RATIO ANALYSIS

1. PROFITABILITY RATIOS
a) Gross profit mark-up
It is gross profit expressed as a % of cost of sales.

Gross profit mark-up = Gross profit x 100

Cost of sales

A low mark-up may be attributable to:

 Pilferage of stock
 Goods taken for own use
 Increased purchase or production cost
 Reduced selling prices

b) Gross profit margin or % ratio

It is gross profit expressed as % of sales. This is the margin that a firm makes on its sales, and
would normally be expected to remain reasonably constant.

Gross profit margin = Gross profit x 100

Sales

A change in the margin may be attributable to a change in:

 Selling prices (deliberate or increased competition)

 Sales mix
 Purchase cost or production cost
 Inventory – errors in counting, valuing or cut-off, inventory shortages

c) Return on capital employed (ROCE)

It is net profit expressed as % of capital employed.

ROCE = Profit before interest and tax (PBIT) x 100

Capital employed

NB: Capital employed = Total assets – Current liabilities

ROCE should be compared with:
 The prior year ROCE
 A target ROCE
 The cost of borrowing
 Other companies’ ROCE in the same industry

A ROCE which exceeds the above benchmarks is desirable

d) Return on equity (ROE)
It is profit attributable to ordinary shareholders (earnings) expressed as a % of equity.

Return on equity = Earnings x 100

Equity

NB: Equity = Ordinary shares + Reserves

ROE is compared with:

 The prior year ROE
 ROE for other companies in the same industry

A higher ROE figure is desirable

e) Operating expenses as to sales ratio

It is operating expenses expressed as % of sales. It indicates the relative efficiency of a business
after taking into account all revenues and expenses.

Operating expenses as to sales ratio = Operating expenses x 100

Sales

A lower % signals better control of operating expenses and a higher % is indicative of a failure to
control operating expenses.

f) Net profit margin or % ratio

It is net profit expressed as % of sales

Net profit margin = Net Profit x 100

Sales

A higher net profit margin is desirable.

2. LIQUIDITY RATIOS
a) Current Ratio
It is current assets expressed as fraction of current liabilities. It measures a firm’s ability to meet
short-term liabilities.

Current ratio = Current assets

Current liabilities
 Traditionally, a current ratio of 2:1 is considered satisfactory. 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
 High cash levels which could be put to better use (e.g by investing in non-current assets)

b) Quick / Acid test ratio

It is current assets (excluding inventory) expressed as a fraction of current liabilities

Quick ratio = Current assets - inventory

Current liabilities

The most ideal quick ratio is 1:1

3. ACTIVITY RATIOS
a) Stock turnover ratio
It is the rate at which inventory is converted into cash.

Rate of stock-turn = Cost of sales

Average stock

NB: Average stock = opening stock + closing stock

2

A higher ratio indicates that the firm is turning over its stock into cash at a faster rate and vice
versa.

b) Average stock holding period

Average stock holding period (days) = Number of days in a year

Stock turnover rate
OR
= Average stock x 365 days
Cost of sales

An increase in number of days implies that inventory is turning over less quickly which is
regarded as a bad sign as it may indicate:
 Lack of demand for the goods
 Poor inventory control
 An increase in costs (storage, insurance, obsolescence)
 However, it must be noted that they may be buying in large quantities in order to:

 Take advantage of trade discounts

 Avoid stock-outs

c) Debtors collection period

It is the time taken to collect debts from credit customers.

Debtors collection period = Debtors x 365 days

Credit sales

Increasing collection period is usually a bad sign suggesting lack of proper credit control which
may lead to irrecoverable debts. Conversely, falling collection period is a good sign.

d) Creditors payment period

It is the time taken to pay suppliers of goods.

Creditors payment period = Creditors x 365 days

Credit purchases

NB: If it is impracticable to determine purchases use Cost of sales in place of purchases

A long credit period may:

 Be good as it represents a source of free finance
 Indicate that the company is unable to pay more quickly because of liquidity problems

e) Non-current assets turnover ratio

It measures the degree of utilisation of non-current assets in relation to revenue generated.

Non-current assets turnover ratio = Sales

Non-current assets (NBV)

The higher the ratio the more efficient and vice versa

f) Debtors turnover ratio

Debtors turnover ratio = Sales

Average Debtors

A higher ratio is desirable

4. GEARING RATIOS
a) Debt-equity ratio
It measures the proportion of debt as to equity

Debt-equity ratio = Total liabilities x 100

OSC + Reserves

A firm is considered highly geared if the debt-equity ratio exceeds 100%

In highly geared companies:

 There is a greater risk of insolvency
 Returns to shareholders will grow proportionately more if profits are growing

Low geared companies:

 Can usually borrow more easily

b) Debt to total assets ratio

It is the proportion of debt as to total assets

Debt to total assets ratio = Total liabilities x 100

Total assets
A firm is considered highly geared if the debt to total assets ratio exceeds 100%

c) Gearing ratio

Gearing ratio = Debentures (or loan) + Preference shares x 100

Debentures + Preference shares + Equity

A firm is considered highly geared if the gearing ratio exceeds 50%

d) Interest cover
It indicates a firm’s ability to pay interest out of profits generated.

Interest cover = PBIT

Interest

A low interest cover:

 Indicates to shareholders that their dividends are at risk
 That the firm may have difficulty financing its debts if its profits fall

Interest cover of less than 2 is usually considered unsatisfactory

e) Fixed charges cover
It measures the number of times these fixed costs are covered.

Fixed charges cover = PBIT

Interest + preference div

5. INVESTMENT RATIOS
a) Earnings per share
It is the amount earned by an ordinary shareholder per share held.

Earnings per share = Earnings

No. of ordinary shares

An increasing EPS is seen as good sign.

b) Price/earnings ratio (PER)

It is the market price expressed as fraction of earnings. It represents the market’s view of the
future prospects of the shares.

Price/earnings ratio (PER) = Market price per share (MPS)

Earnings per share (EPS)

A high PER suggests that high growth is expected

c) Earnings yield
It indicates potential return on investments. It highlights the amount earned on the shares
relative to their market value.

Earnings yield = Earnings per share (EPS) x 100

Market price per share (MPS)

d) Dividend per share (DPS)

It indicates the dividend and retention policy of a company.

Dividend per share (DPS) = Ordinary dividends

No. of ordinary shares

A higher DPS is attractive to potential investors and vice versa.

e) Dividend yield
It indicates the current return on investment.

Dividend yield = Dividends per share (DPS) x 100

Market price per share (MPS)

The lower the dividend yield, the more the market is expecting future growth in the dividend
and vice versa.

f) Dividend cover
It measures the no. of times the ordinary dividend is covered by earnings. It is the relationship
between available profits and the dividends payable out of the profits

Dividend cover = Earnings per share (EPS)

Dividends per share (DPS)

The higher the dividends cover, the more likely it is that the current dividend level can be
sustained in the future.

g) Dividend pay-out ratio

It is the amount of dividend in proportion to the amount available to pay dividends.

Dividend pay-out ratio = Dividends per share (DPS) x 100

Earnings per share (EPS)

A low % indicates that a company has a conservative dividend policy and a higher % indicates
that a company has an aggressive dividend policy.