RATIO ANALYSIS:

Interpretation of Financial Statements

RATIO FORMULAE NORM EXPLANATION

1) Profitability Ratios
Measures the Profit (Return) that a business
a] ROCE (PBIT ÷ Capital Employed) n/a generates from the resources available to it (its
(Return On x 100% capital employed).
Capital
Employed)

(Net profit ÷ Sales) x 100% n/a Measures the average profit in comparison to the
b] Net Profit Sales Revenue.
Margin or %

(Gross profit ÷ Sales) x n/a Measures gross profit as a % of Sales. It normally

c] Gross Profit 100% increases as the NP margin increases. If different,
Margin or % the Expenses ratio given below:

(Operating Expenses ÷ n/a If high, the business usually has a low Net profit
d] Expenses Sales) x 100% margin, i.e. the expenses of the business are too
Ratio high.

(Sales ÷ Capital employed) n/a Measures the efficiency with which the organisation
e] Asset times uses its resources (net assets) or capital employed
turnover ratio to generate sales.

2) Liquidity Ratios
a] Current Current assets ÷ Current 2:1 Measures the ability of the entity to meet its debts
ratio liabilities when they fall due. It shows the extent to which
current liabilities are covered by cash/assets that
can be converted into cash within a reasonably
short period of time.

Measures the immediate solvency of the entity or

b] Quick (Current assets – Stock) ÷ 1:1 the extent to which current liabilities are covered
ratio/Acid current liabilities by cash and debtors. Inventory (stock) is excluded
Test ratio as it is less liquid (i.e. must be sold  converted
into receivables  and eventually into cash.
NB – If both or either of them(Current ratio and Quick ratio) are too high, it implies that cash or
current assets are being tied up instead of being reinvested so as to accumulate more cash flows into
the business.
 3) Efficiency Ratios

(Cost of Sales ÷ Inventories) n/a

a] Inventory Or
turnover (Cost of Sales ÷ average Shows how rapidly an organisation’s inventory is
inventory) times sold on average during the year.
Where:
average inventory = op stock + cl stock
2

b] Inventory (Inventories ÷ Cost of sales) x Same interpretation as above

days 365 days

Shows the average period taken to collect money from

c] Receivables (Receivables ÷ Credit Sales) x receivables (debtors). Total Sales (Revenue) is used if credit
days or 365 days sales are not given.
Debtors’ ratio

d] Payables (Trade payables ÷ Cost of

days or Sales) x 365 days or Calculates the average period taken to pay suppliers. Cost of
Creditors’ (Creditors ÷ Credit sales is used if Credit Purchases is not given.
ratio purchases) x 365 days

NB – a shorter Payables’ days than Receivables’ days may lead to cash or liquidity problems as
debtors will not be paying as much as the company is paying its suppliers.

4) Capital Structure Ratios

a] Equity:
Loan capital Shareholders’ fund includes ordinary shares, any reserves and
ratio or (Equity funds ÷ Borrowed Retained profits. Borrowed funds include debentures and any
Shareholders’ funds) x 100% Long-term loans. Potential investors/Lenders prefer that
funds : Total owners of the business (Equity) should be having above 50%
indebtness ownership of assets.
ratio

Almost the same as above, but Gearing measures the extent to

which an organisation is financed by debt rather than by
shareholders’ equity. A company with a high proportion of
b] Gearing (Debt ÷ Capital Employed) debt to equity is said to be highly geared. If highly geared, the
x 100% high interest charges mean less profit to pay dividends. So the
company is unattractive to potential investors. It may be
difficult to raise additional finance. Banks and lenders are
normally reluctant to lend to a company that is already heavily
in debt. If the company makes a loss, there is a greater chance
that it may go into liquidation – if interest payments cannot be
met, loan creditors may demand entire loan repayment.

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 5) Investment Ratios

Shows the number of times the profits available to ordinary

a] Ordinary shareholders can cover the actual dividend paid. It secures the
dividend (PAIT- Preference dividend) ÷ future investor on future dividends and how far they can be
cover ordinary dividend [times]
covered. It also shows investors the capacity of management
to retain some of the annual profits back into the company.
Too low dividends/infrequent dividends  market price of the
shares may fall. Too high dividends  limit the company from
growth without acquiring loan finance or new shares as
reserves would have been exhausted.

b] Earnings (PAT – Preference dividends) Shows how much of Net Profit could have been received by
per share ÷ Number of Ordinary shares each shareholder (Equity) had the whole Net Profit been paid
(EPS) [pence] out as dividends.

For example, the P/E ratio of company [A] with a share price of
$10 and earnings per share of $2 is 5. The higher the P/E ratio,
c] Price Market price per share ÷ EPS the more the market is willing to pay for each dollar of annual
Earnings ratio earnings. Companies with high P/E ratios are more likely to be
considered "risky" investments than those with low P/E ratios,
since a high P/E ratio signifies high expectations. Comparing
P/E ratios is most valuable for companies within the same
industry.

*Ratio analysis is a powerful accounting tool, but it has its own disadvantages, among
others are the following:

-It is based on historical information, i.e. ratios are calculated from financial statements
from previous years.

- Different businesses may use different accounting conventions, e.g. depreciation methods
etc.

- Ratio analysis on its own cannot uncover the real business issues that may have caused the
trends in the ratios. It can work as a starting point for questions on what and why there
have been the manifested trends.

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 The Accounting Equation
Assets = Capital (Equity) + Liabilities

e.g.

A business acquires a building (asset) for P1 000 000, where P600 000 came from the
owners’ funds (Equity/ Capital and the rest of the money (the P400 000) was a loan (liability)
that was borrowed from the bank. Using the accounting equation, this transaction can be
represented as follows:

Asset (A) = Capital (C) + Liabilities (L)

P1 000 000 vehicle = P600 000 + P400 000

However, from our mathematical know-how, if

A=C+L

We can also express the accounting equation as follows:

1) C=A–L
e.g.
C = A - L
P600 000 capital = P1 000 000 asset - P400 000 loan or

2) L = A – C.
e.g.
L = A - C
P400 000 liability/loan = P1 000 000 asset - P600 000 equity/capital

Conclusion: From the original accounting equation, we can derive 2 other

accounting equations, hence the different ways in which a Balance
sheet can be structured!

Accounting fact: Mostly,

Assets and Expenses  Debit balance Liabilities and Income  Credit balance
(Receiving accounts) (Giving accounts)

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