C2 Markets and Ratios

Corporate Finance

Ratio Categories

• Profitability

• Activity

• Liquidity

• Gearing

• Investor

Profitability Ratios

• Return on capital employed (ROCE)

profit before interest & tax/capital employed x 100

• Net profit margin (%)

profit before interest & tax/ sales x 100

• Net asset turnover (times)

sales/capital employed

• Gross profit margin (%)

Gross profit/sales x 100

Activity Ratios

• Receivables’ ratio or receivable days

trade receivables/credit sales x 365

• Payables’ ratio or payable days

trade payables/cost of sales x 365

• Inventory days

inventory/cost of sales x 365

• Cash conversion cycle (days)

Inventory days + receivable days - payable days 

• Non-current asset turnover (times)

sales or revenue/non-current assets

• Sales or net working capital (times)

sales or revenue/net current assets

Cash Conversion Cycle

The overall goal for a company is to have a shorter CCC, which generally indicates better working capital management and financial health.

• Shorter CCC (Good): The company quickly converts its product into cash. This improves liquidity and reduces the need to borrow money to fund operations.

• Longer CCC (Bad): The company's cash is tied up for a longer period, which can strain liquidity, increase the risk of obsolete inventory, and require more external financing.

• Negative CCC (Excellent): In rare cases, a company (like some major retailers) can have a negative CCC. This means they are collecting cash from customers before they have to pay their suppliers. Essentially, their suppliers are financing their operations.

Liquidity ratios

• Current ratio (times)

current assets/current liabilities

• Quick ratio (times)

Current assets - inventory/current liabilities

Gearing ratios

• Capital gearing ratio (%)

long term debt capital/capital employed x 100

• Debt/equity ratio (%)

long term debt capital/share capital and reserves x 100

• Interest coverage ratio (times)

profit before interest & tax/interest charges

Investor ratios

• Return on equity (ROE)(%)

earnings after tax and preference dividends/shareholders’ funds

• Dividend per share (pence)

total dividend paid to ordinary shareholders/number of issued ordinary shares

• Earnings per share (EPS)(pence)

earnings after tax and preference dividends/number of issued ordinary shares

• Dividend cover (times)

earnings per share/dividend per share

• Price or earnings ratio (P/E ratio) (times)

market price of share/earnings per share

• Payout ratio (%)

ordinary dividends/distributable earnings x 100

• Dividend yield (%)

dividend per share/share price x 100

• Earnings yield (%)

earnings per share/share price x 100

Problems with ratio analysis

• The Balance Sheet (or Financial Position Statement) shows a company's financial status on only one specific day (e.g., December 31st). This single "snapshot" might not reflect the company's financial situation throughout the rest of the year

• Hard to find a truly similar competitor to compare your company's ratios against, which makes judging your performance (intercompany comparisons) difficult.

• Companies can use legal but tricky accounting methods (like off-balance-sheet financing) to make their financial statements and resulting ratios look better than they truly are.

• Ratio analysis is just the first step in financial investigation. It mainly raises questions that require a much deeper look into the business and its accounting practices.

Economic Profit or Residual Income 

The profit left after you've paid all taxes and covered the cost of using the company's capital (like interest on loans and the return shareholders expect)

\text{Economic Profit} = (\text{Operating Profit after Tax}) - (\text{Cost of Capital Charge on Capital Employed})

Economic Value Added (EVA)

Adjusts the numbers of the published financial statements to get a "fair value" for the money invested.

Directing attention to the drivers creating
wealth for shareholder

EVA suggests shareholder value can be created by:

EVA suggests shareholder value created by:
• Seeking ways to increase net operating profit after tax without increasing capital invested (e.g., running current assets more efficiently).
• Investing in projects giving returns greater than company’s cost of capital.
• Reducing capital charge by reducing cost of capital (e.g., by changing the mix of debt and equity) or reducing amount of invested capital (e.g., by selling off unnecessary assets)