Ratio analysis

Chapter 3
 Learning outcomes
By the end of this chapter, you should be able to:
• discuss the requirements for financial ratios
• identify the norms of comparison used to evaluate ratios
• identify the different types of ratios
• define, calculate and interpret profitability, liquidity, solvency and
investor ratios
• explain financial gearing
 Introduction
• Information provided in financial statements is used to calculate financial
ratios
• Ratios attempt to provide more information in format that is comparable
over time, between companies and between industries/countries
• Ratios are more understandable than the financial figures in financial
statements
• Meaningful relationships between items from the financial statements are
investigated with ratios
 Requirements for financial ratios
• Meaningful
 Logical comparison between items from financial statements
• Relevant
 True indication of financial situation
• Comparable
 Ratio calculated in a consistent manner
 Norms of comparison
• Conventions
 Norms developed over time (e.g. CR =2:1)
 May differ between firms/industries
• Comparison over time
 Determine if financial situation improved or declined
 Determine trends in the values of the ratios
• Comparison between companies
 Determine the competitive position of the company relative to its competitors
 Types of ratios
• Profitability ratios
• Profit margins
• Turnover ratios
• Liquidity ratios
 Turnover times
• Solvency ratios
 Coverage ratios
• Cash flow ratios
 Cash coverage ratios
• Investment ratios
 Profitability ratios
• Evaluates efficiency with which a company utilises its capital to generate
turnover
 Small investment in assets generates large income – company is highly profitable
 Large investment in assets generates small income – assets are not utilised
efficiently
• Possible to calculate the profitability of different capital items
• Ensure relevant comparison between capital item and corresponding
income/profit
 Return on assets (ROA)
• Measures how efficiently total assets are utilised to generate turnover
• Compares profit after tax with total assets

ROA =

• In order to improve ROA:

• Improve profit figure, reduce amount of assets, or combination
 Return on equity (ROE)
• Indicates return generated on total equity
• Total equity includes ordinary shareholders’ equity, preference share
capital and minority interest
• Profit after tax represents profit available to equity providers
ROE =
 Return on shareholders’ equity (ROSE)
Returns generated on shareholders’ equity.
• Shareholders’ equity includes ordinary shareholders equity and preference
shareholders capital
• Profit after tax represents profit available to shareholders equity.
ROSE =
Return on ordinary shareholders’ equity
(ROSHE)
•
 Profit margins
• Indication of the percentage of turnover that shows as profit
after certain deductions are made
• Profit margins could influence profitability ratios
 Higher profit margins should increase profitability levels
 Gross profit margin (GP)
• Portion of turnover that is realised as gross profit after cost of sales has
been subtracted.

GP =
 Operating profit margin (OP)
• Portion of turnover that is realised as operating profit after operating
expenses have been subtracted.

OP =
 Earnings before interest and tax margin
(EBIT)
• Profit made before taking any finance cost and tax into consideration.

EBIT =
 Net profit margin (NP)
• Portion of turnover available after tax is paid
• Important to the equity providers
 Indication of portion of the turnover that belongs to non-controlling
interest holders, which can be paid out as ordinary or preference
dividends or can be reinvested as part of the company’s reserves

• NP =
 Turnover ratios
• Indicates speed with which an investment in assets is converted
into turnover
 Higher the value of the ratio the more times per year the investment is
utilised to generate turnover, and the higher the total profit should
become
• Influences the profitability of a company
 Higher turnover ratios should increase profitability levels
 Total asset turnover ratio
• Indicate efficiency with which total assets are utilised to generate turnover
• The higher the value of TA turnover ratio, the more times per year the
investment in total assets is converted into turnover.
• If a company is able to improve TA turnover ratio while maintaining same
profit margins, its return on assets should increased.
TA =
 Current asset turnover ratio
• Indicates the number of times per year that the investment in the current
assets is converted into turnover.

CA Turnover =
 Trade receivables turnover ratio
• Shows number of times per year that investment in trade receivables is
converted into turnover

• TR turnover =
 Inventory turnover ratio
• Focuses on investment in inventory
• Cost of sales is determined by the amount of inventory that is sold so INV
ratio does not focus on the value of the company’s turnover
• Cost of sales figure is used instead

• INV turnover =
 Trade payables turnover ratio
• Evaluates efficiency with which company utilises trade payables to
finance its purchases
• When the TP turnover ratio is calculated, purchases of inventory during
the year are required

• TP turnover =
 Liquidity ratios
• Liquidity refers to ability to honour short-term obligations
 Adequate liquidity: sufficient current assets are available to cover
current liabilities
 If company’s liquidity is consistently at insufficient levels, it may
eventually result in problems with solvency in the long term: could
threaten the survival of the business
 Current ratio
• Compares current assets and current liabilities
 Conventional norms of comparison: value of 2:1 if company maintains
acceptable levels of liquidity
 Value less than one: indicates that there is less than R1 of current assets
to cover R1 of current liabilities – this could indicate insufficient
liquidity

• Current ratio =
 Quick ratio
• Focuses on current assets and liabilities
• Unlike current ratio, not all current assets are included:
 Takes time to sell inventory
 Prepayments cannot be reclaimed
 Value of quick ratio more conservative estimate of current assets
available to cover current liabilities
• Quick ratio =
 Cash ratio
• Focus is placed solely on cash and cash equivalents available
 Cash ratio indicates if sufficient cash is available to cover current
liabilities

• Cash ratio =
 Turnover time ratios
• Turnover times of current assets provide indication of time it takes to convert
investment into turnover
 Longer turnover times: weaker liquidity
• Turnover times of current liabilities provide an indication of average period of
time before liability is redeemed
 Shorter turnover times: liabilities are paid earlier; negative effect on liquidity
• Turnover times influence cash conversion cycle
• More efficient management of working capital components could result in
improved liquidity
 Trade receivables turnover time
• Average time it takes to convert investment in TR into turnover
 Represents average collection period of trade receivables (i.e. how long
customers that purchase items on credit take on average to pay accounts)
• Increase in value of ratio over time could be sign of decreased
liquidity; could also be indication that credit terms are too lenient

• TR turnover time = X
 Inventory turnover time
• Calculates average time it takes to convert inventory into
turnover
 Provides average age of inventory (i.e. how long an item of inventory
has been in the business before it is sold)

• INV turnover time = X

 Trade payables turnover time
• Indicates average period it takes before trade payables are
repaid
 If TP turnover time decreases: trade payables are repaid earlier;
negative effect on liquidity
 Increase in TP turnover time: improved liquidity

• TP turnover time = X
 Cash conversion cycle
• Indication of the time that elapses from when cash is spent on
purchase of inventory until it is received back again
 Inverse relationship between CCC and profitability; could improve
profitability by reducing CCC
CCC = TR Turnover time + Inventory Turnover time – TP Turnover time