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Ratio Analysis
Ch 28
Ratio Analysis Ratio analysis is the calculation and interpretation of financial ratios in order to
draw draw conc conclu lusi sion on or rais raisee ques questi tions ons about about fina financ ncial ial posi positi tion on and and fina financi ncial al performance of a business. Ratio A financial ratio is simply a relationship between one figure appearing in financial
statements and another. Use of Ratios Ratios can be used to evaluate performance of a business in following ways,
Past Performance Ratios of one year can be compared with the ratios of previous year to check that current year performance is better b etter or worse. Competitors Performance
Ratios of one company can be compared with the ratios of other company in same industry industry that our company’s performance performance is better better or worse than others. Average of Industry
Rati Ratios os of one compan company y can be comp compar ared ed with with the the aver averag agee rati ratios os of industry to check that our company’s performance is better or worse than whole industry. Expected Performance
Ratios of one company can be compared with the budgets and ratios of forecast financial statements. Types of Ratio
1) Profitability Ratios These ratios tell us about financial performance of the business. These ratios tell us about how much profit the business makes in relation to its sales or assets. i.
Gross Profit Ratio = Gross Profit x 100 = %
Sales If this ratio has increased it is better. It can change because of selling price and cost of goods sold change. Net Profit Ratio= Net Profit x 100 = %
ii.
Sales If this ratio has increased it is better. It can change because of gross profit and operating expenses. Return on Capital Employed Ratio= Profit before interest and tax x 100
iii.
=%
Capital Employed If this ratio has increased it is better. It can change because of change in net profit ratio and asset turnover ratio.
Note:
Capital Employed = Total Assets – Current Liability Or
Capital Employed = Long Term Liability + Capital + Reserves Return on Equity Ratio= Profit before Ordinary Dividend
iv.
x 100 = %
Equity If this ratio has increased it is better. It can change because of change in net profit, interest expense.
Note:
Equity = Total Assets – Current Liability- Long Term Liability Or
Equity = Capital + Reserves
2) Liquidity/Working Capital/Short Term Solvency Ratios
i.
Liquidity Liquidity is ability of company to meet its short term obligations. Working Capital It is cash tied up in the day to day operations of the business.
Current Ratio = Current Asset = answer : 1
Current liability There is no hard and fast rule about this ratio. It depends on the type of organization that how much this ratio should be. If this ratio is too high, it is not good because the company is loosing the opportunity to earn profit by investing this money elsewhere. If this ratio is too low then
there is a danger that creditors can not be paid on time and company can be declared as bankrupt. ii.
Quick/Asset Test Ratio = Current Asset – Stock = answer : 1
Current liability
There is no hard and fast rule about this ratio. It depends on the type of organization that how much this ratio should be. This ratio is called asset test ratio because it is very stringent test of liquidity in that it takes into account only the more liquid assets by exclusion of stocks and short term investments which are not easily convertible into cash. This ratio excludes stock because it can not be converted into cash without loss.
3) Efficiency/Activity/Performance Ratios These ratios are calculated to evaluate the performance of management. These ratios tell that how effectively and efficiently current assets and liabilities are managed. i.
Stock Turnover Ratio = Cost of Goods Sold = Times
ii.
Average Holding period = Average Stock
iii.
x365 = Days
Credit Sales This ratio tells that after how many days debtors made their payments during the year. If this ratio is low it is better because it means debtors are managed efficiently.
Creditor Turnover Ratio = Credit Purchase = Times
vi.
Average Debtor This ratio tells that how many times debtors paid during the year. If this ratio is high it is better because it means debtors are managed efficiently.
Average Collection period = Average Debtor
v.
x365 = Days Cost of Goods Sold This ratio tells that after how many days on average stock is converted into sales during the year. If this ratio is low it is better because it means stock is managed efficiently.
Debtor Turnover Ratio = Credit Sales = Times
iv.
Average Stock This ratio tells that how many times stock is converted into sales during the year. If this ratio is high it is better because it means stock is managed efficiently.
Average Creditor This ratio tells that how many times we paid to creditor during the year. If this ratio is low it is better because it means creditors are managed efficiently but it should not be at the cost of relationship with supplier.
Average Payment period = Average Creditors
x365 = Days
vii.
Credit Purchases This ratio tells that after how many days we are making payments to creditors during the year. If this ratio is high it is better because it means creditors are managed efficiently. Asset Turnover Ratio = Sales = Times Capital Employed This ratio tells that with the help of capita employed how many sales are made during the year. If this ratio is high it means that company is making more sales by using less resource. It means that fixed assets are utilized efficiently.
4) Gearing / Long Term Solvency/Leverage Ratios Gearing measures the extent to which a company is finance by borrowing (debentures, loans) as opposed to equity (capital + reserves). i.
Debt to Equity Ratio = Long Term Liability = answer : 1
Capital + Reserves For every company there is an optimal level of debt. If company has not borrowed very much, it may be missing out on new opportunities due to lack of cash. However, if a company has borrowed too much and can not meet its repayments, then it is in danger of going bust. Therefore if gearing is high, the financial risk of a business is also high. Interest Cover Ratio= Profit before interest and tax = Times
ii.
Interest Expense This ratio tells that how many times interest can be paid with the help of curren currentt earnin earnings. gs. If this this ratio ratio is high high then then it is better better for debent debenture ure holders because they are sure that they will get interest payments. On the other hand shareholders will also be happy because enough amount will be left to pay dividend.
5) Investment/Shareholder Ratios These ratios are important for existing and potential investors in quoted companies and also for top management, responsible for the overall stock exchange rating of their shares. Shareholders are interested in increase in the value of share (capital gain) and dividend received. From these two factors they will decide whether they should invest in the company or not. i.
Earning per Share(EPS) Ratio = Profit after Interest and Tax = pence per share
ii.
Price/ Earning Ratio = Market Price per Share
iii.
Earning per Shares This ratio indicates the number of years it would take to recover the share price out of current earnings of the company. This ratio also shows confidence level of the investors on the future prospects of company. Higher the P/E ratio higher will be the confidence level. Higher P/E ratio may also mean that share is over valued and not worth buying.
Dividend Cover Ratio = Profit Profit after Interest and Tax = Times Times
iv.
Number of Ordinary Shares According to FRS 14 every company is required to state its EPS in publish accounts. A high EPS is usually good and it is reflected in the form of rising market price.
Ordinary Dividend The dividend cover ratio indicates the proportion of earnings retain by the the comp compan any y and and the the leve levell of risk risk,, shou should ld earn earnin ing g decli decline, ne, for for the the company to able to maintain the same dividend payments. Interpretation of dividend ratio is difficult because some investors prefer low pay out (dividend) and others high pay outs. Other things being equal, a lower pay out leads to greater growth in the value of the company.
Dividend Yield Ratio = Dividend per Ordinary Share
x 100 = %
Market Price Dividend yield expresses the dividend as a return on actual amount paid for share and/ or the current market price of the share. Investors will always welcome higher dividend yield.
