Ratio Analysis
Liquidity
The word liquidity means the ability of a business to pay its debts as they are due for payment
Two ratios current ratio, quick asset
Current Ratio
The current ratio or the working capital ratio is a measure of the ability of a business to pay its short term debts, that is, debts payable within 12 months.
If the business had a current ratio of 155%, it has $1.55 of current assets to pay $1 of its current liabilities
Interpretation:
Current Ratio of less than 100%: The business may find it difficult to pay its short term debts or the business is operating in an industry in which money is collected from sales very quickly. Examples, Coles and Woolworths.
Current Ratio of between 100% and 200%: A current ratio of between 100% and 200% indicates that a business should be able to pay its short term debts.
Current Ratio of more than 200%. A current ratio of more than 200% indicates that a company should be able to comfortably pay its short term debts or that a company has an excessive level of current assets and is not making the best use of its resources to generate revenue.
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Quick Asset Ratio
The quick asset ratio is a measure of the ability of a business to pay its short term debts (excluding any bank overdraft) using only its more liquid current assets
If the business had a current ratio of 85%, it has $0.85 of highly liquid current assets to pay $1 of its current liabilities except for the bank overdraft.
Interpretation
A quick asset ratio of 100% or more indicates that a business should be able to pay its short term debts.
A quick asset ratio of less than 100% indicates that a business may not be able to pay its short term debts.
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Stability
A business can purchase assets using borrowed money, share capital or form the cash generated from the profit
Stability ratios measure the medium to long term survival prospects of a business based on the extent of the borrowings of that business.
Gearing or leverage is the term used to describe the extent of the borrowings of a business. A highly geared business has a large interest and loan repayments and has an increased risk of failure.
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Debt to Equity Ratio
Measures the debt to equity ratio of the gearing of the business
Total liabilities/Equity
Interpretation:
There is no acceptable figure for the debt to equity ratio. It should be compared with industry averages and past performance. Generally, the higher the ratio, the worse off the business is due to liabilities increasing
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Times Interest Earned
The number of times that the interest of a company is covered by the profit before tax.
Interpretation
Anything within 3-4 times offer a good safety margin for a company
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Profitability Ratios
Profit Margin Ratio
Percentage of profit after income tax that is contained in each dollar of sales
Profit (after tax)/ Net Sales
The profit after tax is used as this is the profit available to the shareholders
Interpretation
An increase in the profit margin may be caused by:
A reduction in expenses
An increase in selling prices compared to cost of sales
Cheaper supplier of inventory has been found
A decrease in the profit margin may be caused by:
Expense increases that are not being fully passed on to consumers in the form of increased selling prices
Increase competition causing the business to lower its selling prices
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Rate of Return on Assets
The rate of return on assets measures how efficiently a business has used its assets to generate a profit
Interpretation
Should be compared to industry standards. Bigger number better.
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Market Ratios
Market ratios are used by investors to review the performance of public companies listed on the ASX
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Earnings per Ordinary Share
The portion of the company’s annual profit after tax and preference dividends allocated to each issued ordinary share.
Interpretation
Should be compared to past profits and other companies. Bigger number better.
Price Earnings Ratio
The number of times earnings per ordinary share that an investor is prepared to pay to purchase an ordinary share in the company.
Interpretation
A high price earnings ratio (compared to industry average) indicates investors believe good future economic growth or is overconfident
A low price earnings ratio indicates that investors believe the company has poor profit growth prospects or is underconfident.
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Dividend Yield
Shows how much a company has paid out in dividends in a year relative to its share price
Interpretation
Just how much return on profit it can generate
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Efficiency ratio
Evaluate the performance of the management of a company in the areas of inventory and accounts receivable
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Debtors Collection Period
Measures how quickly a business collects the money owing from credit sales.
Interpretation
An increase in the debtors collection may be caused by:
Poor debt collection procedures
The slow process of sales invoice.
Failing to check credit rating of new customers
A business may offer longer credit terms to potential customers
A decrease in this ratio would indicate it has improved
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Inventory Turnover
How many times a business each year replaces its inventory.
Interpretation
An increasing inventory turnover ratio mean that the products sold by the company are doing well
A decreasing inventory turnover ratio indicates the inventory management policy is inefficient, out of they over ordered inventory or slow moving/obsolete inventory
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Limitations of Ratio Analysis
Ratios do not identify the causes of problems.
Ratios are usually only of limited value. They often need to be compared to an industry average.
Limited disclosure of information makes it impossible to calculate some ratios
It is not always possible to compare ratios between businesses as different accounting policies may have been chosen that will affect ratio calculations
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Diversification of Investment
A rule of thumb is not to put all your eggs in one basket
This is to offset any potential fluctuations