Section M - Ratio Analysis

The Analysis of Financial Statements - Ratios

Section Overview

  • Learning Outcome: Understand and calculate various accounting ratios.

    • Ratios to cover: ROCE, gross profit margin, profit margin, inventory turnover, days’ sales in trade receivables, current ratio, acid test ratio, and gearing ratio.

Introduction to Accounting Ratios

  • Objectives: By the end of this module, students should be able to:

    • Identify various accounting ratios businesses use.

    • Explain the significance of these ratios.

    • Calculate and interpret different accounting ratios.

Reading Materials

  • Chapter 36: Introduction to Ratio Analysis and Liquidity Ratios (Pages 263 – 265).

  • Chapter 37: Gearing Ratios (Pages 266 – 268).

  • Chapter 38: Efficiency Ratios (Pages 269 – 272).

  • Chapter 39: Profitability Ratios (Pages 273 – 275).

Overview of Ratio Analysis

  • Understanding Financial Statements:

    • Financial accounts carry important messages that require interpretation.

    • Ratio analysis serves as a tool to decode these messages.

Definitions and Importance of Ratios

  • What are Ratios?

    • Ratios are calculations that compare accounting figures over time.

    • It involves one number expressed as a percentage of another, often derived from financial statements.

  • Sources of Calculation: Primarily derived from the Income Statement and Statement of Financial Position.

Ratio Analysis

  • Purpose: To examine relationships between accounting figures to evaluate organizational performance.

  • User Base: Information primarily accessible to business owners and appointed accountants due to the private nature of sole trader and partnership accounts.

Four Main Categories of Ratios

  1. Profitability Ratios

  2. Liquidity Ratios

  3. Activity/Efficiency Ratios

  4. Gearing Ratios

  • Comparison: Generated figures should be compared to previous years and industry average/benchmarks.

Profitability Ratios

  • Definition: Measures the ability of a business to generate profit relative to expenses incurred.

    • Indicators of overall financial health and performance.

  • Gross Profit Margin:

    • Formula: (Gross Profit / Revenue) x 100.

    • Indicates profit from sales after deducting costs; improved by managing selling prices or costs.

  • Operating (Net) Profit Margin:

    • Formula: (Operating Profit / Revenue) x 100.

    • Reflects profitability after deducting all operational expenses; improved by enhancing revenue or reducing expenses.

  • Return on Capital Employed (ROCE):

    • Formula: (Operating Profit / Capital Employed) x 100.

    • Assesses profit generated versus capital investments; higher values are desirable.

Ways to Improve Profit Margins

  • Reduce direct costs: Use cheaper materials, outsource labor.

  • Increase product prices as needed.

  • Lower overhead costs through efficient property management.

Limitations

  • Potential damage to product quality affecting reputation.

  • Price elasticity leading to customer shifts to alternatives.

  • Possible reduced sales from cutting promotions.

Liquidity Ratios

  • Definition: Assess the organization's ability to meet short-term liabilities.

    • Focus on immediate assets and liabilities.

  • Current Ratio:

    • Formula: Current Assets / Current Liabilities.

    • Ideal ratio: 1.5:1 or 2:1.

  • Acid Test Ratio:

    • Formula: (Current Assets - Inventory) / Current Liabilities.

    • Ideal ratio: 1:1.

Limitations of Liquidity Ratios

  • Variations in industries may affect interpretation

  • Vital for creditors to assess repayment safety but can misrepresent realities in unique business contexts.

Financial Efficiency Ratios

  • Purpose: Evaluate how effectively a company utilizes its resources; critical for good cash flow.

  • Key Ratios to Know: Inventory Turnover Ratio, Days' Sales in Accounts Receivables.

Inventory Turnover Ratios

  • Inventory Turnover Ratio (Days):

    • Formula: (Inventory / Cost of Sales) x 365.

    • Measures average duration for inventory utilization.

  • Days’ Sales in Accounts Receivable:

    • Formula: (Trade Receivables / Revenue) x 365.

    • Indicates average time taken to collect debts from customers.

Improvement Strategies for Efficiency

  • Manage inventory to avoid excess holding time.

  • Shorten customer payment terms for better cash flow management.

Limitations of Efficiency Ratios

  • May vary considerably across different industries.

Gearing Ratios

  • Definition: Reflects the degree of financial risk by comparing long-term debt against total capital.

    • More than 50% indicates high-risk positioning.

    • 2 or 5 is bad because it means the business isn’t expanding

  • Formula: (Non-current Liabilities / Capital Employed) x 100.

  • Management Strategies:

    • Increase gearing: Repurchase shares.

    • Decrease gearing: Issue shares, retain profits, repay loans.

Capital Employed Formula

  • Capital Employed = Non-current liabilities + Shareholders’ equity.

Conclusion

  • Many ratios play a role in assessing organizational performance, but should not be considered in isolation.

  • Ratios serve as a starting point for comprehensive financial statement interpretation.