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This usually involves the computation of percentage or ratios and then followed by comments on or the
interpretation of ratios. This analysis is usually utilized in the appraisal of the performance of a business entity.
The ratios are meant to reveal the financial strengths or weaknesses of a business entity, underlying trends and the
causes that have led to these strengths and weaknesses.
Ratios are computed using historical data. It is generally believed that historical ratios will help work out what is
likely to happen in the future.
Ratios need to be interpreted intelligently otherwise they may give information that is not useful.
Interested Persons
1. Owners/shareholders
2. Debenture holders / holders of long term loan capital
3. Banks & Financial Institution
4. Investors & their professional adviser
5. Creditors
6. Tax office (URA)
Areas of Interest
1. Profitability – how much profit is being made in relation to size of investment workforce or other measure.
2. Solvency – are sufficient liquid funds available to meet entity financial obligations.
3. Working capital management
4. capital structure
5. Financial Strength
6. Borrowing potential
7. Divided cover
8. Cost structure – fixed & variable cost
9. Ownership & control
10. Value Added Tax
11. Trends
IMPORTANCE OF RATIOS:
We have so far considered the rules that are utilized in compiling financial statements. We have assumed that their
utility is enhanced by adherence to the generally accepted
Accounting principle and that their comparability will be facilitated by the adherence to accounting standards.
However merely examining figures in the financial statements is not particularly useful but through comparison the
significance of certain figures will be established.
Ratios assist in the comparison of two sets of figures because they highlight the arithmetic relationship between
pairs of figures in the sets of accounts.
A myriad number of ratios can be computed from a set of financial statements but one ought to concentrate only
on the key ones in order to be able to judge the financial health and prospects of an entity.
The utility of ratios computed from a set of accounts will be limited because the accounts may have been drawn up
using different accounting policies.
Ratio analysis should be regarded as part and parcel of the overall exercise of interpreting financial statements. The
others includes scrutiny of accounting policies, funds flow statements, use of intuition etc.
It should be noted that there are no ideal ratios: they vary over time, from company to company, industry to industry
etc.
Categories of ratios
Ratios are usually categorized into three groups:-
Balance Sheet ratios: `
a) These are derived from B/S figures and give an indication about the financial strengths
and liquidity of a company.
b) Profit and loss account ratios
They are extracted from the P+L a/c and show profitability + growth of the company.
c) Operating or management ratios
These are also known as inter-statement ratios and are computed by comparing related
figures of the B/S + P+L a/c
Types of ratios
1. ROCE (Return on capital employed)
This is sometimes considered to be the most important ratio. It shows how much profit has been made in
relation to the resources employed.
It measures the efficiency with which an entity utilizes funds at its disposal.
Example:
A B
Profit 10,000 10,000
Sales 100,000 100,000
Capital Employed 20,000 40,000
ROCE 50.2 25%
ROCE may be computed in different ways as there is some disagreement about which figures to include in capital
and profit.
e.g
- Assets value – cost or replacement values?
- Depreciation – some say exclusion of depreciation makes the statements more
Comparable.
- intangible assets = should be excluded from capital
- bank drafts – to be included if permanent etc.
2. Profit Margin:
This measures the success of a business in earning profits from its trading operations.
Profit before interest and taxation
X 100
Sales
It may be necessary to exclude investment income and rental income if the margin is only to reflect trading
operations.
3. Asset Turnover
This indicate the efficiency with which the business is utilizing its assets
Asset turnover = Sales
Capital employed
Fixed Assets
Average Stock
The above were turnover ratios. The following are liquidity ratios
f) Current ratio/working capital ratio
Current ratio = Current assets
Current liabilities
A figure of 2 & 3 is considered reasonable
g) Quick ratio
It is a test of the immediate solvency of a business
Quick ratio = liquid assets
Current liabilities
Capital Ratios
Liquid assets include cash and those assets that can quickly be turned into cash such as debtors and short-time
investments. Stock are usually excluded because they may first have to be sold on credit and some of them may
end up being bad debts.
The following are capital ratios: Capital of a company can be divided into two groups:-
- share capital, and
- loan capital
Striking an adequate capital mix is a complex business because enough capital should be raised to cater for both
fixed assets and working capital and at the same time be sufficient to enable a company to produce/sell enough
goods and service to be able to make a satisfactory return.
Over capitalization occurs when the level of capital is too large in relation to a business and undercapitalization is
when there is inadequate working capital.
h) Gearing ratio
This is the ratio between share capital and fixed interest bearing securities.
Fixed Interest Capital
Fixed interest capital usually consists of preferences shares, loan capital, bank overdrafts and short
term loans.
a) Debt Ratio
This ratio used to indicate the acceptable limits borrowing.
Total Debt
Total Assets
Total assets normally exclude intangible assets. Total debt includes long-term borrowing short-term loans,
overdrafts and all other liabilities excluding short-term dividends.
b) Borrowing Ratio
The ratio also measures debt capacity:
The following are ratios that assist analysis, + existing and potential investors to compare alternative investments.
6. a) Investors’ Ratio
This gives an indication about how efficiently a business is run – its profitability.
b) Dividend Yield
e) Dividend cover
Shows the number of times the actual dividend could be paid out of current profits
Dividend Cover = Maximum possible dividend that could be
Paid out of current profit
Actual dividends
f) Earnings Yield
Grossed up equivalent EPS Calculated on net basis x 100