Implementing Ratio Analysis

Four distinct areas of a company's activities are normally analysed, each with its own different ratios. These areas are:

• Liquidity
• Activity
• Debt
• Profitability

Liquidity

Liquidity refers to a firm's ability to meet its obligations over the short-term that is to have the necessary cash available from cash reserves, cash sales and debtors to pay for enough stock and to make payments due to creditors.

All current assets are eventually transformed into cash. All current liabilities must eventually be paid for with cash.

The source for the cash, which is needed to pay current liabilities, is current assets. There should, therefore, always be enough current assets in relation to the level of current liabilities.

This relationship is called liquidity.

Two ratios are commonly used to measure a firm's liquidity:

Current Ratio:

= current assets ÷ current liabilities

= 24 000 000 ÷ 10 000 000

= 2.4 times

It gives an indication of the company's ability to meet its obligations over the short-term (also called the liquidity ratio). Jimco had R2.40 in current assets for every R1.00 in current liabilities. This compares favourably with the rule of thumb of 2 for the current ratio.

Quick Ratio:

= (current assets – stock) ÷ current liabilities

= (24 000 000 – 12 000 000) ÷ 10 000 000

= 1.2 times

This is a stricter measure of liquidity than the current ratio and is also known as the acid test. Stock must first be sold before it can be converted into cash. Jimco had R1.20 of cash/cash claims (debtors) for every R1.00 in current liabilities.

This does compare favourably with the rule of thumb of 1 for the quick ratio. Investment in stock may be too high if this ratio is out of line, especially if the previous one was in line.

These ratios measure the speed (in terms of days or number of times per year) current assets and liabilities are converted into cash. Activity ratios are, therefore, also a measure of a firm's liquidity.

There are two good reasons for selling stock as quickly as possible:

• There are costs involved in keeping stock on hand e.g. storage costs, insurance costs and the cost of the funds tied up in capital.
• The only way to get the gross profit connected to stock is to sell it.
• The speed at which stock is sold is measured by the stock turnover ratio.

Stock Turnover Ratio:

= cost of goods sold ÷ stock

= R38 000 000 ÷ R12 000 000

= 3.17 times per year

This means that Jimco managed to sell the average amount of stock 3.17 times per year.

Industry average 2.9 times.

It is customary to express stock turnover in days. This is done by dividing 365 by the stock turnover ratio just calculated.

Stock Turnover in Days:

= 365 ÷ 3.17

= Therefore, it takes 115 days, on average, to sell Jimco’s stock.

Cross-sectional or time series analysis is needed to judge this figure. Stock turnovers vary widely over different industries e.g. greengrocers vs. jewellers.

Similar to stock, the quicker debtors are collected the better for the company.

Debtor’s Collection Ratio:

= credit sales ÷ debtors

= R51 000 000 ÷ R10 000 000

= 5.1 times

This means that Jimco, on average, collects its outstanding short-term debt 5,1 times per year.

It is more customary to express this ratio in days per year.

Debtor’s Collection Period in Days:

= 365 ÷ 5.1

= 71.57 days

Jimco takes, on average, 71.57 days to collect its outstanding short-term debt (debtors). Cross-sectional or time series analysis is needed to judge this figure. If Jimco extended credit terms of 30 days to its customers, a collection period of 71.57 days would be reason for concern.

The speed with which the company pays its creditors is measured by the next ratio. The object here is to pay slower rather than quicker, but to take care not to jeopardise the relationship with the suppliers.

Creditor’s Payment Ratio = Credit Purchases ÷ Creditors:

= R38 000 000 ÷ R3 000 000

= 12.67 times

Once again, it is more customary to express this ratio in days:

Creditor’s Payment Period:

= 365 ÷ 12.67

= 28.81 days

Jimco takes, on average, 28.81 days to pay its creditors. Cross sectional or time series analysis is needed to judge this figure. If Jimco received credit terms of 30 days from its suppliers, a payment period of 28.81 days may indicate that they have no difficulty in meeting creditor payments on time.

Debt

A company's ability to survive over the long-term, which is related to its debt position, is measured by these ratios. The debt position of a firm indicates the amount of non-owner or non-self-generated funds used by the business. In general, the more debt a firm uses, the higher the risk. Due to the influence of financial leverage, debt could increase the return to owners but at the risk of possible insolvency, should the company not be able to service its debt.

Debt is part and parcel of the way modern companies are financed. If the margin of safety provided by own funds is enough and the company can meet its debt-related obligations, there is no reason why debt could not be used. The only proviso is that the company must earn more with the borrowed funds than the cost thereof; that is positive financial leverage.

Debt ratio = Total Liabilities ÷ Total Assets

= R10 000 000 + R10 700 000 ÷ R31 000 000

= 0.668 or 66.8%

Industry norm 47.7%

For each rand invested in assets, R0.66 was financed by debt. Put differently, only R0.34 of each rand invested in assets belongs to the owners.

Times Interest Earned (TIE)

= Earnings before interest and tax ÷ Interest paid

= R4 000 000 ÷ R1 000 000

= 4 times

Interest is covered more than the 2.4 times of the industry norm. Note that, when TIE equals 1, net income before tax is zero. Although Jimco's debt ratio seems to be on the high side, interest payments should be met easily, as indicated by the TIE ratio.

These two ratios should always be judged together. A company can have a low (good) debt ratio and a very low (bad) TIE ratio, and vice versa.

Profitability

Companies need profits to survive; without profits, there would not be much point in continuing to trade. Profits vary from year to year, even from season to season. If there is a trend in profits, especially downwards, this should be identified as soon as possible.

Gross Profit Margin

= gross profit ÷ sales

= R13 000 000 ÷ R51 000 000

= 25.49 %

Industry margin – 27.5 %

The gross margin indicates what portion of the selling price remains after paying for the stock. This is directly related to the pricing policy of either the company itself or its suppliers.

Increasing selling prices would increase the gross margin but could lead to less units being sold because of price competition. Buying for less will also increase the gross margin, but care should be taken to buy stock of the right quality.

Operating Profit Margin = Operating Income ÷ Sales

= R4 000 000 ÷ R51 000 000

=7.84 %

Industry average – 8.1 %

The operating margin indicates what portion of the selling price remains to pay for interest, taxes, and dividends. It is also an indication of the control over operating expenses. A decreasing operating profit margin, while the gross profit margin stays constant, points to an increase in overheads without a comparative increase in prices and/or volumes.

Net Income Margin = Net Income ÷ Sales

= R1 800 000 ÷ R51 000 000

= 3.53 %

Industry average – 3 %

The net profit margin measures the percentage remaining from each sales Rand after all expenses have been paid. This ratio is often cited as the measure of a company's success. What constitutes a "good" net profit margin differs considerably across industries. A better measure of success is to relate the net income to funds invested, as in the next ratio.

Return on Assets (ROA) = Net Income ÷ Total Assets

=R1 800 000 ÷ R31 000 000

= 5.81%

Industry average – 4.2 %

Also called the return on investment, this ratio measures the overall effectiveness of management in generating after tax profits with available assets (which equals total capital). The owners of Jimco will have to decide whether this is acceptable or not. If an increasing trend in ROA can be identified, this low percentage may be quite acceptable.

The Return on owner’s equity (ROE) ratio is also calculated from the information given in the Income and Expenditure statement. This ratio is of the net income of the business after it has paid tax to the owner’s equity (the amount of money which the owner or owners have invested in the business, also known as the net worth of the business). It calculates the return that the owner is getting on the money he invested in the business.

The results of this ratio are also shown as a percentage. It is calculated as follows:

Net income after tax x 100

Owner’s equity

The Debt Equity Ratio shows how a business is financed; in other words, how much money the business is lending in comparison to the amount of money that the owner has invested in the business.

It is important to note that if a business has borrowed more than what the owner has invested, it might be a sign that the owner lacks confidence in the business, or that he does not have the funds necessary to expand the business.

Debt Equity Ratio:

Total Debt

÷

Total Equity

This calculation requires the total debt, that is short-term and long-term debt. It also requires the total equity, that is the full amount that the owner has invested in the business, together with any profits that the business has made since the business opened.