Introduction to financial ratios
In our introduction to interpreting financial information we identified five main areas forinvestigation of accounting information. The use of ratio analysis in each of these areas isintroduced below:
These ratios tell us whether a business is making profits - and if so whether at an acceptablerate. The key ratios are:RatioCalculationComments
[Gross Profit /Revenue] x 100(expressed as apercentageThis ratio tells us something about the business's abilityconsistently to control its production costs or to manage themargins its makes on products its buys and sells. Whilst salesvalue and volumes may move up and down significantly, thegross profit margin is usually quite stable (in percentageterms). However, a small increase (or decrease) in profitmargin, however caused can produce a substantial change inoverall profits.
[Operating Profit /Revenue] x 100(expressed as apercentage)Assuming a constant gross profit margin, the operating profitmargin tells us something about a company's ability tocontrol its other operating costs or overheads.
Return oncapitalemployed ("ROCE")
Net profit before tax,interest and dividends("EBIT") / total assets(or total assets lesscurrent liabilitiesROCE is sometimes referred to as the "primary ratio"; it tellsus what returns management has made on the resourcesmade available to them before making any distribution of those returns.
These ratios give us an insight into how efficiently the business is employing those resourcesinvested in fixed assets and working capital.RatioCalculationComments
Sales / CapitalemployedA measure of total asset utilisation. Helps to answer thequestion - what sales are being generated by each pound'sworth of assets invested in the business. Note, whencombined with the return on sales (see above) it generatesthe primary ratio - ROCE.
Sales or Profit /Fixed Assets
Sales or profit / FixedAssetsThis ratio is about fixed asset capacity. A reducing sales orprofit being generated from each pound invested in fixedassets may indicate overcapacity or poorer-performingequipment.
Cost of Sales /Average Stock ValueStock turnover helps answer questions such as "have we gottoo much money tied up in inventory"?. An increasing stockturnover figure or one which is much larger than the"average" for an industry, may indicate poor stockmanagement.
CreditGiven /"Debtor Days"
(Trade debtors(average, if possible) / (Sales)) x365The "debtor days" ratio indicates whether debtors are beingallowed excessive credit. A high figure (more than theindustry average) may suggest general problems with debtcollection or the financial position of major customers.