Health check of a company
This document contemplates on presenting an analysis ratios and how to use these ratios to analyze a company. Ratios are derived from the three main financial statements which are profit and loss statement, balance sheet and cash flow statement. And this is the most scientific way to understand a company’s performance.
The following is an extract of a profit and loss statement.

Sales Revenue	2000
Cost of Sales	(1200)
Gross profit	800
Distribution Costs	(400)
Administrative Expenses	(240)
Other Income	40
Profit before Tax	200
Income Tax Expenses	(50)
Profit for the year	150

1. Gross Profit Margin
Gross Profit (GP) Margin can be calculated as follows,

GP Margin = (Gross Profit/Sales Revenue) %

In this Scenario the gross profit margin of the company is 40%.

What does this ratio mean? Does this mean the company is doing well? Is the company performing exceptional? The main objective of this document is to develop the ability to analyze a company based on the financial performances.
When analyzing a ratio the most important thing is to break down the ratio into to atomic units to understand the insight of the ratio.

Gross profit (Sales Revenue – Cost of sales)
Sales Revenue (selling price per unit * No: of units)
Cost of Sales (Opening inventory + Purchases – Closing Inventory)

Gross profit margin could increase mainly because sales revenue increasing or the cost of sales is being reduced.
For the sales revenue to increase either the selling price of a unit should increase or the number of units should increase.
You would like to know the answers for the following questions to conclude.
Questions
a) Has the company increased the selling price to earn higher revenue but has it decreased on the number of units sold.

b) If the number of units being sold is decreasing is there high competition in the market, what is the market share of the company?

c) Has the sales revenue increased/ decreased compared with the previous years? What is the percentage increase in sales Revenue?

d) How are competitors doing?

When analyzing ratios it should be critically appraised and should always question the atomic principles of the ratios.

For the gross profit to increase the other things possible is that the cost of sales has increased. Cost of sales gives insight to the effectiveness of the supply chain management of the company.
With reference to the breakdown of the cost of sales you should try to look for answers on,
a) Has the opening stock increased or decreased?

b) Has the closing stock increased or decreased?
*Company which has implemented Supply chain management concepts like Just in Time would not have an impact on closing and opening stock on the Cost of goods sold

c) Has the cost of purchases increased/Decreased compared to previous years. Has the inflation levels impacted the cost of purchases.

2. Percentage change in Revenue
This Ratio is important to benchmark the sales revenue against the performance of the previous years.
% Change = [(Sales in base year – Sales in previous year) /Sales in Previous year] %

This will give insight to the company’s performance on sales on a year on year basis. In the example since the company has increased the percentage of growth in the year 2010 it could be concluded that the company is well.

Yet this could have happened due to other reasons such as ill performance of competition where its customers coming to our company.
A better analysis would dig deep into the sales revenue trying to understand the variations of selling price and the units.

3 Percentage change in selling price
% Change = [(Selling price in base year – Selling price in previous year) /Selling price in Previous year] %

4 Percentage change in number of units sold
% Change = [(No: of units in base year – No: of units price in previous year) /No: of units in Previous year] %

Let’s apply these two ratios to the given scenario.

Deeper analysis shows that the prices of the product have increased but the number of units has decreased.
a) Has the sales price increased due to inflation or is the company focusing on a premium pricing strategy?

b) How are the competitors doing on pricing?

c) The number of units are decreasing drastically are these customers switching to competitors? How to get the lapsed customers back to the company? Are the competitors reducing prices to attract customers?

Building this analytical thinking would enable to master in ratios and better analyze a company’s portfolio.

5. Compound Annual growth Rate (CAGR)

This ratio contemplates on arriving at an average figure to for the year on year growth rate.
You can use the following ratio to calculate it
Future Value (FV) = Present value (PV) (1 + Rate(R)) ^ Number of years
In applying to the above scenario,
FV = 2000, PV = 1800, R=?, Years = 2
After applying the values to the formula you get a CAGR of 8.475%, this presents an average value for the year on year revenue growth, and this can be used as a bench mark to compare the growth rates for each year. For instance in compared with the CAGR year 2010 the company has done well in terms of sales. This ratio could be used to compare with competitors.

6. Percentage Change in Cost of sales
% Change = [(COGS in base year – COGS in previous year) /COGs in Previous year] %
This Ratio gives insight to the direct cost structure direct costs related to the company.
Increase in this ratio could be due to many reasons,
a) Increase in the inflation of the country

b) Weak supply chain management, change in suppliers.

c) Weak management in the inventory levels

This ratio could decrease,
a) Better management in supply chain, Change in suppliers
Companies may select low cost suppliers to reduce cost of sales, but it is important that suppliers are selected not purely based on the price variable. As lower quality inputs could lead to low quality outputs (Garbage IN – Garbage OUT)
b) Decrease in Inflation, Taxes which affects in decreasing the cost of inputs.
Trying to analyze the ratios from a critical perspective enables to get into more insight.

7. Distribution cost as a percentage of Sales
This Ratio is important to understand how well the company is using the channels. This could be calculated as,

Distribution cost as a percentage of sales =
Distribution costs/Sales Revenue%

This revenue explains the effectiveness of managing distribution channels which is normally the responsibility of the procurement department. In this explain this ratio 20%. Decreasing in the revenue highlights better management of distribution channels.
a) This ratio could change based on the number of units sold as to distribute more products distribution cost would increase but maintaining a stable portfolio is important.

b) Based on the target geographical area, this ratio might change since distribution costs increases based on the geographical span covered.

To arrive at a better conclusion it is better to compare the ratio with previous year’s figures.

8. Profit before Interest and Tax (PBIT) Margin
PBIT Margin = PBIT/Sales Revenue%

Let’s consider a break down of the PBIT.
PBIT = Gross Profit – Operational Expenses
Thus for the PBIT margin to increase either the gross profit should increase or the operational expenses should decrease. How to increase the gross profit was discussed in the earlier sections of this document and thus see how we can reduce the operational expenses.

The operational expenses consist of the administration expenses, depreciation, distribution costs. An improvement in the PBIT margin signifies that the company is better managing the above mentioned operational expenses. Thus this ratio clearly highlights the managerial capability and thus this can be used as a performance measurement of the management of the company.

9. Interest Cover
Interest cover can be calculated as follows,
Interest Cover = PBIT/Interest Expenses

This ratio will give an indication of the company’s burden in debt expenses. The lower the interest cover the company is ridden by debt.
To understand this lets see how interest expense is calculated.
Interest Expense = Debt * Annual Debt Rate


Higher the interest expense is higher the company’s debts. For the company to afford the finance cost or the interest cost it is important that PBIT covers the expenses. If the Ratio is below 1.5 company’s ability to meet interest expenses is questionable.
For a better analysis answers to following issues might need to be looked into.
a) The company might not been looking to optimize its capital structure

b) The company might be charged high interest rates and the company might not be effective in finding lower cost financing means.

c) The countries economic policy and due to high inflation interest rates might have gone up.

10. EBITDA

EBITDA is the earnings before interest, tax, depreciation and amortization.
EBITDA = Revenue – Expenses (Excluding Tax, Interest, Depreciation, Amortization)

This ratio is very important to compare profitability among competition because it eliminates the accounting and financing decisions. For instance a company adopting a reducing balanced depreciation policy may have higher depreciation costs in the initial year after the purchase of assets in compared with a company which is adopting a straight line method to calculate depreciation.
And also different companies adopt different strategies to finance operations. For instance a listed company can use a rights issue to finance which is lower cost of finance in compared to borrowing.

11. EBITDA to Interest Cover
This ratio can be calculated as follows,
EBITDA to Interest Cover = EBITDA/ Interest Payments

This Ratio assesses a company’s profitability at least to pay the interest expenses. A ratio greater than 1 indicates that the company has coverage to pay off its interest expenses.
EBITDA eliminates the cost of depreciation and amortization thus would give a better indication of the financial durability of the company.

12. Profit after tax Margin
Profit after tax is also known as the earnings attributable to share holders. Since only after arriving at the profit after tax the company decides on the dividends and the amount of retained earnings. This ratio can be calculated as follows,

PAT Margin = Profit after Tax / Sales Revenue %

PAT margin in the above example is 7.5%. In other words for each $100 sold the company generates a net profit of $7.5.
To arrive at a conclusion on profitability, a year on year basis profit variance should be calculated, and also compared with the competition.
An increase on sales does not necessary mean that the profit margins would improve. If the cost structure increases at a higher rate the profit margin will be affected. This ratio will give a good indication about the cost management.

13. Pre tax Margin
Pre tax margin can be calculated as follows,
Pre Tax Marin = Profit before tax/ Sales Revenue%

In the above example the pre tax margin accounts to 10%. Comparison of the pre tax margin with after tax margin will show the tax margin.

14 Contribution Margin
In understanding the contribution margin, it is important to define contribution,

Contribution = Sales – Variable Costs

The difference between contribution and profit is that contribution does not take into account the fixed costs. This ratio is important for product profitability analysis.

The contribution margin can be calculated as follows,
Contribution Margin = Contribution / Sales Revenue%

Variable costs are mainly the direct costs in line with the product or service, thus contribution margin will highlight the effectiveness in managing the direct costs with relate to production. Better analysis would try to find answers to the following
a) Comparison of the contribution revenue with the net profit margin. This will highlight the fixed asset portion

b) What is the method company used to absorb overhead costs? Can we propose Activity based costing to improve profit calculations?