Ratio Analysis

Liquidity

* The ability of a business to pay its debts as they are due for payment.
* Two ratios current and quick asset

Current Ratio

* A measure of the ability of a business to pay its short-term debts, calculated by dividing current assets by current liabilities.
* If the business had a current ratio of 155%, it has $1.55 of current assets to pay $1 of its current liabilities
* Interpretation:
* Current Ratio of less than 100%: The business may find it difficult to pay its short term debts or the business is operating in an industry in which money is collected from sales very quickly. Examples, Coles and Woolworths.
* Current Ratio of between 100% and 200%: A current ratio of between 100% and 200% indicates that a business should be able to pay its short term debts.
* Current Ratio of more than 200%. A current ratio of more than 200% indicates that a company should be able to comfortably pay its short term debts or that a company has an excessive level of current assets and is not making the best use of its resources to generate revenue.

Quick Asset Ratio

* A measure of the ability of a business to pay its short-term debts using only its more liquid current assets, excluding any bank overdraft.
* If the business had a current ratio of 85%, it has $0.85 of highly liquid current assets to pay $1 of its current liabilities except for the bank overdraft.
* Interpretation
* A quick asset ratio of 100% or more indicates that a business should be able to pay its short term debts.
* A quick asset ratio of less than 100% indicates that a business may not be able to pay its short term debts.

Stability

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* A business can purchase assets using borrowed money, share capital or form the cash generated from the profit
* Stability ratios measure the medium to long term survival prospects of a business based on the extent of the borrowings of that business.
* Gearing or leverage is the term used to describe the extent of the borrowings of a business. A highly geared business has a large interest and loan repayments and has an increased risk of failure.
* The two ratios are debt to equity ratio and times interest earned

Debt to Equity Ratio

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* Measures the debt to equity ratio of the gearing of the business
* Total liabilities/Equity
* Interpretation:
* There is no acceptable figure for the debt to equity ratio. It should be compared with industry averages and past performance. Generally, the higher the ratio, the worse off the business is due to liabilities increasing

Times Interest Earned

* The number of times that the interest of a company is covered by the profit before tax.


* Interpretation
* Anything within 3-4 times offer a good safety margin for a company

Profitability Ratios

Profit margin and rate of return on assets

Profit Margin Ratio

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* Percentage of profit after income tax that is contained in each dollar of sales
* Profit (after tax)/ Net Sales
* The profit after tax is used as this is the profit available to the shareholders
* Interpretation
* An increase in the profit margin may be caused by:
* A reduction in expenses
* An increase in selling prices compared to cost of sales
* Cheaper supplier of inventory has been found
* A decrease in the profit margin may be caused by:
* Expense increases that are not being fully passed on to consumers in the form of increased selling prices
* Increase competition causing the business to lower its selling prices

Rate of Return on Assets

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* The rate of return on assets measures how efficiently a business has used its assets to generate a profit
* Interpretation
* Should be compared to industry standards. Bigger number better.

Market Ratios

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* Market ratios are used by investors to review the performance of public companies listed on the ASX
* The three ratios are earnings per ordinary share, price earnings ratio and dividend yield

Earnings per Ordinary Share

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* The portion of the company’s annual profit after tax and preference dividends allocated to each issued ordinary share.
* Interpretation
* Should be compared to past profits and other companies. Bigger number better.

Price Earnings Ratio

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* The number of times earnings per ordinary share that an investor is prepared to pay to purchase an ordinary share in the company.
* Interpretation
* A high price earnings ratio (compared to industry average) indicates investors believe good future economic growth or is overconfident
* A low price earnings ratio indicates that investors believe the company has poor profit growth prospects or is underconfident.

Dividend Yield

### Dividend Yield

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* Shows how much a company has paid out in dividends in a year relative to its share price
* Interpretation
* Just how much return on profit it can generate

Efficiency Ratio

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* Evaluate the performance of the management of a company in the areas of inventory and accounts receivable
* Debtors collection period and inventory turnover

Debtors Collection Period

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* Measures how quickly a business collects the money owing from credit sales.
* Interpretation
* An increase in the debtors collection may be caused by:
* Poor debt collection procedures
* The slow process of sales invoice.
* Failing to check credit rating of new customers
* A business may offer longer credit terms to potential customers
* A decrease in this ratio would indicate it has improved

Inventory Turnover

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* How many times a business each year replaces its inventory.
* Interpretation
* An increasing inventory turnover ratio mean that the products sold by the company are doing well
* A decreasing inventory turnover ratio indicates the inventory management policy is inefficient, out of they over ordered inventory or slow moving/obsolete inventory

Limitations of Ratio Analysis

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1. Ratios do not identify the causes of problems.
2. Ratios are usually only of limited value. They often need to be compared to an industry average.
3. Limited disclosure of information makes it impossible to calculate some ratios
4. It is not always possible to compare ratios between businesses as different accounting policies may have been chosen that will affect ratio calculations