Financial Accounting

Ratios Self Guided Tutorial

Ratio Analysis

Interpreting Business Accounts

 RATIO ANALYSIS
 ABC LTD RATIO ILLUSTRATION

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Ratio analysis
 Used in the assessment of the trading performance and financial standing of a company.
 Required in assessing an application for new lending facilities or the renewal of existing
facilities.
 Highlights customer’s need for a particular financial service
 Enables lender to translate financial data into a format that facilitates comparison and
interpretation

Basic rules for using ratio analysis

1. Compare ‘like’ with ‘like’
Year on year
Company to company (within the same industrial sector)
Average industrial sector - benchmarking
Note: Comparison is only possible if an identical basis of compilation is used and if there
is uniformity in the preparation of the financial statements.
2. Awareness of underlying trends
Changes in these underlying values over time may be obscured in the final ratio
User must be aware that the ratio is not saying anything about the trends
3. Clear definition of the financial ratio
Understanding of precise implications only possible with a clear definition of its
constituent parts

Advantages of ratio analysis

 Allow comparison between years/firms
 Allow relationship between accounting figures to be analysed
 Well understood

Accounting ratios can detect:

 Weak cash flow: Low current ratio, long creditor/debtor days, high gearing.
 Overtrading: High gearing - using short-term sources of finance (accounts payables, bank
overdraft) instead of long-term sources. Sales increasing very quickly, very little finance for
working capital, high inventory and accounts receivables because of increased sales.
 Weak profitability: Low gross/net profit ratios compared with other firms/years. Low return
on capital employed.
 High gearing: High gearing ratio. Owners have not invested enough capital into the business –
the extra debt is making the company more risky.

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Limitations of ratio analysis
 Must be compared with similar firms or past years' data
 Any changes in environment, market conditions, in the business from one year to the next
must be adjusted for
 Difficulty in comparisons due to different accounting policies
 Difficulty in comparisons where method of calculating the ratio differs
 Benchmarks or industry norms must be available against which to assess the ratio

Comparison against benchmark comparable company

Ratios, on their own are difficult to interpret. Comparison against a peer company, or against
industry norms, or standards, add insights into the performance of companies.

The main groups of ratios used by lenders:

Ratios can be categorized into groups:
 Operating ratios
 Financial ratios
There are many different and acceptable ways of calculating ratios. However, the calculation
should be internally consistent or logical.
For each ratio, you need to identify not only its strengths but also its limitations.

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Operating ratios
To assess profit generated in relation to sales and how the company is trading
 Profitability ratios
 Activity ratios

Profitability ratios
 Assessing the trading performance of a business.
Shows: Efficiency of production operations
Appropriateness product pricing policy
Major trends

Return on = Profit before interest and tax (PBIT) (Expressed as a %)

capital employed Capital employed

Capital employed comprises:

 Share capital,
 Share premium Shareholders’
 Capital reserves (e.g. revaluation Funds (Equity)
reserve)
 Revenue reserves (e.g. profit and loss
account)
 Long-term borrowings

Return on = Profit before tax (PBT) (Expressed as a %)

shareholders' funds Shareholders' funds
(Return on shareholders' funds  Return on equity)

When reviewing profitability consider both the Gross Profit, using the Gross Profit Margin as well as the Net
Profit using the Net Profit (before Tax) Margin. Both of these ratios should be assessed in light of the changes in
sales level as highlighted by the Sales Growth Rate

Sales growth rate % p.a. = Sales (Year 2 – Year 1) (Expressed as a %)

Sales Year 1
This ratio indicates:
 The progress of the business
 Its need for services in the short-term

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Gross profit ratio = Gross profit (Expressed as a %)
Sales

Points to note
 Expected to remain stable over a number of years.
 Varies greatly from business to business e.g. Supermarket v’s Boutique.
 Shows ability to maintain profitability and react to changes in market place.
o Heavily influenced by:
 Level of competition in the industry
 Level of quality
 Product differentiation
Higher margins can often be commanded by businesses selling goods of a higher quality or
distinctive advantage.
 Indicates the level of efficiency of a business in terms of the manufacture of goods as
well as the control of inventory costs - shows if costs are increasing at a faster rate than
can be recovered by increasing sales.
 Where the business is a substantial customer of its suppliers it may have a high level of
‘buying power’ allowing it achieve a higher margin than would otherwise be the case.

Net Profit margin = PBIT (Expressed as a %)

Sales
Points to note:
 Useful indicator of the level of cost control in the business, with a lower margin
signaling potential problems in this area.
 Level of efficiency of management - gauged in terms of changes on the Net Profit
Margin.
 Interest costs are deducted - large increases in overdraft interest due to the business
exceeding its overdraft limit may be signaled by this ratio.
 Directors’ salaries may represent significant expense - understand the impact of changes
in Directors’ salaries If directors forego increases in salaries/ take salary decrease the Net
Profit Margin will appear higher than it would otherwise.

Treatment of taxation in calculating the above ratios

Ratios are often based on before tax amounts as tax is a function of government policy rather
than company policy and can be a distorting or confounding factor.

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Activity ratios
Inventory turnover = Average inventory x 365 = days turned over
Cost of goods sold

Cost of goods sold = number of times turned over

Average inventory

Expressed as number of times turned over or by number of days in period.

 Ratio indicates ability to convert inventory into cash/accounts receivables.

 Varies from business to business.
 Lower inventory - efficiency of inventory management; if lower industry average may
indicate inefficiency due to inability to meet orders, interruptions in production.
 Decline in ratio or deterioration of inventory turnover may indicate slow
moving/obsolete inventory, fall off in sales demand, inefficiencies in control of
inventory-excessive purchasing, inefficiencies in production - over-production.

Accounts receivables days = Accounts receivables x days in period x (365 days year)
(Expressed in days) Credit sales

If credit sales not available, use total sales.

This ratio measures the average time debts are outstanding.
To improve cash collection:
 Quality of goods delivered
 Deliveries on time
To improve ratio:
 Accounts receivables contains large bad debt which should be written off (aged list of accounts
receivables would highlight this)
 Prompt invoicing
 Accuracy invoicing
 Effective cash collection and monitoring procedures
 Cash discounts
 Cash lodgement procedures tightened

Credit period Accounts payables x days in period x (365 days year) (Expressed
in days)
received Credit purchases

If credit purchases are not available use cost of goods sold.

The ratio should be high but not so high as to lose discounts, or to adversely affect the
company’s relationship with suppliers.

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If the ratio is very high this may indicate an inability to pay and cash flow problems.
Financial ratios
 Focus on the business’ liquidity and its financial risk.
 Liquidity - firm’s ability to manage its working capital (accounts receivables, accounts
payables inventory).
 Financial risk - level of debt in the capital funding of the business.
 Liquidity problems are often caused by incorrect financing of assets.
 General rule: long-term assets should be financed by long-term finance.

To assess cash flow problems and whether business adequately financed

 Liquidity ratios
 Gearing/leverage ratios

Liquidity ratios

Current ratio = Current assets

Current liabilities

 Crude measure of liquidity.

 Measure of adequacy of working capital.
 The current ratio indicates the firm's ability to meet its short-term cash obligations. 2:1 is
considered appropriate (generous? “more than 1” better?) for most businesses.
 Depends on the nature of the industry and the 'age' of the assets and liabilities.
 Ratio highlight inefficiencies.
 High current ratio - over-investment in current assets
 Low current ratio - unable to meet short-term liabilities

Acid-test (quick) ratio = Current assets – inventory

Current liabilities

 Ratio measures the firm's ability to pay its short-term debts.

 Better measure of contribution to a firm’s liquidity.
 Inventory is excluded because it is not 'liquid' i.e. inventory cannot be sold off quickly to
pay short-term debts. If sell inventory to pay debts, how can continue to trade? A 1:1
ratio is considered appropriate for most businesses.

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Gearing /Leverage ratios
Gearing - business is financed, at least in part, by borrowing, instead of by finance provided by
the owners (the shareholders).
A business’s level of gearing is an important factor in assessing risk.
Borrowing → commitment to pay interest charges and make capital repayments→ significant
financial burden→ increase the risk of insolvency.
If gearing is a risk, then why take on borrowing?
 Owners may have insufficient funds
 Can increase the returns to owners
 Interest rates → relatively low→ tax deductible→ effective cost of borrowing quite
cheap
One of the most significant effects of gearing is that returns to shareholders become more
sensitive to changes in profits.
For a highly geared company, a change in profits can lead to a proportionately greater change in
ROSF.

Type of finance Return Tax deductible Risk

Share capital Dividend No Low
Retained earnings No No No
Long-term Interest Yes High
borrowings

 Capital structure - function of cost of capital.

 Debt is a cheaper source of finance
 Acceptable risk levels constrain or limit the amount of debt
 Should not be so highly geared as to get into financial distress.
 Increase borrowings - return may go up because interest is a cheaper source of finance -
risk will increase because interest must be paid.

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Debt / equity ratio = Long-term debt (Expressed as a %)
Shareholders' funds

Shareholders' funds includes ordinary share capital, share premium, capital reserves and revenue
reserves

Debt / capital = Long-term debt (Expressed as a %)

employed ratio Capital employed

Indicates the company’s ability to make capital repayments.

Excessive gearing - risk for ordinary shareholders.

Total Gearing = Total debt (Expressed as a %)

Total Capital

 Gearing measures the level of debt used to fund the running of the business. It indicates
how vulnerable the business is to trading setbacks, which may require further finance to
be raised. When viewed in conjunction with Total Gearing %, the user may get an
overview of the level of business funding being provided by both Banks and other debt
providers.

Interest Cover = Profit before interest and tax (Expressed as number of times)
Interest

 Interest cover represents the capacity of the business to service the cost of debt (interest
only). As such it is a useful measure of the ability of a business to take on further debt.
An interest cover of 3 times is traditionally regarded as adequate. However this should be
assessed in terms of the whole financial position of the firm when making an assessment.

Breakeven Point = All overheads

Gross profit %

 Breakeven point measures the level of sales that must be made at existing Gross Profit
Margins to pay for overheads. Businesses with a higher breakeven point will need to
generate a higher amount of sales to cover their overheads as compared to a business
with a lower breakeven point.

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RATIO ANALYSIS ILLUSTRATION
Statement of Financial Position of ABC Co as at 31 December 2002
(Current) (Comparative)
Notes 20x2 20x1
€000 €000
Non-current assets 43 31
Current assets
Inventory 33 23
Accounts receivables 26 15
Cash 3 1
62 39
Total assets 105 70

Equity and Liabilities

Share capital 40 12
Retained profit 26 15
66 27

Long-term liabilities 3 5

Current Liabilities
Accounts payables 30 28
Bank overdraft 6 10
36 38
Total Equity and Liabilities 105 70

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Income Statement of ABC Ltd for the year ended 31 December 2002
(Current) (Comparative
Notes 20x2
)20x1

€000 €000
Turnover 117 84
Less: Cost of sales 50 37
Gross profit 67 47
Distribution costs 27 20
Administration costs 16 11
Operating profit 24 16
Interest payable 2 1
Profit before tax 22 15
Tax 7 5
Profit after tax 15 10
Dividends paid and proposed 4 2
Retained profit 11 8

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Operating ratios
Profitability ratios
Return on = Profit before interest and tax (PBIT) (Expressed as a %)
capital employed Capital employed

Return on = Profit before tax (PBT) (Expressed as a %)

shareholders' funds Shareholders' funds

Sales growth rate % p.a. = Sales (Year 1 – Year 2) (Expressed as a %)

Sales Year 1

Gross profit ratio = Gross profit (Expressed as a %)

Sales

Net Profit margin = PBIT (Expressed as a %)

Sales

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Activity ratios
Inventory turnover = Average inventory x 365 = days turned over
Cost of goods sold

Cost of goods sold = number of times turned over

Average inventory

Accounts receivables days = Accounts receivables x days in period x (365 days year)
(Expressed in days) Credit sales

Credit period Accounts payables x days in period x (365 days year) (in days)
received Credit purchases

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Financial ratios
Liquidity ratios
Current ratio = Current assets X
Current liabilities

Acid-test (quick) ratio = Current assets – inventory

Current liabilities

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Gearing /Leverage ratios
Debt / equity ratio = Long term debt (Expressed as a %)
Shareholders' funds

Debt / capital = Long-term debt (Expressed as a %)

employed ratio Capital employed

Total Gearing = Total debt (Expressed as a %)

Total Capital

Interest Cover = Profit before interest and tax (Expressed as number of times)
Interest

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