FINANCIAL ANALYSIS (Ratio)

A. Profitability Ratios (AS Level)

(i) Gross Profit margin
It indicates the percentage of revenue that is being converted into profits excluding the running expenses
of the business. The higher it is, the better.

Gross profit
100
Revenue

(ii) Gross Profit mark - up

It indicates the rate of return on investment in goods for resale. The higherit is, the better.
Gross profit
 100
Cost of sales

Ways to increase Mark up / Margin Ways to reduce Mark up / Margin

 Increase the selling price  Decrease the selling price

 Decrease the purchase price
 Decrease carriage costs, freight
and custom duty
 Benefit from trade discount
 Overvalued closing inventory
 Increase the purchase price
 Increase carriage costs, freight
and custom duty
 No trade discount
 Undervalued closing inventory

Conversion
Margin to Mark up Mark up to Margin
A = A C = C
B (B+A) D (D-A)

E.g 1 = 1 3 = 3
3 (3 + 1) 5 (3+5)
= 1 = 3
4 8
(iii) Profit Margin
It indicates the management’s efficiency of converting revenue into profit. The higher it is, the better.

Profit for the year × 100 OR Profit for the year (after interest)
 100
Revenue Revenue

Ways to increase Profit Margin Ways to reduce Profit Margin

 Increase the selling price  Decrease the selling price

 Decrease the purchase price
 Decrease carriage costs, freight
and custom duty
 Benefit from trade discount
 Overvalued closing inventory
 Decrease in expenses
 Increase in sales volume
 Increase in other income
 Increase the purchase price
 Increase carriage costs, freight
and custom duty
 No trade discount
 Undervalued closing inventory
 Increase in expenses
 Decrease in sales volume
 Decrease in other income

(iv) Return on capital employed (ROCE)

It indicates the efficiency and effectiveness of the business in using the total resources invested in the
business to generate profit. The higher it is, the better.

Profit from operations

 100
Capital employed

- Capital employed = issued shares + reserves + non-current liabilities

OR
= Non current asset + Current asset - Current liability

Ways to increase ROCE Ways to reduce ROCE

 Increase the selling price or sales  Decrease in selling price or sales

volume volume
 Decrease the purchase price  Increase the purchase price
 Decrease in expenses  Increase in expenses
 Increase in other income  Decrease in other income
(v) Expenses to revenue ratio
It indicates how well a business is controlling all its expenses. The lower it is, the
better.
Expenses × 100
Revenue

(vi) Operating expenses to revenue ratio

It indicates how well a business is controlling expenses excluding interest. The lower
it is, the better.

Operating expenses 100


Revenue

Note : Taxation is not considered as an expense.

Ways to reduce Ratio Ways to increase Ratio

 Increase the selling price or sales  Decrease in selling price or sales

volume volume
 Decrease in expenses  Increase in expenses

B. Liquidity Ratios (AS Level)

(i) Current ratio / working capital ratio
It shows how much current asset the business has to pay / sacrifice to pay for every
short term debts (current liabilities). The ideal ratio for this is 2:1.
Current assets
Current liabilities

Note: Current liabilities always equal to 1.

 How to improve current ratio How to deteriorate current ratio

 Increase sales volume  Decrease sales volume

 Sales of surplus NCA  Investment in NCA
 Reduction in cash drawings  Larger drawings
 Introducing capital in cash

(ii) Liquid ratio / Acid test ratio

It shows how much current asset the business has to pay / sacrifice to pay for every
short term debts (current liabilities) but by emphasising on the current assets that
can be easily converted to cash (more liquid). The ideal ratio for this is 1:1.

(Current assets – inventory)

Current liabilities

Note: Current liabilities always equal to 1.

How to improve liquid ratio How to deteriorate liquid ratio

 Increase sales volume  Decrease sales volume

 Sales of surplus NCA  Investment in NCA
 Efficient use of existing assets  Larger drawings
 Investment in inventory

C. Efficiency ratios (AS Level)

(i) Non current assets turnover (in times)
It indicates how much revenue is generated for every NCA being used. The higher the
times, the better.

Net revenue
Total net book value of non-current assets
 How to increase ratio How to decrease ratio

 Increase sales volume  Decrease sales volume

 Sales of surplus NCA  Over investment in NC

(ii) Trade receivables turnover

It shows the number of days on average it takes for a business to receive money
from its credit customers after selling goods on credit. The lower the days, the
better.
Trade receivables
 365 days
Credit sales

Ways to improve ratio Ways to deteriorate ratio

 Offering cash discount  No discount facilities

 Issue statement of account on a  No reminder sent to credit
regular basis customers
 Charging interest in overdue  No time limit given to credit
 Imposition of credit limits customers
 No sanction given on overdue
receipts
 Allow to much credit facilities

(iii) Trade Payables turnover

It represents the number of days on average it takes the business to pay suppliers.
The higher the days, the better.

Trade payables
 365 days
Credit purchases
 Ways to improve ratio Ways to deteriorate ratio

 Good relations with supplier  Lack of trust from supplier

 Good debt management  Poor debt management
 Long payment period  Short payment period

(iv) Inventory turnover (Days)

It indicates the average number of days during the year it takes the business to sell
inventory. The lower the days, the better.

Average inventory
 365 days
Cost of sales

(v) Rate of inventory turnover (in times)

It indicates the number of times during the year the average inventory has been sold.
The higher the times, the better.

Cost of sales
Average inventory

Ways to improve ratio Ways to deteriorate ratio

 Reducing the inventory level  High inventory level

 Just in time purchasing  Poor management in replenishing
 Aggressive marketing of inventory
 Competitive selling price  No marketing made to attract
 Provide quality products potential customers
 High selling price
 Poor quality products
D. Solvency and other ratios (A Level)
(i) Working capital cycle (Days)
Also known as the operating cycle or cash operating cycle, it shows the time it takes
for cash to be available from payment for goods bought and receipt from the sales of
those same goods. The lower the days, the better.

Trade receivables turnover (days) + inventory turnover (days) – trade payables turnover (days)

Ways to improve ratio Ways to deteriorate ratio

 COMBINATION OF THE WAYS TO  COMBINATION OF THE WAYS TO

IMPROVE TRADE RECEIVABLES DETERIORATE TRADE RECEIVABLES
TURNOVER, TRADE PAYABLES TURNOVER, TRADE PAYABLES
TURNOVER AND INVENTORY TURNOVER AND INVENTORY
TURNOVER TURNOVER

(ii) Net working capital to revenue ratios

It shows the likely amount of additional working assets funding needed from a given
increase in revenue. E.g If the ratio is 20%, this means that for every increase of $1 in
sales, an additional working assets of 20 cents will be required. The lower the ratio,
the better.

Net working assets

× 100
Revenue (sales)

Net working assets = inventories + trade receivables – trade payables

 Ways to improve ratio Ways to deteriorate ratio

 COMBINATION OF THE WAYS TO  COMBINATION OF THE WAYS TO

IMPROVE TRADE RECEIVABLES DETERIORATE TRADE RECEIVABLES
TURNOVER, TRADE PAYABLES TURNOVER, TRADE PAYABLES
TURNOVER AND INVENTORY TURNOVER AND INVENTORY
TURNOVER TURNOVER
 Increase in selling price and sales  Increase in selling price and sales
volume volume

(iii) Interest cover (Times)

It shows the number of times interest payable during an accounting year is covered
by operating profits during that period. The higher the times, the better.

Profit from operations

Interest Payable

Ways to improve Ratio Ways to increase Ratio

 Increase the selling price or sales  Decrease in selling price or sales

volume volume
 Decrease in operating expenses  Increase in operating expenses
 Bargain for lower interest  Face high interest

(iv) Gearing ratio

It indicates the proportion of capital employed sacrificed by the company for
payment of fixed cost. The lower the ratio, the better.

Fixed cost capital Non-current liabilities

 100 That is
Total capital Issued ordinary share capital + all reserves + non-
current liabilities
 How to improve gearing ratio How to deteriorate gearing ratio

 Reduce long term debts  Increase long term debts

 Selling of shares  High operational costs
 Reducing operational costs  Low profits
 Converting loans into shares
 Increase profits

Guidelines for gearing ratios

 Above 50% → High gearing
 Below 25% → Low gearing
 Between 25% - 50% → Optimal gearing

E. Investment ratios (A Level)

(i) Earnings per share (EPS)
It indicates how much profit can be attributed to each ordinary share of a company.
E.g If a business has an EPS of $0.25, it means that it is the amount of profit the
business is received for every shares the possessed. The higher the ratio, the better.

Profit for the year

Number of issued ordinary shares

How to improve EPS How to deteriorate EPS

 Increasing sales  Reduce sales

 Expanding market share  Issue of new shares
 Reducing costs  High tax rate reduces net income
 Buy back shares or selling les  High interest costs
shares
 Pay less dividend
(ii) Price earnings ratio (Times)
It indicates the price an investor has in relation to the earnings of the shares. The
higher the ratio, the better.

Market price per share

Earnings per share

Uses of the price earning ratio

1. Assess the market expectation vis a vis the company.
2. It is an indicator of future prospects of the company
3. It is an indicator of the current profitability of the company
4. Helps to evaluate whether the market price of a share is over valued or under
valued
5. Provide an insight about the demand of the share
Limitations of a price earning ratio
1. It uses earnings per share which makes the profit used unreliable since it can
easily be manipulated.
2. Market price per share also cannot be relied on as it is dependent on investor’s
behaviours, business conditions and speculations.
3. Inflation can distort figures overtime
(iii) Dividend per share
It shows the amount of dividend actually earned by a shareholder on each share he
own. The higher it is, the better.

Annual ordinary dividend

Number of issued ordinary shares

Annual ordinary dividend = interim dividend paid + final dividend proposed

(iv) Dividend yield
It indicates the return that investors earn from holding shares in a company. The
higher it is, the better.

Dividend per share

Market Price per share

(v) Dividend cover

It shows the number of times dividends are covered by profits for the year which are
available to pay dividends. The higher it is, the better.

Profit for the year available to pay ordinary dividend

Annual ordinary dividend