FINANCIAL RATIO ANALYSIS.

Introduction

Ratio analysis is an accounting tool, which can be used to measure the solvency, the
profitability, and the overall financial strength of a business, by analysing its financial accounts
(specifically the balance sheet and the profit and loss account).

Accounting ratios are very easy to calculate and they enable a business to highlight which areas
of its finances are weak and therefore require immediate attention.

There are five main categories of accounting ratio:

1. Liquidity ratios, these measure the solvency of the business and its ability to meet short-
term debts.
2. Profitability (or 'performance') ratios, these analyse the profit made over the last year.
3. Financial efficiency (or 'activity') ratios, these analyse the efficiency of the business in
terms of the use of its resources in generating sales.
4. Gearing ratio, this measures the proportion of the capital of the business which has
come from external sources, and must be repaid with interest.
5. Shareholders' ratios, these measure the strength of the company, its share price and its
dividends.

Liquidity Ratios

There are two main ratios that can be used to measure the liquidity of a business:

1. The current ratio

2. The 'acid-test' ratio

The current ratio

The current ratio. This measures current assets as a proportion of current liabilities. It is
calculated using the following formula:

For example, if a business has current assets of shs250,000 and current liabilities of shs180,000,
then the current ratio would be:

This means that for every shs1 of current liabilities, the business has shs1.39 of current assets
available. Ideally, the answer should be between 1.5 and 2. A figure less than 1.5 indicates that
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the business may experience difficulties in meeting its short-term debts (i.e. a liquidity crisis).
An answer of more than 2 indicates that the business may be holding cash in an unproductive
and unprofitable form, and it may be better used elsewhere.

The acid test ratio

The 'acid-test' ratio. This measures current assets less stock as a proportion of current
liabilities. It is calculated using the following formula:

Stock is excluded because a business may not be able to convert it into cash quickly. For
example, if a business has current assets less stock of shs150,000 and current liabilities of
shs180,000, then the current ratio would be:

This means that for every shs1 of current liabilities, the business has shs0.83 of cash available at
short-notice. Ideally, the answer should be between 1 and 1.2. A figure less than 1 indicates that
the business may experience difficulties in meeting its short-term debts (i.e. a liquidity crisis).
An answer of more than 1.2 indicates that the business may be holding cash in an unproductive
and unprofitable form, and it may be better used elsewhere.

Profitability Ratios

There are three main ratios that can be used to measure the profitability of a business:

1. The gross profit margin.

2. The net profit margin.
3. Return on Capital Employed (R.O.C.E).

The gross profit margin

This measures the gross profit of the business as a proportion of the sales revenue. It is calculated
using the following formula:

For example, if a business has gross profit of shs4 million and sales revenue of shs6 million,
then the gross profit margin would be:

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This means that for every shs1 of sales revenue, shs0.67 remains after all direct expenses have
been deducted. This money then contributes towards covering the other expenses of the business.

The business would want this margin to be as high as possible, since a high margin will leave
more profit for covering the remaining expenses and, if the business is a 'company', for covering
the dividend payments to shareholders.

The net profit margin

This measures the net profit of the business as a proportion of the sales revenue. It is calculated
using the following formula:

For example, if a business has net profit of shs1 million and sales revenue of shs6 million, then
the net profit margin would be:

This means that for every shs1 of sales revenue, 16.7 pence remains after all direct and indirect
expenses have been deducted. This money then contributes towards covering the corporation tax
that must be paid on profits to the Inland Revenue and, if the business is a 'company', covering
the dividend payments to shareholders.

Any profit which remains is kept in the business for re-investment and is called 'retained profit'.
Again, the business would want this margin to be as high as possible, allowing both large
dividend payments to shareholders and a significant amount of profit to be retained for growth.

Return on Capital Employed (R.O.C.E)

This is often referred to as the 'primary accounting ratio' and it expresses the annual percentage
return that an investor would receive on their capital. It basically relates the profit to the size of
the business and it is calculated using the following formula:

For example, if a business had a net profit of shs2.2m and a capital employed of shs7.6m, then
the Return on Capital Employed figure would be:

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This means that for every shs1 of capital invested in the business, the annual return would be
28.9 pence. Capital employed is equal to shareholders' funds plus long-term liabilities, and it is
the final line in the balance sheet (remember that it is the same value as 'assets employed').

Clearly an investor would like to receive as high a R.O.C.E. as possible, although the figure
would need to be compared to last year's return, to competitors' returns and to the returns on
other investments.

Financial Efficiency Ratios

There are three main ratios that can be used to measure the financial efficiency of a
business:

1. The asset turnover ratio.

2. The stock turnover ratio.
3. The debtor days ratio.

The asset turnover ratio

This measures the productivity of the business (i.e. how many pounds worth of sales revenue can
be generated from the assets employed?). It is calculated using the following formula:

For example, if a business has sales revenue of shs8 million and net assets of shs5 million, then
the asset turnover ratio would be:

This means that for every shs1 of net assets, the business generates shs1.60 of sales revenue.
Clearly the higher the answer, the better. It is normal for service industries (e.g. supermarkets) to
have a much higher asset turnover ratio than manufacturing industries, since service industries
generate very high sales in relation to their net assets.

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The stock turnover ratio

This measures the number of times in a 12-month period that a business sells its stock. It is
calculated using the following formula:

For example, if a business has a 'cost of goods sold' figure of shs2 million and an average 'stock'
figure of shs0.5 million, then the stock turnover ratio would be:

This means that the business would turn its stock over (i.e. sell the lot and order some more) four
times per year, or every 91 days on average. However, care must be taken when comparing the
stock turnover ratios of different businesses, since a supermarket, for example, is likely to have a
much higher stock turnover (especially for vegetables, fruit and other perishables) than a retailer
such as 'Dixons' (for televisions, washing machines, etc).

The debtor days ratio

This shows how long, on average, a business takes to collect the debts owed to it by customers
who have purchased their goods on credit. It is calculated using the following formula:

For example, if a business had debtors of shs1.2m and a sales turnover of shs9.1m, then the
debtor days figure would be:

This means that, on average, it takes the business 48 days to collect its trade debts. This may be
due to a poor debt-collection system, or it may be due to the fact that it allows customers a
number of weeks before payment is due as part of its marketing strategy.

Ideally, the sooner the business receives all the cash from sales revenue, the better, since it can
be used to boost the day-to-day capital (working capital) that is available to pay bills, etc.

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The Gearing Ratio

This measures the proportion of capital employed (i.e. the value of the business) which is funded
by long-term liabilities (i.e. the proportion of the value of the business which is interest-bearing
debt). It is calculated using the following formula:

For example, if a business had long-term liabilities (loans, mortgages and debentures) totalling
shs3.5 million, and a 'capital employed' figure of shs8.3 million, then its gearing ratio would be:

An answer of more than 50% indicates that the business is 'highly geared', since it has to make
large monthly debt repayments. This can become a problem (especially if the economy heads
into a recession or the industry goes into decline) because the business will still have to make its
monthly repayments, even though its cash inflows may be deteriorating.

A business with a gearing ratio of less than 50% is said to have 'low gearing', since its monthly
debt repayments do not form a significant proportion of its monthly outgoings.

Shareholders Ratios

There are five main ratios that can be used by shareholders in order to assess the worth of
a particular company and their shares:

1. Earnings per share (E.P.S).

2. Price/ Earnings (P/E) ratio.
3. Dividend per share.
4. Dividend yield.
5. Dividend cover.

Earnings per share (E.P.S)

This measures the company's potential dividends that it could pay to shareholders. It is calculated
using the following formula:

For example, if a company has profit after tax of shs12m and it has issued 40 million ordinary
shares, then its E.P.S. would be:

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This means that every ordinary share could pay a dividend of 30 pence IF all the profit after tax
is distributed as dividends. However, it is most likely that some of the profit after tax will be kept
in the company for re-investment (this is called retained profit).

Clearly the shareholders would want as much of the profit after tax as possible to be payable to
themselves.

Price Earnings (P/E) ratio

This measures the market price of the share as a proportion of the earnings per share calculated
above. It is calculated using the following formula:

For example, if the current market price for a company's share is shs1.50, and the earnings per
share is 30 pence, then the P/E ratio would be:

This answer indicates that it would take an investor 5 years to recover the cost of the share. This
figure would need to be compared to other companies' P/E ratios before a judgement could be
made.

In general, the higher the P/E ratio, then the better the expectations of the company's future
profitability. However, the share price of the company is likely to fluctuate frequently, and
therefore the P/E ratio of the share will not be the same for very long - this can make it difficult
to compare the P/E ratio with other companies.

Dividends per share

This measures the size of the dividends that the company actually pays to its shareholders. It is
calculated using the following formula:

For example, if a company has profit after tax of shs12m (and issues 25% of this as dividends)
and it has issued 40 million ordinary shares, then its dividend per share would be:

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This means that every ordinary share would pay a dividend of 7.5 pence. The remaining shs9m
of profit after tax would be retained for future investment. Clearly, the shareholders would want
the dividend per share to be as high as possible, in order to maximise their return on their
investment.

Dividend Yield

This shows the dividend per share expressed as a percentage of the market price of the share. It is
calculated using the following formula:

For example, if a company had a dividend per share of 7.5 pence, and a market price of shs1.50,
then the dividend yield would be:

This is not a very high return for the risk involved in investing money in shares. This figure
would need to be compared to other investments (e.g. other companies, banks, etc) to see if it is
providing a competitive return.

Dividend cover

This measures how many more times the dividends could have been paid out of the profit after
tax. It is calculated using the following formula:

For example, if a business had profit after tax of shs12m and it paid total dividends of shs3m,
then the dividend cover would be:

This means that the company did not pay the shareholders a significant proportion of the profit
after tax in the form of dividends - the company has actually only paid a quarter of their profit
after tax as dividends.

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This means that the company kept much of the profit after tax as retained profit for re-
investment.

Limitations to Ratio Analysis

There are many different groups of people (or stakeholders) who are interested in the accounts of
a company, including:

1. The management and the employees - to see if pay rises are likely, or to ensure that
their jobs are secure.
2. Creditors - to ensure that the business has the necessary money to repay them.
3. Potential lenders - to see if the business is solvent and profitable enough to repay any
loans.
4. The community - to ensure that jobs and services for the local community are assured.

Using financial ratios can assist these people in identifying the financial strengths and
weaknesses of a company, as well as indicating to the company itself those areas that need
corrective action.

However, ratio analysis does not provide a complete and exhaustive analysis of a company, and
there are several other factors that the stakeholders and the company will need to take into
account, in order to get the 'full picture' of its financial position:

 The state of the economy (i.e. if the economy is in a recession, then the ratios are more
likely to be unsatisfactory than if the economy is experiencing a 'boom').
 The performance of competitors (i.e. it may be the case that the industry is in decline,
in which case all the rival businesses are likely to be experiencing deteriorating ratios).
 Comparison year on year, The ratios for the business from the current year must be
compared to the ratios from previous years, in order to see any marked improvement or
deterioration in the financial performance.
 External factors. The financial ratios do not take into consideration any effects on the
local community or the environment (i.e. they ignore the effects of pollution, job losses,
etc). Therefore, in order to measure the performance of a business, factors other than
mere financial ratios need to be considered.

Financial ratios:

 are useful indicators of a firm's performance and financial situation. Most ratios can be
calculated from information provided by the financial statements. Financial ratios can be
used to analyze trends and to compare the firm's financials to those of other firms. In
some cases, ratio analysis can predict future bankruptcy.

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Financial ratios can be classified according to the information they provide. The following
types of ratios frequently are used:
 Liquidity ratios
 Asset turnover ratios
 Financial leverage ratios
 Profitability ratios
 Dividend policy ratios

Liquidity Ratios

Liquidity ratios provide information about a firm's ability to meet its short-term financial
obligations. They are of particular interest to those extending short-term credit to the firm. Two
frequently-used liquidity ratios are the current ratio (or working capital ratio) and the quick
ratio.

The current ratio is the ratio of current assets to current liabilities:

Current Assets
Current Ratio =
Current Liabilities

Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may
prefer a lower current ratio so that more of the firm's assets are working to grow the business.
Typical values for the current ratio vary by firm and industry. For example, firms in cyclical
industries may maintain a higher current ratio in order to remain solvent during downturns.
One drawback of the current ratio is that inventory may include many items that are difficult to
liquidate quickly and that have uncertain liquidation values. The quick ratio is an alternative
measure of liquidity that does not include inventory in the current assets. The quick ratio is
defined as follows:
Current Assets - Inventory
Quick Ratio =
Current Liabilities

The current assets used in the quick ratio are cash, accounts receivable, and notes receivable.
These assets essentially are current assets less inventory. The quick ratio often is referred to as
the acid test.

Finally, the cash ratio is the most conservative liquidity ratio. It excludes all current assets
except the most liquid: cash and cash equivalents. The cash ratio is defined as follows:

Cash + Marketable Securities

Cash Ratio =
Current Liabilities

The cash ratio is an indication of the firm's ability to pay off its current liabilities if for some
reason immediate payment were demanded.

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Asset Turnover Ratios

Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They sometimes are
referred to as efficiency ratios, asset utilization ratios, or asset management ratios. Two
commonly used asset turnover ratios are receivables turnover and inventory turnover.
Receivables turnover is an indication of how quickly the firm collects its accounts receivables
and is defined as follows:

Annual Credit Sales

Receivables Turnover =
Accounts Receivable

The receivables turnover often is reported in terms of the number of days that credit sales remain
in accounts receivable before they are collected. This number is known as the collection period.
It is the accounts receivable balance divided by the average daily credit sales, calculated as
follows:
Accounts Receivable
Average Collection Period =
Annual Credit Sales / 365

The collection period also can be written as:

365
Average Collection Period =
Receivables Turnover

Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in a time
period divided by the average inventory level during that period:

Cost of Goods Sold

Inventory Turnover =
Average Inventory

The inventory turnover often is reported as the inventory period, which is the number of days
worth of inventory on hand, calculated by dividing the inventory by the average daily cost of
goods sold:
Average Inventory
Inventory Period =
Annual Cost of Goods Sold / 365

The inventory period also can be written as:

365
Inventory Period =
Inventory Turnover

Other asset turnover ratios include fixed asset turnover and total asset turnover.

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Financial Leverage Ratios

Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike
liquidity ratios that are concerned with short-term assets and liabilities, financial leverage ratios
measure the extent to which the firm is using long term debt.
The debt ratio is defined as total debt divided by total assets:

Total Debt
Debt Ratio =
Total Assets

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The debt-to-equity ratio is total debt divided by total equity:

Total Debt
Debt-to-Equity Ratio =
Total Equity

Debt ratios depend on the classification of long-term leases and on the classification of some
items as long-term debt or equity.

The times interest earned ratio indicates how well the firm's earnings can cover the interest
payments on its debt. This ratio also is known as the interest coverage and is calculated as
follows:
EBIT
Interest Coverage =
Interest Charges

where EBIT = Earnings Before Interest and Taxes

Profitability Ratios

Profitability ratios offer several different measures of the success of the firm at generating
profits.

The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin
considers the firm's cost of goods sold, but does not include other costs. It is defined as follows:

Sales - Cost of Goods Sold

Gross Profit Margin =
Sales

Return on assets is a measure of how effectively the firm's assets are being used to generate
profits. It is defined as:
Net Income
Return on Assets =
Total Assets

Return on equity is the bottom line measure for the shareholders, measuring the profits earned
for each dollar invested in the firm's stock. Return on equity is defined as follows:
Net Income
Return on Equity =
Shareholder Equity

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Dividend Policy Ratios

Dividend policy ratios provide insight into the dividend policy of the firm and the prospects for
future growth. Two commonly used ratios are the dividend yield and payout ratio.
The dividend yield is defined as follows:

Dividends Per Share

Dividend Yield =
Share Price

A high dividend yield does not necessarily translate into a high future rate of return. It is
important to consider the prospects for continuing and increasing the dividend in the future. The
dividend payout ratio is helpful in this regard, and is defined as follows:

Dividends Per Share

Payout Ratio =
Earnings Per Share

Use and Limitations of Financial Ratios

Attention should be given to the following issues when using financial ratios:
 A reference point is needed. To be meaningful, most ratios must be compared to
historical values of the same firm, the firm's forecasts, or ratios of similar firms.
 Most ratios by themselves are not highly meaningful. They should be viewed as
indicators, with several of them combined to paint a picture of the firm's situation.
 Year-end values may not be representative. Certain account balances that are used to
calculate ratios may increase or decrease at the end of the accounting period because of
seasonal factors. Such changes may distort the value of the ratio. Average values should
be used when they are available.
 Ratios are subject to the limitations of accounting methods. Different accounting choices
may result in significantly different ratio values.

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