The Major Profitability Ratios
The major profitability ratios are: 1. 1. 1. 1RETURN ON CAPITAL: Describes the earning capacity of the enterprise and it is measured by the following ratio: Profit before interest and taxation Average operating Assets The Return On Capital ratio measures how well the average operating assets (assets such as debtors, cash, fixed assets, stock) are generating the company s income, and is indicative of the management techniques applied by the company to utilise its assets. A poor income rate of return could indicate that valuable assets are under utilised.
As a result of this problem, an enterprise, which shows a negative Return on capital could be under the influence of poor management. The earning capacity of XYZ Limited for 1998 and 1999 |Ratio|2000|1999|1998|Comments| |||||| Return on|||||| Capital|NPBT|100|88|70|| |Av. OA|(286 + 230) ?? 2|(230 + 162) ?? 2|(162 + 144)|Industry ave| ||100 x 100|88 x 100|?? 2|| ||258|196|70 x 100|| ||38, 76%|44, 9%|153|| ||||45. 7%|| |||||| I N T E R P R E T A T I O N : XYZ Limited s return on capital declined from 45. 7% in 1998 to 44. 9% in 1999.
This decrease is mainly due to the increase in assets, but further investigation is required to analyse the extent of this decrease. The decrease continued further from 44. 9% in 1999 to 38. 76% in 2000. Again this decrease is due to an increase in assets. The question that arises therefor is: “Is this phenomena as a result of mismanagement of assets, or just because XYZ Limited is starting up and still growing? ” Additional investigation would be required to analyse the extent of the decrease. 1. 1. 1. 2NET PROFIT RATIO: The primary objective of an enterprise is to make a profit.
Profit is earned from sales and serves as an important measure of return of capital. The Net Profit percentage can be measured by the following ratio: Net Profit Sales This Net Profit Ratio measures the overall effectiveness of the enterprise s operations, before interest, tax and other non-“operating” items. The shortfall of this ratio in terms of its effectiveness is perhaps the fact that its usefulness is limited to comparisons with other companies. In addition, there is no guideline as to what the ideal absolute value should be. Changes to the Net Profit % can be influenced by one of two components, viz. – ?? Gross Profit Percentage ?? Operating Expenditure In addition, the percentage of sales consumed by operating expenses (i. e. Gross Profit % – Net Profit %) is often indicative of management efficiency in controlling operating costs. Disciplined management techniques, for example, by cutting costs can lead to two consequences, viz. : – ?? A more profitable enterprise ?? An efficiently operating enterprise The Net Profit % of XYZ Limited is as follows: – Net Profit % Margin|2000|1999|1998| Net Operating Income|100|88|70| Net Sales|900|800|700| |11. 11%|11. 00%|10. 00%| |||| I N T E R P R E T A T I O N :
The Net Profit Percentage Margin increased steadily in proportion to the Gross Profit percentage during the horizon of 1998 to 1999 (10% to 11%). This improvement in the enterprise s return on capital indicates that a proportionately greater profit was earned from sales in 1999 that in 1998. The crux of the matter, however, is not yet known whether this improvement is as a result of larger Gross Profit or lower expenses. Further analysis would be required. During the period of 1999 to 2000 the Net Profit Percentage Margin increased by a further 0. 11% (11% in 1999 to 11,11% in 2000).
Again this improvement can be ascribe to an improvement in the enterprise s return on capital. And as noted in the previous horizon, it cannot be determined whether this improvement is as a result of larger Gross Profit or lower expenses. Further analysis would be required. 1. 1. 1. 3Gross Profit % Margin Gross Profit % is an indication of the return of the enterprise s core business. The Gross Profit percentage can be measured by the following ratio: Gross Profit Sales The Gross Profit percentage ratio may be difficult to calculate, as many companies do not disclose their Gross Profit figures.
This ratio measures the overall profit margin the enterprise is making on the goods it sells. Perhaps a weakness of this ratio is that by disclosing this type of information a company could potentially expose itself to its competitors. Changes in the Gross Profit % can be influenced by the following factors: ?? Change in markup – changes in the selling prices of goods, or possibly trade discounts will have a direct impact on the GP margin. ?? Sales Mix – an enterprise may deal with numerous different products, which have different mark-ups, and as a result, the sales mix will have an influence on Gross Profit % margin.
A changing sales mix should be ascertainable from the segment report (if prepared) by the enterprise. Inventory theft – the theft of inventories would cause unequal quantities of inventories to be reflected as sales and cost of sales, and will definitely have a negative impact of the GP margin. The Gross Profit % of XYZ Limited is as follows: – Gross Profit Margin|2000|1999|1998| Gross Profit X 100%|300|256|210| Sales|900|800|700| |33. 33%|32. 00%|30. 00%| |||| I N T E R P R E T A T I O N : During the period 1998 to 1999, XYZ Limited s Gross Profit percentage margin increased from 30. 3% in 1998 to 32. 9% in 1999.
Changes in Gross Profit from one period to the next may be influenced by an increase in sales volume, but further analysis would be required. During the period 1999 to 2000, XYZ Limited s Gross Profit percentage margin increased by 1,1% (from 32. 0% in 1999 to 33. 3% in 1999). A closer look into the enterprise would be required to analyse the following factors: – ?? Higher selling prices ?? Lower purchasing prices ?? Incorrect inventory counts ?? Stricter prevention or loss control policies For obvious reasons, this type of analysis is only possible if the unit selling price and the costs are known. 1. 1. 1. Return on Equity (ROE) Return on Equity is measured by the following ratio: Net Profit After Tax Total Equity Return On Equity (ROE) is an indication of good or bad the shareholders prospered during the year. The objective of any enterprise must be to yield sufficient returns in line with the risks taken on by the owner. In addition, the Return on Equity ratio also gives the investor an idea of the sort of return of investment he/she is achieving. This can be compared with returns on alternative investment opportunities such as savings accounts, gilts, and fixed properties. The ROE of XYZ Limited is as follows: –
Return on Equity200019991998 Net Profit After Tax|56|48|33| Total equity|186|154|102| |30. 11%|31. 17%|32. 35%| |||| I N T E R P R E T A T I O N : During 1998 the Return on Equity ratio, as calculated above, indicated that for every rand in equity XYZ Limited generated 32. 35 cents in profit. Also noticeable is that during 1999 and 2000 this profit was measured as 31,17 and 30. 11 respectively. Apart from the fact that there was a mediocre decline in percentage over the three-year period, nothing signifies that the company is undergoing stress in terms of the ROE figures. Thus no further analysis would be required. . 1. 1. 5Earnings Per Share Describes the earning per share of the entity and it is measured by the following ratio: Earnings Per Share Total Equity Earnings Per Share indicates the value of the company s share as perceived by the market. The higher increase in value, the higher the favourable perception of the enterprise. The EPS of XYZ Limited is as follows: – Earnings Per Share|2000|1999|1998| Net Profit After Tax|56|48|33| Number of Shares Issued|10|10|8| |R5. 60|R4. 80|R4. 13| |||| I N T E R P R E T A T I O N : XYZ Limited s earnings per share favourably increased over the three horizons from R4. 3 (1998), to R4. 80 (1999), to R5. 60 (2000). This steady increase in share value over the three-year period is indicative of the higher favourable perception of XYZ Limited s 1. 1. 1. 6P/E Ratio Describes Price/Earnings per share capacity of the entity and it is measured by the following ratio: Price Earnings Per Share Price/Earnings Per Share indicates the internal growth of an enterprise. The P/E ratio also signifies how much investors are willing to pay per rand of current earnings. Furthermore, an increase in P/E usually indicates that an enterprise shows potential for future growth.
The P/E Ratio of XYZ Limited is as follows: – P/E ratio|2000|1999|1998| Price per Share|28|20|16| Earnings Per Share|6|5|4| |5. 00|4. 17|3. 90| I N T E R P R E T A T I O N : The Price/Earnings per share for XYZ Limited steadily increased over the horizons of 1998 (3. 90) to 1999 (4. 17); an increase of 0. 27. This increase is healthy for the company as it reflects it as a growing capability. However, since XYZ Limited is in its start-up phase this increase is understandable. The Price/Earnings per share for XYZ Limited, again, steadily increased over the horizons of 1999 (4. 17) to 2000 (5. 00); an increase of 0. 3. What is interesting to note is that this internal growth suggests that perhaps it is one of the contributory factors, which influenced the negative trend in the return of capital and since the company is relative new, growth is inevitable. 1. 1. 2 Liquidity Ratios Liquidity ratios, in essence, measure the ability of the enterprise to pay its bills on time. In other words, the more liquid an enterprise possesses, the more able it would be in terms of paying its bills. In addition, Liquidity ratios also measure the management of a firm s ability to employ working capital. The major liquidity ratios are: ??
Current Ratio ?? Acid-test Ratio ?? Stock Turnover days ?? Creditors payment ratio 1. 1. 2. 1Current Ratio The Current ratio measures the amount of times the company s assets cover its liabilities. Current liabilities consist of creditors who must be paid in cash in the short term. Current assets mainly consist of stock, debtors, and cash. The calculation of the current ratio is as follows: Current Assets Current Liabilities There is no generic rule of thumb about what the figure should be, but generally speaking, an acceptable ratio usually computes between 1 and 2, even though this may vary from industry to industry.
The significant thing about the current ratio is that it is used to make comparisons, rather than an absolute measure of liquidity. As a short-term ratio, it makes sense, due to the fact the company s liquidity in the short term depends upon whether it has enough current assets to pay its current liabilities. Another important aspect of the Current Ratio is that it is an important tool for creditors and bank managers (in the case of overdrafts) as signifies that the company can make the commitment to its lenders. The current ratio could also be used in terms of risk management in the event of a negative trend in this ratio.
For example, if the rate at which the company s assets are converted into cash is slower than that of the repayment of the company s creditors, there would be liquidity problems in that enterprise. The Current ratio of XYZ Limited is as follows: – Current Ratio|2000|1999|1998| Current Assets|186|110|22| Current Liabilities|70|36|20| |2. 66 : 1. 0|3. 06:1. 0|1. 10:1. 0| |||| I N T E R P R E T A T I O N : The Current ratio for XYZ Limited during the period 1998 to 1999 increased considerably from 1. 10:1. 0 to 3. 06:1. 0. The poor acid-test ratio in 1998 indicated that the company had experienced problems.
This is obviously not the case due to the fact that the enterprise was just starting up. Another observation of this particular horizon is that it signifies that in 1999 the company expanded (grew) substantially since its inception – which contributed to the enormity of the gap. During the period of 1999 to 2000 the current ratio of XYZ Limited expectedly “levelled-out” from (3. 06: 1. 0) to (2. 66:1. 0); and even though it is still above the industry norm (2:1). Even though this horizon indicates that XYZ Limited has the capabilities of servicing long-term debt and current liabilities, it must still be viewed with caution. 1. 1. 2. Acid Test Ratio The Acid-Test ratio (or sometimes referred to as the Quick ratio) is a more severe form of the current ratio where current assets are readily converted to cash are calculated as a proportion of the current liabilities. The calculation of the Acid-test ratio is as follows: Current Assets – Stock Current Liabilities The Acid-test ratio also compares current assets to current liabilities, but removes stock from the assets, since stock is usually the least liquid of all the assets and the most difficult to convert into cash. This ratio, in fact, gives us a more accurate assessment of the liquidity of the enterprise.
A quick ratio of 1:1 would be considered as the norm , but may vary from industry to industry. The Quick ratio of XYZ Limited is as follows: – Acid Test Ratio|2000|1999|1998| Current assets – Stock|120|70|7| Current Liabilities|70|36|20| |1. 71:1. 0|1. 94:1. 0|0. 35:1. 0| |||| I N T E R P R E T A T I O N : The Current ratio for XYZ Limited during the period 1998 to 1999 increased considerably from 0. 35:1. 0 to 1. 94:1. 0 respectively. The poor acid-test ratio in 1998 is indicative of the fact that the company was in its infancy stage and was probably committed to its lenders.
XYZ Limited then somewhat leap-frogged in 1999 to a more favourable position due its debtors recovery. During the period of 1999 to 2000 the quick ratio of XYZ Limited declined marginally from (3. 06: 1. 0) to (2. 66:1. 0) respectively; and even though it is still above the industry norm (1:1). The decrease in XYZ Limited s quick ratio could be ascribed to expansion in operations and growth and even though was still able to meet its short-term commitments. 1. 1. 2. 3Stock turnover days The calculation of the stock turnover days is as follows: Average inventory X 365 Cost of sales
The inventory stock days calculates the sales an enterprise contains in its year-end inventory. The most efficient scenario would be to have no inventory holding, but is impractical, as it would make an enterprise inoperable. It would therefor be considered as a management inventory control policy. The Stock turnover days ratio of XYZ Limited is as follows: – Stock Inventory Turnover Days|2000|1999|1998| Ave inventory X 365|66|40|15| Cost of sales|600|544|490| |40. 15|26. 84|11. 17| I N T E R P R E T A T I O N : It is interesting to note that during the period 1998 and 1999 this figure for the stock turnover days seemingly increased by 25. 7 days (from 11. 17 days in 1998 to 26. 84 days in 1999). This increase in the number of days could be as a result of growth or due to stock holding. XYZ Limited showed an increase in the number of days for the horizon 1999 (26 days) and 2000 (40 days). This negative trend over this period and the previous horizon could be misleading and potentially indicates that stock piling occurs. It is difficult to assess this condition as the company could be in the process of delivering a huge order or has over stocked in anticipation of sales projection. 1. 1. 2. 4Creditors Payments
The calculation of the creditors payments is as follows: Average Creditors X 365 Cost of sales The creditors payments days indicates the period an enterprise uses to pay it s trade collectors. This can potentially give rise to cash discounts by suppliers. The Creditors Payments ratio of XYZ Limited is as follows: – Stock Inventory Turnover Days|2000|1999|1998| Ave Creditor X 365|40|26|20| Cost of sales|600|544|490| |24 days|17days|14days| I N T E R P R E T A T I O N : XYZ Limited showed an increase in the number of days for the horizon 1998 (14 days) and 1999 (17 days). And again during 2000 (24 days).
This, however, does not signify anything as the company is still able to pay its suppliers in less that 30 days, which suggests an efficient payment process. 1. 1. 3 Leverage Ratios Leverage (Gearing) ratios, in essence, gives the analyst an indication of the sort of debt an enterprise has and how the operations is financed. All leverage ratios will contain long-term debts and short-term debts. This is usually compared with the total assets of the company. Financial institutions and banks are usually keen to know the company s leverage as they are keen to find out how much an enterprise has borrowed and what it can afford to borrow.
The major leverage ratios are: 1. 1. 3. 1Debt Ratio The debt ratio is an indicator of all the debt that the company has , to its total assets. The calculation of the debt ratio is as follows: Total liabilities Total assets Due to the accounting equation, it can be generally assumed that the company has financed its assets by the above proportion of “non-owner” funds. “Owner funds” refers to share capital and retained earnings. Lenders generally stipulate that this ratio should not exceed a certain percentage because it is usually more risky to lend to a company who lacks owners funds (i. . share capital + retained earnings) as apposed to its “non-owners” funds. Again, the desirable value of this ratio is difficult to evaluate and its usefulness lies in how it compares to the same ratio in other similar companies. The debt ratio of XYZ Limited is as follows: – Debt ratio|2000|1999|1998| Total liabilities|100|76|60| Total assets|286|230|162| |34. 97%|33. 04%|37. 04%| |||| I N T E R P R E T A T I O N : The debt ratio for XYZ Limited during the period 1998 to 1999 decreased marginally from 37. 04% to 33. 04%. this was mainly due to an increase in assets.
Due to this effect on leverage, the debt equity ratio caused the return on shareholder s equity to remain fairly constant even though an increase in return on capital was encountered. During the period of 1999 to 2000 the debt ratio of XYZ Limited increased marginally, suggesting that the company did not have the same profitability as the previous horizon. 1. 1. 3. 2Long-term Debt Ratio The long-term debt ratio is an indicator of only the long-term debt that the company has, to its total assets. The calculation of the long-term debt ratio is as follows: Long-term Debt Total assets
Long term debt is fairly static. Generally lenders do not like to give long-term loans to finance short-term (current assets). They prefer to lend on a long-term basis for items such as fixed assets. The ratio therefor indicates what proportion of the assets has been financed by long-term debt. The debt ratio of XYZ Limited is as follows: – Long-term debt ratio|2000|1999|1998| Long-term debt|30|40|40| Total assets|286|230|162| |10. 49%|17. 39%|24. 69%| |||| I N T E R P R E T A T I O N : The debt ratio for XYZ Limited during the period 1998 to 1999 decreased marginally from 24. 9% to 17. 39%. This was mainly due to an increase in total assets. Due to this effect on leverage, the debt equity ratio caused the return on shareholder s equity to remain fairly constant even though an increase in return on capital was encountered. During the period of 1999 to 2000 the debt ratio of XYZ Limited increased significantly mainly due to an increase in total assets and a decrease in long-term debt. What is noticeable in this ratio is that XYZ Limited is not particularly bad for the company. In fact, the company is seemingly doing very well.