ASSIGNMENT TOPIC: “APPLYING RATIOS FOR FINANCIAL DECESION

MAKING”

What is meant by ratio analysis?

Corporate finance ratios are measurements that are quantifiable and used to evaluate
companies. Financial analysts, stock research analysts, investors, and asset managers use
these ratios to assess a company's overall financial health in order to help them make better
investment decisions. Financial managers and C-suite executives also make extensive use of
corporate finance ratios to gain insight into how their companies are doing.

Why we need ratio analysis?

Ratio a useful tool for comparing two businesses with dissimilar operations and management
styles is ratio analysis. It's also a terrific tool to measure how successful a business is
expected to be and how well-run its operations are. One way to evaluate a company's ability
to satisfy its financial obligations is through the use of solvency ratios.

Types of Ratios?

Corporate finance ratios can be broken down into four categories that measure different types
of financial metrics for a business: liquidity ratios, operational risk ratios, profitability ratios,
and efficiency ratios

1. Profitability ratio
2. Efficiency ratio
3. Liquidity ratio
4. Gearing ratio

Profitability Ratio

Financial indicators known as profitability ratios are employed by analysts and investors to
assess a company's capacity to turn a profit in relation to its revenue, balance sheet assets,
operating expenses, and shareholders' equity over a given time frame. They demonstrate
how well a business makes use of its resources to generate revenue and add value for
investors.
Return on assets
One kind of profitability ratio that gauges a company's profitability in relation to its total
assets is return on assets (ROA). By comparing a company's earnings (net income) to the
total capital it has invested in assets, this ratio shows how well the business is doing.
Formula:
ROA = Net Income / Total Assets
When analysing a company's profitability, the ROA formula is a crucial statistic to consider.
When evaluating a company's success over time or contrasting two distinct businesses of
comparable size and sector, the ratio is commonly employed. Keep in mind that while
comparing two distinct companies using ROA, it is crucial to take into account the size of the
company and the operations carried out.

Generally speaking, ROAs vary by industry. Because a capital-intensive industry's big asset
base increases the formula's denominator, industries that depend heavily on fixed assets for
operations will typically have lower ROAs. It is all relative, though, and a corporation with a
huge asset base may be able to have a large ROA provided its income is high enough.

Return on Capital Employed

The profitability ratio known as return on capital employed, or ROCE, gauges how
effectively a business uses its capital to produce profits. Investors sometimes use the return
on capital employed, which is regarded as one of the best profitability statistics, to assess a
company's suitability for investment.

Formula:

ROCE = Operational profit *100 / Capital employed

The amount of operating revenue produced for every dollar invested in capital is displayed
by the return on capital employed. Since a higher ROCE indicates that more profits are
made for every dollar of invested capital, it is always preferable.

Merely figuring out a company's ROCE is insufficient, much like with other financial ratios.
To ascertain if a business is indeed profitable or not, ROCE should be used in conjunction
with other profitability ratios including return on equity, return on invested capital, and
return on assets.

Gross Margin Ratio

A profitability ratio that assesses a company's gross margin in relation to its sales is called
the gross margin ratio, sometimes referred to as the gross profit margin ratio. It displays the
amount of profit a business makes following the settlement of its cost of goods sold
(COGS). A high gross margin ratio is naturally desirable as it shows the percentage of each
dollar of revenue that the business keeps as gross profit.

Formula:

Gross Profit Margin Ratio = Gross Profit *100 / Sales.

A corporation that performs poorly is not always indicated by a low gross margin ratio.
Comparing gross margin ratios within an industry is more significant than comparing them
between other industries.
Operating Profit Margin

The percentage of profit generated by a company's operations before deducting taxes and
interest is known as the operating profit margin, which is a profitability ratio. It is computed
as a percentage and is obtained by dividing operating profit by total revenue. The EBIT
(Earnings before Interest and Tax) margin is another name for the margin.
Formula:

Operating Profit Margin = Net Profit*100 / Sales

The percentage of operational profit that comes from total revenue is known as the operating
profit margin. A 15% operational profit margin, for instance, translates into $0.15 in
operating profit for every $1 in revenue.

Net Profit Margin

A financial ratio called net profit margin, sometimes referred to as "profit margin" or "net
profit margin ratio," is used to determine how much of a company's total sales represents
profit. It calculates how much net profit a business makes for every dollar of revenue.

When net profit (also called net income) is divided by total sales and stated as a percentage,
the result is the net profit margin.
Formula:
Net Profit Margin = Net Income / Total Revenue

After subtracting all of the company's costs from its total revenue, net profit is determined.
The profit margin computation yields a percentage; for instance, a 10% profit margin
indicates that the company makes $0.10 in net profit for every $1 in revenue.
Revenue is the sum of a company's sales during a given time frame.
Depending on the industry a firm operates in, its usual profit margin ratio may vary.
Efficiency Ratios

Efficiency ratios are employed to evaluate an organization's resource and asset utilization.
These ratios typically look at how frequently a company can do a task in a given amount of
time or how long it takes a company to complete certain tasks.

 Accounts Receivable Turnover Ratio

 Asset Turnover Ratio
 Inventory Turnover Ratio
 Inventory Turnover Days
Accounts Receivable Turnover Ratio

The accounts receivable turnover ratio, also referred to as the debtor's turnover ratio,
calculates how frequently an organization collects its average amount of accounts receivable
over a given time frame.
Accounts receivable days, or the average number of days it takes to collect credit sales from
customers, can also be obtained by manipulating the accounts receivable turnover ratio.
Formula:
Accounts Receivable Turnover Ratio = Net credit sales / Average accounts receivable.

Net Credit Sales = Sales on Credit – Sales Returns – Sales Allowances

For instance, a corporation may have credit sales of $50,000 and returns of $3,200 at the
conclusion of its fiscal year. The company has $6,000 in accounts receivable as of
December 31st. There were $3,000 in accounts receivable as of January 1.

Thus, during this fiscal period (365 days), its accounts receivable turnover ratio would be =
(50,000 – 3,200) / ((6,000 + 3,000) / 2) = 10.4.

Based on an analysis of this, the company's annual accounts receivable collection rate is
10.4 times.

This figure needs to be compared to industry averages in order to determine how well the
business collects money in comparison to its rivals.

Based on an analysis of this, the company's average time to recover accounts receivable is
35.1 days.

Asset Turnover Ratio

The asset turnover ratio, sometimes referred to as the total asset turnover ratio, gauges how
well a business makes use of its resources to produce revenue. This ratio examines the
amount of revenue earned for every dollar of total assets owned by the business.

Formula;
Net Assets Turnover Ratio = Sales*100 / Capital employed

In this instance, a business's annual net sales total $100,000. The company's total assets as
of December 31st were $65,000. The company's total assets were $57,000 as of January 1.
The asset turnover ratio for the business would therefore be equal to 100,000 / ((65,000 +
57,000) / 2) = 1.64. This implies that the corporation makes roughly $1.64 in net sales for
every dollar of total assets.
The asset turnover ratio for a single time is not particularly relevant by itself, similar to
many other ratios. On the other hand, it might show how well the business is performing in
comparison to rivals when compared to the asset turnover ratios of similar businesses in the
same sector. The industry in which a corporation operates determines the optimal or average
asset turnover ratio.
A larger ratio is usually preferable as it shows that assets are being used efficiently. On the
other hand, a low ratio might indicate inadequate inventory management, inadequate
collection techniques, or inadequate asset use.

Inventory Turnover Ratio

The inventory turnover ratio calculates the frequency with which a company sells and
replenishes its stock of items over a certain time frame. This ratio examines the cost of
products sold in relation to the period's average inventory.
This ratio shows how effectively a company clears its inventory.
Formula:
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

Inventory Turnover Period = Inventory *365Days / Cost of sales

For instance, a business's cost of goods sold for the fiscal year is $3 million. The firm has
$350,000 worth of inventory as of December 31st. There was $260,000 in inventory as of
January 1. As a result, the inventory turnover ratio for the corporation would be equal to
3,000,000 / ((35,000 + 26,000) / 2) = 9.84. This figure indicates that throughout the fiscal
year, the firm sold all of its inventory 9.84 times.

The inventory turnover ratio may also be adjusted to produce inventory turnover days,
which are the typical number of days needed to sell the full stock of items, just as the
accounts receivable turnover ratio.

Inventory Turnover Days

The average number of days needed to sell an inventory stock is known as inventory turnover
days. The inventory turnover ratio that was previously indicated is used to create this
calculation. Inventory turnover days serve as a gauge of a company's efficiency, much as the
inventory turnover ratio.

Formula:

Inventory Turnover Days = Number of Days in Period / Inventory Turnover Ratio

Inventory turnover days are the average number of days required to sell an inventory supply.
This computation is made using the previously mentioned inventory turnover ratio. Similar to
inventory turnover ratio, inventory turnover days are a measure of a company's effectiveness.
Liquidity Ratios
Financial analysts assess a company's financial stability using liquidity ratios. These ratios
assess a business's capacity to pay back short- and long-term debt. When assessing a
company's riskiness and determining whether to grant credit, liquidity ratios are frequently
utilized.
Current Ratio

The working capital ratio, sometimes referred to as the current ratio, assesses a company's
capacity to pay short-term debt that matures within a year. Total current assets and total
current liabilities are compared using the ratio. The current ratio examines how a business
can pay off debt by maximizing the liquidity of its current assets.

Formula:

Current Ratio = Quick (Current Asset- Inventory) / Current liabilities

The current ratio takes into account all current assets, including cash marketable securities,
accounts receivable, and inventories, making it more thorough than other liquidity ratios like
the quick ratio.
A company has a current ratio of two if its current assets are $60 million and its current
liabilities are $30 million. According to this 2:1 ratio, the company's current assets may cover
its current liabilities—like accounts payable—twice over.
A current ratio of more than one usually indicates a company's financial health. An
excessively high current ratio, however, may also indicate that the business is hoarding cash
rather than using it for expansion-oriented initiatives.

Quick Ratio

The fast ratio, sometimes referred to as the acid-test ratio, assesses a company's capacity to
meet its immediate obligations by looking at its easily convertible assets into cash. Cash,
marketable securities, and accounts receivable are these assets. Due to their ease of
conversion into cash, these assets are referred to as "quick" assets.

Formula:

Quick Ratio = Cash + Marketable Securities + Accounts Receivable / Current Liabilities

The quick ratio just considers the assets that are the most liquid, in contrast to the current
ratio. The fast ratio assesses whether a business can meet its short-term obligations using
only assets that can be turned into cash very rapidly.
For this reason, accounts like inventory and pre-paid costs are not included in the fast ratio.
A company's quick ratio is 1.52 if it has $20 million in cash, $10 million in marketable
securities, $18 million in accounts receivable, and $25 million in current liabilities. This
indicates that the company's most liquid assets can cover 1.52 times its current liabilities. A
fast ratio of more than one indicates that the business is financially stable since it
demonstrates that it has enough liquid assets to cover its short-term debt payments. Like the
current ratio, an excessively high quick ratio, however, also raises the possibility that the
business is hoarding cash rather than investing it for development or profits.
Gearing Ratios

Financial gearing ratios are a class of commonly used financial ratios that compare an
organization's debt to other financial measurements like corporate equity or company assets.
Gearing ratios, a measure of financial leverage, indicate the proportion of a company's
activities that are funded by shareholder equity as opposed to debt from creditors. Gearing
ratios are an important part of fundamental analysis. A company's gearing ratio can help
reveal where its operational cash originates from, providing investors with further
information about the business's reliability and ability to withstand periods of uncertain
financial conditions.

For illustration, suppose that ABC Company's financials are as follows:

$100,000 in total debt and $400,000 in total equity the debt to equity ratio of Company ABC
may be computed by dividing the total debt by the total equity. The ratio is then multiplied by
100 to get the percentage.
Debt to equity ratio = 25% ($100,000 ÷ $400,000 x 100).

Formula:

Interest Cover Ratio = PBIT / Interest payable.

QUESTION:

Kitah sells clothes through stores in retail shopping centres throughout the country. Over the
last two years it has experienced declining profitability and is wondering if this is related to
the sector as whole. It has recently subscribed to an agency that produces average ratios
across many businesses. Below are the ratios that have been provided by the agency for
kitah’s business sector based on a year end of 30 June 20X2
 Sector

Return on year‐end capital employed (ROCE) 16.8%

Net asset (total assets less current liabilities) turnover 1.4 times

Gross profit margin 35%

Operating profit margin 12%

Current ratio 1.25:1

Average inventory turnover 3 times

Trade payables payment period 64 days

Debt to equity 38%

The financial statements of Kitah for the year ended 30 September 20X2 are shown below

Statement of profit or loss $000 $000

Revenue 60,000
Opening inventory 8,300
Purchases 43,900
–––––––
52,200
Closing inventory (10,200)
–––––––
(42,000)
–––––––
Gross profit 15,000
Operating costs (9,800)
Finance costs (800)
–––––––
Profit before tax 3,400
Income tax expense (1,000)
–––––––
Profit for the year 2,400
–––––––
Statement of financial position $000 $000
Assets
Non‐current assets
Property and shop fittings 25,600
Deferred development expenditure 5,000
–––––––
Current assets 30,600
Inventory 10,200
Bank 1,000
–––––––
11,200
–––––––
Total assets 41,800
–––––––
Equity and liabilities
Equity
Equity shares of $1 each 15,000
Property revaluation surplus 3,000
Retained earnings 8,600
–––––––

26,600
Non‐current liabilities
10% loan notes 8,000
Current liabilities
Trade payables 5,400
Current tax payable 1,800 7,200

–––––––
–––––––
Total equity and liabilities 41,800
Note: The deferred development expenditure relates to an investment in a process to
manufacture artificial precious gems for future sale by kitah in the retail jewellery market.
Required:
(a) Prepare the ratios for kitah equivalent to those of the sector.

(b) Assess the financial and operating performance of kitah in comparison to its
Sector averages.

ANSWER:

Return on Capital employed = PBIT/Capital employed *100

=4200/34600*100
=12%
Net asset turnover = Total assets –Current liabilities/Capital employed
=41800 -7200/34600
=1 times
Gross Profit Margin = Gross Profit/ Sales*100
=15000/60000*100
=25%
Operating Profit Margin = PBIT /Sales *100
=4200/60000*100
=7%

Current Ratio =Current asset/ Current liabilities

=11200/7200 = 7:4.5
Average Inventory Turnover =Cost of sales /Inventory
42000/9250 = 4.5 times
Trade Payable Payment Method = Average trade payable /credit purchase*365 days
= 5400/43900*100
= 45days
Debit- equity ratio =Debit/Equity*100
= 8000/25000*100
=32%
Therefore, ratios are important elements for every business evaluation and comparison.