Showing that i know how to work out ratios and why there needed - Essay Example

MacDonald’s Ratio Analysis The financial analysis of a company is best done using financial ratios that are used to describe the performance of a company (Neely, 2002). Financial ratios are usually divided into several groups, but the best indicators of a firm’s performance are the profitability ratios and the pyramid of ratios (Neely, 2002). The best ratios that can be used to describe the performance of a company include the current and quick ratio and all the ratios that are included in the pyramid of ratios.

These ratios are the Return on Capital employed, the Return on Investment, the Leverage, Asset turnover, Asset leverage and the net margin ratio. The relationship between these ratios can be seen on the diagram below (Graham, 2010): 1. Return on Capital employed (ROCE) The return on capital employed measures the return that a business gets from the amount of money invested in it, meaning that it is a measure used by investors to rate the business (Graham, 2010). The return on capital employed is calculated as Net income after tax divided by the Total Equity, which, for MacDonald’s is displayed below.

ROCE = NIAT/Equity = $5,503,100,000/$32,989,900,000 =0.167 2. Leverage The return on capital employed is a ratio made up of two other ratios, the leverage and the Return on Investment (ROI) (Neely, 2002). The leverage is a ratio used to measure the amount of owner money invested in the business as a ratio of the amount of debt that the business incurred for running the business. The leverage ratio is important in determining the relative stake that the owners have in the business, and for MacDonald’s, is given as: Leverage = Total Capital / Equity = $14,390,200,000 / $18,599,700,000 =0.

77 Leverage is an important ratio for the business since it improves the availability for the company to use, but too much leverage can be detrimental especially if the market is risky. In the case of MacDonald’s, the leverage is not more than 1, meaning that the company is sufficiently leveraged. 3. Return on Investment (ROI) The return on investment (ROI) measures the efficiency of the business in utilizing invested capital to earn a return for the stakeholders in the business (Graham, 2010).

The ROI is a ratio given by dividing the net income after tax by the capital invested in the business. = $5,503,100,000/$14,390,200,000 = 3.824 This ratio is used to measure the underlying performance of the business, which is displayed by how the company utilizes invested equity to return profits. The final ratios used in the pyramid of ratios are in the third tier, and include the asset turnover ratio, the asset leverage ratio and the net margin. These three ratios, when combined, give the ratios in the second hierarchy of the ratios, which are the ROI and the leverage.

In turn, the ROI and leverage give the highest ratio in the hierarchy, which is the ROCE. 4. Asset Turnover Ratio The asset turnover ratio is used as an indicator of how quickly the business is running or how the company works the assets in the business (Neely, 2002). The asset turnover ratio is given as the division of the turnover and the total assets. For MacDonald’s, the ratio is given as: Turnover/Total Assets = $27,006,000,000/$32,989,900,000 = 0.818 5. Asset Leverage Ratio This ratio measures the way the asset base is leveraged against the equity in the business, and is given as the total assets divided by the total equity in the business (Graham, 2010).

For MacDonald’s, this is given as: Total assets/ equity = $32,989,900,000/ $18,599,700,000 = 1.77 This ratio indicates that the company has more asset leverage that the equity, which is a plus for the business. 6. Net Margin This ratio measures the profitability of the business as a percentage of the turnover, which is a measure of how the company utilizes the sales to generate profits (Neely, 2002). The net margin is given as net income being a percentage of the turnover, and indicates how the company utilizes sales to generate income after tax and costs of goods sold.

For MacDonald’s, the ratio is given as: = $5,503,100,000/$27,006,000,000 = 0.203. This indicates that the company does not fully utilize its turnover as a means of generating profits, since the net margin is very low. 7. Current ratio The last two ratios that are used to measure a firm’s performance are the quick and current ratios, which are used to indicate how much of the company is able to cover liabilities (Neely, 2002). The current ratio is given as a division of the current assets and the current liabilities, which for MacDonald’s is given as: = Current Assets / Current Liabilities = $4,403,000,000/ $3,509,200,000 = 1.

254 This ratio indicates that the company has more current assets than liabilities, which means that it can cover current liabilities as they fall due. 8. Quick ratio The quick ratio is given as the current ratio but without the inventory in the current assets. The inventory is removed as a measure of determining the most liquid current assets, since the inventory would require some time before it is disposed. = (Current Assets – Inventory)/ Current Liabilities = ($4,403,000,000-116,800,000)/ $3,509,200,000 = 1.

2214 The above ratio analyses indicate that MacDonald’s corporation is performing well in terms of the ratios analyzed. The company is profitable and the investment ratios indicate that the assets are well leveraged against the debts and equity. References Neely, A. (2002). Business Performance Measurement: Theory and Practice. Cambridge: Cambridge University Press. Graham, F. (2010). Ratio Analysis. Essential Business Finance. New York: Prentice Hall.