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Financial ratio analysis is a fascinating topic to study because it can teach us so much about accounts and businesses. When we use ratio analysis we can work out how profitable a business is, we can tell if it has enough money to pay its bills and we can even tell whether its shareholders should be happy! Ratio analysis can also help us to check whether a business is doing better this year than it was last year; and it can tell us if our business is doing better or worse than other businesses doing and selling the same things. In addition to ratio analysis being part of an accounting and business studies syllabus, it is a very useful thing to know anyway! The overall layout of this section is as follows: We will begin by asking the question, What do we want ratio analysis to tell us? Then, what will we try to do with it? This is the most important question, funnily enough! The answer to that question then means we need to make a list of all of the ratios we might use: we will list them and give the formula for each of them. Once we have discovered all of the ratios that we can use we need to know how to use them, who might use them and what for and how will it help them to answer the question we asked at the beginning? At this stage we will have an overall picture of what ratio analysis is, who uses it and the ratios they need to be able to use it. All that's left to do then is to use the ratios; and we will do that step- bystep, one by one.

By the end of this section we will have used every ratio several times and we will be experts at what do we want ratio analysis to tell us?

The key question in ratio analysis isn't only to get the right answer: for example, to be able to say that a business's profit is 10% of turnover. We have to start working on ratio analysis with the following question in our heads: What are we trying to find out? Isn't this just blether, won't the exam just ask me to tell them that profit is 10% of turnover? Well, yes, but then they want to know that you are a good student who understands what it means to say that profit is 10% of turnover. We can use ratio analysis to try to tell us whether the business 1. 2. is profitable has enough money to pay its bills

3. 4. 5. 6. 7.

could be paying its employees higher wages is paying its share of tax is using its assets efficiently has a gearing problem is a candidate for being bought by another company or investor

and more, once we have decided what we want to know then we can decide which ratios we need to use to answer the question or solve the problem facing us. There are ratios that will help us with question 1, but that wouldn't help us with question 2; and ratios that are good for question 5 but not for question 4 - we'll see! Let's look at the ratios we can use to answer these questions.

The Ratios

We can simply make a list of the ratios we can use here but it's much better to put them into different categories. If we look at the questions in the previous section, we can see that we talked about profits, having enough cash, efficiently using assets - we can put our ratios into categories that are designed exactly to help us to answer these questions. The categories we want to use, section by section, are: 1. 2. 3. 4. 5. 6. Profitability: has the business made a good profit compared to its turnover? Return Ratios: compared to its assets and capital employed, has the business made a good profit? Liquidity: does the business have enough money to pay its bills? Asset Usage or Activity: how has the business used its fixed and current assets? Gearing: does the company have a lot of debt or is it financed mainly by shares? Investor or Shareholder

Not everyone needs to use all of the ratios we can put in these categories so the table that we present at the start of each section is in two columns: basic and additional. The basic ratios are those that everyone should use in these categories whenever we are asked a question about them. We can use the additional ratios when we have to analyse a business in more detail or when we want to show someone that we have really thought carefully about a problem.

**Users of Accounting Information
**

Now we know the kinds of questions we need to ask and we know the ratios available to us, we need to know who might ask all of these questions! This is an important issue because the person asking the question will normally need to know something particular.

Of course, anyone can read and ask questions about the accounts of a business; but in the same way that we can put the ratios into groups, we should put readers and users of accounts into convenient groups, too: let's look at that now. The list of categories of readers and users of accounts includes the following people and groups of people:

• • • • • • • • • • •

Investors Lenders Managers of the organisation Employees Suppliers and other trade creditors Customers Governments and their agencies Public Financial analysts Environmental groups Researchers: both academic and professional

sing and understanding what they tell us.

Basic Profitability

First some basic profitability equations: Gross Profit * 100 Turnover Operating Profit * 100 Turnover

Gross Profit Margin =

Operating Profit Margin =

Net Profit Margin =

Net Profit * 100 Turnover Retained Profit * 100 Turnover

Retained Profit Margin =

Profit Mark up =

Profit * 100 Cost

What are you going to do if someone asks you to tell them whether a business is profitable or not? Firstly, do you remember what profit is? Profit is the difference between turnover, or sales, and costs: that is, profit = turnover - costs One problem is that there are several ways of measuring profit: gross profit; net profit before and after taxation; and retained profit are just some of them. So, you didn't print out those Tesco accounts we showed you did you? Well, look back at them to remind yourself of all these names for profit A profit margin is one of the profit figures we just mentioned shown as a percentage of turnover. They always tell us how much profit, on average, our business has earned per £1 of turnover. We already know from the ratios table that there are several ratios we could use to calculate the profitability of a business. Next we'll discuss gross and net profit margins.

**Gross Profit Margin
**

First some basic profitability equations: Gross Profit * 100 Turnover

Gross Profit Margin = Remember: Turnover = Sales

Gross Profit = Turnover - Cost of Sales The gross profit margin ratio tells us the profit a business makes on its cost of sales, or cost of goods sold. It is a very simple idea and it tells us how much gross profit per £1 of turnover our business is earning. Gross profit is the profit we earn before we take off any administration costs, selling costs and so on. So we should have a much higher gross profit margin than net profit margin.

**Here are a few examples of the gross profit margins from different businesses:
**

Leisure International Manufacturer Retailer Discount Refining & Hotels Gross 9.64% 5.62% 35.14% 11.41% 27.46% 11.99% 47.52% 89.55% Airline Airline Pizza Restaurants Accounting Software

profit See how the gross profit margins vary from business to business and from industry to industry. For example, the international airline has a gross profit margin of only 5.62% yet the accounting software business has a gross profit margin of 89.55%. If a company's raw materials and factory wages go up a lot, the gross profit margin will go down unless the business increases its selling prices at the same time.

**Net Profit Margin
**

First some basic profitability equations: Net Profit Profit before Interest and Taxation * 100 = * 100 Turnover Turnover

Net Profit Margin = Remember:

Net Profit = Gross Profit - Expenses Why do we have two versions of this ratio - one for net profit and the other for profit before interest and taxation? Well, in some cases, you will find they use the term net profit and in other cases, especially published accounts, they use profit before interest and taxation. They both mean the same: look back at the financial statements for Tesco where we compared different names for the same things. The net profit margin ratio tells us the amount of net profit per £1 of turnover a business has earned. That is, after taking account of the cost of sales, the administration costs, the selling and distributions costs and all other costs, the net profit is the profit that is left, out of which they will pay interest, tax, dividends and so on. Here are a few examples of the net profit margins from the same businesses we saw in the gross profit margin section:

Leisure International Manufacturer Retailer Discount Refining & Hotels Net Profit 7.36% 4.05% -10.48% 1.63% 10.87% 12.63% Airline Airline

Pizza Restaurants

Accounting Software

7.55%

27.15%

Just like the gross profit margins, the net profit margins also vary from business to business and from industry to industry. When we compare the gross and the net profit margins we can gain a good impression of their non-production and non-direct costs such as administration, marketing and finance costs.

We saw that the international airline's gross profit margin was the lowest of this group of eight businesses at only 5.62%; but look, its net profit margin is 4.05%, only a little bit lower than its gross profit margin. On the other hand, the discount airline's gross profit margin is 27.46% but its net profit margin is a lot less than that at 10.87%. As we just said, these comparisons give us a great insight into the cost structure of these businesses. Look at the software business too, a very high gross profit margin of 89.55% but a net profit margin of 27.15%. This is still high, but we can now see that the administration and similar expenses are very high whilst its cost of sales and operating costs are relatively very low.

Rate of Return

First some basic Rate of Return equations: Profit for the Year * 100 Equity Shareholders' Funds

Return on Capital Employed (ROCE) =

Return on Total Assets (ROTA) =

PBIT * 100 Total Assets

The rate of return ratios are thought to be the most important ratios by some accountants and analysts. One reason why the rate of return ratios are so important is that they are the ratios that we use to tell if the managing director is doing their job properly.

**Return on Capital Employed Ratio
**

The Return on Capital Employed ratio (ROCE) tells us how much profit we earn from the investments the shareholders have made in their company. Think of it this way: if we had a savings account with a bank and we'd been paid, say, £25 interest at the end of a year; and we had saved £500, we could work out the rate of interest we had earned: Interest earned 25 1 100 * 100 = * 100 = * 100 = = 5% Amount saved 500 20 20

Rate of interest =

So, we have earned 5% interest on our savings. Imagine now that instead of talking about a savings account, we were talking about a company and the profit for the year and its capital employed had been £25 and £500 respectively then the ROCE for that company would be 5% too. Profit for the Year 25 1 100 * 100 = * 100 = * 100 = = 5% Equity Shareholders' Funds 500 20 20

ROCE =

Did you notice that we use the Equity Shareholders' Funds instead of Capital Employed? In fact, they are different names for the same thing! We could call the ratio the Return on Shareholders'

Funds (ROSF) just as easily if we wanted; but generations of accountants and students only know it as ROCE. In accounting, there can be different definitions of what certain terms mean. The use of the term 'capital employed' can mean different things. It can, for example, include bank loans and overdrafts since these are funds employed within the firm. Because there are different interpretations of what ROCE can mean, it is suggested that you use a method which you feel comfortable with but be aware that others may interpret your definition in a different way. Below is a guide to some of the interpretations that we have found on this issue.

Source and/or Definition of Return Elliott & Elliott: ROCE = Net profit/capital employed Investor Words:

Definition of Capital Employed Capital employed = total assets Capital employed = fixed assets + current assets current liabilities Capital employed = ordinary share capital + reserves + preference share capital + minority interest + provisions + total borrowings - intangible assets TRADING capital employed = share capital + reserves + all borrowings including lease obligations, overdraft,

investopedia.com: Return = Profit before tax + interest paid

Holmes & Sugden: Return = trading profit plus income from investment and company share of the profit of associates

minority interest, provisions, associates and investments OVERALL capital employed = share capital + reserves + all borrowings including lease obligations, overdraft, minority interest, provisions Capital employed = total fixed assets + current assets

DTI

- (current liabilities + long term liabilities + provisions)

Johnson Matthey Annual Report & Accounts

Capital employed = fixed assets + current assets (creditors + provisions)

Let's calculate the ROCE for the Carphone Warehouse now; and here are the figures we need:

Carphone Warehouse

31 March 2001 £'000

25 March 2000 £'000 16,327 44,190

Profit for the financial period Equity shareholders' funds Off you go! Did you get this?

38,159 436,758

What do we think of these results? Well, the question we have to ask is "Could we have earned more money (profit) if we had invested in a different business or simply put our money in the bank?" Well, interest rates at the bank were somewhere around 4 or 5% in 2001 so we did better than that; but there are many businesses that have a ROCE of higher than 8 or 9%. Still, in 2000 the Carphone Warehouse had an ROCE of almost 37%: that's very good by all standards. So what went wrong between 2000 and 2001? What happened, it didn't necessarily go wrong, was that the capital employed increased from £44,190,000 to £436,758,000 (a 10 fold increase) BUT the profits increased from £16,327 to only £38,159... they only just about doubled. It's no surprise then that the ROCE fell so sharply as capital employed increased 5 times faster than the profit did. It will be interesting to see what 2002 brings for the Carphone Warehouse and their ROCE. We will look at Vodafone's ROCE shortly, but for interest here are some other ROCE values to compare with the Carphone Warehouse:

Leisure International Manufacturer Retailer Discount Refining & Hotels ROCE 5.56% 3.16% -12.12% -0.12% 33.63% 16.17% Airline Airline

Pizza Restaurants

Accounting Software

16.14%

16.29%

Again, these other ROCE values demonstrate that not everyone can get the same results for the same ratio at the same time: it depends on the industry, the management, the economy and so on. The ROCE results in this new table relate to the Carphone Warehouse's results for the year ended 25 March 2000 of 36.95%. This is a good result as it shows that the business is effectively earning around 37% on the (investment) funds that the shareholders have invested in it. Contrast the other ROCE values with the Carphone Warehouse and we can see that only the discount airline has a ROCE value anywhere near it. The international airline's ROCE is extremely low at just over 3%. Wouldn't the shareholders be better off selling the business and putting the money in the bank as it would earn more than that? We should also compare these ROCE values with the profitability values. Let's just compare net profitability with the ROCE.

Leisure International Manufacturer Retailer Discount Refining & Airline Airline

Pizza Restaurants

Accounting Software

Hotels Net Profit ROCE 5.56% 3.16% -12.12% -0.12% 33.63% 16.17% 16.14% 16.29% 7.36% 4.05% -10.48% 1.63% 10.87% 12.63% 7.55% 27.15%

Putting the data from this table on a graph can help us to see if there is a relationship between them:

There does seem to be a relationship between the net profit margin and the ROCE: the higher the net profit margin, the higher the ROCE. After all, the curve on this graph is not a straight line and it might even be a true curve meaning that the relationship is more complex than we might think. Keep an eye on this relationship whenever you assess the profitability of a business.

Liquidity ratios

Current Assets: Current Liabilities (Current Assets-Stocks): Current Liabilities The two liquidity ratios, the current ratio and the acid test ratio, are the most important ratios in almost the whole of ratio analysis are also the simplest to use and to learn

**The Current Ratio
**

The current ratio is also known as the working capital ratio and is normally presented as a real ratio. That is, the working capital ratio looks like this:

Current Assets: Current Liabilities = x: y eg 1.75: 1 The Carphone Warehouse is our business of choice, so here is the information to help us work out its current ratio.

Consolidated Balance Sheet

31 March 2001 £'000

25 March 2000 £'000 171,160 173,820

Total Current Assets Creditors: Amounts falling due within one year

315,528 222,348

As we saw in the brief review of accounts section with Tesco's financial statements, the phrase current liabilities is the same as Creditors: Amounts falling due within one year. Here's the table to fill in. OK, so we've done this one for you!

Current Ratio For the Carphone Warehouse 31 March 2001 Current Assets: Current Liabilities 25 March 2000 Current Assets: Current Liabilities 315,528: 222,348 1.42: 1

171,160: 173,820 0.98: 1

Maths revision. How did we get 1.42: 1 for the year ended 31 March 2001? All we did was to divide the current assets by the current liabilities and that gives us: current assets 315,528 = = 1.42 current liabilities 222,348 so we automatically know that our ratio is 1.42: 1 The same with the year before: current assets 171,160 = = 0.98 current liabilities 173,820 so the ratio is 0.98: 1

Asset Usage

The assessment of asset usage is important as it helps us to understand the overall level of efficiency at which a business is performing. The basic equations for this section are: Turnover Total Assets

Total Asset Turnover =

Stock Turnover =

Average Stocks Credit Sales/365 Average Debtors Credit Sales/365 Average Creditors Credit Sales/365

Debtors' Turnover =

Creditors' Turnover =

The assessment of asset usage is important as it helps us to understand the overall level of efficiency at which a business is performing. Our basic ratios for this section are Total asset turnover - The overall efficiency of the business. We will look at total asset turnover and net asset turnover; then we will investigate the fixed and current asset turnover ratios. Stock turnover, Debtors' turnover and Creditors' turnover help us to assess the liquidity position as well as giving us detailed information about stock control and credit control. We'll look at total asset turnover first and then we'll look at the other three together, under the general heading of working capital management II

**Working Capital Management II
**

What we are about to study - stock, debtors and creditors control - are all part of working capital management in the same way that a discussion of liquidity was part of working capital management. We know that working capital is concerned with the ability of a business to be able to pay its way. The three ratios we are concerned with now are concerned with spending and saving money in the right places. Too much stock and we waste money on buying it and keeping it. Too much money loaned to our debtors and it's money we can't use for something else, such as buying machinery, paying our creditors or even investing it. Too much money in the form of creditors and we might have a problem that no one else will give us credit for anything else because they think we can't afford it, and, if we suddenly have a cash problem, we might not be able to pay our creditors. Working capital management is concerned with the control aspects of the issues we have just mentioned.

Stock Turnover: stock control

In principle, the lower the investment in stocks the better. Apart from buffer stocks that businesses sometimes need in case of shortages of supply and strategic stocks in case of war, sudden changes in demand and so on, modern stock control theory tells us to minimise our investment in stocks. Let's see how the Carphone Warehouse behaves in this respect. The formula for this ratio is: Average Stocks (Cost of Sales/365) 31 March 2001 25 March 2000

Stock Turnover =

Carphone Warehouse Consolidated Profit and Loss Account

£'000 Cost of sales Stock 830,126 52,437

£'000 505,738 51,842

Stock Turnover Ratio for the Carphone Warehouse 31 March 2001 52,437 830,126 / 365 25 March 2000 51,842 505,738 / 365 If you use alternative formulae and are happy with them, that's fine. If you think you need help because of that, see your teacher/lecturer for guidance. 37.42 days 23.06 days

• • •

Firstly, the result of this calculation is that the answer is instantly in terms of the number of days, on average, that the stocks are held in the business. Secondly, we use the cost of sales figure because stocks are bought and shown in the profit and loss account and the balance sheet at cost; so we need to compare like with like. Thirdly, we only have two years' worth of stock information, so we can't use the average stock for both years as we should do according to the formula. Never mind, even though the answer won't be 100% spot on, it will give us a very good estimate of how stock control is going.

How can we interpret this ratio? With a result of 23.06 days, we can imagine that we bought our £52,437,000 worth stocks of raw materials or whatever they were on 1st January 2002. We then know that we ran out of those raw materials on 1 + 23.06 days = just into 25th January. Similarly with the result of 37.42 days, if we bought our £51,738,000 worth of raw materials on 1st January, we would run out and have to buy some more on 7th February.

This ratio has fallen from 37 days to 23 days over the two years and that is probably a good thing. If there's less stock to worry about, lower investment in stocks meaning that the money they used to have tied up in the stock room is now free to spend somewhere else. In fact, stocks have remained at around £52 million as we mentioned before, but the cost of sales has increased by 64% over the two years. Put these two facts together and that explains the improvement in this ratio. Well done the Carphone Warehouse! Remember that we talked about the liquidity of stocks when we discussed the acid test ratio. Now we can see that the Carphone Warehouse's stocks are fairly liquid, since a turnover ratio of 23 days isn't too bad!

Debtors' Turnover

In the same way that stock control is a vital aspect of working capital management, so too is debtors' control. Many businesses need to sell their goods on credit, otherwise they might find it difficult to survive if their competitors provide such credit facilities; this could mean losing customers to the opposition. Nevertheless, since we do provide credit, we must do so as optimally as possible. We've used the word 'optimal' before and let me confirm that it doesn't necessarily mean the best possible, but the best possible under the circumstances. Why is credit control so important? For the Carphone Warehouse, the total amount owing by debtors was £149 million at the end of 31 March 2001, which as a percentage of total assets, is 14.09%. That's a lot of money in absolute terms and relatively, and it's 80% more than it was the year before. So, they've given an additional £69 million worth of credit to their customers over the year. What we need to know, though, is whether they are controlling these debtors. We can do that by looking at their debtors' turnover ratios for the two years, firstly.

Carphone Warehouse

31 Mar 2001 £000

25 Mar 2000 £000 697,720 82,826

Turnover Debtors due within one year

1,110,678 149,200

The formula for debtors' turnover is: Average Debtors Credit Sales/365

Debtors' Turnover =

We have to assume, by the way, that all sales are credit sales unless we know which sales are for cash. The calculations:

Debtors Turnover Ratio for the Carphone Warehouse 31 March 2002 149,200 1,110,678 ÷ 365 25 March 2001 82,826 697,720 ÷ 365 Well, what do you think of that? Firstly, the ratio seems to have worsened by going from 43 to 49 days over the two years; and it means that, on average, the Carphone Warehouse's debtors are taking one and a half months to pay their accounts. Does this sound as if it's a good policy? How do we know? One of the ways we can tell, in fact, whether this ratio is good or not is to go to a Carphone Warehouse shop or go to their Web site and find out their terms of business. If we sign up with them, will they give us around 49 days to pay our bills? At the time of writing, the page http://www.carphonewarehouse.com/commerce/servlet/gbenstore-Mobile shows that there are a number of ways we can choose to get a phone from the Carphone Warehouse: 43.33 days 49.03 days

• • • •

Pay monthly Handset only Pay for calls ... no line rental Pay as you go

Try and work out how it's possible to have a debtors' turnover figure of 49 days from these deals ... it's not! So what's the problem? Well, do they have corporate customers who are allowed to pay after, say, 55 days or 60 days? Do some research and find the answer if you can.

**Creditors' Turnover Ratio
**

Creditors are the businesses or people who provide goods and services in credit terms. That is, they allow us time to pay rather than paying in cash.

There are good reasons why we allow people to pay on credit even though literally it doesn't make sense! If we allow people time to pay their bills, they are more likely to buy from your business than from another business that doesn't give credit. The length of credit period allowed is also a factor that can help a potential customer decide whether to buy from your business or not: the longer the better, of course. In spite of what we have just said, creditors will need to optimise their credit control policies in exactly the same way that we did when we were assessing our debtors' turnover ratio - after all, if you are my debtor I am your creditor! We give credit but we need to control how much we give, how often and for how long. Let's do some calculations for the Carphone Warehouse. The formula for this ratio is: Average Creditors (Cost of Sales/365)

Creditors' Turnover =

As with the stock turnover ratio, creditor values relate to the costs of raw materials, goods and services, which is why we use the cost of sales figure in the denominator (Remember the numerator? Well, this is the opposite. The denominator is the bottom part of a fraction!)

Carphone Warehouse

31 March 2001 £'000

25 March 2000 £'000 505,738 173,820

Cost of sales Creditors: Amounts falling due within one year

830,126 222,348

Creditors Turnover Ratio for the Carphone Warehouse 31 March 2001 222,348 830,126 ÷ 365 25 March 2000 173,820 505,738 ÷ 365 We interpret this ratio in exactly the same way as the debtors' turnover ratio. That is, in 2001 if we had bought some supplies for £222,348 on 1st January, we would have paid for them 97.76 days later on 6th April. You can work out the payment date for 2000 if we imagine buying some supplies for £173,820 on 1st January of that year. Having found that debtors are taking somewhere between 30 and 50 days to pay their accounts, notice that the business is taking over three months credit for itself in 2001 and about four months' credit in 2000. These results are worrying: especially when we know that small businesses in the UK 125.45 days 97.76 days

are suffering because large businesses take too long to pay their accounts; and if the Carphone Warehouse has many small suppliers that is worrying. You can now attempt an additional question. Additional notes are available on advanced stock, creditors and debtors or you can move on to the Gearing section.

Gearing 1

Gearing = Long Term Liabilities Equity Shareholders' Funds

Gearing is concerned with the relationship between the long terms liabilities that a business has and its capital employed. The idea is that this relationship ought to be in balance, with the shareholders' funds being significantly larger than the long term liabilities.

Gearing 1

Shareholders ought to have the upper hand because if they don't that could cause them problems as follows:

• • • •

Shares earn dividends but in poor years dividends may be zero: that is, businesses don't always need to pay any! Long term liabilities are usually in the form of loans and they have to be paid interest; even in bad years the interest has to be paid Equity shareholders have the voting rights at general meetings and can made significant decisions Long term liability holders don't have any voting rights at general meetings but they have the power to override the wishes of the shareholders if there are severe problems over their interest or capital repayments

So, shareholders like to see the gearing ratio, the relationship between long term liabilities and capital employed, being in their favour! Let's look at the Carphone Warehouse's gearing ratio. The formula: Long Term Liabilities Equity Shareholders' Funds

Gearing =

The data:

Carphone Warehouse

31 March 2001 £'000

25 March 2000 £'000 21,033 44,190

Creditors: Amounts falling due after more than one year Equity shareholders' funds

14,107 436,758

Gearing Ratio for the Carphone Warehouse 31 March 2001 25 March 2000 14,107: 436,758 21,033: 44,190 0.032: 1 0.476: 1

A shareholder of the Carphone Warehouse will be happy with these results. Even in 2000 when the ratio was relatively high at 0.476 or 47.6% they probably were not too worried because their other ratios were fine too. In 2001 the gearing ratio fell to almost zero indicating that the business much prefers equity funding to debt funding. This minimises the interest payment problems and the control problems of having a dangerously high level of long-term debt on the balance sheet.

Gearing 2

There is an alternative gearing ratio, we can call it the Gearing Ratio II. The formula for this ratio is: Long Term Liabilities Long Term Liabilities + Equity Shareholders' Funds

Gearing 2 =

Let's just get on with this one. Gather the necessary data from both of our businesses, Carphone Warehouse and Vodafone and calculate this ratio for them. The calculations:

Gearing II Ratio for the Carphone Warehouse 31 March 2001 14,107: 436,758 + 14,107 0.031: 1 25 March 2000 21,033: 44,190 + 21,033 0.322: 1

Gearing II Ratio for Vodafone 31 March 2002 13,118: 130,573 + 13,118 0.091: 1 31 March 2001 11,235: 145,007 + 11,235 0.072: 1

In the case of both the Carphone Warehouse and Vodafone, these ratios are, as we should expect, smaller than Gearing 1 and they are still, therefore, insignificant by the end of the two years we are analysing here

Investor ratios

Basic equations you'll need: Profit available to equity shareholders Average number of issued equity shares Dividends paid to equity shareholders Average number of issued equity shares

Earnings per share =

Dividends per share =

Dividend yield =

Latest annual dividends Current market share price Net profit available to equity shareholders Dividends paid to equity shareholders Current market share price Earnings per share

Dividend cover =

Price/earnings or p/e ratio =

Investor ratios

Most of the investor ratios that we might need to use are relatively simple both to use and to understand. We can contrast these ratios with others, such as stock and debtors' turnover; and the relationships between the ROCE and the profit margin and assets turnover ratios, at the top of the pyramid of ratios. That's good news, then! The basic five ratios we are interested in are:

• • • • •

Earnings per share Dividends per share Dividend yield Dividend cover P/E ratio

As before, we'll take each ratio in turn and use the Carphone Warehouse and Vodafone accounts to apply them.

**Earnings per share: EPS
**

This is, perhaps, the fundamental investor ratio: in this case, we work out the average amount of profits earned per ordinary share issued. The formula is: Profit available to equity shareholders Average number of issued equity shares

Earnings per share =

Here are the extracts from the accounts that we need and they are followed by the results for one of the two years, you should calculate the EPS for the other year.

The Carphone Warehouse Consolidated Profit and Loss Account Profit for the financial period (£) Weighted average number of issued shares

31 March 2001

25 March 2000

38,159,000 833,000,000

16,327,000 600,000,000

31 March 2001 EPS 38,159,000 833,000,000 Did you get this?

25 March 2000

£0.04648 _____________

The good news for investors here is that the average earnings per issued ordinary share has almost doubled over the two years. Notice that the number of shares issued has increased from 600 million to 833 million, so this really is a good result as profits available for shareholders must have increased significantly too from £16,327,000 to £38,159,000.

**Dividends per Share: DPS
**

The DPS ratio is very similar to the EPS: EPS shows what shareholders earned by way of profit for a period whereas DPS shows how much the shareholders were actually paid by way of dividends. The DPS formula is: Dividends paid to equity shareholders Average number of issued equity shares

Dividends per share =

Oops, there are no dividend data for the Carphone Warehouse, on page 13 of their annual report and accounts they say:

Profit for the period attributable to shareholders was £38.2m resulting in total shareholders' funds of £436.8m at the period end. As in previous periods

the Board has decided to retain these earnings for continued investment in the development of the Group and the future enhancement of shareholder value and is not therefore proposing a dividend for the period.

Vodafone has paid dividends in recent years so gather the relevant data from the database and calculate the DPS for it. Here are the templates we so kindly began to provide under the EPS heading! Here are two templates to help you along: aren't we kind?

Vodafone Consolidated Profit and Loss Account Equity dividends (£) Weighted average number of issued shares

31 Mar 2002

31 Mar 2001

31 Mar 2002

31 Mar 2001

DPS __________ £ ______ __________ £ ______

Did you get this? Vodafone themselves report the DPS as

**Dividend per share 1.4721p in 2002 and 1.4020p in 2001
**

In conclusion we can see that even though Vodafone is suffering large losses, it is still paying dividends to its shareholders, yet the Carphone Warehouse, which is apparently in a better position is not paying dividends.

Dividend Yield

The dividend yield ratio allows investors to compare the latest dividend they received with the current market value of the share as an indictor of the return they are earning on their shares. Note, though, that the current market share price may bear little resemblance to the price that an investor paid for their shares. Take a look at the history of a business's share price over the last year or two and you will see that today's share price might be a lot higher or a lot lower than it was a year ago, two years ago and so on. We clearly need the latest share price for this ratio and we can get that from newspapers such as the Financial Times, The Times, The Guardian and the Daily Telegraph. We can also find the share prices on the Internet. The formula for the dividend yield is:

Dividend yield =

Latest annual dividends Current market share price

It is common for newspapers and others to calculate the dividend yield automatically as part of their offerings. Take a look at the extract from The Times and you'll find the dividend yield figure in the second right hand column, before the P/E ratio. Here's an extract from The Times newspaper's share page (Source: The Times Newspaper 18 September 2002) together with a few links to some Web sites where we can find share prices. Use them now or later.

Dividend Cover

The dividend cover ratio tells us how easily a business can pay its dividend from profits. A high dividend cover means that the company can easily afford to pay the dividend and a low value means that the business might have difficulty paying a dividend. Here's the formula followed by an example. Net profit available to equity shareholders Dividends paid to equity shareholders

Dividend cover =

Since the Carphone Warehouse hasn't paid a dividend, let's turn to Vodafone immediately. In the database find the data you need to calculate the dividend coverage for the two years for which we have data for Vodafone and calculate the dividend cover ratio for those two years. Here's a template for you to fill in with the data you find.

Vodafone Consolidated profit and loss account

31 Mar 2002

31 Mar 2001

£m Profit for the financial period Dividends

£m

Vodafone dividend cover Profit for the financial period Dividends Did you get this?

31 Mar 2002

31 Mar 2001

In this case, we see a terrible situation, as usual, for Vodafone. The profit for the period is in fact negative, so these results are dreadful - even though the values are positive, that is only because of the mathematics ... Vodafone has no dividend cover at all for these two years

**Price Earnings Ratio: P/E ratio
**

The P/E ratio is a vital ratio for investors. Basically, it gives us an indication of the confidence that investors have in the future prosperity of the business. A P/E ratio of 1 shows very little confidence in that business whereas a P/E ratio of 20 expresses a great deal of optimism about the future of a business. Here's the formula, then we'll work through an example Current market share price Earnings per share

Price/earnings or p/e ratio =

Here are the P/E ratios of five businesses in the Telecommunications sector:

Telecommunications BT Project Telecom Telecom Plus Vanco Vodafone Average

P/E ratio 48.4 12.0 19.7 78.4 17.9 35.28

Source: The Times Newspaper 18 September 2002 See how big some of these P/E ratios are - that's not necessarily a good thing! Let's look at the calculations and then we can interpret our findings. Again, we need current market share prices as well as the EPS values. This means we can go back to the Carphone Warehouse even though it isn't paying dividends at the moment:

The Carphone Warehouse pence Current market share price EPS Note: 1. 2. 76.0 4.6

P/E ratio 16.52

the current market share price is taken from The Times newspaper 18 September 2002 and the EPS is taken from the table below (previously calculated in the EPS section, above) we have worked in pence here; but we could just as easily have worked in Pounds and the answer would have been the same, at a P/E ratio of 16.52

The Carphone Warehouse 31 March 2001 EPS 38,159,000 833,000,000 £0.046

What does a P/E ratio of 16.52 mean? In raw terms it means that investors are currently paying the equivalent of 16.52 years' worth of earnings to own a share in the Carphone Warehouse. That is, they hare currently paying 76 pence per share and since the EPS is 4.6 pence per share, this means that they will recover their investment in a share after 16.52 years - equivalent to the break even and payback period if you like. 16.52 is a high value for a P/E ratio; but not the highest and essentially the higher the ratio the better. However, we would say that P/E ratios of 78.4 and 48.4 are excessive and might reflect an unreal situation. It's possible in extreme circumstances that the share price is, in fact, independent of the current market share price so that a high P/E ratio is actually based on more up to date news than last years EPS value. BT has a P/E ratio of 48.4 yet it is not too long ago that it was heading for potential liquidation as its victory in securing its third generation licences had led to its taking on a massive debt burden that it could not, in reality, sustain. However, it seems now that investors like the current performance of BT and are voting for it by buying its shares at highly inflated values relative to its EPS.

Ratio

From Wikipedia, the free encyclopedia

(Redirected from Ratio analysis) Jump to: navigation, search For the use of ratio as a human capacity, see reason.

A ratio is a dimensionless, or unitless, quantity denoting an amount or magnitude of one quantity relative to another. Throughout the physical sciences, ratios of physical quantities are treated as real numbers. For example, the ratio of 2πr metres to 1 metre is the real number 2πr. That is 2πrm/1m = 2πr. Accordingly, the classical definition of measurement is the estimation of a ratio between a quantity and a unit of the same kind of quantity. The term ratio is also used to denote one proportion of a whole relative to the other proportion. With such usage, the ratio is usually written as two numbers separated by a colon (:) which is read as the word "to". A ratio of 2:3 ("two to three") means that the whole is made up of 2 parts of one thing and 3 parts of another — thus, the whole contains five parts in all. To be specific, if a basket

contains 2 apples and 3 oranges, then the ratio of apples to oranges is 2:3. If another 2 apples and 3 oranges are added to the basket, then it will contain 4 apples and 6 oranges, resulting in a ratio of 4:6, which is equivalent to a ratio of 2:3 (thus ratios "reduce" like regular fractions). In both cases, there are 2/3 as many apples as oranges in the basket, or 3/2 as many oranges as apples. Note that in the previous example the proportion of apples in the basket is 2/5 ("two fifths", "two of five", "two out of five") or 40%. Thus a proportion compares part to whole instead of part to part. A rate is a special kind of ratio in which the two quantities being compared are of different units. The units of a rate are the units of the first quantity "per" unit of the second — for example, a rate of speed or velocity can be expressed in "miles per hour". In algebra, two quantities having a constant ratio are in a special linear relationship called proportionality.

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More examples

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A new grey colour of paint is made by mixing 3 parts of black paint with 5 parts of white. The ratio of black to white is therefore 3:5 and the ratio of white to black 5:3. The black paint constitutes 3/8 (37.5%) of the grey paint and the white paint 5/8 (62.5%). Such a mixture of grey paint would be slightly lighter than a 2:3 mixture of black to white, since the latter is 2/5 (40%) black paint and only 3/5 (60%) white. Note that these ratios can be compared directly as regular fractions (3/5 is less than 2/3), but this method may obscure the true meaning of the ratios, as explained above. If a school has a 20:1 student-teacher ratio, there are twenty times as many students as teachers. The ratio of heights of the Eiffel Tower (300 m) and the Great Pyramid of Giza (139 m) is 300:139, so one structure is more than two times the height of the other (more precisely, 2.16 times). The ratio of the mass of Jupiter to the mass of the Earth is approximately 318:1. If two axles are connected by gear wheels, the number of times one axle turns for each turn of the other is known as the gear ratio, one familiar example of which is the number of turns of the pedals of a bicycle compared with number of turns of the rear wheel. The ratio of hydrogen atoms to oxygen in water (H2O) is 2:1.

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Ratio analysis

More colloquially, a ratio is a value calculated by dividing one number by another. Five divided by two gives a ratio of 2.5. In the business world it is typical to use ratios to analyze financial statements. For example, the current ratio assesses liquidity, or time required for some asset to be converted to cash. The current ratio looks at current assets relative to current liabilities. One indicator, or ratio, for strength or stability of revenue in government is own source revenues (property taxes, for example) divided by total revenues (property tax and outside grants). In some respects, a high ratio suggests safety and stability. Grants or intergovernmental revenues can be taken away and heavy reliance on these outside sources, which would produce a low ratio, can spell trouble for a state or local government.

**Ratio Analysis Equations for Accountants
**

This page contains graphics images of the main and basic ratio analysis equations or formulae that accountants and analysts use for ratio analysis. Feel free to download them for your own use by cutting and pasting from here ... don't forget where you got them from!

**New Ratio Analysis Equations
**

Profitability Gross Profit Margin

Operating Profit Margin

Net Profit Margin

Retained Profit Margin

Profit Mark up

PBIT

PBT

Rate of Return Return on Capital Employed (ROCE)

Return on total Assets (ROTA)

Return on Fixed Assets (ROFA)

Return on Working Capital (ROWC)

**Working Capital Management
**

Liquidity Current Ratio

Acid Test

NOTES: Current Ratio = Working Capital Ratio Acid Test Ratio = Quick Ratio

Asset Usage Total Asset Turnover

Stock turnover

Debtors Turnover

Creditors Turnover

Fixed Asset Turnover

Capital Employed Turnover

Working Capital Turnover

NOTE in the US stock = inventory, debtors = accountsreceivable, creditors = accounts payable

Alternative formulae:

Stock Turnover

Debtors Turnover

Gearing Gearing 1

Gearing 2

NOTE: in the US known as leverage

Investor Earnings per Share

Dividends per Share

Dividend Yield

Dividend Cover

P/E (Price Earnings)

Interest Cover

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