Concept of Efficiency and Profitability

Concept of Efficiency and Profitability By : Varun Sood Roll No. : 31ProfitabilityProfitability measures - how much profit the firm generates from sales or from its capital assets

Different measures of profit gross and net

Gross profit effectively total revenue (turnover) variable costs (cost of sales)

Net Profit effectively total revenue (turnover) variable costs and fixed costs (overheads)

Gross profitequals salesrevenueminuscost of good sold(COGS), thus removing only the part of expenses that can be traced directly to the production or purchase of the goods.

Gross Profit Margin = Gross profit / turnover x 100

The higher the better

Enables the firm to assess the impact of its sales and how much it cost to generate (produce) those sales

A gross profit margin of 45% means that for every 1 of sales, the firm makes 45p in gross profit

Net Profit Margin = Net Profit / Turnover x 100

Net profit takes into account the fixed costs involved in production the overheads

Keeping control over fixed costs is important could be easy to overlook for example the amount of waste - paper, stationery, lighting, heating, water, etc.

e.g. leaving a photocopier on overnight uses enough electricity to make 5,300 A4 copies. (1,934,500 per year)1 ream = 500 copies. 1 ream = 5.00 (on average)Total cost therefore = 19,345 per year or 1 persons salary

Return on Capital Employed (ROCE) = Profit / capital employed x 100

The higher the better

Shows how effective the firm is in using its capital to generate profit

A ROCE of 25% means that it uses every 1 of capital to generate 25p in profit

Partly a measure of efficiency in organisation and use of capital

Other profit measuresOperating profit [Earnings Before Interest and Taxes(EBIT)]equals sales revenue minus cost of goods sold and all expenses except for interest and taxes. This is the surplus generated by operations.

Net Profit Before Tax[Earnings Before Tax(EBT)]equals sales revenue minus cost of goods sold and all expenses except for taxes.

Earnings BeforeInterest,Taxes,Depreciation, andAmortization(EBITDA) equals sales revenue minus cost of goods sold and all expenses except for interest, amortization, depreciation and taxes. It measures the cash earnings that can be used to pay interest and repay the principal.

Net Profit After Tax (Earnings After Tax) equals sales revenue after deducting all expenses, including taxes (unless some distinction about the treatment of extraordinary expenses is made).Ratio-analysis is a concept or technique which is as old as accounting concept. Financial analysis is a scientific tool. It has assumed important role as a tool for appraising the real worth of an enterprise, its performance during a period of time and its pit falls. Financial analysis is a vital apparatus for the interpretation of financial statements. It also helps to find out any cross-sectional and time series linkages between various ratios.RATIO ANALYSISUnlike in the past when security was considered to be sufficient consideration for banks and financial institutions to grant loans and advances, nowadays the entire lending is need-based and the emphasis is on the financial viability of a proposal and not only on security alone. Further all business decision contains an element of risk. The risk is more in the case of decisions relating to credits. Ratio analysis and other quantitative techniques facilitate assessment of this risk.RATIO ANALYSISRatio-analysis means the process of computing, determining and presenting the relationship of related items and groups of items of the financial statements. They provide in a summarized and concise form of fairly good idea about the financial position of a unit. They are important tools for financial analysis.RATIO ANALYSISWHY FINANCIAL ANALYSISLenders need it for carrying out the following Technical AppraisalCommercial AppraisalFinancial AppraisalEconomic AppraisalManagement AppraisalRatio AnalysisIts a tool which enables the banker or lender to arrive at the following factors :Liquidity positionProfitabilitySolvencyFinancial StabilityQuality of the ManagementSafety & Security of the loans & advances to be or already been providedClassification of RatiosBalance Sheet RatioP&L Ratio or Income/Revenue Statement RatioBalance Sheet and Profit & Loss RatioFinancial RatioOperating RatioComposite RatioCurrent RatioQuick Asset RatioProprietary RatioDebt Equity RatioGross Profit RatioOperating RatioExpense RatioNet profit RatioStock Turnover RatioFixed Asset Turnover Ratio, Return on Total Resources Ratio, Return on Own Funds Ratio, Earning per Share Ratio, Debtors Turnover Ratio,

Current Ratio : It is the relationship between the current assets and current liabilities of a concern. Current Ratio = Current Assets/Current Liabilities If the Current Assets and Current Liabilities of a concern are Rs.4,00,000 and Rs.2,00,000 respectively, then the Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1 The ideal Current Ratio preferred by Banks is 1.33 : 1

Net Working Capital : This is worked out as surplus of Long Term Sources over Long Tern Uses, alternatively it is the difference of Current Assets and Current Liabilities. NWC = Current Assets Current LiabilitiesCurrent Assets : Raw Material, Stores, Spares, Work-in Progress. Finished Goods, Debtors, Bills Receivables, Cash.

Current Liabilities : Sundry Creditors, Installments of Term Loan, DPG etc. payable within one year and other liabilities payable within one year.

This ratio must be at least 1.33 : 1 to ensure minimum margin of 25% of current assets as margin from long term sources.

Current Ratio measures short term liquidity of the concern and its ability to meet its short term obligations within a time span of a year. It shows the liquidity position of the enterprise and its ability to meet current obligations in time.Higher ratio may be good from the point of view of creditors. In the long run very high current ratio may affect profitability ( e.g. high inventory carrying cost) Shows the liquidity at a particular point of time. The position can change immediately after that date. So trend of the current ratio over the years to be analyzed. Current Ratio is to be studied with the changes of NWC. It is also necessary to look at this ratio along with the Debt-Equity ratio.3. ACID TEST or QUICK RATIO : It is the ratio between Quick Current Assets and Current Liabilities. The should be at least equal to 1.

Quick Current Assets : Cash/Bank Balances + Receivables upto 6 months + Quickly realizable securities such as Govt. Securities or quickly marketable/quoted shares and Bank Fixed Deposits

Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities

Example : Cash 50,000Debtors 1,00,000Inventories 1,50,000 Current Liabilities 1,00,000Total Current Assets 3,00,000

Current Ratio = > 3,00,000/1,00,000 = 3 : 1Quick Ratio = > 1,50,000/1,00,000 = 1.5 : 1

DEBT EQUITY RATIO : It is the relationship between borrowers fund (Debt) and Owners Capital (Equity).

Long Term Outside Liabilities / Tangible Net Worth Liabilities of Long Term Nature

Total of Capital and Reserves & Surplus Less Intangible Assets For instance, if the Firm is having the following :

Capital = Rs. 200 Lacs Free Reserves & Surplus = Rs. 300 Lacs Long Term Loans/Liabilities = Rs. 800 Lacs

Debt Equity Ratio will be => 800/500 i.e. 1.6 : 1

5. PROPRIETARY RATIO : This ratio indicates the extent to which Tangible Assets are financed by Owners Fund.Proprietary Ratio = (Tangible Net Worth/Total Tangible Assets) x 100 The ratio will be 100% when there is no Borrowing for purchasing of Assets.

6. GROSS PROFIT RATIO : By comparing Gross Profit percentage to Net Sales we can arrive at the Gross Profit Ratio which indicates the manufacturing efficiency as well as the pricing policy of the concern.

Gross Profit Ratio = (Gross Profit / Net Sales ) x 100

Alternatively , since Gross Profit is equal to Sales minus Cost of Goods Sold, it can also be interpreted as below : Gross Profit Ratio = [ (Sales Cost of goods sold)/ Net Sales] x 100 A higher Gross Profit Ratio indicates efficiency in production of the unit. 7. OPERATING PROFIT RATIO : It is expressed as => (Operating Profit / Net Sales ) x 100

Higher the ratio indicates operational efficiency

NET PROFIT RATIO :

It is expressed as => ( Net Profit / Net Sales ) x 100

It measures overall profitability.

9. STOCK/INVENTORY TURNOVER RATIO :

(Average Inventory/Sales) x 365 for days (Average Inventory/Sales) x 52 for weeks (Average Inventory/Sales) x 12 for months

Average Inventory or Stocks = (Opening Stock + Closing Stock) ----------------------------------------- 2 . This ratio indicates the number of times the inventory is rotated during the relevant accounting period

10. DEBTORS TURNOVER RATIO : This is also called Debtors Velocity or Average Collection Period or Period of Credit given .

(Average Debtors/Sales ) x 365 for days (52 for weeks & 12 for months)

11. ASSET TRUNOVER RATIO : Net Sales/Tangible Assets

12. FIXED ASSET TURNOVER RATIO : Net Sales /Fixed Assets

13. CURRENT ASSET TURNOVER RATIO : Net Sales / Current Assets

14. CREDITORS TURNOVER RATIO : This is also called Creditors Velocity Ratio, which determines the creditor payment period.

(Average Creditors/Purchases)x365 for days (52 for weeks & 12 for months)

15. RETURN ON ASSETS : Net Profit after Taxes/Total Assets 16. RETURN ON CAPITAL EMPLOYED :

( Net Profit before Interest & Tax / Average Capital Employed) x 100 Average Capital Employed is the average of the equity share capital and long term funds provided by the owners and the creditors of the firm at the beginning and end of the accounting period.

Composite Ratio

17. RETRUN ON EQUITY CAPITAL (ROE) : Net Profit after Taxes / Tangible Net Worth

EARNING PER SHARE : EPS indicates the quantum of net profit of the year that would be ranking for dividend for each share of the company being held by the equity share holders.

Net profit after Taxes and Preference Dividend/ No. of Equity Shares

19. PRICE EARNING RATIO : PE Ratio indicates the number of times the Earning Per Share is covered by its market price.

Market Price Per Equity Share/Earning Per Share

20. DEBT SERVICE COVERAGE RATIO : This ratio is one of the most important one which indicates the ability of an enterprise to meet its liabilities by way of payment of installments of Term Loans and Interest thereon from out of the cash accruals and forms the basis for fixation of the repayment schedule in respect of the Term Loans raised for a project. (The Ideal DSCR Ratio is considered to be 2 )

PAT + Depr. + Annual Interest on Long Term Loans & Liabilities --------------------------------------------------------------------------------- Annual interest on Long Term Loans & Liabilities + Annual Installments payable on Long Term Loans & Liabilities ( Where PAT is Profit after Tax and Depr. is Depreciation)

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Strategies For Cutting Cost & Improving ProfitabilityManaging Vendor and Customer RelationshipsOutsourcing IT applications (ex. Network Alliance), benefits, sales financial management, etc.Cooperatives for purchasing, advertising, etc. (including trade associations)Joint Ventures and strategic alliancesEmployee incentives and rewards for cost-cutting initiativesBootstrappingCash flow managementManaging employee retention and turnover costsBudgeting, planning, forecastingEstimates and price quotesCorporate restructuring, recapitalization and reorganizationCompetitive bidding and RFPs for vendor needsGrassroots and guerilla sales and marketing techniquesPR vs. Advertising CostsCustomer referral, retention and loyalty systems (80/20 rule of costs of getting new customers)Barter networks26Best PracticesWalk the talk if you are serious about controlling costs, then demonstrate it with your actions and your employees will do the sameBuild and embrace a dashboard and reporting system which will help you monitor and measure key metricsConsider third-party cost management services who work on a contingent basis (ex. PRS)Build an expense-control culture which recognizes and rewards employees (and others) who figure out ways to control costs and improve profitabilityBenchmarking is key know the typical ratios within your industry and manage accordingly27Best Practices (Contd)Closely examine each category of your expenses and ask: Do we really need to incur this cost? Is there an alternative and more efficient source or solution available? How will a reduction in this particular category of cost (or change in our approach) affect our other operations or successes to date?Understand the direct and indirect impact of your cost-cutting strategies on your culture and the fabric and values of your company the key to this process is to cut fat without cutting into muscle or boneAct with integrity and honesty . Cost-cutting can be creative and aggressive but do not sacrifice your values and key relationships along the way communication is critical

28Best Practices (Contd)Lean and Mean does not need to translate into a compromise of your culture rigor can be instilled without rigor mortis and discipline can be instilled without fearChanging bad habits and empowering and rewarding the right behaviors with a focus on profitability is the key there must be an educational component to the implementation of the cost-management planProfitability-improvement programs do not always need to be focused on reducing costs there should also be an effort to develop higher-margin revenue streams EfficiencyEfficiencyin general describes the extent to which time or effort is well used for the intended task or purpose.

It is often used with the specific purpose of relaying the capability of a specific application of effort to produce a specific outcome effectively with a minimum amount or quantity of waste, expense, or unnecessary effort.

In general, efficiency is a measurable concept, quantitatively determined by the ratio of output to input.Outputs are the goods and services provided by industry. 11Inputs are the resources needed to provide those products and services.Constraints on Productivity are things that hold down the equation as a whole.30Any production method relies on efficiency this can be viewed in different ways:Productivity a measurement of output per unit of the factor used (labour, capital or land) Total Output Productivity = ------------------- Units of Factor

Technical Efficiency output produced using the fewest possible inputsProductive Efficiency output produced at the lowest possible costProduction decisions involve deciding methods for new production runs and analysis of existing methods.Decisions may include:Substitute machinery for labour? Use of new technology? Organisation of the production layout? Change of production method?Example: Agriculture tends to be very land intensive efficiency could be measured in terms of output per acre/hectare.

There are 5 general ways to increase output:1. Process improvement2. Regulate work flow3. Use more modern (efficient) equipment4. Train employees5. Motivate employees33There are 6 general ways to decrease input:1. Improve qualitya. Increase reliabilityb. Minimize rework2. Minimize waste.3. Minimize tardiness, absenteeism, turnover.4. Reduce the cost of labora. Number of man-hours requiredb. Cost per man-hour 5. Reduce the cost of parts and suppliesa. Number of parts and supplies requiredb. Cost per part and supply6. Reduce overhead34There are 5 general constraints to increasing productivity:1. Government regulations 2. Union rules3. Management limitations4. Employee skills5. Employee attitudes35Cultivating competition and recognizing those individuals and groups that excel has proven to counter these types of problems. Important Note:Group norms that discourage individual and group accomplishments and social loafing where diffusion of responsibility by individuals in a group are the bane of industry. 36Sources:

Essentials of Contemporary Management. 2nd. Jones, G.R. & George, J.M. (Yeargain Library). (McGraw-Hill Irwin. 2007).Organizational Behavior: A Management Challenge. 2nd. Northcraft, G. & Neale, M. (Yeargain Library).(The Dryden Press. 1994).

Strategic Management: creating competitive advantage.3rd.Dess, Lumpkin, Eisner. (Yeargain Library).(McGraw-Hill Irwin. 2007).Supervision: Quality, Diversity, and Technology. 2nd. Certo, S.C. (Yeargain Library).(Irwin. 1997). 3738Thank You