RATIOS for ANALYSING AND INTERPRETING FINANCIAL STATEMENTS

Financial ratios should be compared with some “benchmark” ratios, based on:

 Past periods for the same business

 Performance in relation to similar businesses for the same or past periods

 The comparison of planned performance (planned ratios) with actual performance to assess
the level of achievement attained

Profitability: Profitability ratios provide insights relating to the degree of success in creating
wealth for owners.

1. Return on ordinary shareholders’ funds (ROSF) measures the amount of profit for the
period available to the owners’ average stake in the business during that same period.

Profit for the year ( less any preference dividend )

ROSF= ×100
Ordinary share capital + Reserves

* ROSF = ROE (Return on equity (ROE) ratio)

Earnings after tax∧interest ( EATI )

ROE= ×100
Average equity

2. Return on capital employed (ROCE) measures how efficiently a company can generate profit
from its average long-term capital invested in the business

Operating profit
ROCE= × 100
Share capital + Reserves+ Non current liabilities

* Operating profit = Profit before tax and interest (EBIT)

3. Operating profit margin ratio (net profit margin) measures how much profit a company can
gain after paying the variable costs of production

Operating profit ( EBIT )

Operating profit margin= ×100
Sales revenue

4. Gross profit margin ratio measures the proportion of money left over from revenues after
accounting for the cost of goods sold

Gross profit
Gross profit margin= × 100
Sales revenue

* Gross profit = Sales revenue – cost of good sold

5. Return on asset (ROA) ratio measures the percentage of how profitable a company's assets
are in generating revenue

Profit before taxation

ROA= ×100
Average total assets

Efficiency: Efficiency ratios are used to analyse the efficiency with which particular
resources (assets and liabilities) have been used internally.
 1. Average inventories turnover period ratio shows how many times a company's inventory is
sold and replaced over a period of time

Average inventories held

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒊𝒏𝒗𝒆𝒏𝒕𝒐𝒓𝒊𝒆� 𝒕𝒖𝒓𝒏𝒐𝒗𝒆𝒓 𝒑𝒆𝒓𝒊𝒐𝒅 = ×365
Cost of sales

2. Average settlement period for trade receivables ratio calculates how long, on average,
credit customers take to pay the amounts that they owe to the business

Average trade receivables

Average settlement period for trade receivables = ×365
Credit sales revenue

3. Sale revenue to capital employed ratio examines how effectively the assets of the business
are being used to generate sales revenue.

𝑺𝒂𝒍𝒆� 𝒓𝒆𝒗𝒆𝒏𝒖𝒆 𝒕𝒐 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒐𝒚𝒆𝒅 𝒓𝒂𝒕𝒊𝒐 =

Sales revenue
Share capital +reserves+ Noncurrent liabilities

4. Sale revenue per employee ratio examines how effectively the company using its staff to
generate revenue

Sales revenue
Sales revenue per employee=
Number of employees

Note 1:

The main elements of the ROCE ratio

Operating profit
ROCE= ×100
Long term capital employed

Operating profit Sales revenue

¿ ×
Sales revenue Longterm capital employed

Net profit Sale revenue

margin to capital
employed

*Long-term capital employed = share capital + reserves + long-term liabilities

Liquidity: Liquidity ratios measure a company's ability to pay off its short-term debt
obligations. Comparing the company's most liquid assets (easily converted to cash) with its short-
term liabilities

1. Current ratio measures a company's ability to pay short-term obligations

Current assets
Current ratio=
Current liabilites
 2. Acid test ratio or quick ratio measures a company's ability (excludes inventories) to pay
short-term obligations

Current assets−inventories
Acid test ratio=
Current liabilites

3. Cash generated from operations to maturing obligations ratio (operating cash flow ratio)
measures how much cash a company's business operations generates relative to its current
liabilities

𝑪𝒂�� 𝒈𝒆𝒏𝒆𝒓𝒂𝒕𝒆𝒅 𝒇𝒓𝒐𝒎 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒐𝒏� 𝒕𝒐 m𝒂𝒕𝒖𝒓𝒊𝒏𝒈 𝒐𝒃𝒍𝒊𝒈𝒂𝒕𝒊𝒐𝒏�

Cash generated
= ¿ operations ¿
Current liabilites

4. Financial gearing ratios assess the degree of risk associated with a business by financing the
business made by borrowings instead of financing by the owners (equity)

𝑮𝒆𝒂𝒓𝒊𝒏𝒈 𝒓𝒂𝒕𝒊𝒐 =

Long term ( non current ) liabilities

× 100
share capital +reserves+longterm ( non current ) liabilities

5. Interest cover ratio measures the amount of operating profit available to cover interest
payable

Operating profit
Interest cover ratio=
Interest payable

Investment: Investment ratios are concerned with assessing the returns and performance of
shares in a particular business from the shareholders.

1. Dividend payout ratio measures the proportion of earnings that business pays out to
shareholders in the form of dividends

Dividends announced for the year

𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒑𝒂𝒚𝒐𝒖𝒕 𝒓𝒂𝒕𝒊𝒐 = ×100
Earnings for the year available for dividend

Or

Earnings for the year available for dividend

𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 𝒄𝒐𝒗𝒆𝒓 𝒓𝒂𝒕𝒊𝒐 =
Dividends announced for the year

2. Dividend yield ratio indicates how much a business pays out in dividends relative to its
current market value

share∗¿
Dividend per × 100
Market value per share
Dividend yield=¿

*Dividend per share = dividend proposed/ number of shares

*In the UK, considering dividend tax credit rate

3. Earning per share (EPS) ratio relates the earnings generated by the business, and available to
shareholders, during a period to the number of shares in issue
 Earnings available
𝑬𝒂𝒓𝒏𝒊𝒏𝒈 𝒑𝒆𝒓 ��𝒂𝒓𝒆 = ¿ ordinary shareholders ¿
Number of ordinary shares∈issue

* Earnings available to ordinary shareholders = Profit after taxation – any preference dividend (if
any)

4. Cash generated from operations per share ratio measures the ability of business to pay
dividends and to undertake planned expenditures.

Cash generated ¿ operations per share =

Cash generated
¿ operations less preference dividend (if any) ¿
Number of ordinary shares∈issue

5. Price/ earnings (P/E) ratio measures the market value of a share to its current level of
earnings.

Market value per share

P/ E ratio=
Earnings per share

Note 2:

Overtrading occurs where a company is operating at the level more than what its finances allow
(inadequate finance to fund operating activities)

Reasons:

• Inflation and high prices

• Over - expanding business

• Misjudge the level of expected sales demand

• Fail to control the costs

• Unable to inject further funds into the business

Note 3:

Shortcomings of financial ratio analysis

1. Quality of financial statement: the limitation of financial statement is failure to include all
resources controlled by the business (Internally generated goodwill and brands)

2. Inflation: can distort the information (understating the value of asset, understating
expenses and overstating profit)

3. The restricted view of ratios: only measure relative performance and position, cannot
provide the picture of assessing changes in absolute size or differences in scale between
businesses

4. The basis for comparison: difficult to find a suitable benchmark to compare because of
differences in accounting policies, financing methods and financial year ends
 5. Ratios relating to the statement of financial position: some ratios (liquidity ratios) could
mislead due to the snapshot of the statement of financial position at a particular moment
in time.

Statement of finacial positon

ASSETS
Non-current assets
Land & building 130
Accumulated depreciation for land and building 30
Plant and Mechinery 70
Accumulated depreciation for plant and machinery 17

Current assets
Inventories 25
Trade receivables 16
Short-term investment 12
Cash at bank 7 60
TOTAL ASSETS 213

EQUITY & LIABILITIES

Equity
Ordinary share 100
General Reserve 19
Retained earnings 36

Liabilities
Non-current liabilities
Borrowing – 10% loan notes 20
Current liabilities
Trade payables 31
Taxation 7
TOTAL EQUITY AND LIABILITIES 213

Income Statement

Revenue 173
Cost 96
Gross profit 77

Heat & Light 24

Administation Expenses 18
Operating Profit 35

Interest paid 2
Taxation paid 16
Profit of the period 17
 17
1. ROSF=
100+19
x 100% =14.3%

2. Current Ratio = 60/38 = 1.6 times

173
3. Sale Revenue to capital employed ratio =
100+ 36+20
=1.1 times

35
4. Operating Profit margin = x 100% =20.2%
173
77
5. Gross prophit margin ration = x 100% = 44.5%
173