Ratio Analysis looks at the pairing of financial data in order to get a picture of the performance of the organisation.
Ratios allow a business to identify aspects of their performance to help decision making
Ratio Analysis allows you to compare performance between departments and over time
Five different types of ratios can be used to measure:
- 1. Profitability – how profitable the firm is
- 2. Liquidity – the businesses ability to pay
- 3. Asset Efficiency Ratios - Firms need to use their assets as efficiently as possible
- 4. Investment/shareholders – allows businesses to look at risk and potential earnings of investments
- 5. Gearing – looks at the balance between loans and shares in a business
Profitability Ratios
Return on capital employed (ROCE) = net profit / capital employed x 100
This shows the profitability of the investment by calculating its percentage return. The return shown can then be compared with the expected return from other investments. The normal figure used by companies is profit on ordinary activities before taxation rather than after tax (the tax charge may vary from year to year, so using profit after tax would not lead to comparing like with like). If PBIT – profit before interest and tax – is used, the profit figure is compared with capital employed, i.e. share capital plus long-term loan capital.
Typically should be 20-30%. Need to compare to previous years and competitors to get a clear picture. Can improve this by increasing profits without increasing fixed assets / capital
ROCE can be sub-divided:
ROCE = Profit margin × Asset turnover
PBIT / capital employed = PBIT / sales × sales / capital employed
The profit margin ratio (see below) shows whether the company is making a low or a high profit margin on its sales; the asset turnover ratio measures how efficiently the company’s net assets are being used to generate its sales.
Asset turnover ratio looks at a businesses sales compared to the assets used to generate the sales
Asset turnover = sales (turnover) / net assets
Net assets = Total assets – current liabilities
The value will vary with the type of business:
- Businesses with a high value of assets who have few sales will have a low asset turnover ratio
- If a business has a high sales and a low value of assets it will have a high asset turnover ratio
- Businesses can improve this by either increasing sales performance or getting rid of any additional assets
Gross profit margin (GP ratio, or GP %) = gross profit / turnover x 100
This indicates the percentage of turnover – net sales (sales less VAT and any returns) – represented by gross profit. If the gross profit margin is 30%, this means the firm’s cost of sales are 70% of its turnover (because turnover = cost of sales + gross profit).
The higher the better. Allows the firm to assess the impact of its sales and how much it cost to generate (produce) those sales.
A gross profit margin of 35% means that for every £1 of sales, the firm makes 35p in gross profit
Net profit margin (NP ratio, or NP %) = net profit / turnover x 100
This shows the percentage of turnover represented by net profit, i.e. how many pence out of every £1 sold is net profit. The NP margin will fall if the GP margin has fallen and rise if the GP% has increased: but it is also affected when the firm’s other expenses as a percentage of turnover have changed.
Includes overheads / fixed costs. Net profit is more important than gross profit for a business as all costs are included. A business would like to see that this ratio has improved over time
Liquidity ratios
Liquidity ratios help establish whether a firm is overtrading, expanding without sufficient long-term capital. This puts pressure on its working capital, the excess of current assets over current liabilities.
Working capital (current) ratio = current assets (CA):current liabilities (CL)
If current liabilities exceed current assets, the firm may have difficulty in meeting its debts. Extra short-term borrowing, to pay off creditors, costs the firm money (interest). If the firm sells assets to help meet its debts, it risks loss of production and future expansion.
Liquid ratio (‘Acid test’ or ‘Quick assets’) = CA minus stock:CL
Using this ratio lets us see whether the firm can meet short-term debts without having to sell stock, which is regarded as the least liquid current asset (and the prudence concept encourages accountants to assume the firm will not automatically sell – realise – its stock).
1:1 seen as ideal
Again if it is too high means that the business is very liquid – may be able to use the cash for other activities to increase performance
If it is too low then the business may face working capital problems
Some types of business need more cash than others so acid test would be expected to be higher
Debtors’ collection period (‘Debtor days’) = debtors / sales x 365
This liquidity (or efficiency) ratio shows the time, measured in average days, that it takes debtors to pay the firm.
The lower the figure the better as get cash more quickly
However sometimes need to offer credit terms to customers so this may increase it
Need to ensure keep track of any changes in credit terms as these should impact this ratio
Creditors’ collection period (‘Creditor days’) = creditors / purchases x 365
This ratio calculates the average length of credit the firm receives from its suppliers.
Asset efficiency ratios
Firms need to use their assets as efficiently as possible. The efficiency of both current and fixed assets can be measured.
Rate of stock turnover (‘Stockturn’) = cost of sales / average stock (stated as ‘ … times per period’)
The purpose is to calculate how frequently the firm sells its stock: if stock turnover is slowing, the firm is holding more stock than before, it may be facing problems selling its products, or it may have bought additional stock to take advantage of discounts offered.
An alternative calculation to display ‘stock days’ is average stock / cost of sales x 365
This is a useful analysis when used in conjunction with debtor days and creditor days in showing cash-flow timings.
High stock turnover means increased efficiency
However it depends on the type of business
Low stock turnover could mean poor customer satisfaction as people might not be buying the sto
Asset turnover sales / net assets
This ‘secondary ratio’ from ROCE (see above) assesses the value of sales generated by the net assets representing the capital being employed in the firm. It illustrates how efficiently the firm is using its assets to generate turnover.
Investment / Shareholders
Shareholders are interested in the following ratios:
Dividends per share
- Total dividends / number of shares issued
- A higher figure means the shareholder got a larger return
- Good to compare with competitors
- Businesses can improve this themselves by increasing dividend payments
Dividend yield
- Ordinary share dividend / market price x 100
- Compares the return amount with what would be needed to purchase a share
- The higher the better
- This ratio varies daily with changes to a companies share price
Gearing
- This is an efficiency ratio.
- Looks at the relationship between borrowing and fixed assets
Gearing Ratio = Long term loans / Capital employed x 100
The higher it is the greater the risk the business is under if interest rates increase
Limitations with Accounting Ratios
To be most beneficial the results need to be compared with other data including:
- The results for the same business over previous years
- The results of ratio analysis for their competitors
- The results of ratio analysis for other firms in other industries
Other Factors to consider
- The market the business is trading in
- The position of the firm in the market
- The quality of the workforce and management
- The economic environment
Summary
- Ratios are used to look at the performance of a business
- Liquidity ratios look at the firms ability to meet its debts
- Current ratio = current assets – current liabilities
- Acid test ratio = current assets - stock : current liabilities
- Shareholder ratios these are ratios that shareholders would be interested in
- Dividends per share = total dividends / number of shares issued
- Dividend yield = ordinary share dividend / market price x 100
- Efficiency ratios are how well the business is operating
- Gearing = Long term loans / Capital employed x 100
- Stock turnover ratio = cost of sales / stock
- Asset turnover = sales (turnover) / net assets
- Debtors collection period debtors x 365 / turnover
- Profitability ratios – assess the profitability of the business
- Gross profit = Gross profit / turnover x 100
- Net profit = Net profit / turnover x 100
- Return on capital employed = Profit / capital employed x 100
- Limitations of ratio analysis – need to be able to compare figures over time and between companies to be most effective
