Month: June 2020

Gross profit ratio (GP ratio) is a profitability ratio that shows the relationship between gross profit and total net sales revenue. It is a popular tool to evaluate the operational performance of the business. The ratio is computed by dividing the gross profit figure by net sales.

Gross profit margin is a profitability ratio that calculates the percentage of sales that exceed the cost of goods sold. In other words, it measures how efficiently a company uses its materials and labor to produce and sell products profitably. You can think of it as the amount of money from product sales left over after all of the direct costs associated with manufacturing the product has been paid. These direct costs are typically called cost of goods sold or COGS and usually consist of raw materials and direct labor.

The gross profit ratio is important because it shows management and investors how profitable the core business activities are without taking into consideration the indirect costs. In other words, it shows how efficiently a company can produce and sell its products. This gives investors a key insight into how healthy the company actually is. For instance, a company with a seemingly healthy net income on the bottom line could actually be dying. The gross profit percentage could be negative, and the net income could be coming from other one-time operations. The company could be losing money on every product they produce, but staying a float because of a one-time insurance payout.

Gross profit = Total Sales – Cost of Goods Sold

Gross profit Ratio = Gross Profit / Net Sales

Significance and interpretation:

Gross profit is very important for any business. It should be sufficient to cover all expenses and provide for profit.

There is no norm or standard to interpret gross profit ratio (GP ratio). Generally, a higher ratio is considered better.

The ratio can be used to test the business condition by comparing it with past years’ ratio and with the ratio of other companies in the industry. A consistent improvement  in gross profit ratio over the past years is the indication of continuous improvement. When the ratio is compared with that of others in the industry, the analyst must see whether they use the same accounting systems and practices.

A firm has assets and liabilities to its name. Some are fixed in nature and then there are current assets and current liabilities. These are short-term in nature and easily convertible into cash. The liquidity ratios deal with the relationship between such current assets and current liabilities.

Liquidity ratios evaluate the firm’s ability to pay its short-term liabilities, i.e. current liabilities. It shows the liquidity levels, i.e. how many of their assets can be quickly converted to cash to pay of their obligations when they become due.

It is not only a measure of how much cash there is but also how easily current assets can be converted to cash or marketable securities. Now let us look at some of the important liquidity ratios.

Current Ratio

The current ratio is also known as the working capital ratio. It will measure the relationship between current assets and current liabilities. It measures the firm’s ability to pay for all its current liabilities, due within the next one year by selling off all their current assets. The formula for is as follows

Current Ratio = Current Assets/Current Liabilities

Current Assets include,

• Stock
• Debtors
• Cash and Bank Balances
• Bills receivable
• Accruals
• Short term loans that are given
• Short term Securities

Current Liabilities include

• Creditors
• Outstanding Expenses
• Short Term Loans that are taken
• Bank Overdrafts
• Provision for taxation
• Proposed Dividend

The ideal current ratio, according to the industry standard is 2:1. That means that a firm should hold at least twice the amount of current assets than it has current liabilities. However, if the ratio is very high it may indicate that certain current assets are lying idle and not being utilized properly. So maintaining the correct balance between the two is crucial.

Quick Ratio

The other important one of the liquidity ratios is Quick Ratio, also known as a liquid ratio or acid test ratio. This ratio will measure a firm’s ability to pay off its current liabilities (minus a few) with only selling off their quick assets.

Now Quick assets are those which can be easily converted to cash with only 90 days notice. Not all current assets are quick assets. Quick assets generally include cash, cash equivalents, and marketable securities. The formula is

Quick Ratio = Quick Assets/(Current Liabilities/Quick Liabilities)

Quick Assets = All Current Assets – Stock – Prepaid Expenses

Quick Liabilities = All Current Liabilities – Bank Overdraft – Cash Credit

The ideal quick ratio is considered to be 1:1, so that the firm is able to pay off all quick assets with no liquidity problems, i.e. without selling fixed assets or investments. Since it does not take into consideration stock (which is one of the biggest current assets for most firms) it is a stringent test of liquidity. Many firms believe it is a better test of liquidity than the current ratio since it is more practical.

Absolute Cash Ratio

This is an even more rigorous liquidity ratio than quick ratio. Here we measure the availability of cash and cash equivalents to meet the short-term commitment of the firm. We do not consider all current assets, only cash. Let us see the formula,

Absolute Cash ratio = (Cash+ Bank Balance + Marketable Securities) /Current Liabilities

As you can see, this ratio measures the cash availability of the firm to meet the current liabilities. There is no ideal ratio, it helps the management understand the level of cash availability of the firm and make any changes required.

However, if the ratio is greater than 1 it indicates poor resource management and very high liquidity. And high liquidity may mean low profitability.

Operating profit ratio establishes a relationship between operating Profit earned and net revenue generated from operations (net sales). operating profit ratio is a type of profitability ratio which is expressed as a percentage.

Net sales include both Cash and Credit Sales, on the other hand, Operating Profit is the net operating profit i.e. the Operating Profit before interest and taxes. Operating Profit ratio helps to find out Operating Profit earned in comparison to revenue earned from operations.

Formula to Calculate Operating Profit Ratio

Operating Profit Ratio = [Operating Profit / Revenue from Operations(Net Sales)] * 100

Note: It is represented as a percentage so it is multiplied by 100.

Operating Profit = Net profit before taxes + Non-operating expenses – Non-operating incomes

or

Operating Profit = Gross profit + Other Operating Income – Other operating expenses

Revenue From Operations (Net Sales) = (Cash sales + Credit sales) – Sales returns

High and Low Operating Profit Ratio

This ratio helps to analyze a firm’s operational efficiency, a trend analysis is usually done between two different accounting periods to assess improvement or deterioration of operational capability.

High: A high ratio may indicate better management of resources i.e. a higher operational efficiency leading to higher operating profits in the company.

Low: A low ratio may indicate operational flaws and improper management of resources, it is an indicator that the profit generated from operations are not enough as compared to the total revenue generated from sales.

The net profit percentage is the ratio of after-tax profits to net sales. It reveals the remaining profit after all costs of production, administration, and financing have been deducted from sales, and income taxes recognized. As such, it is one of the best measures of the overall results of a firm, especially when combined with an evaluation of how well it is using its working capital. The measure is commonly reported on a trend line, to judge performance over time. It is also used to compare the results of a business with its competitors.

Net profit is not an indicator of cash flows, since net profit incorporates a number of non-cash expenses, such as accrued expenses, amortization, and depreciation.

The formula for the net profit ratio is to divide net profit by net sales, and then multiply by 100. The formula is:

(Net profit after tax ÷ Net sales) x 100

The measure could be modified for use by a nonprofit entity, if the change in net assets were to be used in the formula instead of net profit.

Significance and Interpretation:

Net profit (NP) ratio is a useful tool to measure the overall profitability of the business. A high ratio indicates the efficient management of the affairs of business.

There is no norm to interpret this ratio. To see whether the business is constantly improving its profitability or not, the analyst should compare the ratio with the previous years’ ratio, the industry’s average and the budgeted net profit ratio.

The use of net profit ratio in conjunction with the assets turnover ratio helps in ascertaining how profitably the assets have been used during the period.

A high net profit margin means that a company is able to effectively control its costs and/or provide goods or services at a price significantly higher than its costs. Therefore, a high ratio can result from:

• Efficient management
• Low costs (expenses)
• Strong pricing strategies

A low net profit margin means that a company uses an ineffective cost structure and/or poor pricing strategy. Therefore, a low ratio can result from:

• Inefficient management
• High costs (expenses)
• Weak pricing strategies

Investors need to take numbers from the profit margin ratio as an overall indicator of company profitability performance and initiate deeper research into the cause of an increase or decrease in the profitability as needed.

Limitations of Net Profit Margin Ratio

When calculating the net profit margin ratio, analysts commonly compare the figure to different companies to determine which business performs the best.

While this is common practice, the net profit margin ratio can greatly differ between companies in different industries. For example, companies in the automotive industry may report a high profit margin ratio but lower revenue as compared to a company in the food industry.  A company in the food industry may show a lower profit margin ratio, but higher revenue.

It is recommended to compare only companies in the same sector with similar business models.

Other limitations include the possibility of misinterpreting the profit margin ratio and cash flow figures. A low net profit margin does not always indicate a poorly performing company. Also, a high net profit margin does not necessarily translate to high cash flows.

The operating ratio compares production and administrative expenses to net sales. The ratio reveals the cost per sales dollar of operating a business. A lower operating ratio is a good indicator of operational efficiency, especially when the ratio is low in comparison to the same ratio for competitors and benchmark firms.

The operating ratio is only useful for seeing if the core business is able to generate a profit. Since several potentially significant expenses are not included, it is not a good indicator of the overall performance of a business, and so can be misleading when used without any other performance metrics. For example, a company may be highly leveraged and must therefore make massive interest payments that are not considered part of the operating ratio. Nonetheless, this ratio is commonly used by investors to evaluate the results of a business.

To calculate the operating ratio, add together all production costs (i.e., the cost of goods sold) and administrative expenses (which includes general, administrative, and selling expenses) and divide by net sales (which is gross sales, less sales discounts, returns, and allowances). The measure excludes financing costs, non-operating expenses, and taxes. The calculation is:

(Production expenses + Administrative expenses) ÷ Net sales = Operating ratio

A variation on the formula is to exclude production expenses, so that only administrative expenses are matched against net sales. This version yields a much lower ratio, and is useful for determining the amount of fixed administrative costs that must be covered by sales. As such, it is a variation on the breakeven calculation. The calculation is:

Administrative expense ÷ Net sales

Significance and interpretation:

The operating ratio is used to measure the operational efficiency of the management. It shows whether or not the cost component in the sales figure is within the normal range. A low operating ratio means a high net profit ratio (i.e., more operating profit) and vice versa.

The ratio should be compared: (1) with the company’s past years ratio, (2) with the ratio of other companies in the same industry. An increase in the ratio should be investigated and brought to attention of management as soon as possible. The operating ratio varies from industry to industry.

Components of the Operating Ratio

Operating expenses encompass all costs except interest payments and taxes. Organizations do not factor in non-operating expenses, such as exchange rate costs, into the operating ratio, as these are extra expenses unrelated to core business activities.

Operating expenses include overheads such as general sales or administrative costs. Examples of overhead include expenses accrued because of owning a corporate office since, although it is necessary, it is not linked to the production process. Operating expenses include:

• Legal and accounting fees
• Banking charges
• Marketing or sales costs
• Office costs
• Wages or salaries

In some instances, operating costs include the cost of goods sold (COGS). Such expenses are directly related to the production process. That said, some companies prefer to keep operating costs and direct production costs separately. The direct product costs can include:

• Material costs
• Labor cost
• Wages and benefits for production workers
• Machine repair and maintenance costs

Total sales or revenue usually appears at the top of an income statement as the sum total that an organization generates.

The proprietary ratio (also known as the equity ratio) is the proportion of shareholders’ equity to total assets, and as such provides a rough estimate of the amount of capitalization currently used to support a business. If the ratio is high, this indicates that a company has a sufficient amount of equity to support the functions of the business, and probably has room in its financial structure to take on additional debt, if necessary. Conversely, a low ratio indicates that a business may be making use of too much debt or trade payables, rather than equity, to support operations (which may place the company at risk of bankruptcy).

Thus, the equity ratio is a general indicator of financial stability. It should be used in conjunction with the net profit ratio and an examination of the statement of cash flows to gain a better overview of the financial circumstances of a business. These additional measures reveal the ability of a business to earn a profit and generate cash flows, respectively.

To calculate the proprietary ratio, divide total shareholders’ equity by total assets. The results will be more representative of the company’s true situation if you exclude goodwill and intangible assets. from the denominator.

The more restrictive version of the formula is:

Shareholders’ equity ÷ Total tangible assets

Significance and interpretation:

The proprietary ratio shows the contribution of stockholders’ in total capital of the company. A high proprietary ratio, therefore, indicates a strong financial position of the company and greater security for creditors. A low ratio indicates that the company is already heavily depending on debts for its operations. A large portion of debts in the total capital may reduce creditors interest, increase interest expenses and also the risk of bankruptcy.

Having a very high proprietary ratio does not always mean that the company has an ideal capital structure. A company with a very high proprietary ratio may not be taking full advantage of debt financing for its operations that is also not a good sign for the stockholders.

Return on capital employed or ROCE is a profitability ratio that measures how efficiently a company can generate profits from its capital employed by comparing net operating profit to capital employed. In other words, return on capital employed shows investors how many dollars in profits each dollar of capital employed generates.

ROCE is a long-term profitability ratio because it shows how effectively assets are performing while taking into consideration long-term financing. This is why ROCE is a more useful ratio than return on equity to evaluate the longevity of a company.

This ratio is based on two important calculations: operating profit and capital employed. Net operating profit is often called EBIT or earnings before interest and taxes. EBIT is often reported on the income statement because it shows the company profits generated from operations. EBIT can be calculated by adding interest and taxes back into net income if need be.

Capital employed is a fairly convoluted term because it can be used to refer to many different financial ratios. Most often capital employed refers to the total assets of a company less all current liabilities. This could also be looked at as stockholders’ equity less long-term liabilities. Both equal the same figure.

Formula

Return on capital employed formula is calculated by dividing net operating profit or EBIT by the employed capital.

Return on Capital Employed = Net Operating Profit / Employed Capital

If employed capital is not given in a problem or in the financial statement notes, you can calculate it by subtracting current liabilities from total assets. In this case the ROCE formula would look like this:

Return on Capital Employed = Net Operating Profit / Total Assets – Current Liabilities

Where:

• Fixed Assets, also known as capital assets, are assets that are purchased for long-term use and are vital to the operations of the company. Examples are property, plant, and equipment (PP&E).
• Working Capital is the capital available for daily operations and is calculated as current assets minus current liabilities.

It isn’t uncommon for investors to use averages instead of year-end figures for this ratio, but it isn’t necessary.

Analysis

The return on capital employed ratio shows how much profit each dollar of employed capital generates. Obviously, a higher ratio would be more favorable because it means that more dollars of profits are generated by each dollar of capital employed.

For instance, a return of .2 indicates that for every dollar invested in capital employed, the company made 20 cents of profits.

The return on equity ratio or ROE is a profitability ratio that measures the ability of a firm to generate profits from its shareholders investments in the company. In other words, the return on equity ratio shows how much profit each dollar of common stockholders’ equity generates.

So, a return on 1 means that every dollar of common stockholders’ equity generates 1 dollar of net income. This is an important measurement for potential investors because they want to see how efficiently a company will use their money to generate net income.

ROE is also an indicator of how effective management is at using equity financing to fund operations and grow the company.

Formula

The return on equity ratio formula is calculated by dividing net income by shareholder’s equity.

Return on Equity Ratio = Net income / Shareholder’s Equity

Most of the time, ROE is computed for common shareholders. In this case, preferred dividends are not included in the calculation because these profits are not available to common stockholders. Preferred dividends are then taken out of net income for the calculation.

Also, average common stockholder’s equity is usually used, so an average of beginning and ending equity is calculated.

Analysis

Return on equity measures how efficiently a firm can use the money from shareholders to generate profits and grow the company. Unlike other return on investment ratios, ROE is a profitability ratio from the investor’s point of view not the company. In other words, this ratio calculates how much money is made based on the investors’ investment in the company, not the company’s investment in assets or something else.

That being said, investors want to see a high return on equity ratio because this indicates that the company is using its investors’ funds effectively. Higher ratios are almost always better than lower ratios, but have to be compared to other companies’ ratios in the industry. Since every industry has different levels of investors and income, ROE can’t be used to compare companies outside of their industries very effectively.

Interpreting the Return on Equity

The return on equity is similar to the “return on assets”. Assets come from two sources: debt and equity. The ROE focuses on the latter. Return on equity measures profitability using resources provided by investors and company earnings.

A high return on assets shows than the business was able to successfully utilize the resources provided by its equity investors and the company’s accumulated profits in generating income. Nonetheless, just like any other financial ratio, the ROE is more useful if it is compared to a benchmark such as the average ROE in the industry where the company operates or the company’s ROE in the past years.

The amount of current assets that a company has on hand at any given time, in excess of its current liabilities, is known as its net working capital (NWC).

These funds are what allow a business to run its daily operations. One of the short-term assets held by many companies is the cash invested in its inventory. But if this inventory amount is relatively large compared to other assets, it can skew the perception of just how readily available a firm’s cash truly is for paying off short-term debts. Sometimes a company’s inventory can suffer from extremely low turn-over, or simply becomes outdated and difficult to sell.

The inventory to net working capital ratio allows you to calculate exactly what proportion of a business’s working capital is tied up in its inventory, giving you a more accurate picture of its liquidity position.

Stock (Inventory) to Working capital Ratio = Inventory / (Accounts Receivables+ inventory – Accounts Payable)

Cautions & Further Explanation

Analyzing a company’s inventory to net working capital ratio is best done over a number of periods to accurately identify trends in the use of a firm’s working capital.

Such trends can help to reveal any problems in a company’s regular operations, including the rising ratio values associated with heavy quantities of outdated stock, inferior purchasing control, and inefficient sales forecasts.

Ideally, you should use the inventory to NWC ratio at the same time as you examine a company’s inventory turnover rate, since stock that consistently turns over quickly will contribute far more positively to an organization’s level of liquidity.

Interpretation & Analysis

In general, the lower a company’s inventory to working capital ratio is, the higher its liquidity.

This will be particularly true for those businesses that hold large quantities of inventory and that require certain levels of cash to fund their operations.

While some analysts consider ratio values of less than 100% to be sufficient proof of a company’s liquidity, this value often proves to be too generic for every situation.

Inventory to WC ratios vary widely between industries and companies, and you’ll glean more meaningful information by using industry averages as a benchmark in your analyses.