Jonny Buchanan

Ratio analysis is boring Financial statements can be indecipherable But... Combine the two, and you can start to understand whats going on behind the numbers.

Will I lose money if I buy this stock? Does this company match my risk profile? Will the company go bust? What are the chances the company will grow? How effective is the companys management?

Broadly, the areas ratios can help us with are:

Profitability: Compared to its turnover, is the

company making a good profit? Liquidity: Can the company pay its bills? Management Activity: How fast is cash flowing into and out of the business? Risk: What is the risk of the company going under?

Return On Capital Employed = PBIT/Capital Employed x 100%

Higher is better

Capital employed = shareholders funds + long-

term creditors (total assets current liabilities)

Net Profit Margin = PBIT/Turnover x 100%

Higher is better low might suggest high costs

Current Ratio = Current Assets/Current Liabilities Quick Ratio = (Current Assets Stock)/Current Liabilities
As the current ratio, but takes into account the

fact that stock is not always liquid.

Always look at the industry average. A low ratio may be the norm.

These ratios give an indication of the trading effectiveness of the business. Debtor Days = Trade Debtors/Credit Sales x 365

The effectiveness of the business at collecting its debts.

Shorter is better.

Creditor Days = Trade Creditors/Purchases x 365

The credit the business is taking from its suppliers. Longer

is better.

Stock Turnover = Cost of Sales/Stock

The number of times stock was sold in the year.

Gearing:
i) Gearing = Loan Capital/shareholders funds x

100% ii) Gearing = Loan Capital/Capital Employed (Debt + Equity) x 100%

Consistency is most important

Interest Cover = PBIT/Interest Expenses

High gearing may not be a problem if interest

cover is high.

Look for higher year-on-year profit growth Higher P/E multiples can be expected Expect higher gearing levels and lower interest cover

Look for low gearing and high interest cover Dont expect high year-on-year profit increases Look for consistency in dividend payments & dividend yields

Historic information, not current Financial statements can be manipulated Different companies have different accounting policies (e.g. depreciation) When comparing ratios, the companies must be comparable. You cannot interpret ratios in isolation e.g. Recent takeover as explanation for falling costs (rather than management.)

Ratios can help you tell a companys story They can help you get a clearer picture of where a company sits in relation to its peers. But... Ratios can be manipulated, and should not be interpreted in isolation.