MODULE 4 - RATIO ANALYSIS

Learning Outcomes

1) Financial Performance Ratios/Profitability Ratios

2) Financial Position Ratios – Liquidity, Efficiency, Solvency
3) Investor Analysis

INTRODUCTION

Ratios are a means of interpreting the financial statements in a way that makes it clearer for users to get
more information from the statements. In order to make more meaning of financial statements, users
need to be able to compare statements either across time periods, or between two or more competitor
companies. Historical statements can also be compared against future forecasts for more detailed
analysis.

When analyzing and commenting on data, the following checklist may be useful:

● What does the ratio literally mean? This can be identified by looking at the variables used in the
ratio.
● What does a change in the ratio mean?
● What is the standard/norm?
● What are the limitations of the ratio?

Several ratios may be calculated to further analyse the financial statements:

Ratio Category Ratios

Financial ● Gross Profit margin
Performance/Profitability ● Operating profit margin
● Net profit margin
● Asset turnover
● Return on Capital Employed
(ROCE)

Financial Position - ● Current ratio

Liquidity ● Quick (acid test) ratio
Financial Position - ● Receivable days
Efficiency ● Inventory days
● Inventory turnover
● Payable days

Financial Position - ● Gearing

Solvency ● Interest cover
Investor Analysis ● Earnings per share
● P/E ratio
● Dividend yield
 ● Dividend cover

1. FINANCIAL PERFORMANCE/PROFITABILITY RATIOS

These ratios help to analyse the profit position of a business.

Gross Profit Margin

This shows the percentage of profit made from trading activities (purchases and sales) of the business.

Gross Profit Margin = Gross profit x 100

Sales revenue

Operating Profit Margin

This measures operating profit as a percentage of sales. It looks at the effectiveness of the organisation
with regards to operational cost (admin and distribution expenses) management.

Operating profit margin = Operating profit x 100

Sales revenue

Net Profit Margin

This measures net profit as a percentage of sales. It looks at the effectiveness of the organisation with
regards to total cost management. Any difference between operating profit margin and net profit
margin is due to finance costs and tax.

Net profit margin = Net profit x 100

Sales revenue

Net Asset Turnover

Asset Turnover measures the efficiency of the business in generating revenue from the capital
employed/net assets in its business. The ratio shows how efficiently the business is using its resources.
The higher the ratio, the more efficient the business is.

Net Asset Turnover = Revenue

Net assets

*Net Assets is the difference between Total Assets and Total Liabilities. Net Assets is the same as Capital
invested/Equity in the business.
Return on Capital Employed (ROCE)

This allows users to assess how much of return is generated for every $1 invested in the business by
both debt and equity holders.

ROCE = Operating profit x 100

Capital employed

Capital employed is the total capital (Debt – what lenders have provided +Equity – what owners have
provided) used in the business.

2. FINANCIAL POSITION – LIQUIDITY, EFFICIENCY & SOLVENCY RATIOS

Financial Position ratios are used to analyse the financial position (reflected through the Statement of
Financial Position) in greater detail. These ratios focus highlight whether or not the business is in a
strong position to continue in operations. These ratios assess liquidity, efficiency and solvency of the
business.

2.1 Liquidity Ratios

Liquidity is the ability of the business to generate cash. Liquidity ratios help to assess the liquidity
position of the business. The focus is on analysing Current Assets and Current Liabilities – are the
Current Assets of the business sufficient to meet the Current Liabilities. Therefore, the liquidity ratios
show the ability of a business to meet its short-term obligations.

Current ratio

This measures the adequacy of current assets to meet current liabilities as they fall due. A ratio of 1.5
times is considered satisfactory for most businesses.

Current Ratio = Current Assets

Current Liabilities

Quick ratio/Acid-test ratio

This is a more strict analysis of liquidity by eliminating inventory (the least liquid asset) from the current
assets used in the calculation. It looks at whether the business has sufficient current assets (excluding
inventory – i.e. cash and receivables) to meet its short-term obligations.

Quick Ratio = Current Assets- Closing Inventory

Current Liabilities

A quick ratio of between 0.7 times to 1 times is considered normal.

2.2 Efficiency Ratios/ Working Capital Ratios

Efficiency ratios assess how usefully the company is managing its working capital requirements. The
Working Capital of a business shows the money available to meet all of the business’ short-term
expenses due within a year. Working capital is the difference between Current Assets and Current
Liabilities.

Inventory days

This looks at how long (days) the inventory remains in the business before being sold.

Inventory-holding period (days) = Inventory x 365

Cost of sales

The risk of holding inventory for too long is that there is a cost involved in storing, handling and insuring
inventory, as well as an increased risk of inventory damage and obsolescence. Also, longer inventory
days means liquidity issues for the business as the inventory is just sitting in the business and not
generating any money.

Inventory Turnover

Another way of measuring inventory period is by looking at the turnover rate – i.e. how many times in a
period does the business replace (turn over) its inventory.

Inventory turnover (times) = Cost of sales

Inventory

A high level of inventory turnover corresponds to a low holding period.

A high level of inventory turnover could mean lack of demand or poor inventory control. Alternatively,
an increase in inventory holding could be due to bulk buying to take advantage of trade discounts,
reducing the risk of stock-outs, or an expected increase in orders.

Inventory turnover ratios depend on the nature of business. E.g. a seller of fresh fish will have an
inventory holding period of 1-2 days, but a building contractor might have a turnover rate of 1 every 365
days.

Receivables Days

This ratio shows on average, how many days it takes to collect cash from credit customers. The
collection period should be compared with the company’s credit policy, previous years’ figures, and the
industry average.
Receivables days = Receivables x 365
Sales

A high collection period indicates poor credit control, liquidity issues and could risk irrecoverable debts.
Payables Days

This is the number of days the business takes to settle its payables.

Payables payment period (days) = Payables x 365

Purchases/Cost of Sales

This represents the credit period taken from suppliers. This ratio should be compared against previous
years as well as the credit agreements with suppliers.

A long credit period is good as it represents a source of free finance to the business. However, on the flip
side it could indicate liquidity problems as a result of which the business is unable to meet supplier
payments as they fall due. If the credit period is long, the entity may develop a poor reputation as a slow
payer and may not be able to find new suppliers, existing suppliers may discontinue supplies and the
entity may lose out on cash discounts.

2.3 Solvency Ratios

Solvency refers to the ability of the business to meet its debt obligations. When assessing the financial
position of a business, the main focus is on its stability and exposure to risk. This is typically assessed by
analyzing the way in which the business is financed (gearing).

Gearing Ratio

Gearing is a measure of the level of external debt an entity has in comparison to equity finance (i.e.
share capital and reserves).

Gearing can be calculated in two ways:

Gearing = Long-term debt x 100

Equity

Gearing = Long-term debt x 100

Equity + Long-term debt

Equity = share capital + reserves

Highly geared companies are considered high-risk as they have mandatory, fixed repayment obligations.
Equity finance is less risky as capital repayments are not mandatory.

Interest cover

This indicates the ability of the business to pay its interest cost out of its profits. It also assesses a
company or group’s ability to absorb more debt.

Interest cover (times) = Profit before interest and tax/ Operating profit
Interest
A low level of interest cover is risky to shareholders as it reduces the likelihood of them receiving
dividends (as most of the operating profits are used to pay off interest).

An interest cover of less than 2 is considered unsatisfactory.

3. INVESTOR ANALYSIS RATIOS

These ratios are relevant to existing and potential shareholders. The management of a company are also
interested in these ratios from the point of view of monitoring them due to their prominence with
investors.

Earnings per Share (EPS)

Earnings per share (EPS) is an important profitability indicator which is published for all listed entities. It
reflects the earnings (profit) attributable to each share held. A higher EPS indicates greater value
because investors will pay more for a company's shares if they think the company has higher profits
relative to its share price.

EPS = Profit to Shareholders

No of shares issued

Price-to-Earnings Ratio (P/E Ratio)

This measures the company’s current market share price (MPS) against its EPS. The P/E Ratio is an
indicator of the market’s confidence in a company or group. It denotes what investors are willing to pay
for a company’s profits. 

P/E ratio = Market price of share (MPS)

EPS

Dividend yield

Dividend yield shows the dividend per share in relation to the share price. This number tells you what
you can expect in future income from a stock based on the price you could buy it for today.

Dividend yield = Dividend per share X 100

Share price

Dividend Cover

Dividend Cover assesses a company or group’s ability to pay its dividend out of profits. Dividend Cover
is a popular measure of dividend safety. It is calculated as Earnings per Share (EPS) divided by the
Dividend per Share (DPS). It provides a quick fix on how many times the dividend is 'covered' by
earnings.
 Dividend cover = EPS

Dividend per share

(DPS)

E.g. 1 – Ratio Analysis Calculations

Neville is a business that manufactures and sells retail office products. Its summarized financial
statements for the years 20X4 and 20X5 are given below:

Statements of Profit or Loss for the year ended 30 June

Statements of financial position as at 30 June

E.g 2 – Investor Analysis Ratios

Rogers Co has just completed their financial statements for the year ended 30 June 20X6. They are
reporting a net profit of $1,250,000 for the current year, and they have $1 million 50 cent shares in
issue. The current market price of Rogers' shares is $3.50. Rogers Co has total dividends during the year
ended 30 June 20X6 of $1,500,000.

a. What is the Price Earning (P/E) ratio of Rogers Co for the year ended 30 June 20X6?

b. What is the Dividend Yield of Rogers Co for the year ended 30 June 20X6?

E.g 3 – Investor Analysis Ratios

D PLC S PLC
Share price 200 p 80 p

EPS 10 p 8p
 Dividend per share 2p 8p

Number of shares 2 million 4 million

Calculate the following ratios:

a. Dividend payout
b. Dividend cover
c. Dividend yield
d. PE ratio

E.g. 4- Investor Analysis Ratios