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Introduction to Financial Ratios

Introduction to Financial Ratios

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Published by syed Muntazir naqvi

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Published by: syed Muntazir naqvi on Feb 10, 2010
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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:
Profitability Ratios
These ratios tell us whether a business is making profits - and if so whether at an acceptablerate. The key ratios are:RatioCalculationComments
GrossProfit Margin
[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.
OperatingProfit Margin
[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.
Efficiency ratios
These ratios give us an insight into how efficiently the business is employing those resourcesinvested in fixed assets and working capital.RatioCalculationComments
Sales /CapitalEmployed 
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 oProfit /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, ipossible) / (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.
Credittaken /"Creditor Days" 
((Trade creditors +accruals) / (cost of sales + otherpurchases)) x 365A similar calculation to that for debtors, giving an insightinto whether a business i taking full advantage of tradecredit available to it.
Liquidity Ratios
Liquidity ratios indicate how capable a business is of meeting its short-term obligations as theyfall due:RatioCalculationComments
Current Assets /Current LiabilitiesA simple measure that estimates whether the business canpay debts due within one year from assets that it expects toturn into cash within that year. A ratio of less than one isoften a cause for concern, particularly if it persists for anylength of time.
Quick Ratio(or "AciTest" 
Cash and near cash(short-terminvestments + tradedebtors)Not all assets can be turned into cash quickly or easily. Some- notably raw materials and other stocks - must first beturned into final product, then sold and the cash collectedfrom debtors. The Quick Ratio therefore adjusts the CurrentRatio to eliminate all assets that are not already in cash (or"near-cash") form. Once again, a ratio of less than one wouldstart to send out danger signals.
Stability Ratios
These ratios concentrate on the long-term health of a business - particularly the effect of thecapital/finance structure on the business:RatioCalculationComments
Borrowing (all long-term debts + normaloverdraft) / NetAssets (orShareholders' Funds)Gearing (otherwise known as "leverage") measures theproportion of assets invested in a business that are financedby borrowing. In theory, the higher the level of borrowing(gearing) the higher are the risks to a business, since thepayment of interest and repayment of debts are not"optional" in the same way as dividends. However, gearingcan be a financially sound part of a business's capitalstructure particularly if the business has strong, predictablecash flows.
Operating profitbefore interest /InterestThis measures the ability of the business to "service" itsdebt. Are profits sufficient to be able to pay interest andother finance costs?
Investor Ratios
There are several ratios commonly used by investors to assess the performance of a business asan investment:RatioCalculationComments
Earnings per share("EPS")
Earnings (profits)attributable toordinary shareholders/ Weighted averageordinary shares inissue during the yearA requirement of the London Stock Exchange - an importantratio. EPS measures the overall profit generated for eachshare in existence over a particular period.

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