Ratio analysis

what is ratio analysis

a technique for assessing the financial health of a business

what benchmarks can we use in ratio analysis

• past period- detect trends, see any changes

• budgets- seeing how performance compares with expectation

• other businesses/industry figures- comparing competition

• investor requirements- could set minimum targets

return on ordinary shareholder funds (ROSF) equation

net profit after tax / average ordinary share capital and reserves x 100

what does ROSF show

return to the owners as a percentage of the money they have invested in the company Want this to be as high as possible

return on capital employed equation

operating profit / capital employed x 100

what does ROCE show

the relationship between operating profit and long term investments in the business

gross profit margin equation

gross profit / sales revenue x 100

operating profit margin equation

operating profit / sales revenue x 100

inventory turnover equation

inventory / cost of sales x 365

what does inventory turnover show

on average how long inventory is being held for before it is sold

what could high inventory turnover mean

possible stock outs

what could low inventory turnover show

inefficiency

trade receivables days equation

trade receivables / credit sales revenue x 365

what does trade receivables days show

how long before we receive money back from a customer who has purchased on credit

trade payables days equation

trade payables / credit purchases x 365

what could high trade payables days show

possible payment problems, suppliers may refuse to supply

what could low trade payables days show

poor use of ‘free’ credit

sales revenue to capital employed (SRCE) equation

sales revenue / capital employed x 100

current ratio equation

current assets / current liabilities in the form X:1

acid test ratio equation

(current assets-inventory) / current liabilities in the form X:1

what could low quick ratio indicate

liquidity problems

what could high quick ratio indicate

poor use of resources

what is gearing

a measurement of what proportion of the entity is financed by borrowings

how can companies be financed

• share capital and reserves

• long term borrowings

what does high gearing indicate

high risk since interest bust be oaud and borrowings must be repaid when due

gearing ratio equation

non current liabilities / capital employed x 100

debt/equity ratio equation

non current liabilities / equity x 100

interest cover equation

operating profit / interest payable

what does interest cover measure

the company’s ability to pay its interest by comparing operating profit with interest cost

dividend cover equation

earnings for year available for dividends / dividends for the year

how do you find earnings available to ordinary shareholders

profit after tax minus preference dividends

earnings per share equation

earnings available to ordinary shareholders / number of ordinary shares in issue

price/earnings ratio equation

market value per share / earnings per share

what are the limitations of ratio analysis

• usually use historical cost figures, not a good indicator for future performance

• not useful in isolation- comparison is needed

• depend on the conventions underlying accounting figures which could affect consistency

• certain ratios may not be relevant depending on the company

• group accounts may distort analysis since results are of the combined entity