lecture 4,5,6 - ratio analysis

8/3/2019 Lecture 4,5,6 - Ratio Analysis

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FinancialStatementsAnalysisRATIOANALYSIS

INTRODUCTION TO RATIO ANALYSIS

Ratio analysis compares one figure with another to place it in context and asses its relative importance. Ithelps analyse date and aids decision making.It is part of the decision making process:

A ratio: Is the mathematical relationship between two quantities in the form of a fraction or percentage.

Ratio analysis: is essentially concerned with the calculation of relationships which after proper

identification and interpretation may provide information about the operations and state of affairs of abusiness enterprise.The analysis is used to provide indicators of past performance in terms of critical success factors of abusiness. This assistance in decision-making reduces reliance on guesswork and intuition and establishesa basis for sound judgement.Note: A ratio on its own has little or no meaning at all.

Significance of Using RatiosThe significance of a ratio can only truly be appreciated when:

1. It is compared with other ratios in the same set of financial statements.2. It is compared with the same ratio in previous financial statements (trend analysis).

3. It is compared with a standard of performance (industry average). Such a standard may be eitherthe ratio which represents the typical performance of the trade or industry, or the ratio whichrepresents the target set by management as desirable for the business.

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!

Set

Objectives

review

implementSelect

course of

action

gather

informationanalyse

information


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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- by-step, one by

one.

By the end of this section we will have used every ratio several times and we will be experts at using and

understanding what they tell us.

What do we want ratio analysis to tell us?

What do the users of accounts need to know?

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. is profitable

2. has enough money to pay its bills

3. could be paying its employees higher wages

4. is paying its share of tax

5. is using its assets efficiently

6. has a gearing problem

7. is a candidate for being bought by another company or investor


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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. Profitability: has the business made a good profit compared to its turnover?

2. Return Ratios: compared to its assets and capital employed, has the business made a good profit?

3. Liquidity: does the business have enough money to pay its bills?

4. Asset Usage or Activity: how has the business used its fixed and current assets?

5. Gearing: does the company have a lot of debt or is it financed mainly by shares?

6. 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.

What do the Users of Accounts Need to Know?

The users of accounts that we have listed will want to know the sorts of things we can see in the table

below: this is not necessarily everything they will ever need to know, but it is a starting point for us to

think about the different needs and questions of different users.

Interest Group What do the Users of Accounts Need to Know? Ratios to watch

Investors to help them determine whether they should buy

shares in the business, hold on to the shares they

already own or sell the shares they already own.

They also want to assess the ability of the business

to pay dividends.

Return on Capital Employed

Lenders to determine whether their loans and interest will

be paid when due

Gearing ratios

Managers might need segmental and total information to see

how they fit into the overall picture

Profitability ratios


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Employees information about the stability and profitability of

their employers to assess the ability of the business

to provide remuneration, retirement benefits and

employment opportunities

Return on Capital Employed

Suppliers and other

trade creditors

businesses supplying goods and materials to other

businesses will read their accounts to see that they

don't have problems: after all, any supplier wants

to know if his customers are going to pay their

bills!

Liquidity

Customers the continuance of a business, especially when they

have a long term involvement with, or are

dependent on, the business

Profitability

Governments and their

agencies

the allocation of resources and, therefore, the

activities of business. To regulate the activities of

business, determine taxation policies and as the

basis for national income and similar statistics

Profitability

Local community Financial statements may assist the public by

providing information about the trends and recent

developments in the prosperity of the business and

the range of its activities as they affect their area

This could be a long and

interesting list

Financial analysts they need to know, for example, the accountingconcepts employed for inventories, depreciation,

bad debts and so on

Possibly all ratios

Environmental groups many organisations now publish reports

specifically aimed at informing us about how they

are working to keep their environment clean.

Expenditure on anti-pollution

measures

Researchers researchers' demands cover a very wide range of

lines of enquiry ranging from detailed statistical

analysis of the income statement and balance sheet

data extending over many years to the qualitative

analysis of the wording of the statements

Possibly all ratios


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TYPES OF RATIO

There are a number of types of ratios of interest to the various stakeholders of a business. The main

classifications of ratios are as follows:

Profitability Ratios Measure the relationship between gross/net profit and sales, assets and

capital employed. These are sometimes referred to as being performance

ratios. Profitability ratios measure the profitability of the organization.

Gross profit, Net profit, Return on capital employed, Return on

Investment, Earnings per share

Activity Ratios These measure how efficiently an organisation uses its resources. These

are sometimes referred to as asset utilisation ratios.

Stock turnover, asset turnover, collection period, payment period

Liquidity Ratios These investigate the short-term and long-term financial stability of the

firm by examining the relationships between assets and liabilities. These

are sometimes also called solvency ratios.

Acid test, current ratio (quick ratio)

Investment Ratios This group of ratios is concerned with analysing the returns for

shareholders. These examine the relationship between the number of

shares issued, dividend paid, value of the shares, and company profits.

For obvious reasons these are quite often categorised as shareholder

ratios.Dividend yield, dividend per share, price/earnings ratio, dividend cover

Gearing Examines the relationship between internal sources and external sources

of finance. It is therefore concerned with the long-term financial position

of the company.

Equity ratio, debt ratio, debt/equity ratio


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1. PROFITABILITY RATIOSProfitability is the ability of a business to earn profit over a period of time. Although the profit figure is

the starting point for any calculation of cash flow, as already pointed out, profitable companies can stillfail for a lack of cash.

Note: Without profit, there is no cash and therefore profitability must be seen as a critical success factors.

A company should earn profits to survive and grow over a long period of time. Profits are essential, but it would be wrong to assume that every action initiated by management

of a company should be aimed at maximising profits, irrespective of social consequences.

Profitability is a result of a larger number of policies and decisions. The profitability ratios show thecombined effects of liquidity, asset management (activity) and debt management (gearing) on operatingresults. The overall measure of success of a business is the profitability which results from the effective

use of its resources.For most private business enterprises one of their main objectives is to make a profit. However, it is not

sufficient just to measure the amount of profit made.

(a) Gross Profit Margin

This ratio examines the relationship between the profits made on trading activities only (gross profit)against the level of turnover/sales made. Normally the gross profit has to rise proportionately withsales. It can also be useful to compare the gross profit margin across similar businesses although therewill often be good reasons for any disparity.It is given by the formula

Gross Profit Margin = gross profit x 100 expressed as a percentage

turnover (sales)

Interpretation: Obviously the higher the profit margin a business makes the better. However, the level of

gross profit margin made will vary considerably between different markets. For example the amount of

gross profit percentage put on clothes, (especially fashion items), is far higher than that put on food items.

So any result gained must be looked at in the context of the industry in which the firm operates.


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Analysis: This ratio is used to determine the amount of profit remaining from each sales dollar aftersubtracting the cost of goods sold. Example: a gross profit margin of 0.05 indicates that 5% of salesrevenue is left to use for purposes other than the cost of goods sold. Measures the margin of profitabilityon sales throughout the year. This is the main indicator when measuring the efficiency of the operation, avery good indicator of the business's ability to withstand falling prices, rising costs or declining sales.

A normal figure for a manufacturing industry would be between 6% and 8%, while high volume/lowmargin activities like food retailing can run very satisfactorily at around 3%. Retailers generally will havea lower profit margin than most industries.

Highest margins of all are usually experienced in service industries where margins above 10% areenjoyed. The percentage should be relatively constant and any reason for decline investigated. Reasonsfor change could be a reduction in selling prices or increase in cost of sales.

(b) Net Profit Margin

This is a widely used measure of performance and is comparable across companies in similar industries.

The fact that a business works on a very low margin need not cause alarm because there are some sectors

in the industry that work on a basis of high turnover and low margins, for examples supermarkets and

motorcar dealers.

What is more important in any trend is the margin and whether it compares well with similar businesses.

As opposed to gross profit margin this ratio measures the relationship between the net profit (profit made

after all other expenses have been deducted) and the level of turnover or sales made. It is given by the

formula:

Net Profit Margin = net profit x 100 expressed as a percentage

turnover (sales)

Interpretation As with gross profit, a higher percentage result is preferred. This is used to establish

whether the firm has been efficient in controlling its expenses. It should be compared with previous

years results and with other companies in the same industry to judge relative efficiency. The net profit

margin should also be compared with the gross profit margin. For if the gross profit margin has improvedbut the net profit margin declined, this shows that profits made on trading are becoming better, however

the expenses incurred in the running of the business are also increasing but at a faster rate than profits.

Thus efficiency is declining.


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Analysis: The net profit margin is calculated by taking the net earnings available to common stockholdersand dividing it by sales. This ratio is used to determine the amount of net profit for each dollar of salesthat remains after subtracting all expenses. Companies with profit margins of less than 5% tend to eitherbe in very competitive sectors or they may be doing badly. Be careful with these companies. A smalleconomic downturn can reduce sales leaving the company making losses.

(c) Return on Capital Employed (ROCE)

This is sometimes referred to as being the primary ratio and is considered to be one of the most important

ratios available. This ratio measures the efficiency of funds invested in the business at generating profits.

This ratio is actually different for different types of business; this is due to the fact that the various types

of business can all raise their capital in different ways. This ratio shows the profit attributable to the

amount invested by the owners of the business. It also shows potential investors into the business what

they might hope to receive as a return. The stockholders equity includes share capital, share premium,

distributable and non-distributable reserves. Once again this is expressed as a percentage.

ROCE = net profit before tax and interest x 100

total capital employed

Total Capital = ordinary share capital + preference share capital + Reserves + Debentures +Long-term

loans

The profit margin is likely to be higher when:

there is limited competition

there is strong brand loyalty

lower unit costs

high price (e.g. orice inelastic product or

exclusive item)

Gross profit is turnover (also called sales or

revenues) minus cost of sales (i.e. overhead costs

have not been deducted)

Net profit is turnover (=sales=revenue) minus

cost of sales and overhead costs

If the gross profits are rising over time but the

net profit is falling that is due to increasingoverheads


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For each type of company the idea is to try to determine how much profit has been made for distribution

from the total amount of assets employed by that business. This is why we ignore tax and interest charges

when calculating ROCE for a limited company. These items will fluctuate at the whim of agencies such

as the government and the Bank of England. Therefore if we were to measure profit after tax and interest

we would get significant variations in our results. These would not reflect changes in the performance of

the business, but external factors.

Interpretation: As with the other ratios examined so far the higher the value of the ratio the better. A

higher percentage can provide owners with a greater return. Inevitably this figure needs to be compared

with previous years and other companies to determine whether this years result is satisfactory or not.

Furthermore, the percentage result arrived at for ROCE for a given organisation needs to be compared

with the percentage return offered by interest-bearing accounts at banks and building societies. Ideally

the ROCE should be higher than any return that could be gained from interest-earning accounts.

Analysis : Return on capital employed (ROCE) ratio measures whether or not a company is generatingadequate profits in relation to the funds invested in it and is a key indicator of investment performance. Abusiness could have difficulty servicing its borrowings if a low return is being earned for any length oftime. In manufacturing we would expect to see figures in excess of 10% rising to over 25% at the top end.In retail lower figures would be experienced, ranging between 5% and 15%. Construction figures show anaverage of about 7% increasing to over 35% for the top performers.

High ROCE can be

achieved by

Increasing sales

Increasing profit

margins

ROCE is likely to be lower if

the markets are in decline

Unit costs are increasing and

the firm cannot increase price

Sales are falling

The return on capital employed islikely to be higher when:

The market is growing

The firm is inceasing its

efficiency

Demand is high


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(d) Return on Investment (ROI)

Income is earned by using the assets of a business productively. The more efficient the production, themore profitable the business. The rate of return on total assets indicates the degree of efficiency withwhich management has used the assets of the enterprise during an accounting period. This is an importantratio for all readers of financial statements.

Investors have placed funds with the managers of the business. The managers used the funds to purchaseassets which will be used to generate returns. If the return is not better than the investors can achieveelsewhere, they will instruct the managers to sell the assets and they will invest elsewhere. The managerslose their jobs and the business liquidates.

ROI = After Tax Earnings : Total Assets

(e) Earnings per Share (EPS)

Whatever income remains in the business after all prior claims, other than owners claims (i.e. ordinarydividends) have been paid, will belong to the ordinary shareholders who can then make a decision as tohow much of this income they wish to remove from the business in the form of a dividend, and how muchthey wish to retain in the business. The shareholders are particularly interested in knowing how much hasbeen earned during the financial year on each of the shares held by them. For this reason, an earning pershare figure must be calculated. Clearly then, the earning per share calculation will be:

EPS = Net Income after Tax Preference Dividend : No. of Issued ordinary Shares

Additional Information : The ROA ratio is calculated by taking the net earnings available to commonstockholders (net income) and dividing it by total assets. This ratio is used to determine the amount ofincome each dollar of assets generates. Example: an ROA ratio of 0.0568 indicates that each dollar ofcompany assets produced income of almost $0.06.

The ROE ratio is calculated by taking the net earnings available to common stockholders and dividing itby common stockholders' equity. This ratio is used to determine the amount of income produced for eachdollar that common stockholders have invested. Example: An ROE ratio of 0.0869 indicates that thecompany returned 8.69% for every dollar invested by common stockholders.


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2. LIQUIDITY RATIOSLiquidity refers to the ability of a firm to meet its short-term financial obligations when and as they falldue.

The main concern of liquidity ratio is to measure the ability of the firms to meet their short-term maturingobligations. Failure to do this will result in the total failure of the business, as it would be forced intoliquidation.

These ratios are concerned with the examination of the financial stability of the organisation. They are

mainly concerned with the organisations working capital and whether or not it is being managed

effectively. Working capital is needed by all organisations in order for them to be able to finance their

day-to-day activities. Too little and the company may not be able to pay all its debts. Too much and they

may not be making most efficient use of their resources.

1. The Current RatioThe Current Ratio expresses the relationship between the firms current assets and its current liabilities.Current assets normally includes cash, marketable securities, accounts receivable and inventories. Currentliabilities consist of accounts payable, short term notes payable, short-term loans, current maturities oflong term debt, accrued income taxes and other accrued expenses (wages).

Current Ratio = current assets: current liabilities

Interpretation: The rule of thumb says that the current ratio should be at least 2, that is the current assetsshould meet current liabilities at least twice.

Analysis For example: a current ratio of 2.57 indicates that the company has $2.57 worth of currentassets for every $1.00 of current liabilities.

One of the most universally known ratios, which reflect the Working Capital situation, indicates theability of a company to pay its short-term creditors from the realisation of its current assets and withouthaving to resort to selling its fixed assets to do so.Ideally the figure should always be greater than 1, which would indicate that there are sufficient assets

available to pay liabilities, should the need arise. The higher the figure the better.For those industries such as transport where the majority of assets are tangible fixed assets, then a figureof 0.6 would be acceptable. In retail and manufacturing we would expect figures between 1.1 to 1.6; inwholesale and construction 1.1 to 1.5 and motor vehicles 1.2 to 1.6. Generally where credit terms andlarge stocks are normal to the business, the current ratio will be higher than, for example, a retail businesswhere cash sales are the norm.


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2. The Acid TestThis ratio is sometimes also called the quick ratio or even the liquid ratio. It examines the businesss

liquidity position by comparing current assets and liabilities but it omits stock from the total of current

assets. This ratio is used to determine the company's ability to repay current liabilities after the least

liquid of its current assets is removed from the equation. It examines the ability of the business to coverits short-term obligations from its quick assets only (i.e. it ignores stock).] This therefore provides a

much more accurate measure of the firms liquidity.The reason for this is stock is the most illiquid current

asset, i.e. it is the hardest to turn into cash without a loss in its value. With the omission of stock

therefore we are able to perform a calculation that directly relates cash and near cash equivalents, (cash,

bank and debtors) to short-term debts. Measures assets that are quickly converted into cash and they are

compared with current liabilities. This ratio realizes that some of current assets are not easily convertible

to cash e.g. inventories.

It is given by the formula

Acid Test = current assets stock: current liabilities

Interpretation: Again conventional wisdom states that an ideal result for this ratio should beapproximately 1.1:1 Thus showing that the organisation has 1.10 to pay every 1.00 of debt. Thereforethe company can pay all its debts and has a ten- percent safety margin as well. A result below this e.g.0.8:1 indicates that the firm may well have difficulties meeting short-term payments. Clearly this ratiowill be lower than the current ratio, but the difference between the two (the gap) will indicate the extent towhich current assets consist of stock.

Analysis : Example: a quick ratio of 2.48 indicates that the company could pay off 248% of its currentliabilities by liquidating all current assets other than inventory.

This ratio indicates the ability of a company to pay its debts as they fall due. It is generally considered tobe a more accurate assessment of a company's financial health than the current ratio as it excludes stock,thus reducing the risk of relying on a ratio that may include slow moving or redundant stock.

Figures of this ratio are lower than the current ratio. Supermarkets can, for example, easily survive onratios as low as 0.4 with cash being receivedfor goods sold, before the goods are actually paid for. Planthire contractors would also expect ratios as low as 0.6 to 0.8. Clothing retailers also operate at very lowlevels, with average figures being between 0.2 and 0.6 and retail as a whole between 0.3 and 0.7. Inmanufacturing figures between 0.7 and 1.1 are seen as acceptable and for wholesalers 0.7 to 1.0.Construction should operate at between 0.6 and 1.0.

Do not want the acid test ratio to be too high

because:

This could mean too many

debtors(i.e too much money

outstanding); this may lead to bad

debts and /or cashflow problems

Could mean too much cash; cash

represents idle money which could

be earning a higher return elsewhere

Do not want acid test ratio to be too lowbecause:

could mean liquidity problems i.e.

may not be able to pay current

liabilities


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3. ACTIVITY RATIOS

Activity ratios or financial efficiency ratios are concerned with how well an organisation manages its

resources. Primarily they investigate how well the management controls the currentsituation of the firm.They consider stock, debtors and creditors. This area of ratios is linked therefore with the management ofworking capital. If a business does not use its assets effectively, investors in the business would rathertake their money and place it somewhere else. In order for the assets to be used effectively, the businessneeds a high turnover.

Unless the business continues to generate high turnover, assets will be idle as it is impossible to buy andsell fixed assets continuously as turnover changes. Activity ratios are therefore used to assess how activevarious assets are in the business.

(a) Stock Turnover

This ratio measures the number of times in one year that a business turns over its stock of goods for sale.

From this figure we can also establish the average length of time (in days) that stock is held by thecompany.This ratio measures the stock in relation to turnover in order to determine how often the stock turns overin the business.It indicates the efficiency of the firm in selling its product. It is calculated by dividing he cost of goodssold by the average inventory.It is given by the formula

Stock Turnover = cost of goods sold expressed as however many times

average stock

where average stock = (opening stock + closing stock)

2

Interpretation: This ratio can only really be interpreted with knowledge of the industry in which the firmoperates. For example, we would expect a greengrocer to turnover his or her stock virtually every day, astheir goods have to be fresh. Therefore, we would expect to see a result for stock turnover ofapproximately 250 to 300 times per year. This allows for closures and holidays and the fact that someproduce will last longer than one day. Conversely if we were examining the accounts of a second handcar sales business we would maybe expect them to turn over their entire stock of cars and replace withnew ones maybe about once a month, therefore we would see a result of 12 times.

Note: Increased turnover can be just as dangerous as reduced turnover if the business does not have theworking capital to support the turnover increase. As turnover increases more working capital and cash isrequired and if not, overtrading occurs.


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As usual we can undertake a comparison with previous years or other similar sized firms in the same

market. As a general rule though the higher the rate of stock turnover the better. It is possible to convert

this ratio from showing the number of times an organisation turns over stock to showing the average

number of days stock is held. It is given by the formula:

Stock Turnover = average stock x 365 expressed as days

cost of goods sold

Interpretation: The high stock turnover ratio would also tend to indicate that there was little chance of thefirm holding damaged or obsolete stock. It is also possible to express stock turnover in terms of weeks ormonths, by multiplying by 52 or 12 as appropriate.

Analysis : A high ratio indicates that the company has inventory that sells well, while a low ratio meansthat the company has inventory that does not sell well. Example: an inventory turnover ratio of 66.67indicates that inventory was sold 66.67 times during the year. Measures the number of times a companyconverts its stock into sales during the year. When examining this ratio it should be borne in mind thatdifferent companies will have varying levels of stock turnover depending on what they produce and theindustry they operate in.

Low figures are generally poor as they indicate excessively high or low moving stocks. At one end of thescale, and apart from advertising agencies and other service industries, ready mixed concrete companiesprobably have one of the better stock/turnover figures.

At the other end companies that maintain depots of finished goods and replacement parts will have much

poorer figures. For example, a manufacturing company with stock/turnover ratio of around 25 - 30 wouldbe reasonable, decreasing with the larger and more complex the goods being made. For retail andwholesale, average figures would be lower at around 9 - 10. For construction, average stock/turnoverfigures would be around 16 and for industries such as transport, where overall stock figures are low, itwould produce results of around 80 - 90.


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(b) Debtors Collection Period

This particular ratio is designed to show how long, on average, it takes the company to collect debts owed

by customers. Customers who are granted credit are called debtors. The formula for this ratio is:

Debtor collection period = debtors x 365 expressed as days

credit sales

Often the figure for credit sales is not actually provided on the profit and loss account. In this case the

sales/turnover figure should be substituted and used instead.

Interpretation:Different industries allow different amounts of time for debtors to settle invoices.Standard credit terms are usually for 30,60,90 and 120 days. The debt collection period figure shouldtherefore be compared against the official number of days the organisation allows for settlement. For thisratio the shorter the debt collection period the better. The shorter the average collection period, the betterthe quality of debtors, as a short collection period implies the prompt payment by debtors.The average collection period should be compared against the firms credit terms and policy to judge its

credit and collection efficiency.An excessively long collection period implies a very liberal and inefficient credit and collectionperformance.The delay in collection of cash impairs the firms liquidity. On the other hand, too low a collection periodis not necessarily favourable, rather it may indicate a very restrictive credit and collection policy whichmay curtail sales and hence adversely affect profit.

Analysis: Example: an average collection period ratio of 65.70 indicates that on average it takes 65.70days for customers to pay off their

account balances. Measures the length of time a company takes to collect its debts and is measured indays. In general terms the figure indicates the effectiveness of the company's credit control department incollecting monies outstanding.

Apart from strictly cash businesses like supermarkets with virtually zero debtors, normal payment termsare at the end of the month following delivery, giving an average credit of between 6 and seven weeks.Clothing retailers show some of the lowest figures with averages of around 7 days. In manufacturingaverage figures are around 63 days, with 42 being experienced at the top end and 84 days at the lowerend. Average for wholesalers is around 56 days, whilst in construction the figures are lower, at around 45days.

Generally the average figure is around 30 days. In the construction industry the average is around 31

days, rising to 54 days at the bottom end and down to 17 days at the top. For wholesalers the average risesto 37 days, with top and bottom figures being 18 and 61 days respectively. For retail the average figuredrops to 23 days with 40 days being in the bottom sector. For food retailers as low as 8 - 12 days is thenorm. In manufacturing averages tend to be around 37 days, with the worst performers rising to 55 daysand the best showing creditor days of around 22 days.


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(c) Asset turnover

This ratio measures a businesss sales in relation to the assets it uses to generate these sales. The formula

to calculate this ratio is

Asset turnover = sales

net assets

This formula measures the efficiency with which businesses use their assets. An increasing ratio overtime generally indicates that the firm is operating with greater efficiency. A fall in the ratio can be causedby a decline in sales or an increase in assets employed.

Interpretation: The results of asset turnover ratios vary enormously. A supermarket may have a highfigure as it has relatively few assets in relation to sales. A shipbuilding firm is likely to have a much

lower ratio because it requires many more assets.Increased turnover can be just as dangerous as reducedturnover if the business does not have the working capital to support the turnover increase. As turnoverincreases more working capital and cash is required and if not, overtrading occurs.

Analysis : Example: a total asset turnover ratio of 0.68 indicates that the dollar amount of sales was 68%of all assets.

The asset turnover indicates how effectively a company utilises its investment in assets. It is a measure ofhow efficient the company has been in generating sales from the assets at its disposal. A low figure wouldsuggest either poor trading performance (which can be evaluated by the profit margin, sales per employeefigures) or an over investment in costly fixed assets. The construction industry shows a mean asset

turnover ratio of 1.6, with the poorer performers averaging 0.6 and the better companies showing anaverage of 2.6. The retail sector has an average asset turnover of 1.9, with poorer performers in the sectoraveraging 0.8 and the better ones showing an average of 3.2.

4. Creditors Payment PeriodThis ratio measures the length of time it takes a company to pay its creditors. This particular ratio is

designed to show how long, on average, it takes the company to pay debts owed to suppliers. Suppliers

who are grant credit are called creditors. The formula for this ratio is:

Debtor collection period = creditors x 365 expressed as days

Credit purchases


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Interpretation : Generally the average figure is around 30 days.

Analysis : In the construction industry the average is around 31 days, rising to 54 days at the bottom endand down to 17 days at the top. For wholesalers the average rises to 37 days, with top and bottom figuresbeing 18 and 61 days respectively. For retail the average figure drops to 23 days with 40 days being in thebottom sector. For food retailers as low as 8 - 12 days is the norm. In manufacturing averages tend to be

around 37 days, with the worst performers rising to 55 days and the best showing creditor days of around22 days.


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5. GEARING The ratios indicate the degree to which the activities of a firm are supported by creditors funds as

opposed to owners. The relationship of owners equity to borrowed funds is an important indicator of financial

strength. The debt requires fixed interest payments and repayment of the loan and legal action can be taken

if any amounts due are not paid at the appointed time. A relatively high proportion of fundscontributed by the owners indicates a cushion (surplus) which shields creditors against possiblelosses from default in payment.Note: The greater the proportion of equity funds, the greater the degree of financial strength.Financial leverage will be to the advantage of the ordinary shareholders as long as the rate ofearnings on capital employed is greater than the rate payable on borrowed funds.The following ratios can be used to identify the financial strength and risk of the business.

(a) The Equity Ratio

The equity ratio is calculated as follows: (this ratio is multiplied by 100 to bring it to a percentage)

Equity Ratio = Ordinary Shareholders Interest : Total Assets

Interpretation: A high equity ratio reflects a strong financial structure of the company. A relativelylow equity ratio reflects a more speculative situation because of the effect of high leverage and thegreater possibility of financial difficulty arising from excessive debt burden.

(b) The Debt Ratio

This is the measure of financial strength that reflects the proportion of capital which has beenfunded by debt, including preference shares.

This ratio is calculated as follows:

Debt Ratio = Total Debt : Total Assets

Interpretation: With higher debt ratio (low equity ratio), a very small cushion has developed thus notgiving creditors the security they require. The company would therefore find it relatively difficult to raiseadditional financial support from external sources if it wished to take that route. The higher the debt ratiothe more difficult it becomes for the firm to raise debt. Debt Ratio is complementary to the equity ratio aslong as total debt plus equity gives 100% of the total assets


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Analysis: An increasing ratio would indicate that borrowing is making a higher contribution to thecapital base of the business than shareholders funds. This may cause problems, particularly if profitmargins are also in decline.

The manufacturing sector shows an average total debt ratio 1.4, with the lower quartile companiesaveraging around 3.4 and the upper quartile showing a ratio of 0.4. The retail sector shows an average of

1.1, with the better performers in retail averaging 0.2: the construction industry averages around 1.5, withthe upper quartile averaging around 0.25.

Debt ratios measure the amount of debt an organization is using and the ability of the organization to payoff the debt. These include the debt to total assets ratio and the times interest earned ratio.

(c) The Debt / EquityRatio

This ratio indicates the extent to which debt is covered by shareholders funds. It reflects therelative position of the equity holders and the lenders and indicates the companys policy on themix of capital funds. The debt to equity ratio is calculated as follows:

Debt to Equity Ratio = Total debt : Total Equity

Gearing is quite often included in the classification of liquidity ratios as this ratio focuses on thelongterm financial stability of an organisation. It measures the proportion of capital employedby the business that is provided by long-term lenders as against the proportion that has beeninvested by the owners. Thus, we can see how much of an organisation has been financed bydebt. It is given by the formula:

Gearing = long term liabilities + preference shares x 100total capital employed

Once again this is expressed as a percentage.

Total Capital = ordinary share capital + preference share capital + Reserves + Debentures +Long-term loans

Long term liabilities = Long-term loans + debentures

Interpretation: The gearing ratio shows how risky an investment a company is. If loans represent

more than 50% of capital employed, the company is highly geared. Such a company has to payinterest on its borrowings before it can pay dividends to shareholders or retain profits forreinvestment. High gearing figures indicate a high degree of risk. As ordinary shareholders shouldenjoy a greater rate of return from lower geared companies. Low geared companies i.e. those under50% should provide therefore a lower risk investment opportunity, they should also be able tonegotiate loans much more easily than a highly geared company as they are not already carrying ahigh proportion of debt.


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Analysis : Gearing is a comparison between the amount of borrowings a company has to its shareholdersfunds (net worth). The result of the calculation will show as a percentage the proportion of capitalavailable within the company in relation to that owed to sources outside the company. Lower figures aremore acceptable, showing that the company is predominantly financed by equity whilst high gearingshows an over reliance on borrowings for a significant proportion of the company's capital requirements.

High gearing is significantly more dangerous at times of high or rising interest rates and also lowprofitability. Businesses that rely on a great deal of tangible assets (such as heavy manufacturing) or haveto replace fixed assets more frequently than other industries are expected to have higher gearing figures.

The transport industry shows an average gearing level of 150%, with the poorer performers sufferinglevels up to 380%. The service sector has an average gearing level of 100%, with the upper quartile ofcompanies showing negative gearing (i.e. surplus of cash over borrowing). The construction industry,where borrowing is usually taken out against work in progress as well as tangible fixed assets such asplant and machinery, shows an average of 130% gearing, with the better performers averaging 30% andthe poorer performing businesses showing gearing levels in excess of 400%.

6. INVESTMENT RATIOS

Shareholders and potential shareholders are primarily concerned with assessing the level of return theymight gain from an investment in a particular company. These ratios are necessary as the value of sharescan vary quite considerably. These ratios indicate the relationship of the firms share price to dividendsand earnings. Note that when we refer to the share price, we are talking about the Market value and notthe Nominal value as indicated by the par value.

HIGH GEARING

Advantages:

borrowing may have enabled profitable

projects to be undertaken

borrowing can be a cheaper source of

finance than shares

Disadvantages

may involve risk-if profits are low the

firm may struggle to repay interest

may be difficult to borrow more finance

Increasing gearing can be risky for firms because of the

interest payments BUT if a firm refuses to borrow it may mi

out on market opportunities. Increasing gearing is acceptable

provided the profits earned more than cover the interest

payments. So the firm needs to consider cover as well as the

gearing ratio.

A typical reaging ratio for UK firms is around 50%

However firms are more likely to be highly geared :

in the early years (as they borrow to set up and

expand)

if interest rates are low (so firms exploit this by

borrowing and fixing interest rates)

if the owners are reluctant to lose control by bringin

in outside finance


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For this reason, it is difficult to perform these ratios on unlisted companies as the market price for theirshares is not freely available. One would first have to value the shares of the business before calculatingthe ratios. Market value ratios are strong indicators of what investors think of the firms past performanceand future prospects.

(a) Dividend Per Share (DPS)

This is an important shareholders ratio. It simply the total dividend declared by a company divided by

the number of shares the business has issued.

Dividend per share = total dividends

number of issued shares

Results of this ratio are expressed as a number of pence per share.

Interpretation: A higher figure is generally preferable to a lower one as this provides the shareholder

with a larger return on his or her investment. However, some shareholders are looking for long-term

investments and may prefer to have a lower DPS now in the hope of greater returns in the future and a

rising share price.

(b) Dividend yield

This is the dividend per share (for the entire year) expressed as a percentage of the market price of theshare. The dividend yield ratio indicates the return that investors are obtaining on their investment in theform of dividends. This yield is usually fairly low as the investors are also receiving capital growth ontheir investment in the form of an increased share price. It is interesting to note that there is strong

correlation between dividend yields and market prices. Invariably, the higher the dividend, the higher themarket value of the share. The dividend yield ratio compares the dividend per share against the price ofthe share

Dividend yield = dividend per share x 100

market share price

Results for this ratio can fluctuate regularly even daily as they depend upon the firms share price. Arising share price will cause the dividend yield to fall. This ratio is most valuable to investors relyingupon an annual income from the purchases of shares. Normally a very high dividend yield signals

potential financial difficulties and possible dividend payout cut. The dividend per share is merely the totaldividend divided by the number of shares issued. The price per share is the market price of the share atthe end of the financial year.

Interpretation: This ratio is expressed as a percentage. Obviously higher percentages are preferred. The

current rates of interest paid on savings accounts provide a useful comparison, although the latter carry no


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risk (of capital loss). Hence many investors would expect dividend yield to exceed the current rate of

interest.

(c) Price/Earning Ratio (P/E ratio)

P/E ratio is a useful indicator of what premium or discount investors are prepared to pay or receivefor the investment.The higher the price in relation to earnings, the higher the P/E ratio which indicates the higher thepremium an investor is prepared to pay for the share. This occurs because the investor is extremelyconfident of the potential growth and earnings of the share.

The price-earning ratio is calculated as follows:

P/E Ratio = Market Price per share : Current earnings per share

High P/E generally reflects lower risk and/or higher growth prospects for earnings.

(d) Dividend Cover

This ratio measures the extent of earnings that are being paid out in the form of dividends, i.e. howmany times the dividends paid are covered by earnings (similar to times interest earned ratiodiscussed above).

A higher cover would indicate that a larger percentage of earnings are being retained and re-investedin the business while a lower dividend cover would indicate the converse.

Dividend Cover = Earning per share : Dividends per share


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LIMITATIONS OF RATIO ANALYSISLIMITATIONS OF RATIO ANALYSIS

1. Many ratios are calculated on the basis of the balance-sheet figures. These figures are as on thebalance-sheet date only and may not be indicative of the year-round position.

2. Comparing the ratios with past trends and with competitors may not give a correct picture as thefigures may not be easily comparable due to the difference in accounting policies, accountingperiod etc.

3. It gives current and past trends, but not future trends.4. Impact of inflation is not properly reflected, as many figures are taken at historical numbers,

several years old.5. There are differences in approach among financial analysts on how to treat certain items, how to

interpret ratios etc.6. The ratios are only as good or bad as the underlying information used to calculate them.

1. Accounting Information

* Different Accounting Policies

The choices of accounting policies may distort inter company comparisons. Example - IAS 16 allows

valuation of assets to be based on either revalued amount or at depreciated historical cost. The business

may opt not to revalue its asset because by doing so the depreciation charge is going to be high and will

result in lower profit.

* Creative accounting

The businesses apply creative accounting in trying to show the better financial performance or position

which can be misleading to the users of financial accounting. Like the IAS 16 mentioned above, requiresthat if an asset is revalued and there is a revaluation deficit, it has to be charged as an expense in income

statement, but if it results in revaluation surplus the surplus should be credited to revaluation reserve. So

in order to improve on its profitability level the company may select in its revaluation programme to

revalue only those assets which will result in revaluation surplus leaving those with revaluation deficits

still at depreciated historical cost.

2. Information problems

* Ratios are not definitive measures

Ratios need to be interpreted carefully. They can provide clues to the companys performance or financial

situation. But on their own, they cannot show whether performance is good or bad. Ratios require some

quantitative information for an informed analysis to be made.

* Outdated information in financial statement

The figures in a set of accounts are likely to be at least several months out of date, and so might not give a


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proper indication of the companys current financial position.

*Historical costs not suitable for decision making

IASB Conceptual framework recommends businesses to use historical cost of accounting. Where

historical cost convention is used, asset valuations in the balance sheet could be misleading. Ratios based

on this information will not be very useful for decision making.

* Financial statements contain summarised informationRatios are based on financial statements which are summaries of the accounting records. Through the

summarisation some important information may be left out which could have been of relevance to the

users of accounts. The ratios are based on the summarised year end information which may not be a true

reflection of the overall years results.

* Interpretation of the ratio

It is difficult to generalise about whether a particular ratio is good or bad. For example a high current

ratio may indicate a strong liquidity position, which is good or excessive cash which is bad. Similarly

Non current assets turnover ratio may denote either a firm that uses its assets efficiently or one that is

under capitalised and cannot afford to buy enough assets.

3. Comparison of performance over time

* Price changes

Inflation renders comparisons of results over time misleading as financial figures will not be within the

same levels of purchasing power. Changes in results over time may show as if the enterprise has

improved its performance and position when in fact after adjusting for inflationary changes it will show

the different picture.

* Technology changes

When comparing performance over time, there is need to consider the changes in technology. The

movement in performance should be in line with the changes in technology. For ratios to be more

meaningful the enterprise should compare its results with another of the same level of technology as this

will be a good basis measurement of efficiency.

* Changes in Accounting policy

Changes in accounting policy may affect the comparison of results between different accounting years as

misleading. The problem with this situation is that the directors may be able to manipulate the results

through the changes in accounting policy. This would be done to avoid the effects of an old accounting

policy or gain the effects of a new one. It is likely to be done in a sensitive period, perhaps when the

businesss profits are low.

* Changes in Accounting standardAccounting standards offers standard ways of recognising, measuring and presenting financial

transactions. Any change in standards will affect the reporting of an enterprise and its comparison of

results over a number of years.

* Impact of seasons on trading

As stated above, the financial statements are based on year end results which may not be true reflection of

results year round. Businesses which are affected by seasons can choose the best time to produce financial


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statements so as to show better results. For example, a tobacco growing company will be able to show

good results if accounts are produced in the selling season. This time the business will have good

inventory levels, receivables and bank balances will be at its highest. While as in planting seasons the

company will have a lot of liabilities through the purchase of farm inputs, low cash balances and even nil

receivables.

4. Inter-firm comparison

* Different financial and business risk profile

No two companies are the same, even when they are competitors in the same industry or market. Using

ratios to compare one company with another could provide misleading information. Businesses may be

within the same industry but having different financial and business risk. One company may be able to

obtain bank loans at reduced rates and may show high gearing levels while as another may not be

successful in obtaining cheap rates and it may show that it is operating at low gearing level. To uninformed analyst he may feel like company two is better when in fact its low gearing level is because it

can not be able to secure further funding.

* Different capital structures and size

Companies may have different capital structures and to make comparison of performance when one is all

equity financed and another is a geared company it may not be a good analysis.

* Impact of Government influence

Selective application of government incentives to various companies may also distort intercompany

comparison. One company may be given a tax holiday while the other within the same line of business

not, comparing the performance of these two enterprises may be misleading.

* Window dressing

These are techniques applied by an entity in order to show a strong financial position. For example, MZ

Trucking can borrow on a two year basis, K10 Million on 28th December 2003, holding the proceeds as

cash, then pay off the loan ahead of time on 3rd January 2004. This can improve the current and quick

ratios and make the 2003 balance sheet look good. However the improvement was strictly window

dressing as a week later the balance sheet is at its old position.

Ratio analysis is useful, but analysts should be aware of these problems and make adjustments as

necessary. Ratios analysis conducted in a mechanical, unthinking manner is dangerous, but if used

intelligently and with good judgement, it can provide useful insights into the firms operations.


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lecture 4,5,6 - ratio analysis

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