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# FinancialStatementsAnalysis RATIOANALYSIS

## INTRODUCTION TO RATIO ANALYSIS

Ratio analysis compares one figure with another to place it in context and asses its relative importance. It helps analyse date and aids decision making.It is part of the decision making process:

Set Objectives

## review implement Select course of action

A ratio: Is the mathematical relationship between two quantities in the form of a fraction or percentage. Ratio analysis: is essentially concerned with the calculation of relationships which after proper identification and interpretation may provide information about the operations and state of affairs of a business enterprise. The analysis is used to provide indicators of past performance in terms of critical success factors of a business. This assistance in decision-making reduces reliance on guesswork and intuition and establishes a basis for sound judgement. Note: A ratio on its own has little or no meaning at all. Significance of Using Ratios The significance of a ratio can only truly be appreciated when: 1. It is compared with other ratios in the same set of financial statements. 2. It is compared with the same ratio in previous financial statements (trend analysis). 3. It is compared with a standard of performance (industry average). Such a standard may be either the ratio which represents the typical performance of the trade or industry, or the ratio which represents the target set by management as desirable for the business. Financial ratio analysis is a fascinating topic to study because it can teach us so much about accounts and businesses. When we use ratio analysis we can work out how profitable a business is, we can tell if it has enough money to pay its bills and we can even tell whether its shareholders should be happy! 1

Ratio analysis can also help us to check whether a business is doing better this year than it was last year; and it can tell us if our business is doing better or worse than other businesses doing and selling the same things. In addition to ratio analysis being part of an accounting and business studies syllabus, it is a very useful thing to know anyway! The overall layout of this section is as follows: We will begin by asking the question, What do we want ratio analysis to tell us? Then, what will we try to do with it? This is the most important question, funnily enough! The answer to that question then means we need to make a list of all of the ratios we might use: we will list them and give the formula for each of them. Once we have discovered all of the ratios that we can use we need to know how to use them, who might use them and what for and how will it help them to answer the question we asked at the beginning? At this stage we will have an overall picture of what ratio analysis is, who uses it and the ratios they need to be able to use it. All that's left to do then is to use the ratios; and we will do that step- by-step, one by one. By the end of this section we will have used every ratio several times and we will be experts at using and understanding what they tell us.

What do we want ratio analysis to tell us? What do the users of accounts need to know?

What do we want ratio analysis to tell us? The key question in ratio analysis isn't only to get the right answer: for example, to be able to say that a business's profit is 10% of turnover. We have to start working on ratio analysis with the following question in our heads: What are we trying to find out? Isn't this just blether, won't the exam just ask me to tell them that profit is 10% of turnover? Well, yes, but then they want to know that you are a good student who understands what it means to say that profit is 10% of turnover. We can use ratio analysis to try to tell us whether the business 1. 2. 3. 4. 5. 6. 7. is profitable has enough money to pay its bills could be paying its employees higher wages is paying its share of tax is using its assets efficiently has a gearing problem is a candidate for being bought by another company or investor 2

The Ratios
We can simply make a list of the ratios we can use here but it's much better to put them into different categories. If we look at the questions in the previous section, we can see that we talked about profits, having enough cash, efficiently using assets - we can put our ratios into categories that are designed exactly to help us to answer these questions. The categories we want to use, section by section, are: 1. 2. 3. 4. 5. 6. Profitability: has the business made a good profit compared to its turnover? Return Ratios: compared to its assets and capital employed, has the business made a good profit? Liquidity: does the business have enough money to pay its bills? Asset Usage or Activity: how has the business used its fixed and current assets? Gearing: does the company have a lot of debt or is it financed mainly by shares? Investor or Shareholder

Not everyone needs to use all of the ratios we can put in these categories so the table that we present at the start of each section is in two columns: basic and additional. The basic ratios are those that everyone should use in these categories whenever we are asked a question about them. We can use the additional ratios when we have to analyse a business in more detail or when we want to show someone that we have really thought carefully about a problem.

What do the Users of Accounts Need to Know? The users of accounts that we have listed will want to know the sorts of things we can see in the table below: this is not necessarily everything they will ever need to know, but it is a starting point for us to think about the different needs and questions of different users.
Interest Group What do the Users of Accounts Need to Know? Ratios to watch

Investors

to help them determine whether they should buy shares in the business, hold on to the shares they already own or sell the shares they already own. They also want to assess the ability of the business to pay dividends.

## Return on Capital Employed

Lenders

to determine whether their loans and interest will be paid when due

Gearing ratios

Managers

might need segmental and total information to see how they fit into the overall picture

Profitability ratios

Employees

information about the stability and profitability of their employers to assess the ability of the business to provide remuneration, retirement benefits and employment opportunities

## Suppliers and other trade creditors

businesses supplying goods and materials to other businesses will read their accounts to see that they don't have problems: after all, any supplier wants to know if his customers are going to pay their bills!

Liquidity

Customers

the continuance of a business, especially when they have a long term involvement with, or are dependent on, the business

Profitability

Governments and their the allocation of resources and, therefore, the agencies activities of business. To regulate the activities of business, determine taxation policies and as the basis for national income and similar statistics

Profitability

Local community

Financial statements may assist the public by providing information about the trends and recent developments in the prosperity of the business and the range of its activities as they affect their area

## This could be a long and interesting list

Financial analysts

they need to know, for example, the accounting concepts employed for inventories, depreciation, bad debts and so on

## Possibly all ratios

Environmental groups

many organisations now publish reports specifically aimed at informing us about how they are working to keep their environment clean.

## Expenditure on anti-pollution measures

Researchers

researchers' demands cover a very wide range of lines of enquiry ranging from detailed statistical analysis of the income statement and balance sheet data extending over many years to the qualitative analysis of the wording of the statements

## Possibly all ratios

TYPES OF RATIO
There are a number of types of ratios of interest to the various stakeholders of a business. The main classifications of ratios are as follows:

Profitability Ratios

Measure the relationship between gross/net profit and sales, assets and capital employed. These are sometimes referred to as being performance ratios. Profitability ratios measure the profitability of the organization. Gross profit, Net profit, Return on capital employed, Return on Investment, Earnings per share

Activity Ratios

These measure how efficiently an organisation uses its resources. These are sometimes referred to as asset utilisation ratios. Stock turnover, asset turnover, collection period, payment period

Liquidity Ratios

These investigate the short-term and long-term financial stability of the firm by examining the relationships between assets and liabilities. These are sometimes also called solvency ratios. Acid test, current ratio (quick ratio) This group of ratios is concerned with analysing the returns for shareholders. These examine the relationship between the number of shares issued, dividend paid, value of the shares, and company profits. For obvious reasons these are quite often categorised as shareholder ratios. Dividend yield, dividend per share, price/earnings ratio, dividend cover

Investment Ratios

Gearing

Examines the relationship between internal sources and external sources of finance. It is therefore concerned with the long-term financial position of the company. Equity ratio, debt ratio, debt/equity ratio

1. PROFITABILITY RATIOS
Profitability is the ability of a business to earn profit over a period of time. Although the profit figure is the starting point for any calculation of cash flow, as already pointed out, profitable companies can still fail for a lack of cash. Note: Without profit, there is no cash and therefore profitability must be seen as a critical success factors.

A company should earn profits to survive and grow over a long period of time. Profits are essential, but it would be wrong to assume that every action initiated by management of a company should be aimed at maximising profits, irrespective of social consequences.

Profitability is a result of a larger number of policies and decisions. The profitability ratios show the combined effects of liquidity, asset management (activity) and debt management (gearing) on operating results. The overall measure of success of a business is the profitability which results from the effective use of its resources. For most private business enterprises one of their main objectives is to make a profit. However, it is not sufficient just to measure the amount of profit made.

(a)

## Gross Profit Margin

This ratio examines the relationship between the profits made on trading activities only (gross profit) against the level of turnover/sales made. Normally the gross profit has to rise proportionately with sales. It can also be useful to compare the gross profit margin across similar businesses although there will often be good reasons for any disparity. It is given by the formula

## gross profit x 100 turnover (sales)

expressed as a percentage

Interpretation: Obviously the higher the profit margin a business makes the better. However, the level of gross profit margin made will vary considerably between different markets. For example the amount of gross profit percentage put on clothes, (especially fashion items), is far higher than that put on food items. So any result gained must be looked at in the context of the industry in which the firm operates.

Analysis: This ratio is used to determine the amount of profit remaining from each sales dollar after subtracting the cost of goods sold. Example: a gross profit margin of 0.05 indicates that 5% of sales revenue is left to use for purposes other than the cost of goods sold. Measures the margin of profitability on sales throughout the year. This is the main indicator when measuring the efficiency of the operation, a very good indicator of the business's ability to withstand falling prices, rising costs or declining sales. A normal figure for a manufacturing industry would be between 6% and 8%, while high volume/low margin activities like food retailing can run very satisfactorily at around 3%. Retailers generally will have a lower profit margin than most industries. Highest margins of all are usually experienced in service industries where margins above 10% are enjoyed. The percentage should be relatively constant and any reason for decline investigated. Reasons for change could be a reduction in selling prices or increase in cost of sales.

(b)

## Net Profit Margin

This is a widely used measure of performance and is comparable across companies in similar industries. The fact that a business works on a very low margin need not cause alarm because there are some sectors in the industry that work on a basis of high turnover and low margins, for examples supermarkets and motorcar dealers.

What is more important in any trend is the margin and whether it compares well with similar businesses. As opposed to gross profit margin this ratio measures the relationship between the net profit (profit made after all other expenses have been deducted) and the level of turnover or sales made. It is given by the formula:

## net profit x 100 turnover (sales)

expressed as a percentage

Interpretation As with gross profit, a higher percentage result is preferred. This is used to establish whether the firm has been efficient in controlling its expenses. It should be compared with previous years results and with other companies in the same industry to judge relative efficiency. The net profit margin should also be compared with the gross profit margin. For if the gross profit margin has improved but the net profit margin declined, this shows that profits made on trading are becoming better, however the expenses incurred in the running of the business are also increasing but at a faster rate than profits. Thus efficiency is declining. 7

Analysis: The net profit margin is calculated by taking the net earnings available to common stockholders and dividing it by sales. This ratio is used to determine the amount of net profit for each dollar of sales that remains after subtracting all expenses. Companies with profit margins of less than 5% tend to either be in very competitive sectors or they may be doing badly. Be careful with these companies. A small economic downturn can reduce sales leaving the company making losses.

The profit margin is likely to be higher when: there is limited competition there is strong brand loyalty lower unit costs high price (e.g. orice inelastic product or exclusive item)

Gross profit is turnover (also called sales or revenues) minus cost of sales (i.e. overhead costs have not been deducted) Net profit is turnover (=sales=revenue) minus cost of sales and overhead costs If the gross profits are rising over time but the net profit is falling that is due to increasing overheads

(c)

## Return on Capital Employed (ROCE)

This is sometimes referred to as being the primary ratio and is considered to be one of the most important ratios available. This ratio measures the efficiency of funds invested in the business at generating profits. This ratio is actually different for different types of business; this is due to the fact that the various types of business can all raise their capital in different ways. This ratio shows the profit attributable to the amount invested by the owners of the business. It also shows potential investors into the business what they might hope to receive as a return. The stockholders equity includes share capital, share premium, distributable and non-distributable reserves. Once again this is expressed as a percentage.

ROCE =

net profit before tax and interest x 100 total capital employed

Total Capital = ordinary share capital + preference share capital + Reserves + Debentures +Long-term loans

For each type of company the idea is to try to determine how much profit has been made for distribution from the total amount of assets employed by that business. This is why we ignore tax and interest charges when calculating ROCE for a limited company. These items will fluctuate at the whim of agencies such as the government and the Bank of England. Therefore if we were to measure profit after tax and interest we would get significant variations in our results. These would not reflect changes in the performance of the business, but external factors.

Interpretation: As with the other ratios examined so far the higher the value of the ratio the better. A higher percentage can provide owners with a greater return. Inevitably this figure needs to be compared with previous years and other companies to determine whether this years result is satisfactory or not. Furthermore, the percentage result arrived at for ROCE for a given organisation needs to be compared with the percentage return offered by interest-bearing accounts at banks and building societies. Ideally the ROCE should be higher than any return that could be gained from interest-earning accounts. Analysis : Return on capital employed (ROCE) ratio measures whether or not a company is generating adequate profits in relation to the funds invested in it and is a key indicator of investment performance. A business could have difficulty servicing its borrowings if a low return is being earned for any length of time. In manufacturing we would expect to see figures in excess of 10% rising to over 25% at the top end. In retail lower figures would be experienced, ranging between 5% and 15%. Construction figures show an average of about 7% increasing to over 35% for the top performers.

## High ROCE can be achieved by Increasing sales Increasing profit margins

ROCE is likely to be lower if the markets are in decline Unit costs are increasing and the firm cannot increase price Sales are falling

The return on capital employed is likely to be higher when: The market is growing The firm is inceasing its efficiency Demand is high

(d)

## Return on Investment (ROI)

Income is earned by using the assets of a business productively. The more efficient the production, the more profitable the business. The rate of return on total assets indicates the degree of efficiency with which management has used the assets of the enterprise during an accounting period. This is an important ratio for all readers of financial statements. Investors have placed funds with the managers of the business. The managers used the funds to purchase assets which will be used to generate returns. If the return is not better than the investors can achieve elsewhere, they will instruct the managers to sell the assets and they will invest elsewhere. The managers lose their jobs and the business liquidates. ROI = After Tax Earnings : Total Assets

(e) Earnings per Share (EPS) Whatever income remains in the business after all prior claims, other than owners claims (i.e. ordinary dividends) have been paid, will belong to the ordinary shareholders who can then make a decision as to how much of this income they wish to remove from the business in the form of a dividend, and how much they wish to retain in the business. The shareholders are particularly interested in knowing how much has been earned during the financial year on each of the shares held by them. For this reason, an earning per share figure must be calculated. Clearly then, the earning per share calculation will be: EPS = Net Income after Tax Preference Dividend : No. of Issued ordinary Shares

Additional Information : The ROA ratio is calculated by taking the net earnings available to common stockholders (net income) and dividing it by total assets. This ratio is used to determine the amount of income each dollar of assets generates. Example: an ROA ratio of 0.0568 indicates that each dollar of company assets produced income of almost \$0.06. The ROE ratio is calculated by taking the net earnings available to common stockholders and dividing it by common stockholders' equity. This ratio is used to determine the amount of income produced for each dollar that common stockholders have invested. Example: An ROE ratio of 0.0869 indicates that the company returned 8.69% for every dollar invested by common stockholders.

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2. LIQUIDITY RATIOS
Liquidity refers to the ability of a firm to meet its short-term financial obligations when and as they fall due. The main concern of liquidity ratio is to measure the ability of the firms to meet their short-term maturing obligations. Failure to do this will result in the total failure of the business, as it would be forced into liquidation. These ratios are concerned with the examination of the financial stability of the organisation. They are mainly concerned with the organisations working capital and whether or not it is being managed effectively. Working capital is needed by all organisations in order for them to be able to finance their day-to-day activities. Too little and the company may not be able to pay all its debts. Too much and they may not be making most efficient use of their resources.

1. The Current Ratio The Current Ratio expresses the relationship between the firms current assets and its current liabilities. Current assets normally includes cash, marketable securities, accounts receivable and inventories. Current liabilities consist of accounts payable, short term notes payable, short-term loans, current maturities of long term debt, accrued income taxes and other accrued expenses (wages). Current Ratio = current assets: current liabilities

Interpretation: The rule of thumb says that the current ratio should be at least 2, that is the current assets should meet current liabilities at least twice.

Analysis For example: a current ratio of 2.57 indicates that the company has \$2.57 worth of current assets for every \$1.00 of current liabilities. One of the most universally known ratios, which reflect the Working Capital situation, indicates the ability of a company to pay its short-term creditors from the realisation of its current assets and without having to resort to selling its fixed assets to do so. Ideally the figure should always be greater than 1, which would indicate that there are sufficient assets available to pay liabilities, should the need arise. The higher the figure the better. For those industries such as transport where the majority of assets are tangible fixed assets, then a figure of 0.6 would be acceptable. In retail and manufacturing we would expect figures between 1.1 to 1.6; in wholesale and construction 1.1 to 1.5 and motor vehicles 1.2 to 1.6. Generally where credit terms and large stocks are normal to the business, the current ratio will be higher than, for example, a retail business where cash sales are the norm.

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2.

## The Acid Test

This ratio is sometimes also called the quick ratio or even the liquid ratio. It examines the businesss liquidity position by comparing current assets and liabilities but it omits stock from the total of current assets. This ratio is used to determine the company's ability to repay current liabilities after the least liquid of its current assets is removed from the equation. It examines the ability of the business to cover its short-term obligations from its quick assets only (i.e. it ignores stock).] This therefore provides a much more accurate measure of the firms liquidity.The reason for this is stock is the most illiquid current asset, i.e. it is the hardest to turn into cash without a loss in its value. With the omission of stock therefore we are able to perform a calculation that directly relates cash and near cash equivalents, (cash, bank and debtors) to short-term debts. Measures assets that are quickly converted into cash and they are compared with current liabilities. This ratio realizes that some of current assets are not easily convertible to cash e.g. inventories. It is given by the formula Acid Test = current assets stock: current liabilities

Interpretation: Again conventional wisdom states that an ideal result for this ratio should be approximately 1.1:1 Thus showing that the organisation has 1.10 to pay every 1.00 of debt. Therefore the company can pay all its debts and has a ten- percent safety margin as well. A result below this e.g. 0.8:1 indicates that the firm may well have difficulties meeting short-term payments. Clearly this ratio will be lower than the current ratio, but the difference between the two (the gap) will indicate the extent to which current assets consist of stock. Analysis : Example: a quick ratio of 2.48 indicates that the company could pay off 248% of its current liabilities by liquidating all current assets other than inventory. This ratio indicates the ability of a company to pay its debts as they fall due. It is generally considered to be a more accurate assessment of a company's financial health than the current ratio as it excludes stock, thus reducing the risk of relying on a ratio that may include slow moving or redundant stock. Figures of this ratio are lower than the current ratio. Supermarkets can, for example, easily survive on ratios as low as 0.4 with cash being received for goods sold, before the goods are actually paid for. Plant hire contractors would also expect ratios as low as 0.6 to 0.8. Clothing retailers also operate at very low levels, with average figures being between 0.2 and 0.6 and retail as a whole between 0.3 and 0.7. In manufacturing figures between 0.7 and 1.1 are seen as acceptable and for wholesalers 0.7 to 1.0. Construction should operate at between 0.6 and 1.0. Do not want the acid test ratio to be too high because: This could mean too many debtors(i.e too much money outstanding); this may lead to bad debts and /or cashflow problems Could mean too much cash; cash represents idle money which could be earning a higher return elsewhere

Do not want acid test ratio to be too low because: could mean liquidity problems i.e. may not be able to pay current liabilities

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3. ACTIVITY RATIOS

Activity ratios or financial efficiency ratios are concerned with how well an organisation manages its resources. Primarily they investigate how well the management controls the current situation of the firm. They consider stock, debtors and creditors. This area of ratios is linked therefore with the management of working capital. If a business does not use its assets effectively, investors in the business would rather take their money and place it somewhere else. In order for the assets to be used effectively, the business needs a high turnover. Unless the business continues to generate high turnover, assets will be idle as it is impossible to buy and sell fixed assets continuously as turnover changes. Activity ratios are therefore used to assess how active various assets are in the business. (a) Stock Turnover

This ratio measures the number of times in one year that a business turns over its stock of goods for sale. From this figure we can also establish the average length of time (in days) that stock is held by the company. This ratio measures the stock in relation to turnover in order to determine how often the stock turns over in the business. It indicates the efficiency of the firm in selling its product. It is calculated by dividing he cost of goods sold by the average inventory. It is given by the formula Stock Turnover = cost of goods sold average stock where average stock = (opening stock + closing stock) 2 Interpretation: This ratio can only really be interpreted with knowledge of the industry in which the firm operates. For example, we would expect a greengrocer to turnover his or her stock virtually every day, as their goods have to be fresh. Therefore, we would expect to see a result for stock turnover of approximately 250 to 300 times per year. This allows for closures and holidays and the fact that some produce will last longer than one day. Conversely if we were examining the accounts of a second hand car sales business we would maybe expect them to turn over their entire stock of cars and replace with new ones maybe about once a month, therefore we would see a result of 12 times. Note: Increased turnover can be just as dangerous as reduced turnover if the business does not have the working capital to support the turnover increase. As turnover increases more working capital and cash is required and if not, overtrading occurs. expressed as however many times

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As usual we can undertake a comparison with previous years or other similar sized firms in the same market. As a general rule though the higher the rate of stock turnover the better. It is possible to convert this ratio from showing the number of times an organisation turns over stock to showing the average number of days stock is held. It is given by the formula: Stock Turnover = average stock cost of goods sold x 365 expressed as days

Interpretation: The high stock turnover ratio would also tend to indicate that there was little chance of the firm holding damaged or obsolete stock. It is also possible to express stock turnover in terms of weeks or months, by multiplying by 52 or 12 as appropriate.

Analysis : A high ratio indicates that the company has inventory that sells well, while a low ratio means that the company has inventory that does not sell well. Example: an inventory turnover ratio of 66.67 indicates that inventory was sold 66.67 times during the year. Measures the number of times a company converts its stock into sales during the year. When examining this ratio it should be borne in mind that different companies will have varying levels of stock turnover depending on what they produce and the industry they operate in. Low figures are generally poor as they indicate excessively high or low moving stocks. At one end of the scale, and apart from advertising agencies and other service industries, ready mixed concrete companies probably have one of the better stock/turnover figures. At the other end companies that maintain depots of finished goods and replacement parts will have much poorer figures. For example, a manufacturing company with stock/turnover ratio of around 25 - 30 would be reasonable, decreasing with the larger and more complex the goods being made. For retail and wholesale, average figures would be lower at around 9 - 10. For construction, average stock/turnover figures would be around 16 and for industries such as transport, where overall stock figures are low, it would produce results of around 80 - 90.

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(b)

## Debtors Collection Period

This particular ratio is designed to show how long, on average, it takes the company to collect debts owed by customers. Customers who are granted credit are called debtors. The formula for this ratio is: Debtor collection period = debtors credit sales Often the figure for credit sales is not actually provided on the profit and loss account. In this case the sales/turnover figure should be substituted and used instead. Interpretation: Different industries allow different amounts of time for debtors to settle invoices. Standard credit terms are usually for 30,60,90 and 120 days. The debt collection period figure should therefore be compared against the official number of days the organisation allows for settlement. For this ratio the shorter the debt collection period the better. The shorter the average collection period, the better the quality of debtors, as a short collection period implies the prompt payment by debtors. The average collection period should be compared against the firms credit terms and policy to judge its credit and collection efficiency. An excessively long collection period implies a very liberal and inefficient credit and collection performance. The delay in collection of cash impairs the firms liquidity. On the other hand, too low a collection period is not necessarily favourable, rather it may indicate a very restrictive credit and collection policy which may curtail sales and hence adversely affect profit. x 365 expressed as days

Analysis: Example: an average collection period ratio of 65.70 indicates that on average it takes 65.70
days for customers to pay off their account balances. Measures the length of time a company takes to collect its debts and is measured in days. In general terms the figure indicates the effectiveness of the company's credit control department in collecting monies outstanding. Apart from strictly cash businesses like supermarkets with virtually zero debtors, normal payment terms are at the end of the month following delivery, giving an average credit of between 6 and seven weeks. Clothing retailers show some of the lowest figures with averages of around 7 days. In manufacturing average figures are around 63 days, with 42 being experienced at the top end and 84 days at the lower end. Average for wholesalers is around 56 days, whilst in construction the figures are lower, at around 45 days. Generally the average figure is around 30 days. In the construction industry the average is around 31 days, rising to 54 days at the bottom end and down to 17 days at the top. For wholesalers the average rises to 37 days, with top and bottom figures being 18 and 61 days respectively. For retail the average figure drops to 23 days with 40 days being in the bottom sector. For food retailers as low as 8 - 12 days is the norm. In manufacturing averages tend to be around 37 days, with the worst performers rising to 55 days and the best showing creditor days of around 22 days. 15

(c) Asset turnover This ratio measures a businesss sales in relation to the assets it uses to generate these sales. The formula to calculate this ratio is

Asset turnover

## sales net assets

This formula measures the efficiency with which businesses use their assets. An increasing ratio over time generally indicates that the firm is operating with greater efficiency. A fall in the ratio can be caused by a decline in sales or an increase in assets employed. Interpretation: The results of asset turnover ratios vary enormously. A supermarket may have a high figure as it has relatively few assets in relation to sales. A shipbuilding firm is likely to have a much lower ratio because it requires many more assets.Increased turnover can be just as dangerous as reduced turnover if the business does not have the working capital to support the turnover increase. As turnover increases more working capital and cash is required and if not, overtrading occurs.

Analysis : Example: a total asset turnover ratio of 0.68 indicates that the dollar amount of sales was 68% of all assets.
The asset turnover indicates how effectively a company utilises its investment in assets. It is a measure of how efficient the company has been in generating sales from the assets at its disposal. A low figure would suggest either poor trading performance (which can be evaluated by the profit margin, sales per employee figures) or an over investment in costly fixed assets. The construction industry shows a mean asset turnover ratio of 1.6, with the poorer performers averaging 0.6 and the better companies showing an average of 2.6. The retail sector has an average asset turnover of 1.9, with poorer performers in the sector averaging 0.8 and the better ones showing an average of 3.2.

4.

## Creditors Payment Period

This ratio measures the length of time it takes a company to pay its creditors. This particular ratio is designed to show how long, on average, it takes the company to pay debts owed to suppliers. Suppliers who are grant credit are called creditors. The formula for this ratio is: Debtor collection period = creditors x 365 expressed as days

Credit purchases

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Interpretation : Generally the average figure is around 30 days. Analysis : In the construction industry the average is around 31 days, rising to 54 days at the bottom end and down to 17 days at the top. For wholesalers the average rises to 37 days, with top and bottom figures being 18 and 61 days respectively. For retail the average figure drops to 23 days with 40 days being in the bottom sector. For food retailers as low as 8 - 12 days is the norm. In manufacturing averages tend to be around 37 days, with the worst performers rising to 55 days and the best showing creditor days of around 22 days.

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5. GEARING

The ratios indicate the degree to which the activities of a firm are supported by creditors funds as opposed to owners. The relationship of owners equity to borrowed funds is an important indicator of financial strength. The debt requires fixed interest payments and repayment of the loan and legal action can be taken if any amounts due are not paid at the appointed time. A relatively high proportion of funds contributed by the owners indicates a cushion (surplus) which shields creditors against possible losses from default in payment. Note: The greater the proportion of equity funds, the greater the degree of financial strength. Financial leverage will be to the advantage of the ordinary shareholders as long as the rate of earnings on capital employed is greater than the rate payable on borrowed funds. The following ratios can be used to identify the financial strength and risk of the business.

(a)

The Equity Ratio The equity ratio is calculated as follows: (this ratio is multiplied by 100 to bring it to a percentage) Equity Ratio = Ordinary Shareholders Interest : Total Assets

Interpretation: A high equity ratio reflects a strong financial structure of the company. A relatively low equity ratio reflects a more speculative situation because of the effect of high leverage and the greater possibility of financial difficulty arising from excessive debt burden.

(b)

## The Debt Ratio

This is the measure of financial strength that reflects the proportion of capital which has been funded by debt, including preference shares. This ratio is calculated as follows: Debt Ratio = Total Debt : Total Assets

Interpretation: With higher debt ratio (low equity ratio), a very small cushion has developed thus not giving creditors the security they require. The company would therefore find it relatively difficult to raise additional financial support from external sources if it wished to take that route. The higher the debt ratio the more difficult it becomes for the firm to raise debt. Debt Ratio is complementary to the equity ratio as long as total debt plus equity gives 100% of the total assets 18

Analysis: An increasing ratio would indicate that borrowing is making a higher contribution to the capital base of the business than shareholders funds. This may cause problems, particularly if profit margins are also in decline. The manufacturing sector shows an average total debt ratio 1.4, with the lower quartile companies averaging around 3.4 and the upper quartile showing a ratio of 0.4. The retail sector shows an average of 1.1, with the better performers in retail averaging 0.2: the construction industry averages around 1.5, with the upper quartile averaging around 0.25. Debt ratios measure the amount of debt an organization is using and the ability of the organization to pay off the debt. These include the debt to total assets ratio and the times interest earned ratio.

(c)

The Debt / EquityRatio This ratio indicates the extent to which debt is covered by shareholders funds. It reflects the relative position of the equity holders and the lenders and indicates the companys policy on the mix of capital funds. The debt to equity ratio is calculated as follows: Debt to Equity Ratio = Total debt : Total Equity

Gearing is quite often included in the classification of liquidity ratios as this ratio focuses on the longterm financial stability of an organisation. It measures the proportion of capital employed by the business that is provided by long-term lenders as against the proportion that has been invested by the owners. Thus, we can see how much of an organisation has been financed by debt. It is given by the formula: Gearing = long term liabilities + preference shares x 100 total capital employed

## Once again this is expressed as a percentage.

Total Capital = ordinary share capital + preference share capital + Reserves + Debentures + Long-term loans Long term liabilities = Long-term loans + debentures

Interpretation: The gearing ratio shows how risky an investment a company is. If loans represent more than 50% of capital employed, the company is highly geared. Such a company has to pay interest on its borrowings before it can pay dividends to shareholders or retain profits for reinvestment. High gearing figures indicate a high degree of risk. As ordinary shareholders should enjoy a greater rate of return from lower geared companies. Low geared companies i.e. those under 50% should provide therefore a lower risk investment opportunity, they should also be able to negotiate loans much more easily than a highly geared company as they are not already carrying a high proportion of debt. 19

Analysis : Gearing is a comparison between the amount of borrowings a company has to its shareholders funds (net worth). The result of the calculation will show as a percentage the proportion of capital available within the company in relation to that owed to sources outside the company. Lower figures are more acceptable, showing that the company is predominantly financed by equity whilst high gearing shows an over reliance on borrowings for a significant proportion of the company's capital requirements. High gearing is significantly more dangerous at times of high or rising interest rates and also low profitability. Businesses that rely on a great deal of tangible assets (such as heavy manufacturing) or have to replace fixed assets more frequently than other industries are expected to have higher gearing figures. The transport industry shows an average gearing level of 150%, with the poorer performers suffering levels up to 380%. The service sector has an average gearing level of 100%, with the upper quartile of companies showing negative gearing (i.e. surplus of cash over borrowing). The construction industry, where borrowing is usually taken out against work in progress as well as tangible fixed assets such as plant and machinery, shows an average of 130% gearing, with the better performers averaging 30% and the poorer performing businesses showing gearing levels in excess of 400%.

HIGH GEARING Advantages: borrowing may have enabled profitable projects to be undertaken borrowing can be a cheaper source of finance than shares Disadvantages may involve risk-if profits are low the firm may struggle to repay interest 6.may be difficult to borrow more finance INVESTMENT RATIOS

Increasing gearing can be risky for firms because of the interest payments BUT if a firm refuses to borrow it may miss out on market opportunities. Increasing gearing is acceptable provided the profits earned more than cover the interest payments. So the firm needs to consider cover as well as the gearing ratio. A typical reaging ratio for UK firms is around 50% However firms are more likely to be highly geared : in the early years (as they borrow to set up and expand) if interest rates are low (so firms exploit this by borrowing and fixing interest rates) if the owners are reluctant to lose control by bringing in outside finance

Shareholders and potential shareholders are primarily concerned with assessing the level of return they might gain from an investment in a particular company. These ratios are necessary as the value of shares can vary quite considerably. These ratios indicate the relationship of the firms share price to dividends and earnings. Note that when we refer to the share price, we are talking about the Market value and not the Nominal value as indicated by the par value. 20

For this reason, it is difficult to perform these ratios on unlisted companies as the market price for their shares is not freely available. One would first have to value the shares of the business before calculating the ratios. Market value ratios are strong indicators of what investors think of the firms past performance and future prospects.

(a)

## Dividend Per Share (DPS)

This is an important shareholders ratio. It simply the total dividend declared by a company divided by the number of shares the business has issued. Dividend per share = total dividends number of issued shares Results of this ratio are expressed as a number of pence per share. Interpretation: A higher figure is generally preferable to a lower one as this provides the shareholder with a larger return on his or her investment. However, some shareholders are looking for long-term investments and may prefer to have a lower DPS now in the hope of greater returns in the future and a rising share price.

(b)

Dividend yield

This is the dividend per share (for the entire year) expressed as a percentage of the market price of the share. The dividend yield ratio indicates the return that investors are obtaining on their investment in the form of dividends. This yield is usually fairly low as the investors are also receiving capital growth on their investment in the form of an increased share price. It is interesting to note that there is strong correlation between dividend yields and market prices. Invariably, the higher the dividend, the higher the market value of the share. The dividend yield ratio compares the dividend per share against the price of the share Dividend yield = dividend per share x 100 market share price Results for this ratio can fluctuate regularly even daily as they depend upon the firms share price. A rising share price will cause the dividend yield to fall. This ratio is most valuable to investors relying upon an annual income from the purchases of shares. Normally a very high dividend yield signals potential financial difficulties and possible dividend payout cut. The dividend per share is merely the total dividend divided by the number of shares issued. The price per share is the market price of the share at the end of the financial year. Interpretation: This ratio is expressed as a percentage. Obviously higher percentages are preferred. The current rates of interest paid on savings accounts provide a useful comparison, although the latter carry no 21

risk (of capital loss). Hence many investors would expect dividend yield to exceed the current rate of interest.

(c)

Price/Earning Ratio (P/E ratio) P/E ratio is a useful indicator of what premium or discount investors are prepared to pay or receive for the investment. The higher the price in relation to earnings, the higher the P/E ratio which indicates the higher the premium an investor is prepared to pay for the share. This occurs because the investor is extremely confident of the potential growth and earnings of the share. The price-earning ratio is calculated as follows: P/E Ratio = Market Price per share : Current earnings per share High P/E generally reflects lower risk and/or higher growth prospects for earnings.

(d)

Dividend Cover This ratio measures the extent of earnings that are being paid out in the form of dividends, i.e. how many times the dividends paid are covered by earnings (similar to times interest earned ratio discussed above). A higher cover would indicate that a larger percentage of earnings are being retained and re-invested in the business while a lower dividend cover would indicate the converse.

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## LIMITATIONS OF RATIO ANALYSISLIMITATIONS OF RATIO ANALYSIS

1. Many ratios are calculated on the basis of the balance-sheet figures. These figures are as on the balance-sheet date only and may not be indicative of the year-round position. 2. Comparing the ratios with past trends and with competitors may not give a correct picture as the figures may not be easily comparable due to the difference in accounting policies, accounting period etc. 3. It gives current and past trends, but not future trends. 4. Impact of inflation is not properly reflected, as many figures are taken at historical numbers, several years old. 5. There are differences in approach among financial analysts on how to treat certain items, how to interpret ratios etc. 6. The ratios are only as good or bad as the underlying information used to calculate them.

1.

Accounting Information

* Different Accounting Policies The choices of accounting policies may distort inter company comparisons. Example - IAS 16 allows valuation of assets to be based on either revalued amount or at depreciated historical cost. The business may opt not to revalue its asset because by doing so the depreciation charge is going to be high and will result in lower profit. * Creative accounting The businesses apply creative accounting in trying to show the better financial performance or position which can be misleading to the users of financial accounting. Like the IAS 16 mentioned above, requires that if an asset is revalued and there is a revaluation deficit, it has to be charged as an expense in income statement, but if it results in revaluation surplus the surplus should be credited to revaluation reserve. So in order to improve on its profitability level the company may select in its revaluation programme to revalue only those assets which will result in revaluation surplus leaving those with revaluation deficits still at depreciated historical cost.

2.

Information problems

* Ratios are not definitive measures Ratios need to be interpreted carefully. They can provide clues to the companys performance or financial situation. But on their own, they cannot show whether performance is good or bad. Ratios require some quantitative information for an informed analysis to be made. * Outdated information in financial statement The figures in a set of accounts are likely to be at least several months out of date, and so might not give a 23

proper indication of the companys current financial position. * Historical costs not suitable for decision making IASB Conceptual framework recommends businesses to use historical cost of accounting. Where historical cost convention is used, asset valuations in the balance sheet could be misleading. Ratios based on this information will not be very useful for decision making. * Financial statements contain summarised information Ratios are based on financial statements which are summaries of the accounting records. Through the summarisation some important information may be left out which could have been of relevance to the users of accounts. The ratios are based on the summarised year end information which may not be a true reflection of the overall years results. * Interpretation of the ratio It is difficult to generalise about whether a particular ratio is good or bad. For example a high current ratio may indicate a strong liquidity position, which is good or excessive cash which is bad. Similarly Non current assets turnover ratio may denote either a firm that uses its assets efficiently or one that is under capitalised and cannot afford to buy enough assets.

3.

## Comparison of performance over time

* Price changes Inflation renders comparisons of results over time misleading as financial figures will not be within the same levels of purchasing power. Changes in results over time may show as if the enterprise has improved its performance and position when in fact after adjusting for inflationary changes it will show the different picture. * Technology changes When comparing performance over time, there is need to consider the changes in technology. The movement in performance should be in line with the changes in technology. For ratios to be more meaningful the enterprise should compare its results with another of the same level of technology as this will be a good basis measurement of efficiency. * Changes in Accounting policy Changes in accounting policy may affect the comparison of results between different accounting years as misleading. The problem with this situation is that the directors may be able to manipulate the results through the changes in accounting policy. This would be done to avoid the effects of an old accounting policy or gain the effects of a new one. It is likely to be done in a sensitive period, perhaps when the businesss profits are low. * Changes in Accounting standard Accounting standards offers standard ways of recognising, measuring and presenting financial transactions. Any change in standards will affect the reporting of an enterprise and its comparison of results over a number of years. * Impact of seasons on trading As stated above, the financial statements are based on year end results which may not be true reflection of results year round. Businesses which are affected by seasons can choose the best time to produce financial 24

statements so as to show better results. For example, a tobacco growing company will be able to show good results if accounts are produced in the selling season. This time the business will have good inventory levels, receivables and bank balances will be at its highest. While as in planting seasons the company will have a lot of liabilities through the purchase of farm inputs, low cash balances and even nil receivables.

4.

Inter-firm comparison

* Different financial and business risk profile No two companies are the same, even when they are competitors in the same industry or market. Using ratios to compare one company with another could provide misleading information. Businesses may be within the same industry but having different financial and business risk. One company may be able to obtain bank loans at reduced rates and may show high gearing levels while as another may not be successful in obtaining cheap rates and it may show that it is operating at low gearing level. To un informed analyst he may feel like company two is better when in fact its low gearing level is because it can not be able to secure further funding. * Different capital structures and size Companies may have different capital structures and to make comparison of performance when one is all equity financed and another is a geared company it may not be a good analysis. * Impact of Government influence Selective application of government incentives to various companies may also distort intercompany comparison. One company may be given a tax holiday while the other within the same line of business not, comparing the performance of these two enterprises may be misleading. * Window dressing These are techniques applied by an entity in order to show a strong financial position. For example, MZ Trucking can borrow on a two year basis, K10 Million on 28th December 2003, holding the proceeds as cash, then pay off the loan ahead of time on 3rd January 2004. This can improve the current and quick ratios and make the 2003 balance sheet look good. However the improvement was strictly window dressing as a week later the balance sheet is at its old position. Ratio analysis is useful, but analysts should be aware of these problems and make adjustments as necessary. Ratios analysis conducted in a mechanical, unthinking manner is dangerous, but if used intelligently and with good judgement, it can provide useful insights into the firms operations.

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