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Chapter 13

Ratio analysis
Purpose of ratio analysis
Absolute figures are of little value. They only provide
insights if they can be compared with other relevant
amounts in ratios, for example,
• Sales as a percentage of gross profits.

Profit as a percentage of sales.


• Is the profit level satisfactory?
Need ‘standards’ for comparison.
Comparisons
(i) Compare with earlier years.
(ii) Compare it with the company's plan.
(iii) Compare with those of other companies in
the same industry.
(iv) Compare with industrial average.
Accounting policies
Ensure that the company has used consistent
accounting policies over time, especially:
• inventory (stock) valuation.
• non-current (fixed) asset revaluation.
• depreciation.
Inflation
No explicit attempt to take into account the effect
of inflation:
• Sales last year £100m, this year £105m.
• Company claims growth rate 5%.
• Is adjustment needed?
– Inflation, say, 2%, then real growth 3%.
– Costs, for example, average earnings rising 5%
per annum.
Systematic analysis
Investor ratios: An aid to judging a company as a
stock market investment.
Management performance: An aid to judging
how well the company is being run by
management.
Liquidity: Aids judgement of the adequacy of
company's cash and near cash resources.
Gearing: (called ‘Leverage’ in American texts)
Measure of the company's financial risk.
Peter Television example
Income statement
Year 2 Year 1
£m £m £m £m
Sales (revenue) 720 600
Cost of sales 432 348
Gross profit 288 252
Distribution costs (72) (54)
Administrative expenses (87) (81)
(159) (135)
Operating profit 129 117
Interest payable (24) (24)
Profit before tax 105 93
Taxation 42 37
Profit for the period 63 56
Statement of financial position
Year 2 Year 1
£m £m £m £m
Land and buildings 600 615
Plant and equipment 555 503
1,155 1,118
Inventory (stock) 115 82
Trade receivables (debtors) 89 61
Prepayments 10 9
Bank 6 46
220 198
Statement of financial position (Continued)

Year 2 Year 1
£m £m £m £m
Trade payables (creditors) (45) (30)
Taxation (21) (19)
Accruals (29) (25)
(95) (74)
Net current assets 125 124
1,280 1,242
6% debentures (400) (400)
880 842
Ordinary shares of £1 500 500
Retained profits 380 342
880 842
Statement of changes in equity

£m
Share capital and reserves end yr 1 842
Less dividend paid (25)
Add profit year 2 63
Share capital and reserves end yr 2 880

Directors’ report
Directors propose a dividend of 6.0 pence per share.
Share prices
Share price used in ratio analysis is the value soon
after the profits of the company have been
announced to the market.
The announcement is by press release called the
Preliminary Announcement. For a 31 December year
end the press release might be in the following
March.
Market price at 1 March Year 2 202 pence
Use to evaluate Year 1 figures
Market price at 1 March Year 3 277 pence
Use to evaluate Year 2 figures
Investor ratios
Earnings per share
profit after tax for ordinary shareholders
number of ordinary shareholders

Earnings per share 63


= 12.6 pence
500

Most often quoted measure of company performance


and progress
Measure percentage increase from year to year
Price earnings ratio
share price
earnings per share
Price earnings ratio 277 pence = 22 times
12.6 pence
• Compares the amount invested by the shareholder in the
company with the earnings per share. Number of years
current profit represented by share price.
• Reflects market's confidence in future prospects of the
company.
• Compare with average P/E for the industry, given daily in the
Financial Times.
• Commonly used as a basis for investment decisions.
Dividend per share
Dividend payable to ordinary shareholders
Number of issued shares

Dividend per share 30 = 6 pence per share


500
• Dividend is the most immediate reward for share
ownership.
• Dividend per share is the cash amount paid by
the company.
• Most companies attempt to maintain a
consistently increasing trend.
• Reduction in dividend per share is often only
Dividend cover (payout ratio)

earnings per share


dividend per share

Dividend cover 12.6 p = 2.1 times


6.0 p
• Number of times dividend can be paid out of
current earnings.
• The higher the dividend cover, the ‘safer’ the
dividend.
Dividend yield
Dividend per share x 100%
Share price
Dividend yield 6.0 x 100% = 2.17%
277
• Compares dividend per share with the amount invested by
the shareholder.
• Might seem low yield compared to other types of
investment.
• Dividends are not the only benefit from share ownership.
There is an expectation of an increase in share price.
Retained profits generate growth in future profits.
Management performance
Return on shareholders’ equity
Profit after tax x 100%
Share capital + reserves
Return on shareholders’ equity
63 x 100% = 7.2%
880

• Performance of company from the shareholders'


perspective.

• Essential to use profit after tax and after interest


charges.
Return on capital employed

Operating Profit (before interest and tax) x 100%


(Total assets – current liabilities)

Return on capital employed

129 x 100 = 10.1%


1,280

• Performance of company as a whole.


• Measure of management efficiency.
• Relates to all sources of long term finance.
Operating profit on sales

Operating profit (before interest and tax) x 100%


Sales (revenue)
Operating profit on sales
129 x 100 = 17.9%
720
‘Operating profit margin’ the higher the better.
Reflects
• degree of competitiveness in the market economic
situation.
• ability to distinguish products.
• ability to control expenses.
Gross profit ratio

Gross profit x 100%


Sales (revenue)

Gross profit percentage 288 x 100 = 40%


720
• Concentrates on costs of making goods and services ready
for sale.
• Small changes in this ratio can be highly significant.
• There tends to be a ‘normal’ value for each industry.
Total assets usage

Sales (revenue)
Total assets

Total assets usage 720 = 0.52 times


(1,155 + 220)

• Indicates how well a company has used its productive


capacity.
• Use in trends of what has happened over time.
Non-current (fixed) assets usage

Sales (revenue)_____
Non-current (fixed) assets

Non-current (fixed) assets usage


720 = 0.62 times
1,155
Interpreted as how many £s of sales have been generated
by each £ of assets i.e. 62 pence of sales for each £1 of
non-current (fixed) asset investment.
Liquidity and working capital
Current ratio

Current assets:current liabilities

Current Ratio 220:95 = 2.3:1


Are short-term assets adequate to settle short-term
liabilities?
If less than 1:1, look closely at cash flow.
Ability to generate daily cash might make this ratio
adequate, for example, a retailer selling to the public
must look at norm for the industry.
Usually between 1.5:1 and 2:1 for manufacturing industry.
Acid test

Current assets minus inventory (stock):Current liabilities

The acid-test (220 – 115) : 95 = 1.11:1

Places emphasis on the most liquid assets.

Excludes inventory (stock).

Expected around 1:1 but varies from industry to industry.


Inventory (stock) holding period

Average inventories (stock) held x 365 days


Cost of sales
Inventory (stock) holding period
(115 + 82)/2 x 365 = 83 days
432
How quickly goods move through the business:
Generally, the shorter the better, but too short may risk
being ‘out of stock’.
Assumption that year end figures represent normal level for
year.
Customers (debtors) collection period

Trade receivables (debtors) x 365


Credit sales (revenue)

Customers collection period


89 x 365 = 45.1 days
720

Speed of collecting from credit customers.

Compare with the credit period given, or the


normal credit period for the industry.
Suppliers payment period

Trade payables (creditors) x 365


Credit purchases
Purchases =
Cost of sales + closing inventory (stock) – opening
inventory (stock)
432 + 115 – 82 = 465
(If no purchases figure, use cost of sales)

Suppliers payment period


45 x 365 = 35.3 days
465
Suppliers payment period (Continued)

(If no purchases figure, use cost of sales)


Suppliers payment period
45 x 365 = 35.3 days
465

• Paying too fast – risk of cash shortage.


• Paying too slowly – risk of losing supplier.
• Companies must disclose this information in the
directors’ report.
Working capital cycle

Working capital cycle Inventory (stock) holding period +


Customers collection period –
Suppliers payment period

Inventory (stock) holding 83.2 days


Debtor collection 45.1 days
127.3 days
Creditor payment 35.3 days
Finance needed for 92.0 days
Gearing
Gearing
Long-term loans x 100%
Ordinary share capital + reserves
Debt/equity ratio 400 x 100 = 45.5%
880
A high figure indicates reliance on sources of long-term
loan finance.
Interest cover

profit before interest and taxes


interest charge

Interest cover 129 = 5.38 times


24
Indicates how ‘safe’ the annual interest payments are in
relation to profit.