Ratio Analysis Ch 28

Ratio Analysis

 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) Profitability
2) Liquidity
3) Efficiency
4) Gearing
5) 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 = %

Sales
 If this ratio has increased it is better. It can change because of selling
price and cost of goods sold change.

ii. Net Profit Ratio= Net Profit x 100 = %

Sales
 If this ratio has increased it is better. It can change because of gross
profit and operating expenses.

iii. 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.

Note: Capital Employed = Total Assets – Current Liability

Or
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.

Note: Equity = Total Assets – Current Liability- Long Term Liability

Or
Equity = Capital + Reserves

2) Liquidity/Working Capital/Short Term Solvency Ratios

 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.

i. Current Ratio = Current Asset = 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. 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
 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.

ii. Average Holding period = Average Stock 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.

iii. Debtor Turnover Ratio = Credit Sales = Times

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.

iv. Average Collection period = Average Debtor 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.

v. Creditor Turnover Ratio = Credit Purchase = Times

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.

vi. Average Payment period = Average Creditors x365 = Days

 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.
vii. 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.

ii. Interest Cover Ratio= Profit before interest and tax = Times
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.

ii. Price/ Earning Ratio = Market Price per Share

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.

iii. Dividend Cover Ratio = Profit after Interest and Tax = Times
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.

iv. Dividend Yield Ratio = Dividend per Ordinary Share 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.