topic 24 ratio analysis

• Ratios are used to compare business results and can be used for:

  • inter year comparison - one firm can compare ratios for one year with another year, is the firm doing better or worse, can a trend be identified
  • inter firm comparison - one firm can be compared to a similar firm to monitor its progress
  • industry average comparison - a firm can compare its ratios to the industry average because there are 'norms' for a particular industry, however the industry average can be distorted by one dominant company or by the top performing companies
• Types of ratios:

  • profitability/performance ratios - measure how well the business has performed by comparing the level of profit to assets or revenue
  • liquidity ratios - measure the short term solvency of the business, is the business in a position to pay its everyday expenses and bills and whether it is likely to face cash flow problems in the future
  • efficiency ratios - profitability is also linked to efficiency which measures how well the business is using its assets
  • investment ratios - is the company a good financial investment for its shareholders
  • gearing ratios - sources of finance
• Profitability: Gross profit margin = Gross profit/Revenue x 100
• Profitability: Gross profit markup = Gross profit/CoS x 100
• Profitability: Profit in relation to revenue = Profit for the year/Revenue x 100
• Profitability: Expenses in relation to revenue = Expenses/Revenue x 100
• Profitability: ROCE = Profit before interest/Capital employed (ncl + capital) x 100
• Liquidity: Rate of inventory turnover = CoS/Avg inv = Times
• Liquidity: Rate of inventory turnover = Avg inv/CoS = Days
• Liquidity: Current ratio = CA/CL
• Liquidity: Liquid capital ratio = CA-Closing inv/CL
• Liquidity: Receivable days = Trade receivables/Credit sales x 365
• Liquidity: Payable days = Trade payables/Credit purchases x 365
• Profitability for limited companies: Profit in relation to revenue = profit from operations/Revenue x 100
• Profitability for limited companies: Profit from operations/Capital employed (ncl + equity) x 100
• Investment for limited companies: Dividend yield = Dividend per share/ Share price x 100
• Investment for limited companies: Earnings per share = Profit for the year after tax/No of ordinary shares issued = Pence
• Investment for limited companies: Dividend cover = Profit for the year after tax/Ordinary dividends paid = Times
• Investment for limited companies: PE ratio = Current share price/EPS
• Investment for limited companies: Interest cover = Profit from operations/Interest payable = Times
• Gearing for limited companies: Gearing = NCL/Capital employed x 100
• Ratios are normally calculated to 2dp
• Profitability:

  • gross profit margin - shows how profitable a business is through its trading activities before taking any overheads into consideration, a rising GP margin would indicate revenue is rising relative to CoS
  • gross profit markup - the percentage addition to cost to get selling price, higher the markup the higher the GP margin
  • profit in relation to revenue - how well a firm controls its expenses
  • expenses in relation to revenue - the lower the better, showing efficient control of operating expenses
  • ROCE - the rate of return on the company as a financial investment
• Liquidity:

  • inventory turnover - how quickly, on average the firm is selling off its goods, higher the times and shorter the days, the better
  • current ratio - company being able to cover its liabilities with its assets
  • liquid capital ratio - inventories may take time to sell, so better indicator of firm's liquidity than the current ratio
  • receivable days - shows how long on average it takes for receivables to pay the firm, prudence concept says always round up to the longer day
  • payables days - shows how long on average the firm takes to pay its suppliers, prudence concept says round down
• Investment:

  • dividend yield - shows the rate of return a shareholder is getting on their investment
  • dividend cover - shows how much profit is potentially available to pay the ordinary shareholder dividend compared to what is actually paid out as a dividend
  • earnings per shares (EPS) - a measure of the profitability of the company to its shareholders
  • price earnings ratio - compares the EPS with the current market price of the share, represents the number of years' earnings that investors are prepared to pay to purchase one of the company's shares
  • interest cover - debenture interest paid?
• Peoples buy shares in companies for:

  • dividends - an annual profit share which is a source of unearned income, these shareholders would be seeking a high rate of dividend and would want a rate of return comparable with other financial investments
  • capital gains - people make personal gains by selling shares for more than they paid for them, these shareholders would be looking for capital growth and would want the company to have high earnings, while retaining most of them
• Gearing - also known as 'leverage' refers to the capital structure of a business, namely how it is financed, focuses on medium/long term finance of a company
• High vs Low Gearing:

  • highly geared is a riskier investment for the shareholders, may be more vulnerable to economic downturns, but is beneficial to the ordinary shareholders during good times, since there will be more profits available for distribution to the ordinary shareholders once finance costs have been met
• Gearing and raising finance - The gearing ratio will change if equity or non-current liabilities change:

  • if ordinary share capital and/or reserves increase gearing will go down
  • if the company takes out more loans or issued debentures gearing will go up
  • if the company repays loans gearing will go down
• How should a company raise finance - should it issue more shares or should it issue debentures? One factor to take into consideration is the company's gearing ratio:

  • if the company is relatively low geared there would be little risk in taking out a loan or issuing debenture
  • however if the company is already high geared then this would be a risky source of finance and it might be better to issue ordinary shares
• Commenting on ratios:

  • is the ratio bettor or worse?
  • how great is the difference - large or small
  • inter-year comparison would require comment on any trend over time
  • inter-firm comparison requires judgement on which is the better firm and why
  • reasons for the results?
  • suggestions for improvement
• Limitations of ratio analysis:

  • ratios cannot be used in isolation - must be compared with previous years or other businesses
  • average ratios may not be reliable - averages could be distorted by some huge companies, not reflecting true picture of industry
  • ratios focus only on numbers - doesn't show qualitative data
  • ratios are based on historical data - may not reflect current position of the business
  • different businesses may use different accounting policies
  • ratios shows the problem but not the cause
  • financial statements could be window dresses (made to look better)