Interpretation of Financial Statements- Ratio analysis

Ratio analysis is a method of evaluating the financial information presented in accounts

There are six main types of ratios: profitability, liquidity, efficiency, gearing, investment and
cash flow ratios.
Profitability ratios
These ratios seek to establish how profitable a business is. The profitability ratios are: Return
on capital employed, gross profit ratio and net profit ratio.
Efficiency ratios
These ratios look at how effectively a business is operating they are primarily concerned with
the efficient use of assets. The main efficiency ratios are debtor’s collection period, creditors
collection period, stock turnover and asset turnover
Liquidity ratios
Liquidity ratios are derived from the statement of financial position and seek to test how
easily a firm can pay its debts. Loan creditors such as bankers who have loaned money to the
business are particularly interested in these ratios. The liquidity ratios are current ratio and
acid test or quick ratio.
Gearing ratios
Gearing ratios are also derived from the statement of financial position. Gearing effectively
represent the relationship between ordinary shareholders ‘funds and the debt capital of a
company.
Limitations of ratios
Ratios must be used in contest, this means that they should be used to compare businesses
that are similar.
Ratios must be calculated on a consistent and comparable basis and international comparisons
must be made with care.

Reasons why ratios are important

They provide a quick and easily digestible snapshot of an organization’s performance.
Ratios provide a good yardstick by which it is possible to compare one company with another
or compare the same company over time.
Ratio analysis takes account of size; one company may make more absolute profit than
another, if size is taken into account the company might not be performing well.

Interpretation of Accounts: Ratio Analysis

Accounting ratios are calculated by expressing one figure as a ratio or percentage of another
with the objective of disclosing significant relationship and trends that are not immediately
evident from the examination of individual balances appearing in the accounts.

Commonly used ratios

Profitability ratios
a) Return on capital employed (ROCE) = Net profit × 100
Capital employed (equity and loan)

or ROCE = Net Profit

Net Assets

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This ratio considers how effectively a company uses its capital employed. Capital employed
covers ordinary share capital plus reserves. The calculated figure indicates the return which
the business earns on the capital.

b) Gross Profit Ratio = Gross Profit × 100

Sales

c) Net profit ratio = Net profit× 100

Sales

d) Return on shareholders funds or Return on equity= Profit after tax × 100

Ordinary share capital +reserves

Liquidity Ratios or solvency Ratios

The two main measures of liquidity are the current ratio and acid test ratio
a) Current Ratio = Current assets
Current liabilities
This ratio compares assets which will become liquid within 12 months with liabilities which
will be due for payment in the same period.

b) Acid test or (quick assets) ratio = Current assets – Inventory

Current liabilities
The ratio measures liquidity of the business without having to sell inventory which might
take a while to sell.
Current ratios tries to find out whether there are enough current assets to cover current
liabilities.

Efficiency Ratios
Efficiency ratios look at how effectively a business is operating. They are primarily
concerned with the effective use of assets.

a) Inventory/stock Turnover Ratio = Cost of sales

Average stock

This ratio measures the speed with which stock move through the business that is the number
of times that inventory is replenished in an accounting period.

b) Debtors Collection Period = Trade receivables × 365

Credit sales

Or Average receivables × 365

Credit sales

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Measures how long customers take to pay debts. The shorter the period the better for the
company
c) Creditors collection/Payment period = Average Trade payables × 365
Credit purchases
Measures how long a business take to pay creditors. The longer the period, the longer the
business has money in the bank.

d) Asset turnover ratio = Revenue/Total assets less current liabilities

This ratio is a measure of how effectively the assets are being used to generate sales.

Capital Structure Ratios

a) Capital Gearing Ratio = fixed interest Loan plus preference share capital
Ordinary share capital

b) Debt Ratio = Total liabilities

Net assets
This ratio measures the debt of a company as a ratio of the total assets. If the ratio is low then
this means that the company financial risk is low and therefore it can borrow more.

Shareholder or Investor or stock market Ratios

Investors can compare the share price of a company with information from that company’s
financial statements to assess how expensive the share is in relation to the last known level of
earnings (income), dividends and underlying assets values
a) Earnings Per Share = Net Profit after tax +preference dividend
No of shares issued
This ratio shows how much profit was earned for each share.

b) Price Earnings Ratio = Market Price per share or share price

Earnings per share Earnings per share
A high price earnings ratio suggests that investors are optimistic about the future of the
company. A P/E ratio 0f say 16 means that the amount investors are willing to pay for shares
is 16 times the last known earnings per share.

c) Dividend Yield = Dividend per share

Market price per share

d) Dividend per share = Total dividend

Number of shares
Investors are not only interested in how much profit a company has made but are also
interested in how much dividend is being paid.

e) Dividend cover = earnings per share or total profit for the period
Dividend per share total dividend

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On average dividend cover should be around 2. Dividend cover measures the extent to which
the dividend is covered by earnings. A company that pays most of its profit as dividend is
unlikely to maintain dividends levels in the future.