accounts assignment

Ratio Analysis

Financial ratios can be used to examine various aspects of the financial position and performance of a business and are widely used for planning and control purposes.

They can be used to evaluate the financial health of a business and can be utilised by management in a wide variety of decisions involving such areas as profit planning, pricing, working-capital management, financial structure and dividend policy.

Ratio analysis provides a fairly simplistic method of examining the financial condition of a business.

A ratio expresses the relation of one figure appearing in the financial statements to some other figure appearing there.

Ratios enable comparison between businesses.

Differences may exist between businesses in the scale of operations making comparison via the profits generated unreliable.

Ratios can eliminate this uncertainty.

Other than comparison with other businesses, it is also a valuable tool in analysing the performance of one business over time.

However useful ratios are not without their problems.

Figures calculated through ratio analysis can highlight the financial strengths and weaknesses of a business but they cannot, by themselves, explain why certain strengths or weaknesses exist or why certain changes have occurred.

Only detailed investigation will reveal these underlying reasons. Ratios must, therefore, be seen as a ‘starting point’.

Financial ratio classification

The following ratios are considered the more important for decision-making purposes:

Ratios can be grouped into certain categories, each of which reflects a particular aspect of financial performance or position.

The following broad categories provide a useful basis for explaining the nature of the financial ratios to be dealt with.

Profitability. Businesses come into being with the primary purpose of creating wealth for the owners. Profitability ratios provide an insight to the degree of success in achieving this purpose. They express the profits made in relation to other key figures in the financial statements or to some business resource.

Efficiency. Ratios may be used to measure the efficiency with which certain resource have been utilised within the business. These ratios are also referred to as active ratios.

Liquidity. It is vital to the survival of a business that there be sufficient liquid resources available to meet maturing obligations. Certain ratios may be calculated that examines the relationship between liquid resources held and creditors due for payment in the near future.

Gearing. This is the relationship between the amount financed by the owners of the business and the amount contributed by outsiders, which has an important effect on the degree of risk associated with a business. Gearing is then something that managers must consider when making financing decisions.

Investment. Certain ratios are concerned with assessing the returns and performance of shares held in a particular business.

Profitability ratios

1. Return on ordinary shareholders’ funds (ROSF)

The return on ordinary shareholders’ funds compares the amount of profit for the period available to the ordinary shareholders with the ordinary shareholders’ stake in the business.

Net profit after taxation and preference dividend (if any) X 100

Ordinary share capital plus reserves

The net profit after taxation and any preference dividend is used in calculating the ratio, because this figure represents the amount of profit available to the ordinary shareholders.

2. Return on capital employed (ROCE)

The return on capital employed is a fundamental measure of business performance. This ratio expresses the relationship between the net profit generated by the business and the long-term capital invested in the business. Expressed as a percentage.

Net profit before interest and taxation x 100

Share capital + reserves + long-term loans

Note, in this case, the profit figure used in the ratio is the net profit before interest and taxation. This figure is used because the ratio attempts to measure the returns to all suppliers of long-term finance before any deductions for interest payable to lenders or payments of dividends to shareholders are made.

ROCE is considered by many to be a primary measure of profitability. It compares inputs (capital invested) with outputs (profit). This comparison is of vital importance in assessing the effectiveness with which funds have been deployed.

3. Net profit margin

The net profit margin ratio relates the net profit for a period to the sales during that period.

Net profit before interest and taxation x 100

Sales

The net profit before interest and taxation is used in this ratio as it represents the profit from trading operations before any costs of servicing long-term finance are taken into account.

This ratio compares one output of the business (profit) with another output (sales).

The ratio can vary considerably between types of business.

For example, a supermarket will often operate on low prices and, therefore, low profit margins in order to stimulate sales and thereby increase the total amount of profit generated.

A jeweller, on the other hand, may have a high net profit margin but have a much lower level of sales volume.

Factors such as the degree of competition, the type of customer, the economic climate and industry characteristics (such as the level of risk) will influence the net profit margin of a business.

4. Gross profit margin

The gross profit margin ratio relates the gross profit of the business to the sales generated for the same period.

Gross profit represents the difference between sales value and the cost of sales.

The ratio is therefore a measure of profitability in buying (or producing) and selling goods before any other expenses are taken into account.

As cost of sales represents a major expense for retailing, wholesaling and manufacturing businesses, a change in this ratio can have a significant effect on the bottom line (that is, the net profit for the year).

Gross profit x 100

Sales

Efficiency ratios

Ratios used to examine the efficiency with which various resource of the business are managed include the following:

1. Average stock turnover period

Stocks often represent a significant investment for a business.

For some types of business (for example, manufacturing), stocks may account for a substantial proportion of the total assets held.

The average stock turnover period measures the average number of days for which stocks are being held.

Average stock held x 365

Cost of sales

The average stock for the period can be calculated as a simple average of the opening and closing stock levels for the year.

A business will normally prefer a low stock turnover period to a high period as funds tied up in stocks cannot be used for other profitable purposes.

2. Average settlement period

A business will usually be concerned with how long it takes for customers to pay the amount owing.

Trade debtors x 365

Credit sales

A business will normally prefer a shorter settlement period.

3. Average settlement period for creditors

The average settlement period for creditors tells us how long, on average, the business takes to pay its trade creditors.

Trade creditors x 365

Credit purchases

Referred to as ‘free’ source of finance for the business, not surprising that some businesses attempt to increase their average settlement period for trade creditors.

4. Sales to capital employed

The sales to capital employed ratio examines how effective the long-term capital employed of the business has been in generating sales revenue.

Sales

Share capital + reserves + long-term loans

Generally a higher ratio for sales to capital employed is preferred to a lower one. A higher ratio will normally suggest that the capital (as represented by total assets minus current liabilities) is being used more productively in the generation of revenue. However, a very high ratio may suggest that the business is undercapitalised – that is, it has insufficient long-term capital to support the level of sales achieved.

Liquidity ratios

1.Current ratio

The current ratio compares the ‘liquid’ assets (cash and those assets held that will soon be turned into cash) of a business with the current liabilities (creditors due within one year).

Current assets

Current liabilities

The ideal is often expressed as 2: 1 meaning that the business can meet its short-term liabilities twice over.

2. Acid test ratio

The acid test ratio represents a more stringent test of liquidity. It can be argued that, for many businesses, the stock in hand cannot be converted into cash quickly. As a result, it may be better to exclude this particular asset from any measure of liquidity.

Current assets (excluding stock)

Current liabilities

Gearing ratio

Financial gearing occurs when a business is financed, at least in part, by contributions from outside parties. An important factor in assessing risk. Where a business borrows heavily, it takes on a commitment to pay interest charges and make capital repayments. This can be a significant financial burden and can increase the risk of a business becoming insolvent.

One particular effect of gearing is that returns to ordinary shareholders become more sensitive to changes in profits. For a highly geared company, a change in profits can lead to a proportionately greater change in the returns to ordinary shareholders.

The gearing ratio measures the contribution of long-term lenders to the long-term capital structure of a business

Long-term liabilities x 100

Share capital + reserves + long-term loans

Interest cover ratio

The interest cover ratio measures the amount of profit available to cover the interest payable.

Profit before interest and taxation

Interest payable

The lower the level of profit coverage, the greater the risk to lenders that interest payments will not be met.

Investment ratios

1. Dividend per share

The dividend per share ratio relates the dividends announced during a period to the number of shares in issue during that period.

Dividends announced during the period

Number of shares in issue

Factors that influence the amount that a company is willing or able to issue in the form of dividends include:

i) The profit available for distribution to investors

ii) The future expenditure commitments of the company

iii) The expectations of shareholders concerning the level of dividend payment.

iv) The cash available for dividend distribution

2. Dividend payout ratio

The dividend payout ratio measures the proportion of earnings that a company pays out to shareholders in the form of dividends.

Dividends announced during the period x 100

Earnings for the year available for dividends

The earnings available for dividends, in the case of ordinary shareholders, would normally be net profit after interest and taxation and after any preference dividends announced during the year.

3. Earnings per share (EPS)

The earnings per share (EPS) relates the earnings generated by the company during the period and available to shareholders to the number of shares in issue. For ordinary shareholders, the amount available will be represented by the net profit after tax (less any preference dividend where applicable).

Earnings available to ordinary shareholders

Number of ordinary shares in issue

Many investment analysts regard the EPS as a fundamental measure of share performance. The trend in earnings per share over time is used to help assess the investment potential of a company’s shares.

4. Price/earnings (P/E) ratio

This ratio relates the market value of a share to the earnings per share.

Market value per share

Earnings per share

The ratio is, in essence, a measure of market confidence in the future of a company. The higher the P/E ratio, the greater the confidence in the future earning power of the company and, consequently, the more that investors are prepared to pay in relation to the earnings stream of the company

Price/earnings ratios provide a useful guide to market confidence concerning the future.

Limitations of ratio analysis

Although a useful tool ratios do have limitations.

Quality of financial statements.

Ratios are based on financial statements and the results of ratio analysis are dependent on the quality of those statements.

One important issue when making comparisons between businesses is the degree of conservatism that each business adopts in the reporting of profit.

Therefore any review of the financial statements should include an examination of the accounting policies that are being adopted.

There are some businesses that may adopt particular accounting policies or structure particular transactions in such a way that portrays a picture of financial health that is in line with what those who prepared the financial statements would like to see rather than what is a true and fair view of financial performance and position.

This practice is referred to as creative accounting and has been a major problem for accounting rule-makers.

Inflation

A persistent problem in most Western countries is that the financial results of a business are distorted as a result of inflation.

One effect of inflation is that the values of assets held for any length of time may bear little relation to current values.

Generally the value of assets will be understated in current terms during a period of inflation as they are usually recorded at their original cost (less any amounts written off for depreciation).

The basis of comparison

Ratios require a basis of comparison in order to be useful. Moreover, it is important that the analyst compares like with like.

When comparing businesses, however, no two businesses will be identical, and the greater the differences between the businesses being compared, the greater the limitations of ratio analysis.

Balance sheet ratios

Because the balance sheet is only a ‘snapshot’ of the business at a particular moment in time, any ratios based on balance sheet figures such as the liquidity ratios, may not be representative of the financial position of the business for the year as a whole.