Welcome to Ratio Analysis!

Financial ratio analysis is a fascinating topic to study because it can teach us so much about
accounts and businesses. When we use ratio analysis we can work out how profitable a business is,
we can tell if it has enough money to pay its bills and we can even tell whether its shareholders
should be happy!

Ratio analysis can also help us to check whether a business is doing better this year than it was last
year; and it can tell us if our business is doing better or worse than other businesses doing and
selling the same things.

In addition to ratio analysis being part of an accounting and business studies syllabus, it is a very
useful thing to know anyway!

The overall layout of this section is as follows: We will begin by asking the question, What do we
want ratio analysis to tell us? Then, what will we try to do with it? This is the most important
question, funnily enough! The answer to that question then means we need to make a list of all of
the ratios we might use: we will list them and give the formula for each of them.

Once we have discovered all of the ratios that we can use we need to know how to use them, who
might use them and what for and how will it help them to answer the question we asked at the
beginning?

At this stage we will have an overall picture of what ratio analysis is, who uses it and the ratios they
need to be able to use it. All that's left to do then is to use the ratios; and we will do that step- by-
step, one by one.

By the end of this section we will have used every ratio several times
and we will be experts at what do we want ratio analysis to tell us?

The key question in ratio analysis isn't only to get the right answer: for example, to be able to say
that a business's profit is 10% of turnover. We have to start working on ratio analysis with the
following question in our heads:

What are we trying to find out?

Isn't this just blether, won't the exam just ask me to tell them that profit is 10% of turnover? Well,
yes, but then they want to know that you are a good student who understands what it means to say
that profit is 10% of turnover.

We can use ratio analysis to try to tell us whether the business

1. is profitable

2. has enough money to pay its bills

 3. could be paying its employees higher wages

4. is paying its share of tax

5. is using its assets efficiently

6. has a gearing problem

7. is a candidate for being bought by another company or investor

and more, once we have decided what we want to know then we can decide which ratios we need to
use to answer the question or solve the problem facing us.

There are ratios that will help us with question 1, but that wouldn't help us with question 2; and
ratios that are good for question 5 but not for question 4 - we'll see!

Let's look at the ratios we can use to answer these questions.

The Ratios

We can simply make a list of the ratios we can use here but it's much better to put them into
different categories. If we look at the questions in the previous section, we can see that we talked
about profits, having enough cash, efficiently using assets - we can put our ratios into categories
that are designed exactly to help us to answer these questions. The categories we want to use,
section by section, are:

1. Profitability: has the business made a good profit compared to its turnover?

2. Return Ratios: compared to its assets and capital employed, has the business made a good
profit?

3. Liquidity: does the business have enough money to pay its bills?

4. Asset Usage or Activity: how has the business used its fixed and current assets?

5. Gearing: does the company have a lot of debt or is it financed mainly by shares?

6. Investor or Shareholder

Not everyone needs to use all of the ratios we can put in these categories so the table that we
present at the start of each section is in two columns: basic and additional.

The basic ratios are those that everyone should use in these categories whenever we are asked a
question about them. We can use the additional ratios when we have to analyse a business in more
detail or when we want to show someone that we have really thought carefully about a problem.

Users of Accounting Information

Now we know the kinds of questions we need to ask and we know the ratios available to us, we
need to know who might ask all of these questions! This is an important issue because the person
asking the question will normally need to know something particular.
Of course, anyone can read and ask questions about the accounts of a business; but in the same
way that we can put the ratios into groups, we should put readers and users of accounts into
convenient groups, too: let's look at that now.

The list of categories of readers and users of accounts includes the following people and groups of
people:

• Investors

• Lenders

• Managers of the organisation

• Employees

• Suppliers and other trade creditors

• Customers

• Governments and their agencies

• Public

• Financial analysts

• Environmental groups

• Researchers: both academic and professional

sing and understanding what they tell us.

Basic Profitability

First some basic profitability equations:

Gross Profit
Gross Profit Margin = * 100
Turnover

Operating Profit
Operating Profit Margin = * 100
Turnover

Net Profit
Net Profit Margin = * 100
Turnover

Retained Profit
Retained Profit Margin = * 100
Turnover

Profit
Profit Mark up = * 100
Cost
What are you going to do if someone asks you to tell them whether a business is profitable or not?

Firstly, do you remember what profit is? Profit is the difference between turnover, or sales, and
costs: that is,

profit = turnover - costs

One problem is that there are several ways of measuring profit: gross profit; net profit before and
after taxation; and retained profit are just some of them. So, you didn't print out those Tesco
accounts we showed you did you? Well, look back at them to remind yourself of all these names for
profit

A profit margin is one of the profit figures we just mentioned shown as a percentage of turnover.
They always tell us how much profit, on average, our business has earned per £1 of turnover.

We already know from the ratios table that there are several ratios we could use to calculate the
profitability of a business. Next we'll discuss gross and net profit margins.

Gross Profit Margin

First some basic profitability equations:

Gross Profit
Gross Profit Margin = * 100
Turnover

Remember:

Turnover = Sales

Gross Profit = Turnover - Cost of Sales

The gross profit margin ratio tells us the profit a business makes on its cost of sales, or cost of
goods sold. It is a very simple idea and it tells us how much gross profit per £1 of turnover our
business is earning.

Gross profit is the profit we earn before we take off any administration costs, selling costs and so
on. So we should have a much higher gross profit margin than net profit margin.

Here are a few examples of the gross profit margins from different businesses:

Leisure International Manufacturer Retailer Discount Refining Pizza Accounting

& Airline Airline Restaurants Software
Hotels

Gross 9.64% 5.62% 35.14% 11.41% 27.46% 11.99% 47.52% 89.55%

profit

See how the gross profit margins vary from business to business and from industry to industry. For
example, the international airline has a gross profit margin of only 5.62% yet the accounting
software business has a gross profit margin of 89.55%.

If a company's raw materials and factory wages go up a lot, the gross profit margin will go down
unless the business increases its selling prices at the same time.

Net Profit Margin

First some basic profitability equations:

Net Profit Profit before Interest and Taxation

Net Profit Margin = * 100 = * 100
Turnover Turnover

Remember:

Net Profit = Gross Profit - Expenses

Why do we have two versions of this ratio - one for net profit and the other for profit before interest
and taxation? Well, in some cases, you will find they use the term net profit and in other cases,
especially published accounts, they use profit before interest and taxation. They both mean the
same: look back at the financial statements for Tesco where we compared different names for the
same things.

The net profit margin ratio tells us the amount of net profit per £1 of turnover a business has
earned. That is, after taking account of the cost of sales, the administration costs, the selling and
distributions costs and all other costs, the net profit is the profit that is left, out of which they will
pay interest, tax, dividends and so on.

Here are a few examples of the net profit margins from the same businesses we saw in the gross
profit margin section:

Leisure International Manufacturer Retailer Discount Refining Pizza Accounting

& Airline Airline Restaurants Software
Hotels

Net 7.36% 4.05% -10.48% 1.63% 10.87% 12.63% 7.55% 27.15%

Profit

Just like the gross profit margins, the net profit margins also vary from business to business and
from industry to industry. When we compare the gross and the net profit margins we can gain a
good impression of their non-production and non-direct costs such as administration, marketing and
finance costs.
We saw that the international airline's gross profit margin was the lowest of this group of eight
businesses at only 5.62%; but look, its net profit margin is 4.05%, only a little bit lower than its
gross profit margin. On the other hand, the discount airline's gross profit margin is 27.46% but its
net profit margin is a lot less than that at 10.87%. As we just said, these comparisons give us a
great insight into the cost structure of these businesses.

Look at the software business too, a very high gross profit margin of 89.55% but a net profit margin
of 27.15%. This is still high, but we can now see that the administration and similar expenses are
very high whilst its cost of sales and operating costs are relatively very low.

Rate of Return

First some basic Rate of Return equations:

Profit for the Year

Return on Capital Employed (ROCE) = * 100
Equity Shareholders' Funds

PBIT
Return on Total Assets (ROTA) = * 100
Total Assets

The rate of return ratios are thought to be the most important ratios by some accountants and
analysts. One reason why the rate of return ratios are so important is that they are the ratios that
we use to tell if the managing director is doing their job properly.

Return on Capital Employed Ratio

The Return on Capital Employed ratio (ROCE) tells us how much profit we earn from the
investments the shareholders have made in their company. Think of it this way: if we had a savings
account with a bank and we'd been paid, say, £25 interest at the end of a year; and we had saved
£500, we could work out the rate of interest we had earned:

Interest earned 25 1 100

Rate of interest = * 100 = * 100 = * 100 = = 5%
Amount saved 500 20 20

So, we have earned 5% interest on our savings.

Imagine now that instead of talking about a savings account, we were talking about a company and
the profit for the year and its capital employed had been £25 and £500 respectively then the ROCE
for that company would be 5% too.

Profit for the Year 25 1 100

ROCE = * 100 = * 100 = * 100 = = 5%
Equity Shareholders' Funds 500 20 20

Did you notice that we use the Equity Shareholders' Funds instead of Capital Employed? In fact,
they are different names for the same thing! We could call the ratio the Return on Shareholders'
Funds (ROSF) just as easily if we wanted; but generations of accountants and students only know it
as ROCE.

In accounting, there can be different definitions of what certain terms mean. The use of the term
'capital employed' can mean different things. It can, for example, include bank loans and overdrafts
since these are funds employed within the firm. Because there are different interpretations of what
ROCE can mean, it is suggested that you use a method which you feel comfortable with but be
aware that others may interpret your definition in a different way. Below is a guide to some of the
interpretations that we have found on this issue.

Source and/or Definition of Return Definition of Capital Employed

Elliott & Elliott: ROCE = Net profit/capital

Capital employed = total assets
employed

Capital employed = fixed assets + current assets -

Investor Words:
current liabilities

Capital employed = ordinary share capital + reserves

investopedia.com: Return = Profit before tax
+ preference share capital + minority interest +
+ interest paid
provisions + total borrowings - intangible assets

TRADING capital employed = share capital + reserves

Holmes & Sugden: Return = trading profit
plus income from investment and company
share of the profit of associates
+ all borrowings including lease obligations, overdraft,
minority interest, provisions, associates and
investments
OVERALL capital employed = share capital + reserves
+ all borrowings including lease obligations, overdraft,
minority interest, provisions

Capital employed = total fixed assets + current assets

DTI - (current liabilities + long term liabilities +
provisions)

Capital employed = fixed assets + current assets -

Johnson Matthey Annual Report & Accounts
(creditors + provisions)

Let's calculate the ROCE for the Carphone Warehouse now; and here are the figures we need:

Carphone Warehouse 31 March 2001 25 March 2000

£'000 £'000

Profit for the financial period 38,159 16,327

Equity shareholders' funds 436,758 44,190

Off you go!

Did you get this?

What do we think of these results? Well, the question we have to ask is

"Could we have earned more money (profit) if we had invested in a different business or simply put
our money in the bank?"

Well, interest rates at the bank were somewhere around 4 or 5% in 2001 so we did better than
that; but there are many businesses that have a ROCE of higher than 8 or 9%. Still, in 2000 the
Carphone Warehouse had an ROCE of almost 37%: that's very good by all standards.

So what went wrong between 2000 and 2001? What happened, it didn't necessarily go wrong, was
that the capital employed increased from £44,190,000 to £436,758,000 (a 10 fold increase) BUT
the profits increased from £16,327 to only £38,159... they only just about doubled.

It's no surprise then that the ROCE fell so sharply as capital employed increased 5 times faster than
the profit did.

It will be interesting to see what 2002 brings for the Carphone Warehouse and their ROCE.

We will look at Vodafone's ROCE shortly, but for interest here are some other ROCE values to
compare with the Carphone Warehouse:

Leisure International Manufacturer Retailer Discount Refining Pizza Accounting

& Airline Airline Restaurants Software
Hotels

ROCE 5.56% 3.16% -12.12% -0.12% 33.63% 16.17% 16.14% 16.29%

Again, these other ROCE values demonstrate that not everyone can get the same results for the
same ratio at the same time: it depends on the industry, the management, the economy and so on.

The ROCE results in this new table relate to the Carphone Warehouse's results for the year ended
25 March 2000 of 36.95%. This is a good result as it shows that the business is effectively earning
around 37% on the (investment) funds that the shareholders have invested in it.

Contrast the other ROCE values with the Carphone Warehouse and we can see that only the
discount airline has a ROCE value anywhere near it. The international airline's ROCE is extremely
low at just over 3%. Wouldn't the shareholders be better off selling the business and putting the
money in the bank as it would earn more than that?

We should also compare these ROCE values with the profitability values. Let's just compare net
profitability with the ROCE.

Leisure International Manufacturer Retailer Discount Refining Pizza Accounting

& Airline Airline Restaurants Software
 Hotels

Net 7.36% 4.05% -10.48% 1.63% 10.87% 12.63% 7.55% 27.15%

Profit

ROCE 5.56% 3.16% -12.12% -0.12% 33.63% 16.17% 16.14% 16.29%

Putting the data from this table on a graph can help us to see if there is a relationship between
them:

There does seem to be a relationship between the net profit margin and the ROCE: the higher the
net profit margin, the higher the ROCE. After all, the curve on this graph is not a straight line and it
might even be a true curve meaning that the relationship is more complex than we might think.
Keep an eye on this relationship whenever you assess the profitability of a business.

Liquidity ratios

Current Assets: Current Liabilities

(Current Assets-Stocks): Current Liabilities

The two liquidity ratios, the current ratio and the acid test ratio, are the most important ratios in
almost the whole of ratio analysis are also the simplest to use and to learn

The Current Ratio

The current ratio is also known as the working capital ratio and is normally presented as a real
ratio. That is, the working capital ratio looks like this:
Current Assets: Current Liabilities = x: y eg 1.75: 1

The Carphone Warehouse is our business of choice, so here is the information to help us work out
its current ratio.

Consolidated Balance Sheet 31 March 2001 25 March 2000

£'000 £'000

Total Current Assets 315,528 171,160

Creditors: Amounts falling due within one year 222,348 173,820

As we saw in the brief review of accounts section with Tesco's financial statements, the phrase
current liabilities is the same as Creditors: Amounts falling due within one year.

Here's the table to fill in. OK, so we've done this one for you!

Current Ratio For the Carphone Warehouse

31 March 2001 Current Assets: Current Liabilities 315,528: 222,348 1.42: 1

25 March 2000 Current Assets: Current Liabilities 171,160: 173,820 0.98: 1

Maths revision. How did we get 1.42: 1 for the year ended 31 March 2001? All we did was to divide
the current assets by the current liabilities and that gives us:

current assets 315,528

= = 1.42
current liabilities 222,348

so we automatically know that our ratio is 1.42: 1

The same with the year before:

current assets 171,160

= = 0.98
current liabilities 173,820

so the ratio is 0.98: 1

Asset Usage

The assessment of asset usage is important as it helps us to understand the overall level of
efficiency at which a business is performing.

The basic equations for this section are:

Turnover
Total Asset Turnover =
Total Assets
 Average Stocks
Stock Turnover =
Credit Sales/365

Average Debtors
Debtors' Turnover =
Credit Sales/365

Average Creditors
Creditors' Turnover =
Credit Sales/365

The assessment of asset usage is important as it helps us to understand the overall level of
efficiency at which a business is performing.

Our basic ratios for this section are

Total asset turnover - The overall efficiency of the business. We will look at total asset turnover
and net asset turnover; then we will investigate the fixed and current asset turnover ratios.

Stock turnover, Debtors' turnover and Creditors' turnover help us to assess the liquidity
position as well as giving us detailed information about stock control and credit control.

We'll look at total asset turnover first and then we'll look at the other three together, under the
general heading of working capital management II

Working Capital Management II

What we are about to study - stock, debtors and creditors control - are all part of working capital
management in the same way that a discussion of liquidity was part of working capital
management.

We know that working capital is concerned with the ability of a business to be able to pay its way.
The three ratios we are concerned with now are concerned with spending and saving money in the
right places. Too much stock and we waste money on buying it and keeping it. Too much money
loaned to our debtors and it's money we can't use for something else, such as buying machinery,
paying our creditors or even investing it. Too much money in the form of creditors and we might
have a problem that no one else will give us credit for anything else because they think we can't
afford it, and, if we suddenly have a cash problem, we might not be able to pay our creditors.

Working capital management is concerned with the control aspects of the issues we have just
mentioned.

Stock Turnover: stock control

In principle, the lower the investment in stocks the better. Apart from buffer stocks that businesses
sometimes need in case of shortages of supply and strategic stocks in case of war, sudden changes
in demand and so on, modern stock control theory tells us to minimise our investment in stocks.

Let's see how the Carphone Warehouse behaves in this respect.

The formula for this ratio is:

Average Stocks
Stock Turnover =
(Cost of Sales/365)

Carphone Warehouse 31 March 2001 25 March 2000

Consolidated Profit and Loss Account

£'000 £'000

Cost of sales 830,126 505,738

Stock 52,437 51,842

Stock Turnover Ratio for the Carphone Warehouse

31 March 2001 52,437 23.06 days

830,126 / 365

25 March 2000 51,842 37.42 days

505,738 / 365

If you use alternative formulae and are happy with them, that's fine. If you think you
need help because of that, see your teacher/lecturer for guidance.

• Firstly, the result of this calculation is that the answer is instantly in terms of the number of
days, on average, that the stocks are held in the business.

• Secondly, we use the cost of sales figure because stocks are bought and shown in the profit
and loss account and the balance sheet at cost; so we need to compare like with like.

• Thirdly, we only have two years' worth of stock information, so we can't use the average stock
for both years as we should do according to the formula. Never mind, even though the answer
won't be 100% spot on, it will give us a very good estimate of how stock control is going.

How can we interpret this ratio? With a result of 23.06 days, we can imagine that we bought our
£52,437,000 worth stocks of raw materials or whatever they were on 1st January 2002. We then
know that we ran out of those raw materials on 1 + 23.06 days = just into 25th January.

Similarly with the result of 37.42 days, if we bought our £51,738,000 worth of raw materials on 1st
January, we would run out and have to buy some more on 7th February.
This ratio has fallen from 37 days to 23 days over the two years and that is probably a good thing.
If there's less stock to worry about, lower investment in stocks meaning that the money they used
to have tied up in the stock room is now free to spend somewhere else.

In fact, stocks have remained at around £52 million as we mentioned before, but the cost of sales
has increased by 64% over the two years. Put these two facts together and that explains the
improvement in this ratio.

Well done the Carphone Warehouse!

Remember that we talked about the liquidity of stocks when we discussed the acid test ratio. Now
we can see that the Carphone Warehouse's stocks are fairly liquid, since a turnover ratio of 23 days
isn't too bad!

Debtors' Turnover

In the same way that stock control is a vital aspect of working capital management, so too is
debtors' control. Many businesses need to sell their goods on credit, otherwise they might find it
difficult to survive if their competitors provide such credit facilities; this could mean losing
customers to the opposition.

Nevertheless, since we do provide credit, we must do so as optimally as possible. We've used the
word 'optimal' before and let me confirm that it doesn't necessarily mean the best possible, but the
best possible under the circumstances.

Why is credit control so important? For the Carphone Warehouse, the total amount owing by debtors
was £149 million at the end of 31 March 2001, which as a percentage of total assets, is 14.09%.
That's a lot of money in absolute terms and relatively, and it's 80% more than it was the year
before.

So, they've given an additional £69 million worth of credit to their customers over the year. What we
need to know, though, is whether they are controlling these debtors. We can do that by looking at
their debtors' turnover ratios for the two years, firstly.

Carphone Warehouse 31 Mar 2001 25 Mar 2000

£000 £000

Turnover 1,110,678 697,720

Debtors due within one year 149,200 82,826

The formula for debtors' turnover is:

Average Debtors
Debtors' Turnover =
Credit Sales/365
We have to assume, by the way, that all sales are credit sales unless we know which sales are for
cash.

The calculations:

Debtors Turnover Ratio for the Carphone Warehouse

31 March 2002 149,200 49.03 days

1,110,678 ÷ 365

25 March 2001 82,826 43.33 days

697,720 ÷ 365

Well, what do you think of that?

Firstly, the ratio seems to have worsened by going from 43 to 49 days over the two years; and it
means that, on average, the Carphone Warehouse's debtors are taking one and a half months to
pay their accounts. Does this sound as if it's a good policy? How do we know?

One of the ways we can tell, in fact, whether this ratio is good or not is to go to a Carphone
Warehouse shop or go to their Web site and find out their terms of business. If we sign up with
them, will they give us around 49 days to pay our bills?

At the time of writing, the page http://www.carphonewarehouse.com/commerce/servlet/gben-

store-Mobile shows that there are a number of ways we can choose to get a phone from the
Carphone Warehouse:

• Pay monthly

• Handset only

• Pay for calls ... no line rental

• Pay as you go

Try and work out how it's possible to have a debtors' turnover figure of 49 days from these deals ...
it's not! So what's the problem? Well, do they have corporate customers who are allowed to pay
after, say, 55 days or 60 days? Do some research and find the answer if you can.

Creditors' Turnover Ratio

Creditors are the businesses or people who provide goods and services in credit terms. That is, they
allow us time to pay rather than paying in cash.
There are good reasons why we allow people to pay on credit even though literally it doesn't make
sense! If we allow people time to pay their bills, they are more likely to buy from your business than
from another business that doesn't give credit. The length of credit period allowed is also a factor
that can help a potential customer decide whether to buy from your business or not: the longer the
better, of course.

In spite of what we have just said, creditors will need to optimise their credit control policies in
exactly the same way that we did when we were assessing our debtors' turnover ratio - after all, if
you are my debtor I am your creditor!

We give credit but we need to control how much we give, how often and for how long. Let's do
some calculations for the Carphone Warehouse.

The formula for this ratio is:

Average Creditors
Creditors' Turnover =
(Cost of Sales/365)

As with the stock turnover ratio, creditor values relate to the costs of raw materials, goods and
services, which is why we use the cost of sales figure in the denominator (Remember the
numerator? Well, this is the opposite. The denominator is the bottom part of a fraction!)

Carphone Warehouse 31 March 2001 25 March 2000

£'000 £'000

Cost of sales 830,126 505,738

Creditors: Amounts falling due within one year 222,348 173,820

Creditors Turnover Ratio for the Carphone Warehouse

31 March 2001 222,348 97.76 days

830,126 ÷ 365

25 March 2000 173,820 125.45 days

505,738 ÷ 365

We interpret this ratio in exactly the same way as the debtors' turnover ratio. That is, in 2001 if we
had bought some supplies for £222,348 on 1st January, we would have paid for them 97.76 days
later on 6th April. You can work out the payment date for 2000 if we imagine buying some supplies
for £173,820 on 1st January of that year.

Having found that debtors are taking somewhere between 30 and 50 days to pay their accounts,
notice that the business is taking over three months credit for itself in 2001 and about four months'
credit in 2000. These results are worrying: especially when we know that small businesses in the UK
are suffering because large businesses take too long to pay their accounts; and if the Carphone
Warehouse has many small suppliers that is worrying.

You can now attempt an additional question.

Additional notes are available on advanced stock, creditors and debtors or you can move on to the
Gearing section.

Gearing 1

Long Term Liabilities

Gearing =
Equity Shareholders' Funds

Gearing is concerned with the relationship between the long terms liabilities that a business has and
its capital employed. The idea is that this relationship ought to be in balance, with the shareholders'
funds being significantly larger than the long term liabilities.

Gearing 1

Shareholders ought to have the upper hand because if they don't that could cause them problems
as follows:

• Shares earn dividends but in poor years dividends may be zero: that is, businesses don't
always need to pay any!

• Long term liabilities are usually in the form of loans and they have to be paid interest; even in
bad years the interest has to be paid

• Equity shareholders have the voting rights at general meetings and can made significant
decisions

• Long term liability holders don't have any voting rights at general meetings but they have the
power to override the wishes of the shareholders if there are severe problems over their
interest or capital repayments

So, shareholders like to see the gearing ratio, the relationship between long term liabilities and
capital employed, being in their favour! Let's look at the Carphone Warehouse's gearing ratio.

The formula:

Long Term Liabilities

Gearing =
Equity Shareholders' Funds

The data:
 Carphone Warehouse 31 March 2001 25 March 2000

£'000 £'000

Creditors: Amounts falling due after more than one year 14,107 21,033

Equity shareholders' funds 436,758 44,190

Gearing Ratio for the Carphone Warehouse

31 March 2001 14,107: 436,758 0.032: 1

25 March 2000 21,033: 44,190 0.476: 1

A shareholder of the Carphone Warehouse will be happy with these results. Even in 2000 when the
ratio was relatively high at 0.476 or 47.6% they probably were not too worried because their other
ratios were fine too.

In 2001 the gearing ratio fell to almost zero indicating that the business much prefers equity
funding to debt funding. This minimises the interest payment problems and the control problems of
having a dangerously high level of long-term debt on the balance sheet.

Gearing 2

There is an alternative gearing ratio, we can call it the Gearing Ratio II.

The formula for this ratio is:

Long Term Liabilities

Gearing 2 =
Long Term Liabilities + Equity Shareholders' Funds

Let's just get on with this one. Gather the necessary data from both of our businesses, Carphone
Warehouse and Vodafone and calculate this ratio for them.

The calculations:

Gearing II Ratio for the Carphone Warehouse

31 March 2001 14,107: 436,758 + 14,107 0.031: 1

25 March 2000 21,033: 44,190 + 21,033 0.322: 1

Gearing II Ratio for Vodafone

31 March 2002 13,118: 130,573 + 13,118 0.091: 1

31 March 2001 11,235: 145,007 + 11,235 0.072: 1

In the case of both the Carphone Warehouse and Vodafone, these ratios are, as we should expect,
smaller than Gearing 1 and they are still, therefore, insignificant by the end of the two years we are
analysing here

Investor ratios

Basic equations you'll need:

Profit available to equity shareholders

Earnings per share =
Average number of issued equity shares

Dividends paid to equity shareholders

Dividends per share =
Average number of issued equity shares

Latest annual dividends

Dividend yield =
Current market share price

Net profit available to equity shareholders

Dividend cover =
Dividends paid to equity shareholders

Current market share price

Price/earnings or p/e ratio =
Earnings per share

Investor ratios

Most of the investor ratios that we might need to use are relatively simple both to use and to
understand. We can contrast these ratios with others, such as stock and debtors' turnover; and the
relationships between the ROCE and the profit margin and assets turnover ratios, at the top of the
pyramid of ratios.

That's good news, then!

The basic five ratios we are interested in are:

• Earnings per share

• Dividends per share

• Dividend yield

• Dividend cover

• P/E ratio

As before, we'll take each ratio in turn and use the Carphone Warehouse and Vodafone accounts to
apply them.
Earnings per share: EPS

This is, perhaps, the fundamental investor ratio: in this case, we work out the average amount of
profits earned per ordinary share issued. The formula is:

Profit available to equity shareholders

Earnings per share =
Average number of issued equity shares

Here are the extracts from the accounts that we need and they are followed by the results for one
of the two years, you should calculate the EPS for the other year.

The Carphone Warehouse 31 March 2001 25 March 2000

Consolidated Profit and Loss Account

Profit for the financial period (£) 38,159,000 16,327,000

Weighted average number of issued shares 833,000,000 600,000,000

31 March 2001 25 March 2000

EPS 38,159,000 £0.04648 _____________

833,000,000

Did you get this?

The good news for investors here is that the average earnings per issued ordinary share has almost
doubled over the two years. Notice that the number of shares issued has increased from 600 million
to 833 million, so this really is a good result as profits available for shareholders must have
increased significantly too from £16,327,000 to £38,159,000.

Dividends per Share: DPS

The DPS ratio is very similar to the EPS: EPS shows what shareholders earned by way of profit for a
period whereas DPS shows how much the shareholders were actually paid by way of dividends. The
DPS formula is:

Dividends paid to equity shareholders

Dividends per share =
Average number of issued equity shares

Oops, there are no dividend data for the Carphone Warehouse, on page 13 of their annual report
and accounts they say:

Profit for the period attributable to shareholders was £38.2m resulting in

total shareholders' funds of £436.8m at the period end. As in previous periods
the Board has decided to retain these earnings for continued investment in
the development of the Group and the future enhancement of shareholder
value and is not therefore proposing a dividend for the period.

Vodafone has paid dividends in recent years so gather the relevant data from the database and
calculate the DPS for it. Here are the templates we so kindly began to provide under the EPS
heading!

Here are two templates to help you along: aren't we kind?

Vodafone 31 Mar 2002 31 Mar 2001

Consolidated Profit and Loss Account

Equity dividends (£)

Weighted average number of issued shares

31 Mar 2002 31 Mar 2001

DPS __________ £ ______ __________ £ ______

Did you get this?

Vodafone themselves report the DPS as

Dividend per share 1.4721p in 2002 and 1.4020p in 2001

In conclusion we can see that even though Vodafone is suffering large losses, it is still paying
dividends to its shareholders, yet the Carphone Warehouse, which is apparently in a better position
is not paying dividends.

Dividend Yield

The dividend yield ratio allows investors to compare the latest dividend they received with the
current market value of the share as an indictor of the return they are earning on their shares.
Note, though, that the current market share price may bear little resemblance to the price that an
investor paid for their shares. Take a look at the history of a business's share price over the last
year or two and you will see that today's share price might be a lot higher or a lot lower than it was
a year ago, two years ago and so on.

We clearly need the latest share price for this ratio and we can get that from newspapers such as
the Financial Times, The Times, The Guardian and the Daily Telegraph. We can also find the share
prices on the Internet.

The formula for the dividend yield is:

 Latest annual dividends
Dividend yield =
Current market share price

It is common for newspapers and others to calculate the dividend yield automatically as part of their
offerings. Take a look at the extract from The Times and you'll find the dividend yield figure in the
second right hand column, before the P/E ratio.

Here's an extract from The Times newspaper's share page (Source: The Times Newspaper 18
September 2002) together with a few links to some Web sites where we can find share prices. Use
them now or later.

Dividend Cover

The dividend cover ratio tells us how easily a business can pay its dividend from profits. A high
dividend cover means that the company can easily afford to pay the dividend and a low value
means that the business might have difficulty paying a dividend. Here's the formula followed by an
example.

Net profit available to equity shareholders

Dividend cover =
Dividends paid to equity shareholders

Since the Carphone Warehouse hasn't paid a dividend, let's turn to Vodafone immediately. In the
database find the data you need to calculate the dividend coverage for the two years for which we
have data for Vodafone and calculate the dividend cover ratio for those two years. Here's a template
for you to fill in with the data you find.

Vodafone 31 Mar 2002 31 Mar 2001

Consolidated profit and loss account

£m £m

Profit for the financial period

Dividends

Vodafone dividend cover 31 Mar 2002 31 Mar 2001

Profit for the financial period

Dividends

Did you get this?

In this case, we see a terrible situation, as usual, for Vodafone. The profit for the period is in fact
negative, so these results are dreadful - even though the values are positive, that is only because of
the mathematics ... Vodafone has no dividend cover at all for these two years
Price Earnings Ratio: P/E ratio

The P/E ratio is a vital ratio for investors. Basically, it gives us an indication of the confidence that
investors have in the future prosperity of the business. A P/E ratio of 1 shows very little confidence
in that business whereas a P/E ratio of 20 expresses a great deal of optimism about the future of a
business.

Here's the formula, then we'll work through an example

Current market share price

Price/earnings or p/e ratio =
Earnings per share

Here are the P/E ratios of five businesses in the Telecommunications sector:

Telecommunications P/E ratio

BT 48.4

Project Telecom 12.0

Telecom Plus 19.7

Vanco 78.4

Vodafone 17.9

Average 35.28

Source: The Times Newspaper 18 September 2002

See how big some of these P/E ratios are - that's not necessarily a good thing! Let's look at the
calculations and then we can interpret our findings.

Again, we need current market share prices as well as the EPS values. This means we can go back
to the Carphone Warehouse even though it isn't paying dividends at the moment:

The Carphone Warehouse pence P/E ratio

Current market share price 76.0

16.52
EPS 4.6

Note:

1. the current market share price is taken from The Times newspaper 18 September 2002 and
the EPS is taken from the table below (previously calculated in the EPS section, above)

2. we have worked in pence here; but we could just as easily have worked in Pounds and the
answer would have been the same, at a P/E ratio of 16.52
The Carphone Warehouse

31 March 2001

EPS 38,159,000
£0.046
833,000,000

What does a P/E ratio of 16.52 mean? In raw terms it means that investors are currently paying the
equivalent of 16.52 years' worth of earnings to own a share in the Carphone Warehouse. That is,
they hare currently paying 76 pence per share and since the EPS is 4.6 pence per share, this means
that they will recover their investment in a share after 16.52 years - equivalent to the break even
and payback period if you like.

16.52 is a high value for a P/E ratio; but not the highest and essentially the higher the ratio the
better. However, we would say that P/E ratios of 78.4 and 48.4 are excessive and might reflect an
unreal situation. It's possible in extreme circumstances that the share price is, in fact, independent
of the current market share price so that a high P/E ratio is actually based on more up to date news
than last years EPS value.

BT has a P/E ratio of 48.4 yet it is not too long ago that it was heading for potential liquidation as its
victory in securing its third generation licences had led to its taking on a massive debt burden that it
could not, in reality, sustain. However, it seems now that investors like the current performance of
BT and are voting for it by buying its shares at highly inflated values relative to its EPS.

Ratio
From Wikipedia, the free encyclopedia

(Redirected from Ratio analysis)

Jump to: navigation, search
For the use of ratio as a human capacity, see reason.

A ratio is a dimensionless, or unitless, quantity denoting an amount or magnitude of one quantity

relative to another.

Throughout the physical sciences, ratios of physical quantities are treated as real numbers. For
example, the ratio of 2πr metres to 1 metre is the real number 2πr. That is 2πrm/1m = 2πr.
Accordingly, the classical definition of measurement is the estimation of a ratio between a quantity
and a unit of the same kind of quantity.

The term ratio is also used to denote one proportion of a whole relative to the other proportion.
With such usage, the ratio is usually written as two numbers separated by a colon (:) which is read
as the word "to". A ratio of 2:3 ("two to three") means that the whole is made up of 2 parts of one
thing and 3 parts of another — thus, the whole contains five parts in all. To be specific, if a basket
contains 2 apples and 3 oranges, then the ratio of apples to oranges is 2:3. If another 2 apples and
3 oranges are added to the basket, then it will contain 4 apples and 6 oranges, resulting in a ratio of
4:6, which is equivalent to a ratio of 2:3 (thus ratios "reduce" like regular fractions). In both cases,
there are 2/3 as many apples as oranges in the basket, or 3/2 as many oranges as apples.

Note that in the previous example the proportion of apples in the basket is 2/5 ("two fifths", "two of
five", "two out of five") or 40%. Thus a proportion compares part to whole instead of part to part.

A rate is a special kind of ratio in which the two quantities being compared are of different units.
The units of a rate are the units of the first quantity "per" unit of the second — for example, a rate
of speed or velocity can be expressed in "miles per hour".

In algebra, two quantities having a constant ratio are in a special linear relationship called
proportionality.

[edit]

More examples

• A new grey colour of paint is made by mixing 3 parts of black paint with
5 parts of white. The ratio of black to white is therefore 3:5 and the
ratio of white to black 5:3. The black paint constitutes 3/8 (37.5%) of
the grey paint and the white paint 5/8 (62.5%). Such a mixture of grey
paint would be slightly lighter than a 2:3 mixture of black to white,
since the latter is 2/5 (40%) black paint and only 3/5 (60%) white. Note
that these ratios can be compared directly as regular fractions (3/5 is
less than 2/3), but this method may obscure the true meaning of the
ratios, as explained above.
• If a school has a 20:1 student-teacher ratio, there are twenty times as
many students as teachers.
• The ratio of heights of the Eiffel Tower (300 m) and the Great Pyramid of
Giza (139 m) is 300:139, so one structure is more than two times the
height of the other (more precisely, 2.16 times).
• The ratio of the mass of Jupiter to the mass of the Earth is
approximately 318:1.
• If two axles are connected by gear wheels, the number of times one axle
turns for each turn of the other is known as the gear ratio, one familiar
example of which is the number of turns of the pedals of a bicycle
compared with number of turns of the rear wheel.
• The ratio of hydrogen atoms to oxygen in water (H2O) is 2:1.

[edit]

Ratio analysis
More colloquially, a ratio is a value calculated by dividing one number by another. Five divided by
two gives a ratio of 2.5. In the business world it is typical to use ratios to analyze financial
statements. For example, the current ratio assesses liquidity, or time required for some asset to be
converted to cash. The current ratio looks at current assets relative to current liabilities.

One indicator, or ratio, for strength or stability of revenue in government is own source revenues
(property taxes, for example) divided by total revenues (property tax and outside grants). In some
respects, a high ratio suggests safety and stability. Grants or intergovernmental revenues can be
taken away and heavy reliance on these outside sources, which would produce a low ratio, can spell
trouble for a state or local government.

Ratio Analysis Equations for Accountants

This page contains graphics images of the main and basic ratio analysis equations or formulae that
accountants and analysts use for ratio analysis. Feel free to download them for your own use by
cutting and pasting from here ... don't forget where you got them from!

New Ratio Analysis Equations

Profitability
Gross Profit Margin

Operating Profit Margin

Net Profit Margin

Retained Profit Margin

Profit Mark up
PBIT

PBT

Rate of Return
Return on Capital Employed (ROCE)

Return on total Assets (ROTA)

Return on Fixed Assets (ROFA)

Return on Working Capital (ROWC)

Working Capital Management

Liquidity
Current Ratio

Acid Test

NOTES: Current Ratio = Working Capital Ratio

Acid Test Ratio = Quick Ratio
Asset Usage
Total Asset Turnover

Stock turnover

Debtors Turnover

Creditors Turnover

Fixed Asset Turnover

Capital Employed
Turnover

Working Capital
Turnover

NOTE in the US stock = inventory, debtors = accountsreceivable, creditors = accounts payable

Alternative formulae:

Stock Turnover
Debtors Turnover

Gearing
Gearing 1

Gearing 2

NOTE: in the US known as leverage

Investor
Earnings per Share

Dividends per Share

Dividend Yield

Dividend Cover

P/E (Price Earnings)

Interest Cover