Financial Interpretation - Ratio Analysis

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Definition

Ratio analysis is a fundamental means of examining the health of a company by studying the relationships of key financial variables.

In other words

Ratio are used to analyze financial statement .They are used to recognised periodical trends of a business and to compare two or more businesses.

Why is it important?

Ratios are one of the most important part of the analysis process of a business. Ratios are normally compared to the ratios of other businesses. For e.g gross profit margin is an indicator of a company's profitability, If it is higher than the other business it shows that the business with higher GP margin is more profitable and attractive for investors.

Lecture Notes

The Ratios are normally classified into following:

1. Profitability ratios

2. Liquidity ratios

3. Efficiency / activity ratios

4. Solvency ratios

5. Investors ratios

Profitability ratios

These ratios measures the business ability to generate profits from its resources

Following are some of the most commonly used profitability ratios

1) Gross Profit Margin

The gross profit margin or net profit margin is calculated as:

Gross Profit / Sales x 100

This is the margin that the company makes on its revenues.

Since the ratio is affected by only a small number of variables, a change in GP margin may be due to a change in:

• selling prices – e.g.because of inflation

• sales mix – often deliberate

• purchase price – including carriage or discounts

2) Operating profit margin (net profit)

The operating profit margin or net profit margin is calculated as:

EBIT / Sales x 100

If there is a change in the above ratio it should be studied more:

• Are they in line with changes in GP margin?

• Are they in line with changes in revenue? as many costs are fixed in nature, they may not necessarily increase/decrease with a change in revenue.

3) Return on Capital Employed (ROCE)

The ROCE is calculated as:

ROCE = Profit / Capital employed x 100

Profit is measured as:

• operating (trading) profit, or

• the EBIT, i.e. the profit before taking account of any interest paid on long term finance

Capital employed is measured as:

• equity plus Long term debt

ROCE should be compared to:

• the previous year ROCE

• a target ROCE

• the cost of borrowing/

• other companies’ ROCE in the same industry.

4) Asset Turnover

It is calculated as:

= Sales / Capital employed

It measures management’s efficiency in generating revenue from the net assets at its disposal:

Note that this can be further subdivided into:

• noncurrent asset turnover (by making noncurrent assets the denominator) and

• working capital turnover (by making net current assets the denominator).

Relationship between ratios

ROCE can be subdivided into profit margin and asset turnover.

Profit margin Asset turnover = ROCE

EBIT Sales revenue EBIT

––––––––––– –––––––––––– = ––––––––––––

Sales revenue Capital employed Capital employed

Two completely different strategies can achieve the same ROCE.

• Sell goods at a high profit margin with sales volume remaining low

• Sell goods at a low profit margin with very high sales volume

Liquidity ratios

measures the ability of a firm to meet its short term debts

There are two ratios used to measure overall working capital:

1. the current ratio

2. the quick or acid test ratio.

1) Current ratio

Current or working capital ratio:

Current assets

–––––––––––– : 1

Current liabilities

The current ratio measures the adequacy of current assets to meet the liabilities as they fall due.

A high or increasing figure may appear safe but should be regarded with suspicion as it may be due to:

• high levels of inventory and receivables (check working capital management ratios)

• high cash levels which could be put to better use (e.g. by investing in noncurrent assets).

2) Quick ratio

Quick ratio (also known as the liquidity and acid test) ratio:

Current assets - inventory

–––––––––––––––––––––– : 1

Current liabilities

The quick ratio is also known as the acid test ratio because by eliminating inventory from current assets it provides the acid test of whether the company has sufficient liquid resources (receivables and cash) to settle its liabilities.

Activity ratios

These ratios measures how efficiently the business is performing its daily activities, such as collection of receivables, inventory handling, payments to suppliers

1) Inventory turnover period

Inventory turnover period is defined as:

Inventory

–––––––– 365 days

COS

An increasing number of days (or a diminishing multiple) implies that inventory is turning over less quickly which is regarded as a bad sign as it may indicate:

However, it may not necessarily be bad where management are:

1. lack of demand for the goods

2. poor inventory control

3. an increase in costs (storage, obsolescence, insurance, damage).

4. buying inventory in larger quantities to take advantage of trade discounts, or

5. increasing inventory levels to avoid stockouts.

2) Receivables collection period

This is normally expressed as a number of days:

Avg. debtors

––––––––––––– 365 days

Credit Sales

The collection period should be compared with:

• the stated credit policy

• previous period figures.

Increasing accounts receivables collection period is usually a bad sign suggesting lack of proper credit control which may lead to irrecoverable debts.

It may, however, be due to:

a deliberate policy to attract more trade, or

a major new customer being allowed different terms.

Falling receivables days is usually a good sign, though it could indicate that

the company is suffering a cash shortage.

3) Payables payment period

This is usually expressed as:

Avg. creditors

––––––––––––– 365 days

Credit Purchases

This represents the credit period taken by the company from its suppliers.

The ratio is always compared to previous years:

• A long credit period may be good as it represents a source of free finance.

• A long credit period may indicate that the company is unable to pay more...

Buy the full version of these notes or essay plans and more in our Accounting (Special Edition) Notes.