introduction to financial ratios

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 i 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.

Accounting Glossary - Key Terms
A	B	C	D	E	F	G	H	I	J
K	L	M	N	O	P	Q	R	S	T
U	V	W	X	Y	Z

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introduction to financial ratios

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