3.3.5.2 Ratio Analysis

Define ratio analysis

a quantitative method of gaining insight into a company's liquidity, operational efficiency, and profitability by studying its financial statements such as the balance sheet and income statement

Profitability, liquidity and gearing ratios

How does a ratio analysis for a more meaningful analysis of published accounts?

• Shows relationship between figures

• Used for comparisons over time

Define inter business comparisons

Inter means between businesses e.g. to compare performance to competitors or to benchmark

Define intra business comparisons

Intra means within a business e.g. over time within one organisation or between branches

Define Gross Profit Margin

a measure of a firm’s profitability by looking at the relationship between gross profit and sales revenue

What is indicated through a low GPM?

• is not managing its cost of sales effectively e.g. are the cost of raw materials increasing?

• sales are in decline

How is gross profit margin calculated?

Gross profit/sales rev x 100

Define Operating Margin Profit

a measure of a firm’s profitability by looking at the relationship between operating profit and sales revenue

What is indicated through a low OPM?

• is not managing its expenses effectively e.g. wages are increasing or overheads are going up

• sales are in decline

How is OPM calculated?

Operating profit / sales rev x 100

Define profit of the year margin

a measure of a firm’s profitability by looking at the relationship between profit for the year and sales revenue

What is indicated through a low profit for the yr margin?

• gross profit or operating profit are in decline

• interest rates have changed

• taxation rates have changed

How do you calculate profit for the year margin?

Profit for the year / sales rev x 100

What is the capital employed figure normally comprised of?

• Share capital + Retained Earnings + Long-term borrowings

• Equity + Non-current liabilities

• Total assets - current liabilities

Give features of gearing ratios

• Measures what proportion of a business’ capital is funded through long term loans

• Loans are “compulsory interest bearing” i.e. you have to pay interest on them even if profits are low or non-existent

• A highly geared business is of greater risk if interest rates are likely to increase

How do you calculate gearing ratio?

Non-current liabilities / capital employed (total equity + non-current liabilities) x 100

Give features of profitability

• Return on Capital Employed (ROCE)

  • A measure of how efficiently a business is using capital employed to generate profits

  • Capital employed = total equity + non-current liabilities i.e. all the money invested in the business from:

    • Share capital

    • Reserves

    • Long term loans

What is the formula for ROCE?

Operating profit / capital employed x 100

(Total equity + non-current liabilities)

Give features of the value of financial ratio when assessing performance

• Value

  • Provides a tool for the interpretation of accounts

  • Structure from which comparisons can be made

    • Overtime

    • With other businesses

  • Aids decision making

    • Internally

    • Externally by investors

• Limitation

  • Possibility that accounts have been window dressed

  • Source of the data

  • Need to consider reasons behind ratios

    • e.g. is ROCE lower than previous years because of an investment programme

  • Quantitative information only