐭𝐬

=

𝟑 𝟓𝟕𝟑 = 𝟐. 𝟗𝟏 𝐭𝐢𝐦𝐞𝐬 𝟏 𝟐𝟐𝟕

Efficient utilisation of property, plant and equipment to generate sales revenue. Total of cash and credit sales should be used above the line. Fixed assets include property, plant and equipment. Higher ratio means company is generating a higher level of sales from fixed assets. Lower ratio means fixed assets might not be used efficiently. Indicates how money invested in fixed assets are recovered. Apply assets productively to manufacture efficiently and generate higher sales when products are sold. Do a proper capital investment appraisal before buying assets. Write off too much depreciation on fixed assets. Managers can deliberately not invest in new assets, to keep the asset base below the line as low as possible. Not investing in new assets will result in lower company growth in the long term. Depending on company – Higher ratio indicates assets are used more productively. Part of “total asset turnover” ratio

OPERATIONAL ASSET TURNOVER Formula (How)

ASSET MANAGEMENT

Information (Why)

Rules (Remember)

Interpret (See as)

Manage (Improve)

Careful (Manipulation)

Ideal (Optimum) Other

𝐒𝐚𝐥𝐞𝐬 𝟑 𝟓𝟕𝟑 = 𝟐. 𝟒𝟗 𝐭𝐢𝐦𝐞𝐬 = 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐨𝐧𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬 𝟏 𝟐𝟐𝟕 + 𝟐𝟎𝟖 Efficient utilisation of operational property, plant, equipment and current assets to generate sales revenue. Total of cash and credit sales should be used above the line. Operating assets include property, plant, equipment and current assets. All assets that are not currently used in the operations are excluded below the line. Higher ratio means company is generating a higher level of sales from operating assets. Lower ratio means operating assets might not be used efficiently. Indicates how money invested in operating assets are recovered. Apply assets productively to manufacture efficiently and generate higher sales when products are sold. Do a proper capital investment appraisal before buying assets, and ensure debtors are creditworthy before selling to them. Write off too much depreciation on fixed assets. Managers can deliberately not invest in new assets, to keep the asset base below the line as low as possible. Not investing in new assets will result in lower company growth in the long term. Depending on company – Higher ratio indicates assets are used more productively. Part of “total asset turnover” ratio

TOTAL ASSET TURNOVER Formula (How)

ASSET MANAGEMENT

Information (Why) Rules (Remember)

Interpret (See as)

Manage (Improve)

Careful (Manipulation)

Ideal (Optimum) Other

𝐒𝐚𝐥𝐞𝐬 𝟑 𝟓𝟕𝟑 = 𝟐. 𝟒𝟗 𝐭𝐢𝐦𝐞𝐬 = 𝟏 𝟐𝟐𝟕 + 𝟐𝟎𝟖 𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬 Efficient utilisation of property, plant, equipment and current assets to generate sales revenue. Total of cash and credit sales should be used above the line. Total assets include property, plant, equipment, investments and current assets. Higher ratio means company is generating a higher level of sales from total assets. Lower ratio means total assets might not be used efficiently. Indicates how m oney invested in total assets are recovered. Apply assets productively to manufacture efficiently and generate higher sales when products are sold. Do a proper capital investment appraisal before buying assets, and ensure debtors are creditworthy before selling to them. Write off too much depreciation on fixed assets. Managers can deliberately not invest in new assets, to keep the asset base below the line as low as possible. Not investing in new assets will result in lower company growth in the long term. Depending on company – Higher ratio indicates assets are used more productively. Included in the Du Pont analysis

RATIOS TO EVALUATE LIQUIDITY LIQUIDITY RATIOS  

Current Ratio Quick Ratio (Acid Test)

CURRENT RATIO Formula (How)

LIQUIDITY

Information (Why) Rules (Remember)

Interpret (See as)

Manage (Improve) Careful (Manipulation) Ideal (Optimum) Other

𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬 𝟐𝟎𝟖 = 𝟏. 𝟕𝟑 ∶ 𝟏 = 𝟏𝟐𝟎 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 Indicates how short term liabilities are covered by short term assets that can be translated into cash in the short term. Indicates if company will be able to service short term debt when it is due. Current assets are short term assets, while current liabilities are short term liabilities. Higher ratio means more short term assets to cover short term liabilities, and can have a higher cost associated with financing those assets. Lower ratio means less short term assets to cover short term liabilities, and can have a higher risk of not meeting obligations. Keep optimum level of current assets, and finance the assets by current liabilities where possible. Ensure enough liquid assets to meet short term obligations. Managers can keep obsolete inventory or irrecoverable debtors on the books to inflate the current assets. Depending on company and industry – Rule of thumb is 2:1. N/A

QUICK RATIO Formula (How)

LIQUIDITY

Information (Why) Rules (Remember)

Interpret (See as)

Manage (Improve) Careful (Manipulation) Ideal (Optimum) Other

𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐞𝐭𝐬 − 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝟐𝟎𝟖 − 𝟔𝟓 = 𝟏. 𝟏𝟗 ∶ 𝟏 = 𝟏𝟐𝟎 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 Indicates how short term liabilities are covered by liquid short term assets that can be translated into cash in the short term (inventory takes longer to translate into cash). Current assets are short term assets (and excludes inventory above the line), while current liabilities are short term liabilities. Higher ratio means more short term assets to cover short term liabilities, and can have a higher cost associated with financing those assets. Lower ratio means less short term assets to cover short term liabilities, and can have a higher risk of not meeting obligations. Keep optimum level of current assets, and finance the assets by current liabilities where possible. Ensure enough liquid assets to meet short term obligations. Managers can keep irrecoverable debtors on the books to inflate the current assets. Depending on company and industry – Rule of thumb is 1:1. N/A

CASH FLOW TO TOTAL DEBT Formula (How)

CASH FLOW

Information (Why) Rules (Remember) Interpret (See as)

Manage (Improve)

Careful (Manipulation)

Ideal (Optimum) Other

𝐂𝐚𝐬𝐡 𝐅𝐥𝐨𝐰 𝐟𝐫𝐨𝐦 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐨𝐧𝐬 𝐓𝐨𝐭𝐚𝐥 𝐃𝐞𝐛𝐭

=

𝟐𝟏𝟗 = 𝟒𝟐. 𝟏𝟐% 𝟓𝟐𝟎

Cash flow is very important, because if cash flow is inadequate the company will be unable to meet i...