In our introduction to interpreting financial information we identified five
main areas for investigation of accounting information. The use of ratio analysis
in each of these areas is introduced below:
Profitability Ratios
These ratios tell us whether a business is making profits -
and if so whether at an acceptable rate. The key ratios are:
Ratio
Calculation
Comments
Gross Profit Margin
[Gross Profit / Revenue] x
100 (expressed as a percentage
This ratio tells us something
about the business's ability consistently to control its production
costs or to manage the margins its makes on products its buys and sells.
Whilst sales value and volumes may move up and down significantly, the
gross profit margin is usually quite stable (in percentage terms). However,
a small increase (or decrease) in profit margin, however caused can
produce a substantial change in overall profits.
Operating Profit Margin
[Operating Profit / Revenue]
x 100 (expressed as a percentage)
Assuming a constant gross
profit margin, the operating profit margin tells us something about
a company's ability to control its other operating costs or overheads.
Return on capital employed
("ROCE")
Net profit before tax, interest
and dividends ("EBIT") / total assets (or total assets less
current liabilities
ROCE is sometimes referred
to as the "primary ratio"; it tells us what returns management
has made on the resources made available to them before making any distribution
of those returns.
Efficiency ratios
These ratios give us an insight into how efficiently the business
is employing those resources invested in fixed assets and working capital.
Ratio
Calculation
Comments
Sales /Capital Employed
Sales / Capital employed
A measure of total asset utilisation.
Helps to answer the question - what sales are being generated by each
pound's worth of assets invested in the business. Note, when combined
with the return on sales (see above) it generates the primary ratio
- ROCE.
Sales or Profit / Fixed
Assets
Sales or profit / Fixed Assets
This ratio is about fixed
asset capacity. A reducing sales or profit being generated from each
pound invested in fixed assets may indicate overcapacity or poorer-performing
equipment.
Stock Turnover
Cost of Sales / Average Stock
Value
Stock turnover helps answer
questions such as "have we got too much money tied up in inventory"?.
An increasing stock turnover figure or one which is much larger than
the "average" for an industry, may indicate poor stock management.
Credit Given / "Debtor
Days"
(Trade debtors (average, if
possible) / (Sales)) x 365
The "debtor days"
ratio indicates whether debtors are being allowed excessive credit.
A high figure (more than the industry average) may suggest general problems
with debt collection or the financial position of major customers.
Credit taken / "Creditor
Days"
((Trade creditors + accruals)
/ (cost of sales + other purchases)) x 365
A similar calculation to that
for debtors, giving an insight into whether a business is taking full
advantage of trade credit available to it.
Liquidity Ratios
Liquidity ratios indicate how capable a business is of meeting
its short-term obligations as they fall due:
Ratio
Calculation
Comments
Current Ratio
Current Assets / Current Liabilities
A simple measure that estimates
whether the business can pay debts due within one year from assets that
it expects to turn into cash within that year. A ratio of less than
one is often a cause for concern, particularly if it persists for any
length of time.
Quick Ratio (or "Acid
Test"
Cash and near cash (short-term
investments + trade debtors)
Not all assets can be turned
into cash quickly or easily. Some - notably raw materials and other
stocks - must first be turned into final product, then sold and the
cash collected from debtors. The Quick Ratio therefore adjusts the Current
Ratio to eliminate all assets that are not already in cash (or "near-cash")
form. Once again, a ratio of less than one would start to send out danger
signals.
Stability Ratios
These ratios concentrate on the long-term health of a business
- particularly the effect of the capital/finance structure on the business:
Ratio
Calculation
Comments
Gearing
Borrowing (all long-term debts
+ normal overdraft) / Net Assets (or Shareholders' Funds)
Gearing (otherwise known
as
"leverage") measures the proportion of assets invested in
a business that are financed by borrowing. In theory, the higher the
level of borrowing (gearing) the higher are the risks to a business,
since the payment of interest and repayment of debts are not "optional"
in the same way as dividends. However, gearing can be a financially
sound part of a business's capital structure particularly if the business
has strong, predictable cash flows.
Interest cover
Operating profit before interest
/ Interest
This measures the ability
of the business to "service" its debt. Are profits sufficient
to be able to pay interest and other finance costs?
Investor Ratios
There are several ratios commonly used by investors to assess
the performance of a business as an investment:
Ratio
Calculation
Comments
Earnings per share ("EPS")
Earnings (profits) attributable
to ordinary shareholders / Weighted average ordinary shares in issue
during the year
A requirement of the London
Stock Exchange - an important ratio. EPS measures the overall profit
generated for each share in existence over a particular period.
Price-Earnings Ratio
("P/E Ratio")
Market price of share / Earnings
per Share
At any time, the P/E ratio
is an indication of how highly the market "rates" or "values"
a business. A P/E ratio is best viewed in the context of a sector or
market average to get a feel for relative value and stock market pricing.
Dividend Yield
(Latest dividend per ordinary
share / current market price of share) x 100
This is known as the "payout
ratio". It provides a guide as to the ability of a business to
maintain a dividend payment. It also measures the proportion of earnings
that are being retained by the business rather than distributed as dividends.
