Ratio Analysis

Financial ratios can be used to examine various aspects

of the financial position and performance of a business
and are widely used for planning and control purposes.

They can be used to evaluate the financial health of a

business and can be utilised by management in a wide
variety of decisions involving such areas as profit
planning, pricing, working-capital management, financial
structure and dividend policy.

Ratio analysis provides a fairly simplistic method of

examining the financial condition of a business.

A ratio expresses the relation of one figure appearing in

the financial statements to some other figure appearing
there.

Ratios enable comparison between businesses.

Differences may exist between businesses in the scale of

operations making comparison via the profits generated
unreliable.

Ratios can eliminate this uncertainty.

Other than comparison with other businesses, it is also a

valuable tool in analysing the performance of one
business over time.
However useful ratios are not without their problems.

Figures calculated through ratio analysis can highlight

the financial strengths and weaknesses of a business but
they cannot, by themselves, explain why certain
strengths or weaknesses exist or why certain changes
have occurred.

Only detailed investigation will reveal these underlying

reasons. Ratios must, therefore, be seen as a ‘starting
point’.

Financial ratio classification

The following ratios are considered the more important

for decision-making purposes:

Ratios can be grouped into certain categories, each of

which reflects a particular aspect of financial
performance or position.

The following broad categories provide a useful basis for

explaining the nature of the financial ratios to be dealt
with.
Profitability. Businesses come into being with the
primary purpose of creating wealth for the owners.
Profitability ratios provide an insight to the degree of
success in achieving this purpose. They express the
profits made in relation to other key figures in the
financial statements or to some business resource.

Efficiency. Ratios may be used to measure the efficiency

with which certain resource have been utilised within the
business. These ratios are also referred to as active
ratios.

Liquidity. It is vital to the survival of a business that

there be sufficient liquid resources available to meet
maturing obligations. Certain ratios may be calculated
that examines the relationship between liquid resources
held and creditors due for payment in the near future.

Gearing. This is the relationship between the amount

financed by the owners of the business and the amount
contributed by outsiders, which has an important effect
on the degree of risk associated with a business. Gearing
is then something that managers must consider when
making financing decisions.

Investment. Certain ratios are concerned with assessing

the returns and performance of shares held in a particular
business.
 Profitability ratios

1. Return on ordinary shareholders’ funds (ROSF)

The return on ordinary shareholders’ funds compares the

amount of profit for the period available to the ordinary
shareholders with the ordinary shareholders’ stake in the
business.

Net profit after taxation and preference dividend (if any) X 100
Ordinary share capital plus reserves

The net profit after taxation and any preference dividend

is used in calculating the ratio, because this figure
represents the amount of profit available to the ordinary
shareholders.

2. Return on capital employed (ROCE)

The return on capital employed is a fundamental measure

of business performance. This ratio expresses the
relationship between the net profit generated by the
business and the long-term capital invested in the
business. Expressed as a percentage.
Net profit before interest and taxation x 100
Share capital + reserves + long-term loans
Note, in this case, the profit figure used in the ratio is the
net profit before interest and taxation. This figure is used
because the ratio attempts to measure the returns to all
suppliers of long-term finance before any deductions for
interest payable to lenders or payments of dividends to
shareholders are made.

ROCE is considered by many to be a primary measure of

profitability. It compares inputs (capital invested) with
outputs (profit). This comparison is of vital importance
in assessing the effectiveness with which funds have
been deployed.

3. Net profit margin

The net profit margin ratio relates the net profit for a
period to the sales during that period.

Net profit before interest and taxation x 100

Sales

The net profit before interest and taxation is used in this

ratio as it represents the profit from trading operations
before any costs of servicing long-term finance are taken
into account.
This ratio compares one output of the business (profit)
with another output (sales).

The ratio can vary considerably between types of

business.

For example, a supermarket will often operate on low

prices and, therefore, low profit margins in order to
stimulate sales and thereby increase the total amount of
profit generated.

A jeweller, on the other hand, may have a high net profit

margin but have a much lower level of sales volume.

Factors such as the degree of competition, the type of

customer, the economic climate and industry
characteristics (such as the level of risk) will influence
the net profit margin of a business.

4. Gross profit margin

The gross profit margin ratio relates the gross profit of

the business to the sales generated for the same period.

Gross profit represents the difference between sales value

and the cost of sales.

The ratio is therefore a measure of profitability in buying

(or producing) and selling goods before any other
expenses are taken into account.
As cost of sales represents a major expense for retailing,
wholesaling and manufacturing businesses, a change in
this ratio can have a significant effect on the bottom line
(that is, the net profit for the year).

Gross profit x 100

Sales

Efficiency ratios
Ratios used to examine the efficiency with
which various resource of the business are
managed include the following:
1. Average stock turnover period

Stocks often represent a significant investment for a

business.

For some types of business (for example,

manufacturing), stocks may account for a substantial
proportion of the total assets held.

The average stock turnover period measures the average

number of days for which stocks are being held.

Average stock held x 365

Cost of sales
The average stock for the period can be calculated as a
simple average of the opening and closing stock levels
for the year.

A business will normally prefer a low stock turnover

period to a high period as funds tied up in stocks cannot
be used for other profitable purposes.

2. Average settlement period

A business will usually be concerned with how long it

takes for customers to pay the amount owing.

Trade debtors x 365

Credit sales

A business will normally prefer a shorter settlement

period.

3. Average settlement period for creditors

The average settlement period for creditors tells us how

long, on average, the business takes to pay its trade
creditors.

Trade creditors x 365

Credit purchases

Referred to as ‘free’ source of finance for the business,

not surprising that some businesses attempt to increase
their average settlement period for trade creditors.
4. Sales to capital employed

The sales to capital employed ratio examines how

effective the long-term capital employed of the business
has been in generating sales revenue.

Sales
Share capital + reserves + long-term loans

Generally a higher ratio for sales to capital employed is

preferred to a lower one. A higher ratio will normally
suggest that the capital (as represented by total assets
minus current liabilities) is being used more productively
in the generation of revenue. However, a very high ratio
may suggest that the business is undercapitalised – that
is, it has insufficient long-term capital to support the
level of sales achieved.

Liquidity ratios

1.Current ratio

The current ratio compares the ‘liquid’ assets (cash and

those assets held that will soon be turned into cash) of a
business with the current liabilities (creditors due within
one year).

Current assets
Current liabilities

The ideal is often expressed as 2: 1 meaning that the

business can meet its short-term liabilities twice over.
2. Acid test ratio

The acid test ratio represents a more stringent test of

liquidity. It can be argued that, for many businesses, the
stock in hand cannot be converted into cash quickly. As
a result, it may be better to exclude this particular asset
from any measure of liquidity.

Current assets (excluding stock)

Current liabilities

Gearing ratio

Financial gearing occurs when a business is financed, at

least in part, by contributions from outside parties. An
important factor in assessing risk. Where a business
borrows heavily, it takes on a commitment to pay interest
charges and make capital repayments. This can be a
significant financial burden and can increase the risk of a
business becoming insolvent.

One particular effect of gearing is that returns to ordinary

shareholders become more sensitive to changes in
profits. For a highly geared company, a change in profits
can lead to a proportionately greater change in the
returns to ordinary shareholders.
The gearing ratio measures the contribution of long-term
lenders to the long-term capital structure of a business

Long-term liabilities x 100

Share capital + reserves + long-term loans

Interest cover ratio

The interest cover ratio measures the amount of profit

available to cover the interest payable.

Profit before interest and taxation

Interest payable

The lower the level of profit coverage, the greater the

risk to lenders that interest payments will not be met.

Investment ratios

1. Dividend per share

The dividend per share ratio relates the dividends

announced during a period to the number of shares in
issue during that period.

Dividends announced during the period

Number of shares in issue
Factors that influence the amount that a company is
willing or able to issue in the form of dividends include:

i) The profit available for distribution to investors

ii) The future expenditure commitments of the
company
iii) The expectations of shareholders concerning
the level of dividend payment.
iv) The cash available for dividend distribution

2. Dividend payout ratio

The dividend payout ratio measures the proportion of

earnings that a company pays out to shareholders in the
form of dividends.

Dividends announced during the period x 100

Earnings for the year available for dividends

The earnings available for dividends, in the case of

ordinary shareholders, would normally be net profit after
interest and taxation and after any preference dividends
announced during the year.
3. Earnings per share (EPS)

The earnings per share (EPS) relates the earnings

generated by the company during the period and
available to shareholders to the number of shares in
issue. For ordinary shareholders, the amount available
will be represented by the net profit after tax (less any
preference dividend where applicable).

Earnings available to ordinary shareholders

Number of ordinary shares in issue

Many investment analysts regard the EPS as a

fundamental measure of share performance. The trend in
earnings per share over time is used to help assess the
investment potential of a company’s shares.

4. Price/earnings (P/E) ratio

This ratio relates the market value of a share to the

earnings per share.

Market value per share

Earnings per share

The ratio is, in essence, a measure of market confidence

in the future of a company. The higher the P/E ratio, the
greater the confidence in the future earning power of the
company and, consequently, the more that investors are
prepared to pay in relation to the earnings stream of the
company
Price/earnings ratios provide a useful guide to market
confidence concerning the future.
 Limitations of ratio analysis

Although a useful tool ratios do have limitations.

Quality of financial statements.

Ratios are based on financial statements and the results

of ratio analysis are dependent on the quality of those
statements.

One important issue when making comparisons between

businesses is the degree of conservatism that each
business adopts in the reporting of profit.

Therefore any review of the financial statements should

include an examination of the accounting policies that
are being adopted.

There are some businesses that may adopt particular

accounting policies or structure particular transactions in
such a way that portrays a picture of financial health that
is in line with what those who prepared the financial
statements would like to see rather than what is a true
and fair view of financial performance and position.

This practice is referred to as creative accounting and

has been a major problem for accounting rule-makers.
Inflation

A persistent problem in most Western countries is that

the financial results of a business are distorted as a result
of inflation.

One effect of inflation is that the values of assets held for

any length of time may bear little relation to current
values.

Generally the value of assets will be understated in

current terms during a period of inflation as they are
usually recorded at their original cost (less any amounts
written off for depreciation).

The basis of comparison

Ratios require a basis of comparison in order to be

useful. Moreover, it is important that the analyst
compares like with like.

When comparing businesses, however, no two businesses

will be identical, and the greater the differences between
the businesses being compared, the greater the
limitations of ratio analysis.

Balance sheet ratios

Because the balance sheet is only a ‘snapshot’ of the

business at a particular moment in time, any ratios based
on balance sheet figures such as the liquidity ratios, may
not be representative of the financial position of the
business for the year as a whole.