ratio analysis

what are the 5 types of financial ratios

1. profitability

2. efficiency

3. liquidity

4. gearing

5. investment

what are the 5 profitability ratios

1. gross profit margin (%)

2. net profit margin (%)

3. return on capital employed

4. return on equity (%)

5. operating profit margin (%)

gross profit margin

gross profit / sales revenue x 100

• Measures the profitability in buying, manufacturing, and selling goods before taking into account of any other expenses.

• This, along with operating profit margin ratio, can vary greatly between different types of businesses.

• There tends to be a 'normal' value for each industry.

net profit margin

profit / sales revenue x 100

• Percentage of profit that remains after all expenses have been accounted for

return on capital employed (ROCE)

OP / (share capital+ reserves+ noncurrent liabilities) x 100

• Primary measure of profitability and business performance.

• Performance of company as a whole

• Measure of management efficiency

return on equity (%)

profit after tax (PAT) / (ordinary share capital + reserves) x 100

• Measures the profitability of the company in terms of the capital provided by the owners of the company who are the ordinary shareholders.

• Performance of company from the shareholders' perspective

operating profit margin (%)

OP / sales x 100

'Operating profit margin' the higher the better. Reflects:

• degree of competitiveness in the market economic situation;

• ability to distinguish products;

• ability to control expenses.

What are the 5 Efficiency Ratios

• Asset turnover

• Inventory holding period (inventory turnover period)

• Trade (Accounts) receivables collection period

• Trade (Accounts) payables payment period

• Sales revenue per employee

Asset Turnover (times)

Sales/(noncurrent liabilities + total equity)

• Examines how efficiently a company's assets are used to generate sales revenue.

• Normally, a higher ratio is preferred to a low one - this would mean that the assets are used effectively in generating revenue

• However, a very high ratio might mean "overtrading"

Inventory Holding Period

InHldPrd in days = Inventory/ Cost of sales X 365

• Measures the average number of days for which inventories are held. In other words, how quickly goods move through the business

alternatively....

inventory turnover= cost of sales/ inventory

• A shorter inventory turnover period is normally preferred to a longer one as it might be costly to hold inventories.

Trade (accounts) receivables collection period

Trade receivables/ Credit sales x 365

• Measures how long it takes (on average) for credit customers to pay the amounts they owe to the business

• A shorter settlement period for trade receivables is normally preferred to a long one

Trade (accounts) payables payment period

Trade payables/ Cost of sales x 365

• Measures how long it takes (on average) for the business to pay the amounts it owes (on credit) to the suppliers of goods and services

• Paying too fast - risk of cash shortage

• Paying too slowly - risk of losing supplier

• Some businesses may attempt to increase their average settlement period for trade payables, but this might bring about negative outcomes as suppliers might no longer be willing to supply goods and services on credit to the business.

Sales revenue per employee

Sales Revenue/Number of Employees

• Measures the productivity of employees.

• A high ratio for sale revenue per employee is normally preferred to a low one (a high ratio mean that the business is deploying their employees efficiently)

What are the 2 liquidity ratios

• current ratio

• quick ratio (acid test)

Current Ratio

current assets / current liabilities

• Compares the liquid assets of businesses with their current liabilities

• A ratio less than 1:1 might give cause of concern because it would indicate that current assets are insufficient to cover the short term payments. look closely at cash flow.

• Ability to generate daily cash might make this ratio adequate.

• Usually between 1.5:1 and 2:1 for manufacturing industry.

Quick ratio (acid test)

(Current Assets - Inventory) / Current Liabilities

• Inventory may not always be converted into cash quickly. Therefore, this ratio excludes inventory

• Assists in answering whether the most liquid assets cover the current liabilities

why is liquidity as important as profit

survival of any business depends on its ability to pay debts on time - therefore cash flow is very important

unprofitable companies can survive if they have enough cash

What are the 3 types of gearing ratios

• Gearing ratio

• Debt to Equity

• Interest cover ratio

Gearing ratio

noncurrent liabilities/(ordinary share capital + reserves + noncurrent liabilities) x 100

• Measures the degree to which a company's long-term funds have been provided by lenders(i.e. to what extent the company is financed by borrowing rather than by owners' equity?).

• A company with a high gearing ratio is known as a "high-geared" company>> high risk investment for the ordinary shareholders.

• A gearing ratio greater than 50% is generally regarded as high

Debt to equity ratio

noncurrent liabilities/(ordinary share capital + reserves ) x 100

• It measures the financial leverage of a company and evaluates the extent to which it can cover its debts.

• Its shows the proportion to which a company is able to finance its operations via debt rather than its own resources.

Interest cover ratio

operating profit/interest payable

• Measures the number of times that the interest payable for an accounting period could have been paid out of the available profits

• Especially important for the providers of loans.

• Indicates how 'safe' the annual interest payments are in relation to profit.

• Indicates how many times profits can fall before the company is unable to cover payments out of current profits.

What are the 4 types of Investment Ratios

• Interest cover

• Earnings per share - EPS

• Price to earnings ratio - P/E

• Dividend cover

Interest cover

operating profit/interest expenses

• Measures the number of times that the interest payable for an accounting period could have been paid out of available profits

Earning per share (EPS)

Net profit/ (number of ordinary shares in issue) x 100p

• Measures the profit earned in an accounting period for each ordinary share in issue during that period.

• A frequently used indicator of financial performance.

• Measure percentage increase from year to year

Price to earning ratio (P/E)

Market price per ordinary share/ EPS

• Compares EPS with market price of ordinary shares

•A low P/E ratio - regarded as attractive

•Fact - a high P/E ratio is viewed more favourably than low ones

•EPS is a measure of past performance

•Market price of a share reflects the stock markets expectations of the company's future performance

Below 10: The market has some concern about the company. It may believe the company is in terminal decline or there is some other reason why the market does not like the company.

10 - 18 : This indicates that the company is probably fairly valued.

18 - 30 : The market expects the company to do extremely well, or the shares are overvalued.

Above 30 : This is suspicious. It indicates that the market has an exceptionally high opinion on future share growth. Such a company could be a bubble that explodes, as happened with many dotcom companies in 1999. An investor should always look to see why the market has such a high view of that company and how realistic this is.

Dividend cover

Profit After Tax - preference dividends/ ordinary dividends

• It shows the number of times that ordinary dividends could be paid out of available profits during the accounting period

what effect can overtrading have on financial ratios

can lead to a LOWER

- current ratio

- acid test ratio

- inventory turnover

- settlement period for trade receivables

can lead to a HIGHER

- settlement period for trade payables

- sales to capital employed ratio

overtrading is a risk for start up/fast growing companies, how can a business prevent overtrading

- reduce inventory holding

- reduce WIP

- reduce finished goods inventory

- reduce credit given to customers

what factors could affect ROCE

- capital employed - which can be affected by investments in assets and working capital (inventory, receivables)

- operating profit increase/decrease

what factors could affect GPM

- revenue and cost of sales

- if revenue rises but cost of sales rises more quickly, could be due to rise in raw material costs/ lower SP

what factors could affect current ratio

- assets/liabs

- if liabs grow quicker than assets ratio will decrease

- CL rise could be due to rise in payables (might be taking longer to pay supplier or funding growth through short term credit)

what factors could affect acid ratio

- assets, stock, liab

- if receivables and cash increase faster than CL, ratio will increase

what factors could affect receivables and payables

R

- how long are the customers taking to pay

- how long is the companies credit terms

P

- how long to pay supplier

- consider if they are using interest free supplier credit

what factors could affect gearing

- long term debt, equity

- if there is a higher gearing there is a higher reliance on debt

what should you always write about at the end of ratio analysis questions

non financial performance indicators

Benefits of ratio analysis

• Provides summary statistics.

• A simple tool for decision making for the businesses.

• Enables a comparison of:

✓ businesses of same/different sizes

✓ different periods for the same business

✓ different divisions within the same business

✓ the financial health of the business with its planned performance.

Limitations of ration analysis

• Lack of uniformity in definitions.

• Unrepresentative figures in the statement of financial position.

• Different accounting policies/standards.

• Open to misinterpretation.