Ratio Analysis Notes

Analysing and Interpreting Financial Statements

Objective: Provide relevant and timely information for decision-making.
Users: Bankers, creditors, investors rely on these statements.
Financial analysis consistently involves comparison.

Financial Ratios

Describe financial condition, efficiency, profitability, and investor perception.
Indicate an organization's past, present, and possible future.
Focus on trends in ratio measurement rather than absolute values.

Contextualizing Financial Information

Financial statements offer quantitative data for assessing performance and risk.
Ratio analysis compares financial data to benchmarks.

Benchmarks for Ratios

Pre-determined targets.
Ratios of similar companies.
Average ratios for the business sector.
Ratios from previous years.
Analytical methods and ratios can compare financial performance over time or to other companies.

Categories of Ratios

Profitability: How well is the firm employing its funds and controlling costs?
Efficiency: How well is the firm managing day-to-day operations?
Liquidity: Can the firm meet its short-term commitments?
Financing & Investment: Can the firm meet its long-term commitments? What return is it generating for investors?

Profitability Ratios

Asset Turnover ratio
Gross profit margin
Operating profit margin
Net profit margin
Return on Equity (ROE)
Return on Assets (ROA)
Return on Capital Employed (ROCE)

Asset Turnover Ratio

Measures how effectively a company uses its assets.
Formula: $Asset Turnover = \frac{Sales}{Average Total Assets (excluding long-term investments)}$

Gross Profit Margin

Indicates income sensitivity to price changes or changes in cost structure.
Formula: $Gross Profit Margin = \frac{Gross Profit}{Sales} * 100\%$

Operating Profit Margin

Represents how efficiently a company generates profit through core operations.
Formula: $Operating profit margin = \frac{operating profit}{sales or revenue} * 100\%$

Net Profit Margin

Measures how much profit a company makes as a percentage of its revenue.
Formula: $Net profit margin = \frac{net profit}{sales or revenue} * 100\%$

Return on Equity (ROE)

A gauge of a corporation's profitability and efficiency in generating profits.
Formula: $Return on Equity = \frac{Net Profit}{Total Equity} * 100\%$

Return on Assets (ROA)

Indicates how much profit a company generates from its assets.
Formula: $Return on Assets = \frac{Net Profit}{Total Assets} * 100\%$

Return on Capital Employed (ROCE)

Measures a company’s profitability in terms of all of its capital.
Formula: $Return on Capital Employed = \frac{Profit before interest and tax}{Total Equity + Long term liability} * 100\%$

Liquidity Ratios

Working capital
Current ratio
Quick ratio

Working Capital

Measures a company’s liquidity and short-term financial health.
Formula: $Working Capital = Current Assets – Current Liabilities$

Current Ratio

Compares a company’s assets to its current liabilities.
Formula: $Current ratio = \frac{Current Assets}{Current Liability}$

Quick Ratio

Measures a company’s capacity to pay its current liabilities without selling inventory.
Formula: $Quick ratio = \frac{Current Assets - Inventory}{Current Liability}$

Efficiency Ratios

Receivable Turnover rate
Receivable collection period
Inventory Turnover rate
Inventory holding period
Payable Turnover rate
Payable payment period
Cash conversion cycle (working capital cycle)

Receivable Turnover Rate

Measures the efficiency of collecting receivables.
Formula: $Receivable Turnover rate = \frac{sales}{receivables}$

Receivable Collection Period

Indicates the effectiveness of account receivable management.
Formula: $Receivable collection period = \frac{Receivable}{sales} * 365 = \frac{365}{Rececivable Turnover rate}$

Inventory Turnover Rate

Measures how efficiently a company uses its inventory.
Formula: $Inventory Turnover rate = \frac{Cost of sales}{Inventory}$

Inventory Holding Period

Shows how long it takes to process raw materials and sell finished goods.
Formula: $Inventory holding period = \frac{Inventory}{Cost of sales} * 365 = \frac{365}{Inventory Turnover rate}$

Payable Turnover Rate

Quantifies the rate at which a company pays its short-term obligations.
Formula: $Payable Turnover rate = \frac{Cost of sales}{Payables}$

Payable Payment Period

Computes the average days a company needs to pay its bills.
Formula: $Payable payment period = \frac{Payable}{Cost of sales} * 365 = \frac{365}{Payable Turnover rate}$

Cash Conversion Cycle

Expresses the number of days it takes to convert inventory into cash flows.
Formula: $Cash conversion cycle = Inventory holding period + Receivable collection period - Payable payment period$

Financing & Investment Ratios

Earnings per share
Price earnings ratio
Interest cover ratio
Gearing ratio
Dividend yield
Dividend payout ratio

Earnings Per Share (EPS)

Indicates how much money a company makes for each share of its stock.
Formula: $Earnings per share = \frac{Net profit}{Number of share issued}$

Price Earnings Ratio (P/E)

Formula: $P / E ratio = \frac{Share price}{Earnings Per Share}$

Interest Cover Ratio

Measures how well a firm can pay interest on outstanding debt.
Formula: $Interest cover ratio = \frac{Profit before interest and tax}{Interest expense}$

Gearing Ratio

Assesses the company's leverage and financial stability.
Formula: $Gearing ratio = \frac{Long term liability}{Long term liability+Equity} * 100\%$

Dividend Yield

The amount of money a company pays shareholders for owning a share of its stock divided by its current stock price.
Formula: $Dividend yield = \frac{Dividend per share}{share price}$

Dividend Payout Ratio

The proportion of earnings paid to shareholders as dividends.
Formula: $Dividend payout ratio = \frac{Dividend}{Net profit} * 100\%$

Steps in Ratio Analysis

Observation: Identify the figures you need
Calculation: Calculate the ratios you need to analyse
Analysis: Put into context i.e. compare with previous years, other companies
Interpretation: Conclude firm performance from the ratios