Ratio Analysis

BUS608 Financial Decision

Making
16
th
April 2013
Amanda Byrne
Lesson Objectives
At the end of this session you should be able to:
Explain the principles of interpretation of
financial information,
Calculate and interpret profitability, liquidity,
gearing, efficiency and investor ratios and be
aware of their significance
Explain the limitations of ratio analysis
Introduction to ratios
Terminology
Profitability ratios are used to compare profits with the size of the
business. These ratios are often called performance ratios because the
primary aim of most businesses is to make a profit.
Gearing ratios focus on the long term liquidity of a business. It allows a
business to determine whether a business will be able to keep up with
interest payments on borrowed capital and whether it will be able to pay
any long term borrowing.
Liquidity ratios are a measure of whether a business would be able to
meet any short term liabilities it may have. Businesses need to ensure
they have enough liquidity to avoid any problems with paying debts.
Efficiency ratios look at how a business manages its working capital. They
are used to measure and evaluate how efficiently a firm manages its
assets and short term liabilities.
Investors ratios are used to determine whether shareholders would be
likely to financially benefit from owning shares within the business.
Ratio Analysis The process
1. In order for ratios to be beneficial, the process has to be
selected carefully and well organised. To ensure that a
business can take full advantage of ratio analysis, the
following process should be followed:
2. Determine the reason for the analysis.
3. Conduct research on which ratios will be most relevant in the
situation.
4. Collect all the information required to calculate the ratios.
5. Make an interpretation of the ratios.
6. Compare the ratios in an appropriate way in an attempt to
understand the significance of the ratios.
7. Plan appropriate action in accordance with the results of the
ratio analysis and implement any action
Steps to Ratio Analysis
Identify users and
their information
needs
Select and
calculate
appropriate ratios
Interpret and evaluate
the results



Note: You need to
compare ratios with a
benchmark which
could be past
performance, industry
performance or
projected performance
A few rules
Always be aware of the context in which the business
operates
Compare like with like
Findings should always be double checked. Do not
base your interpretations on the result of one fact
only
To interpret effectively, the statements of more than
one accounting period should be analysed to give an
idea of the trend.
You can gain an initial overall impression of a
business just by looking at the figures.
Profitability Ratios
Profitability Ratios
Gross Profit Margin =
Gross Profit
Sales Revenue
Net Profit Margin =
Net Profit Before Interest and Taxation
Sales Revenue
X 100
X 100
Return on Capital Employed =
Net Profit Before Interest and Taxation
Capital Employed
X 100
Note: Capital Employed = Share capital + Reserves + Long term loans
A measure of
profitability in buying
(or producing) and
selling goods, before
other expenses
Expresses the
relationship between
net profit generated
and long term capital
investment
Represents profit from
trading operations before
ant interest and taxation.
Often seen as most
appropriate measure of
operational performance
Profitability ratios
Balance Sheet m
Non-current assets 19550
Stock 2375
Debtors 1170
Cash & cash equivalents 2300
Total current assets 5845
Current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets 11235

Share capital 6000
Reserves & retained earnings 5235
Total equity 11235
ROCE
Operating profit x 100
total equity + non-current liabilities

4580 x 100
11235 + 6000

4580 x 100 = 27%
17235

Income Statement m
Revenue 35400
Cost of sales (30100)
Gross profit 5300
Expenses (720)
Operating profit 4580
Finance income 300
Finance cost (260)
Profit before tax 4620
Taxation (1109)
Profit for the year 3511

For every 1 of capital employed in the
Business how much is being
generated in profit?

Why would it be meaningful to compare
this to the current rate of interest?
Liquidity Ratios
Liquidity Ratios
Current Ratio =
Current Assets
Current Liabilities
Acid Test Ratio =
Current Assets - Stock
Current Liabilities
The higher the ratio, the
more liquid the business is
considered to be
The minimum level is
often stated as 1:1; that is
current assets (less stock)
equals current liabilities
Liquidity ratios
Balance Sheet m
Non-current assets 19550
Stock 2375
Debtors 1170
Cash & cash equivalents 2300
Total current assets 5845
Current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets 11235

Share capital 6000
Reserves & retained earnings 5235
Total equity 11235
Current Ratio
Current Assets : Current Liabilities

5845 : 8160
= 0.716 : 1
For every 1 of CL the firm owes it owns
0.716 in CA

Do you think this business
has enough short
term assets to meet
its short term debts?

Liquidity ratios
Balance Sheet m
Non-current assets 19550
Stock 2375
Debtors 1170
Cash & cash equivalents 2300
Total current assets 5845
Current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets 11235

Share capital 6000
Reserves & retained earnings 5235
Total equity 11235
Acid Test
Liquid Assets : Current Liabilities




1170 + 2300 : 8160
= 3470 : 8160
= 0.425 : 1
For every 1 of CL the firm owes it owns
0.425 in CA

Why is the acid test a more
demanding measure?
Comparison
Significant level of
inventories; the
other companies
are service
industries
Comparison
Tesco does not
sell on credit; very
few of BA sales
are on credit
Comparison
Tescos trade
payables are much
higher than its
inventories; so, on
average, they have
the cash from sales
before they need to
pay for the goods
concerned
Gearing Ratios
Gearing Ratios
Capital Gearing Ratio =
Long-Term Loans
Share Capital + Reserves + Long-Term Loans
X 100
Debt/Equity Ratio =
Long-Term Loans
Share Capital + Reserves
X 100
Interest Cover Ratio =
Profit Before Interest and Taxation
Interest Payable
Measures the
contribution of long
term lenders to long
term capital structure
of the business
Measures the amount of
profit available to cover
the interest payable. The
lower the figure, the
greater the risk to
lenders, and
shareholders
Gearing ratio

Balance Sheet m
Non-current assets 19550
Stock 2375
Debtors 1170
Cash & cash equivalents 2300
Total current assets 5845
Current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets 11235

Share capital 6000
Reserves & retained earnings 5235
Total equity 11235 Gearing

Non-Current Liabilities x 100
total equity + non-current liabilities

6000 x 100
(11235 + 6000)
=
6000 x 100
17235
=
35%
For every 1000 invested in this
business how much of it is from
long term loans?

Why might a high gearing be more
of a concern to a business
with small profit margins?
Income Statement m
Revenue 35400
Cost of sales (30100)
Gross profit 5300
Expenses (720)
Operating profit 4580
Finance income 300
Finance cost (260)
Profit before tax 4620
Taxation (1109)
Profit for the year 3511

Efficiency Ratios
Efficiency Ratios
Average Stock Turnover Period =
Average Stock
Cost of Sales
X 365
Average Debtors Settlement Period =
Trade Debtors
Credit Sales Revenue
X 365
Average Creditors Settlement Period =
Trade Creditors
Credit Purchases
X 365
Asset Turnover Ratio =
Sales Revenue
Capital Employed
A business will prefer a
short stock turnover, as
funds tied up in stock
cannot be used for other
purposes
Speed of payment
can have a significant
effect on the
businesss cash flow
Represents a
free source of
finance
A higher asset turnover is
preferred to a lower one, as
it indicates assets are being
used more productively in
generating revenue
Financial Efficiency ratio
Balance Sheet m
Non-current assets 19550
Stock 2375
Debtors 1170
Cash & cash equivalents 2300
Total current assets 5845
Current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets 11235

Share capital 6000
Reserves & retained earnings 5235
Total equity 11235
Asset Turnover

Revenue
Net assets

35400
11235
=
3.15 times
Income Statement m
Revenue 35400
Cost of sales (30100)
Gross profit 5300
Expenses (720)
Operating profit 4580
Finance income 300
Finance cost (260)
Profit before tax 4620
Taxation (1109)
Profit for the year 3511

For every 1 of net assets in
the business how much is being
generated in revenue?

Why might asset turnover help
a business assess operational
efficiency between factories?
Financial Efficiency ratio

Balance Sheet m
Non-current assets 19550
Stock 2375
Debtors 1170
Cash & cash equivalents 2300
Total current assets 5845
Current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets 11235

Share capital 6000
Reserves & retained earnings 5235
Total equity 11235
Stock Turnover

Cost of sales
Stock

30100
2375
=
12.67 times
Income Statement m
Revenue 35400
Cost of sales (30100)
Gross profit 5300
Expenses (720)
Operating profit 4580
Finance income 300
Finance cost (260)
Profit before tax 4620
Taxation (1109)
Profit for the year 3511



On average for how long does this business
hold stock?

What type of business might have this level of
inventory turnover? Justify your answer




Financial Efficiency ratio

Balance Sheet m
Non-current assets 19550
Stock 2375
Debtors 1170
Cash & cash equivalents 2300
Total current assets 5845
Current liabilities (8160)
Net current liabilities (2315)
Non-current liabilities (6000)
Net assets 11235

Share capital 6000
Reserves & retained earnings 5235
Total equity 11235
Receivables (Debtors) days

Receivables x 365
Revenue

1170 x 365
35400
=
12 days
Payables are compared to cost of sales
and receivables to revenue.

What might be the expected debtor days of
a) A high street coffee chain
b) A commercial print company
Income Statement m
Revenue 35400
Cost of sales (30100)
Gross profit 5300
Expenses (720)
Operating profit 4580
Finance income 300
Finance cost (260)
Profit before tax 4620
Taxation (1109)
Profit for the year 3511

Investment Ratios
Earnings Per Share =
Earnings Available to Ordinary Shareholders
Number of Ordinary Shares in Issue
Dividend Cover Ratio =
Earnings Available for Dividend
Dividend for the Year
Dividend Yield Ratio =
Dividend per share before tax
Market Value per share
Price/Earnings Ratio =
Market Value per Share
Earnings per share
Many investors
regard this as a
fundamental
measure of share
performance
The higher the ratio,
the greater the
confidence in future
earning power
Ratio Analysis - Shareholders
Shareholder
Dividend per share (in pence)
Total dividends
number of issued ordinary shares
The return paid to shareholders for their investment
Money paid in dividends reduces retained profit
Will be influenced by financial objectives

If a dividend of 600m was paid out to a total of 750 shareholders
the dividend per share would be:
600m / 750 = 0.80p
For every 1 share owned the shareholder would receive 80p in dividends
Ratio Analysis - Shareholders
Shareholder
Dividend yield
Ordinary share dividend (in pence) x 100
current market price (in pence)
o Measures the return on the investment as a percentage of current
market price
o Market price fluctuates on a regular (constant basis)
o Allows for a more accurate comparison of the value of the
shareholders investment compared to other investment
opportunities

If dividend per share is 80p and the current market share price 15
the dividend yield is:
0.80 / 15.00 x 100 = 5.3%
Do you consider this to be a good return?
How does this compare to savings accounts, ISAs, other share options?
Value and Limitations of Ratio Analysis
Value
Provides a tool for the
interpretation of accounts
Structure from which comparisons
can be made
Aids decision making
Internally
Externally by investors

Limitation
Quality of financial statements- It must always
be remembered that ratios are based on
financial statements, and the results of ratio
analysis are dependent on the quality of these
underlying statements
The restricted vision of ratios. It is important not
to rely exclusively on ratios, thereby losing sight
of information contained in the underlying
financial statements.
It can be difficult to find a suitable benchmark
(for example, another business) to compare
with.
Some ratios could mislead due to the snapshot
nature of the balance sheet. any ratios based on
balance sheet figures, such as the liquidity ratios
above, may not be representative of the
financial position of the business for the year as
a whole.