# Ratio Analysis

Ratio Analysis

Ch 28

 Ratio analysis is the calculation and interpretation of financial ratios in order to draw conclusion or raise questions about financial position and financial 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 or worse.  Competitors Performance Ratios of one company can be compared with the ratios of other company in same industry that our company’s performance is better or worse than others.  Average of Industry Ratios of one company can be compared with the average ratios 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) 2) 3) 4) 5) Profitability Liquidity Efficiency Gearing Investment Performance (Share Holder’s 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 = %

ii.

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 = %

iii. =%

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

Capital Employed If this ratio has increased it is better. It can change because of change in net profit ratio and asset turnover ratio. Capital Employed = Total Assets – Current Liability
Or

Note:

Capital Employed = Long Term Liability + Capital + Reserves iv.
Return on Equity Ratio= Profit before Ordinary Dividend

x 100 = % Equity If this ratio has increased it is better. It can change because of change in net profit, interest expense. Equity = Total Assets – Current Liability- Long Term Liability
Or

Note:

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 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

Current Ratio = Current Asset = answer : 1

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

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. 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. 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. 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. 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. x365 = Days

ii.

Average Holding period = Average Stock

iii.

Debtor Turnover Ratio = Credit Sales = Times

iv.

Average Collection period = Average Debtor

v.

Creditor Turnover Ratio = Credit Purchase = Times

vi.

Average Payment period = Average Creditors

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 current earnings. If this ratio is high then it is better for debenture 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

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. 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. Ordinary Dividend The dividend cover ratio indicates the proportion of earnings retain by the company and the level of risk, should earning decline, for 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. 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.

ii.

Price/ Earning Ratio = Market Price per Share

iii.

Dividend Cover Ratio = Profit after Interest and Tax = Times

iv.

Dividend Yield Ratio = Dividend per Ordinary Share