Ratio analysis

We have examined the purpose, layout and content of the balance sheet and profit and loss account.
We have said that these documents contain a story of the business bit that this story is sometimes
difficult to reveal. We need to find some way of bringing this information to life and to provide
answers to stakeholders on a whole series of questions about the performance, efficiency and
liquidity of the business. We can do this through the use of financial ratios. A ratio is simply a
mathematical relationship between one figure and another. Financial ratios are relationships
between quantities taken from the accounts.

Single balance sheets and profit and loss accounts tell us very little. If we are told that sales this
year were FCFA20m and profit rose to FCFA5m, this information has limited meaning expressed
as it is in absolute terms. What we want is some way to provide a relative comparison. Financial
ratios offer a tool to do this, but are only of significant use when they are compared to other ratios.
In practice, comparison will be between different years and between the firm and its competitors
or industry averages (inter-firm comparisons). However, it is important that any comparison is
between similar organizations. Comparing ratios of the local grocer's shop with multinational
supermarkets will have little practical use.

What we are hoping to reveal are trends in performance or contrasts with similar organizations
that may require further analysis. Ratios should help decision-makers and provide the information
to set future policy

To help us understand more about the firms we are studying, we will be examining specific groups
of ratios, namely:

Profitability ratios examine profit in relation to other figures

Liquidity ratios identify the ability of a firm to pay its current liabilities

Financial efficiency ratios provide information on how effectively resource are used in the business

The gearing ratio shows the long-term liquidity position of the business

Shareholders ratios measure the returns to shareholders

Profitability ratios

Making profit is the main purpose for most business organizations, but what level of profit is
acceptable?

Stakeholders look at profit for a number of reasons, but primarily to see if their investment is worth
it. There are alternatives, such as depositing funds in the bank, so profit has to be compared in
some way with bank interest.

Profitability brings together the two main accounts, the balance sheet and the profit and loss
account. The P&L account gives the quantity of profit, in money terms. The balance sheet enables
it to be expressed as percentages.

We have two terms to remember here,

 Profit
 Profitability

Profit is shown in the profit and loss account in a number of ways. Profitability ratios show how
profitable a firm is.

Profit margins

We can compare profits with sales revenue in two main ways:

Gross Profit margin.

This ratio compares the gross profit achieved by a firm to its sales revenue; in other words the
percentage of the selling price that is gross profit and available to pay for the firm's overheads. The
figure is expressed as a percentage. A figure of 20% is a benchmark for most industries, but will
vary from industry to industry. Gross profit margin is basically the firms mark up on the items it
buys in.

Gross profit Margin = Gross profit x 100

Sales Revenue
Firms that can turn stock over quickly may operate with relatively low gross profit margins. For
example in a hypermarket, the gross profit margin on clothing is higher than on food sales.

If the ratio is falling over time this could be because of failing to pass on increases in the cost of
sales to customers in higher prices or a change in the mix of goods on sale to lower margin
products. A firm may improve its margin by reducing the direct costs of sales (possibly by buying
in bulk or changing suppliers) or by increasing price. However, increasing prices may lead to a
significant fall in sales volume if customers are price sensitive

Net profit margin

This ratio calculates the percentage of a product's selling price that is net profit. Again it is
expressed as a percentage. It may be regarded as a better measure of a firm's performance than
gross profit margin as it includes all of the firm's operating expenses. It measures how successful
the firm is in controlling its expenses. A higher percentage is, therefore, preferable. This may be
achieved by raising sales revenue, while maintaining existing expenses levels or simply reducing
expenses.

Net profit Margin = Net profit x 100

Sales Revenue

A comparison of the two profit margins can raise questions about management efficiency. If, for
instance, the gross profit was improving at the same time as the net profit margin declined, this
would point to poor control of expenses (or increasing overhead costs) as an issue worthy of
investigation.
Liquidity ratios - introduction

Liquidity ratios are concerned with the short term financial health of the business and whether the
working capital of the business is being managed effectively. Working capital is the lifeblood of
an organization. Too little working capital and the firm may not be able to pay all of its debts, and
ultimately this may result in closure. Too much working capital and the business may not be
making the most efficient use of its financial resources for expansion.

Liquidity is the ability of a firm to meet its liabilities, to pay its bills. A firm is liquid if it can pay
its bills, illiquid if it cannot. A firm may be illiquid for a time, but it may not matter. However, at
another time a moment's lack of liquidity may be critical. It all depends which bill it is that the
firm has to pay. The banks and the government pose the greatest problems, and particularly the
government, as these payments are unavoidable. Thus there are some critical creditors who the
firm must pay on time.

There is little liquidity information in the profit and loss account, but the balance sheet is more
valuable. Liquidity is a short-term matter and can change very quickly, so it is always worth
remembering that the balance sheet is simply a snapshot at a particular time.

Now, let's look at the balance sheet. The firm will have to meet its liabilities some time, but the
current liabilities are the most important. As a reminder, current liabilities are:

Creditors

These are people, firms and organizations to which the firm owes money. Some are more important
than others. The critical creditors are probably the tax authorities (which collect company tax,
employees income tax and sales tax) and the banks. Payments are due on a set day, and failure to
pay may lead to the closure of the firm.

Overdrafts

These are short-term borrowings from banks. Firms often use this as a means to make up for
working capital shortages. They generally have to be cleared within 6 months.
Short-term loans

If these are from banks they have to be paid. If the firm is reliable enough it may be able to re-
organize an overdraft or short-term loan into a long-term loan.

On the other hand, the firm has its current assets to help it pay its bills. A reminder that current
assets are:

Cash

Clearly very useful for paying bills as it is the most liquid of funds.

Debtors

These are people or organizations, who owe the firm money. They should pay within the present
financial year, depending on the credit terms given by the firm. They can be turned into cash
quickly if it is necessary. The bills can be factored, that is sold to a firm, which will collect the
revenue when they become due. Obviously, factoring companies will only pay a percentage of the
value of the debts. Debtors are relatively liquid compared to other assets, but are not as good as
cash.

Stock

These are assets of the firm and can, theoretically, be sold to raise cash. In reality, however, this
may not always be the case. They may be out of season, unfashionable or even obsolete. They may
not even be finished goods. Other firms or customers may not want them, and even if they do, only
at a relatively low price. Stocks are considered to be the least liquid of the current assets.

Here are two liquidity ratios:

 Current ratio
 Acid test ratio

Current ratio

One of the most universally known ratios, the current ratio reflects the working capital position
and indicates the ability of a business to pay its short-term creditors from the realization of its
current assets, without having to resort to selling any of its fixed assets.
The current ratio is simply the ratio of all current assets to current liabilities. In other words:

= (stock + debtors + cash)

Creditors + Overdraft = short term loans

Current Ratio = Current Assets x 100

Current liabilities

Ideally the figure should always be greater than 1, which would indicate that there are sufficient
assets available to pay liabilities, should the need arise. The general rule of thumb is that the figure
should lie between 1.5 and 2.0. In other words, for every FCFA 1 of debts the firm will have
between FCFA 1.50 and FCFA 2 in current assets to pay for this. The higher the figure the more
liquid the business, but too high a figure may indicate that the firm is not investing sufficiently in
higher earning assets.

In retail and manufacturing it would be expected that the current ratio would fall between1.1 to
1.5. Generally where credit terms and large stocks are normal to the business, the current ratio will
be higher than, for example, a retail business where cash sales and high stock turnover are the
norm.

The problem with the current ratio is that it includes stock, which may include slow moving or
redundant stock that is not liquid at all. Accepting that stock is a liquid asset assumes:

That a buyer is available. If the product is out of date then perhaps nobody else wants them.

The firm will get a fair price for them. This is unlikely, especially once the word gets around that
the firm needs cash quickly.

Any buyer will pay cash at once for the materials. A credit sale is of no use.

At best the firm can expect only a very poor return. It is best to ignore stocks when looking at
liquidity and calculating ratios - hence use the acid test ratio as the key liquidity ratio. When
comparing the acid test and current ratios, be sure to make it clear what the limitations of the
current ratio are and explain the differences between them.
Acid test ratio

The acid test ratio is the strictest test of liquidity. The term is derived from the use of nitric acid
for testing gold.

Acid test ratio = Current assets less stock x 100

Current liabilities

This ratio is a measure of risk, the risk of going bankrupt and failing. The risk increases as the
value of the ratio falls. A value of 1.0 is considered to be satisfactory as this means that the firm
has sufficient liquid assets to meets its liabilities. Much below 1.0 is generally dangerous, whilst
ratios well above 1.0 may be a sign of poor cash management. A firm can be too liquid; it is then
not using its resources well enough.

Be careful, though, as this ratio, like many others, is industry dependant. Look at the accounts for
a major supermarket and you may find very 'poor' acid test scores, but there clearly is no real risk.
They are strong companies which sell for cash, but get very good credit terms from their suppliers.

So, if you are trying to come to some conclusions about a company, get some accounts for other
firms in the same industry. That will put the ratio into the correct context.

Efficiency ratios

Efficiency ratios show how efficiently the business is using its resources. Shareholders in
particular will want to know how well the firm is using their money! It is advisable for the business
to get as much turnover from its assets as possible and at the same time it is not a good idea for it
to have too many assets in the form of stock or debtors.

Financial efficiency can be examined by using the following ratios:

Return on capital employed

Asset turnover

Stock turnover
Debtor days

What do we mean by the term financial efficiency? A business uses capital - shareholders capital
or that borrowed from the banks - to run its business. These stakeholders are entitled to know how
well this capital is being used. In other words, is the company financially efficient? Are they
growing the firm fast enough?

The last section showed how the acid test ratio could give an indication of financial performance.
It only looked at the capital structure, though, and attempted to measure risk in some way. Other
ratios are perhaps better at assessing performance, or use of money.

A firm uses capital to buy assets, stock and also 'lend' to its customers. How well it does this, may
be checked by analyzing the accounts.

Efficiency ratios - ROCE

All firms use capital to run the business and generate profit. This capital belongs to the owners,
the shareholders, and the lenders, primarily the banks. They want to know how well their money
is being worked and what the return they are achieving on their investment. It should be at least as
high as the interest the firm could get from investing in the bank.

Return on capital employed (ROCE)

This is alternatively known as the primary efficiency ratio as it is regarded as the most important
ratio of all.

ROCE = Net profit before interest and tax x 100

Total capital employed

Which net profit should you use? In your examinations, you will be expected to use operating
profit or net profit before interest and tax (NPBIT). The management of a firm cannot control the
level of taxation or interest rates and so judgment of profit made should be the profit that accrues
from ordinary activities, before taxes and interest are deducted, as this is the value controllable by
the management.
Total capital employed is given by the formula:

 shareholders' funds plus long-term liabilities

 Be careful about the term capital employed. Some textbooks use this to mean shareholders'
funds without long-term liabilities

What is a good ROCE? Certainly, the higher the value of the ratio the better as ROCE measures
profitability and no shareholder will complain about too high levels of profit! If the ROCE is less
than interest rates in the market it is bad news, as the firm (or shareholder) would have been better
advised to leave the money in the bank.

A business could have difficulty servicing its borrowings if a low return is being earned for any
length of time. So what is an acceptable level? In manufacturing it would be expected that ROCE
is in excess of 10% rising to over 25% at the top end. In retail lower figures would be experienced,
ranging between 5% and 15%. Most companies would regard 20% as an acceptable level, but like
all accounting measures it will depend on a number of factors, such as:

The industry

The state of the economy

The interest rate in the economy (short-term and long-term)

The size and age of the firm. Established large firms will usually be making a high rate of return.

The requirements of the firm itself. Here we meet the terms long-termism and short-termism. If
you take a short-term view you want high rates of return, the firm want its money back quickly. If
they take the opposite approach, they will demand less and be prepared to wait for the profit.

Just like other ratios, ROCE should be examined against previous returns achieved by the business.
20% may be acceptable, but if the firm has a history of achieving over 30%, this would represent
a worsening level.
If the ROCE is falling, the firm may address this by:

 Increasing the profit generated by the same level of capital by becoming more efficient
 Maintaining the profits generated, but using less capital

NB

The ROCE is often considered to be a profitability ratio as it measures the efficiency with which
the firm generates profit from the funds invested in the business.