Comprehensive Ratio Analysis Study Notes

RATIO ANALYSIS

Definition of Ratio Analysis

  • Ratio analysis is a quantitative measure of information contained in an entity's financial statements.

  • Used for comparative purposes and to measure various aspects of the entity's financial position and performance.

  • The information may be utilized by various stakeholders, including:

    • Management

    • Owners

    • Investors

    • Creditors

    • Banks and other Financial Institutions

    • Employees

    • Government Regulatory Authorities

  • Results may be expressed in two main forms:

    • Percentages, e.g., 200%

    • Ratios, e.g., 2.0:1.0

Purpose of Ratios

  • Percentages and ratios assist decision-makers in interpreting financial reports in various areas, such as:

    • Profitability

    • Effectiveness of Management Policies

    • Financial Stability

    • Cash Flows

Benchmarking for Decision Making

  • For ratios to be useful in decision-making, they must be compared with benchmarks, including:

    • Industry Averages: Evaluating performance against other businesses offering similar products or services.

    • Previous Accounting Periods: Comparing the same business's financial results over different periods to assess performance and stability changes.

    • Budgeted Amounts: Comparing actual figures with projected ones to gauge performance relative to expectations.

Types of Financial Ratios

1. Liquidity Ratios

  • Measure how easily assets can be converted into cash during normal business operations and the ability to pay debts as they fall due.

  • Key liquidity ratios include:

    • Current Ratio (or Working Capital Ratio)

    • Quick Asset Ratio

2. Leverage Ratios

  • Assess the way a business has financed its assets, indicating whether it relies on owners' resources (equity) or borrowed funds (debt).

  • A primary leverage ratio is:

    • Debt to Equity Ratio

3. Profitability Ratios

  • Evaluate a business's ability to control expenses and earn a profit.

  • Key profitability ratios include:

    • Profit (or Profit Margin) Ratio

    • Gross Profit Ratio

    • Expense Ratio

    • Return on Assets Ratio

Profitability Ratios Explained

Profit (or Profit Margin) Ratio

  • Represents the percentage of profit (after tax) per dollar of sales.

  • Formula:

    • Profit Ratio = racProfitext(AfterTax)imes100NetextSalesrac{Profit ext{ (After Tax)} imes 100}{Net ext{ Sales}}

    • Example:

    • Profit ext{ Ratio} = rac{21,000 imes 100}{150,000} = 14 ext{%}

    • Interpretation: For every $1 of sales, there is a profit of 14 cents after tax.

Interpretation of the Profit Ratio

  • Increase in Profit Ratio: Generally indicates that profit earned has increased relative to total sales, potentially due to:

    • Reduction in expenses

    • Increase in selling prices

    • Reduction in costs of sales

  • Decrease in Profit Ratio: Indicates that profit earned has decreased relative to total sales, potentially due to:

    • Increase in expenses without passing costs to consumers

    • Increased competition necessitating lower selling prices

    • Increase in cost of sales

Suggested Strategies for Improvement

  • Increase average selling prices

  • Reduce operating expenses

  • Seek less expensive suppliers for inventory

Gross Profit Ratio

  • Indicates the percentage of profit the business earns from the sale of stock or inventory.

  • Formula:

    • Gross Profit Ratio = racGrossextProfitimes100NetextSalesrac{Gross ext{ Profit} imes 100}{Net ext{ Sales}}

    • Example:

    • Gross ext{ Profit Ratio} = rac{60,000 imes 100}{150,000} = 40 ext{%}

    • Interpretation: For every $1 of sales, there is a gross profit of 40 cents.

Interpretation of Gross Profit Ratio

  • Increase in Gross Profit Ratio: Typically indicates increased profit from sales, often due to:

    • Higher selling prices

    • Increase in high-profit product sales

    • Reduced cost of sales through cheaper suppliers

  • Decrease in Gross Profit Ratio: Indicates reduced profit from sales relative to total sales, potentially caused by:

    • Selling a higher proportion of lower profit items

    • Increased competition requiring price reductions

    • Rise in cost of sales

Expense Ratio

  • Indicates the amount of sales needed to cover expenses (selling, distribution, general and administrative).

  • Formula:

    • Expense Ratio = racExpensesext(exc.CostofSales)imes100NetextSalesrac{Expenses ext{ (exc. Cost of Sales)} imes 100}{Net ext{ Sales}}

    • Example:

    • Expense Ratio = rac{39,000 imes 100}{150,000} = 26 ext{%}

    • Interpretation: For every $1 of sales, 26 cents are incurred in expenses.

Interpretation of Expense Ratio

  • Increase in Expense Ratio: Indicates expenses are growing faster than total sales, potentially due to:

    • Extraordinary expenses

    • Higher expenses with stagnant or decreasing sales

  • Decrease in Expense Ratio: Indicates expenses decline relative to total sales, potentially due to:

    • Expenses growing slower than sales

    • Lower expenses coinciding with stable or growing sales

Rate of Return on Assets Ratio

  • Measures how efficiently a business utilizes its assets to generate profit.

  • Formula:

    • Return on Assets = racProfitext(BeforeTax)+InterestextExpenseimes100AverageextTotalAssetsrac{Profit ext{ (Before Tax)} + Interest ext{ Expense} imes 100}{Average ext{ Total Assets}}

    • Average Total Assets = racTotalextassetsfrompreviousyear+Totalextassetsfromcurrentyear2rac{Total ext{ assets from previous year} + Total ext{ assets from current year}}{2}

Interpretation of Return on Assets Ratio

  • Should be compared to historical performance or industry averages.

  • High Ratio: Suggests effective asset utilization for profit generation.

  • Low Ratio: Indicative of poor performance in utilizing assets.

  • Factors impacting ratio:

    • Increase: Due to rising sales, expense reduction, or more efficient use of total assets.

    • Decrease: Due to declining sales, increased expenses, or less efficient use of total assets.

Suggested Strategies for Improvement

  • Enhance profitability through increased sales and tight expense control

  • Optimize use of non-current assets; sell or maximize productivity of idle assets.

Liquidity Ratios

Definition

  • Assess a business's ability to convert assets into cash during operations and pay off debts as they become due.

  • Key liquidity ratios include:

    • Current Ratio

    • Quick Asset Ratio

Current Ratio

  • Measures the ability to pay short-term debts with current assets.

  • Formula:

    • Current Ratio = racCurrentextAssetsimes100CurrentextLiabilitiesrac{Current ext{ Assets} imes 100}{Current ext{ Liabilities}}

    • Example:

    • Current ext{ Ratio} = rac{60,000 imes 100}{35,000} = 171 ext{%}

    • Interpretation: $1.71 of current assets is available for every $1.00 of current liabilities.

Interpretation of Current Ratio

  • Less than 100%: Indicates difficulties in paying short-term debts.

  • Between 100% and 200%: Should suffice for short-term debts.

  • More than 200%: Indicates excess current resources, though may signal inefficiency in resource use.

Suggested Strategies for Improvement

  • Enhance debtor repayment speed via tighter credit policies

  • Increase stock turnover to generate cash and improve liquidity

  • Renegotiate short-term loans into long-term debt where applicable

Quick Asset Ratio

  • Measures ability to meet immediate debts with liquid assets.

  • Formula:

    • Quick Asset Ratio = racCurrentextAssetsext(excludingInventoryandPrepaidExpenses)imes100CurrentextLiabilitiesext(excludingBankOverdraft)rac{Current ext{ Assets ext{ (excluding Inventory and Prepaid Expenses)}} imes 100}{Current ext{ Liabilities ext{ (excluding Bank Overdraft)}}}

    • Example:

    • Quick ext{ Asset Ratio} = rac{17,000 imes 100}{15,000} = 113 ext{%}

    • Interpretation: $1.13 of liquid assets available to repay every $1 of current liabilities.

Interpretation of Quick Asset Ratio

  • Greater than 100%: Suggests ability to pay short-term debts.

  • Less than 100%: Indicates potential difficulties in meeting obligations.

Suggested Strategies for Improvement

  • Enhance current assets via increased sales and diligent expense management

  • Tighten credit control to decrease bad debts and improve receivable collection

Leverage Ratio (Debt to Equity)

Definition

  • Leverage (or gearing) indicates the extent of business borrowing, which entails the risk of elevated interest and loan repayments.

  • The Debt to Equity Ratio is a primary metric:

    • Debt to Equity = racTotalextLiabilitiesimes100TotalextEquityrac{Total ext{ Liabilities} imes 100}{Total ext{ Equity}}

    • Where: Total Equity = Total Assets - Total Liabilities

Interpretation of Debt to Equity Ratio

  • High Ratio: Indicates firm may struggle with high external borrowings (highly geared).

  • Low Ratio: Suggests minimal external borrowings, easily manageable (lowly geared).

  • Increasing Ratio: Could arise from more borrowing, which can be positive if financing growth leads to higher profits.

  • Decreasing Ratio: May arise from loan repayments or retained profits, suggesting reduced risk but potentially slower growth due to less available capital for expansion.

Acceptable Ratios

  • Ratios vary by business size; small businesses might aim for a maximum of 70%, while larger firms could operate effectively with ratios between 100% and 200%.

Suggested Strategies to Reduce the Debt to Equity Ratio

  • Reinvest profits back into the business

  • Decrease owner's withdrawals

  • Contribute additional capital

  • Opt for external financing with lower interest rates

Structuring a Ratio Response

  • Numerical Commentary: Provide the specific ratio change (e.g., “The return on assets ratio has increased from 10% to 15%”).

  • Explanatory Analysis: Explain the underlying drivers and implications (e.g., “Total assets increased by $x amount, while profit rose proportionally faster due to increased sales and/or cost reductions, indicating more effective asset utilization for profit generation”).

  • Strategies for Improvement: If applicable, recommend strategies (e.g., “Despite improvement, disposing of non-productive assets and controlling expenses are advisable”).

Limitations of Ratio Analysis

  • Ratios alone do not convey meaningful information without comparison to:

    • Previous accounting periods

    • Competitors and similar businesses

    • Industry averages or established benchmarks

  • Ratios typically require multiple years of calculation before patterns emerge.

  • Ratios do not pinpoint specific problems; changes can stem from various causes that may remain unidentified.

  • Manipulation of ratios is a risk.

  • Comparability of firms may be compromised due to factors like size, product line diversification, and varying financial or business risks.

  • Ratio analysis is grounded in historical data, which may not predict future performance if the business or economic context shifts.

  • Ratios based on historical cost might become misleading if not adjusted for factors like inflation, technological changes, or alterations in asset values, impacting trends and comparisons between firms.