Main Financial RatiosAuthor: Jim Riley Last updated: Wednesday 24 October, 2012Main ratios (introduction)In our introduction to interpreting financial information we identified five main areas forinvestigation of accounting information. The use of ratio analysis in each of these areas isintroduced below:Profitability RatiosThese ratios tell us whether a business is making profits - and if so whether at an acceptable rate.The key ratios are:Ratio Calculation CommentsGross ProfitMargin[Gross Profit /Revenue] x 100(expressed as apercentageThis ratio tells us something about the businesss abilityconsistently to control its production costs or to managethe margins its makes on products its buys and sells.Whilst sales value and volumes may move up and downsignificantly, the gross profit margin is usually quitestable (in percentage terms). However, a small increase(or decrease) in profit margin, however caused canproduce a substantial change in overall profits.OperatingProfit Margin[Operating Profit /Revenue] x 100(expressed as apercentage)Assuming a constant gross profit margin, the operatingprofit margin tells us something about a companysability to control its other operating costs or overheads.Return oncapitalemployed("ROCE")Net profit beforetax, interest anddividends("EBIT") / totalassets (or totalassets less currentliabilitiesROCE is sometimes referred to as the "primary ratio"; ittells us what returns management has made on theresources made available to them before making anydistribution of those returns.Efficiency ratiosThese ratios give us an insight into how efficiently the business is employing those resourcesinvested in fixed assets and working capital.
Ratio Calculation CommentsSales /CapitalEmployedSales / CapitalemployedA measure of total asset utilisation. Helps to answer thequestion - what sales are being generated by eachpounds worth of assets invested in the business. Note,when combined with the return on sales (see above) itgenerates the primary ratio - ROCE.Sales or Profit/ Fixed AssetsSales or profit /Fixed AssetsThis ratio is about fixed asset capacity. A reducing salesor profit being generated from each pound invested infixed assets may indicate overcapacity or poorer-performing equipment.StockTurnoverCost of Sales /Average StockValueStock turnover helps answer questions such as "have wegot too much money tied up in inventory"?. Anincreasing stock turnover figure or one which is muchlarger than the "average" for an industry, may indicatepoor stock management.Credit Given /"DebtorDays"(Trade debtors(average, ifpossible) / (Sales))x 365The "debtor days" ratio indicates whether debtors arebeing allowed excessive credit. A high figure (more thanthe industry average) may suggest general problems withdebt collection or the financial position of majorcustomers.Credit taken /"CreditorDays"((Trade creditors +accruals) / (cost ofsales + otherpurchases)) x 365A similar calculation to that for debtors, giving an insightinto whether a business is taking full advantage of tradecredit available to it.Liquidity RatiosLiquidity ratios indicate how capable a business is of meeting its short-term obligations as theyfall due:Ratio Calculation CommentsCurrentRatioCurrent Assets /Current LiabilitiesA simple measure that estimates whether the businesscan pay debts due within one year from assets that itexpects to turn into cash within that year. A ratio of lessthan one is often a cause for concern, particularly if itpersists for any length of time.Quick Ratio(or "AcidTest"Cash and nearcash (short-terminvestments +trade debtors)Not all assets can be turned into cash quickly or easily.Some - notably raw materials and other stocks - mustfirst be turned into final product, then sold and the cashcollected from debtors. The Quick Ratio therefore
adjusts the Current Ratio to eliminate all assets that arenot already in cash (or "near-cash") form. Once again, aratio of less than one would start to send out dangersignals.Stability RatiosThese ratios concentrate on the long-term health of a business - particularly the effect of thecapital/finance structure on the business:Ratio Calculation CommentsGearing Borrowing (alllong-term debts +normal overdraft) /Net Assets (orShareholdersFunds)Gearing (otherwise known as "leverage") measures theproportion of assets invested in a business that arefinanced by borrowing. In theory, the higher the levelof borrowing (gearing) the higher are the risks to abusiness, since the payment of interest and repaymentof debts are not "optional" in the same way asdividends. However, gearing can be a financially soundpart of a businesss capital structure particularly if thebusiness has strong, predictable cash flows.InterestcoverOperating profitbefore interest /InterestThis measures the ability of the business to "service" itsdebt. Are profits sufficient to be able to pay interest andother finance costs?Investor RatiosThere are several ratios commonly used by investors to assess the performance of a business asan investment:Ratio Calculation CommentsEarningsper share("EPS")Earnings (profits)attributable toordinaryshareholders /Weighted averageordinary shares inissue during the yearA requirement of the London Stock Exchange - animportant ratio. EPS measures the overall profitgenerated for each share in existence over a particularperiod.Price-EarningsRatio ("P/EMarket price ofshare / Earnings perShareAt any time, the P/E ratio is an indication of how highlythe market "rates" or "values" a business. A P/E ratio isbest viewed in the context of a sector or market average
Ratio") to get a feel for relative value and stock market pricing.DividendYield(Latest dividend perordinary share /current market priceof share) x 100This is known as the "payout ratio". It provides a guideas to the ability of a business to maintain a dividendpayment. It also measures the proportion of earningsthat are being retained by the business rather thandistributed as dividends.