Introductory Accounting

Financial Ratios

The key aspects of financial performance / position evaluated by the use of ratios are:

•          Profitability - Measure of success in wealth creation

•          Efficiency - Effectiveness of utilisation of resources

•          Liquidity - The ability to meet short-term obligations

•          Gearing - Measure of degree of risk to do with the amount of leverage used to finance the business

•          Investment - Measure of the returns and performance of shares held by a business

Profitability

1.       Return on shareholders funds (ROSF):

-Compares the amount of profit for the period available to the owners with the owners’ stake in the business, normally expressed as a percentage:

2.       Return on total assets (ROA):

Compares the net profit generated by the business with the assets owned by the business

Normally expressed as a percentage

3.       Net profit margin:

Relates the net profit for the period to the sales during that period

Normally expressed as a percentage

4.       Gross profit margin:

Relates the gross profit of the business to the sales generated during the same period

Gross profit represents the difference between sales and cost of sales

Normally expressed as a percentage

Efficiency

1.       Average inventory turnover period:

Measures the average period inventory was held

Normally expressed in terms of days

Average inventory is the simple average of opening and closing inventory for the period

2.       Average settlement period for accounts receivable (debtors):

Calculates how long, on average credit customers take to pay amounts owed

Normally expressed in terms of days

3.       Average settlement period for accounts payable (creditors):

Calculates how long, on average business takes to pay its creditors

Normally expressed in terms of days

4.       Asset turnover period:

Examines how effectively the assets of the business are being employed in generating sales revenue

Normally expressed in terms of days

Liquidity

1.       Current ratio:

Compares the business’s liquid assets with short-term liabilities (current liabilities)

Expressed in terms of the number of times the current assets will cover the current liabilities

2.       Acid test (also known as the quick or liquid) ratio:

Represents a more stringent test of liquidity than the current ratio

Expressed in terms of the number of times the ‘liquid’ current assets will cover the current liabilities

3.       Cash flows from operations ratio:

Compares the operating cash flows with the current liabilities of the business

Expressed in terms of the number of times the operating cash flows will cover the current liabilities

  Gearing

1.       Gearing ratio:

Measures the contribution of long-term lenders to the long-term capital structure of the business

Expressed in terms of a percentage

2.       Interest cover ratio (times interest earned):

Measures the amount of profit available to cover interest expense of the business

Expressed in terms of the number of times the profit generated by the business will cover the interest expense of its gearing

3.       Dividends per share:

Relates the dividends announced to the number of shares on issue of the business during a period

Not a measure of total return of the business

4.       Dividend payout ratio:

Measures the proportion of earnings that a company pays out to shareholders in the form of dividends

Expressed as a percentage

5.       Dividend yield ratio:

Relates the cash return from a share to its current market value

Expressed as a percentage