2. Ratio analysis
A method of assessing a firmโs
financial situation by comparing two
sets of linked data
3. Concept of ratio analysis
A ratio is a comparison of a figure with another
figure, where the relative values of the two
numbers can be used to make a judgement.
Ratios are expressed as, for example, 2.5:1
Despite the name of this technique, most of the
ratios featured in ratio analysis are actually
stated as a percentage!
4. Ratio analysis
Gives a better understanding of financial accounts
and allows potential investors to make a more
informed decision
There are 5 main types of ratios:
Liquidity Ratios
Profitability Ratios
Efficiency Ratios
Gearing Ratio
Shareholder Ratios
5. Types of ratio Meaning of ration type
Liquidity ratios These show whether a firm is likely to be able to meet its short-
term liabilities. Although profit shows long-term success, it is
vital that a firm holds sufficient liquidity to avoid difficulties is
paying debt.
Profitability ratios These compare profits with the size of the firm. As profit is often
the primary aim of a company, these ratios are often described
as performance ratios.
Efficiency ratios These generally concentrate on the firmโs management of its
management of its working capital. They are used to assess the
efficiency of the firm in itโs management of its assets and short-
term liabilities
Gearing ratios Gearing focuses on long-term liquidity and shows whether a
firmโs capital structure is likely to be able to continue to meet
interest payments on, and to repay, long-term borrowing
Shareholdersโ ratios These focus on drawing conclusions about whether
shareholders are likely to benefit financially from their
shareholding
6. Liquidity: a businessโs ability to meet short-
term cash payments on time.
Current ratio(also known as working capital): a measure of the ability to meet short-term debts
(comparing current assets and current liabilities)
Current ratio= Current assets/Current liabilities
Example: Current assets=250
Current liabilities=200
Ratio= 1:1.25 for every ยฃ1 of current liabilities the business has ยฃ1.25 in current assets
7. Liquidity: a businessโs ability to meet short-
term cash payments on time.
Acid test ratio: a measure of the ability of a business to meet short term debts from liquid assets
(minus stock/inventories)
Acid test ratio= (current assets-inventories)/ current liabilities
Example: current assets= 250
Current liabilities=200
Inventories= 30
Ratio=1:1.1 for every ยฃ1 of current liabilities, the business has ยฃ1.10 in current assets
less inventories
8. โข Current ratio and acid test ratio look at whether the business has enough
short-term assets to be able to pay its short-term debts if immediate
repayment was demanded
โข Acid test ratio is more challenging to a business as it takes into account
that it may be difficult for a firm to turn its stock into cash quickly- this is
likely to affect the price at which the stock is priced
โข the higher the ratio, the more liquid a business- if a firm has high liquidity,
this could mean that it is failing to find suitable, profitable uses for its
cash.
9. Profitability: the relationship between a
businessโs profit and sales revenues.
ROCE: a measure of how efficiently a business is using its capital to generate profits.
ROCE%= operating profit/(total equity+ non-current liabilities)x 100
Example: operating profit= 550
Total equity= 5000
Non-current liabilities= 2000
ROCE= 18.3% for every ยฃ1 capital invested a profit of 0.183p was generated. This
fig. will be compared with the firmโs ROCE from previous years and other companies.
10. Efficiency
Asset turnover: a measure of how effectively a business is using its assets to generate sales.
Businesses will try to achieve a high assets turnover to show that assets are working hard
Asset turnover= Sales/ net assets
Example: Sales=2000
Net assets= 1500
Ratio= 1:1.33 for every ยฃ1 invested in assets, the business generates sales of ยฃ1.33
in one year
Rate of asset turnover will vary between industries depending on the degree of capital intensity.
Asset turnover is particularly useful when looking at the operational efficiency of firms in the same
industry
11. Efficiency
Inventory or stock turnover: a measure of how many times per year a business turns over its stock
through sales
Inventory turnover= cost of sales/ inventory
Example: cost of sales= 600
Inventory= 50
Ratio= 1:12 this means that the business is selling its inventory 12 times a year
i.e. it holds stock for 1month
12. Efficiency
Payables (creditor) days: a measure of the average number of days taken to pay suppliers
Payables (creditors) days= (Payables X 365days)/ credit purchases
Example: (200 X 365)/900
= 81days
If the figure for credit purchases is not available then cost of sales is used. Some firms set themselves
internal targets in relation paying debts. In order to improve cash flow firms often negotiate longer
payback periods
13. Efficiency
Receivables(debtors) days: a measure of the average number of days taken to by a business to
collect its debts from customers
Receivables days= (receivables X 365 days) / Revenue
Example: (135X365) / 1390= 35days approx. takes 1 month to receive payment for sales
14. Gearing: refers to how much of a firms capital is
financed by long-term loans
Gearing ratio %= non-current liabilities / ( total equity+ non-current liabilities) X 100
Example: 2000/ (1500+2000) X100= 57%
For every ยฃ1 invested in the business, 57p is from a long-term liability
If gearing is low it may indicate a firm is being cautions and could possibly be missing out on
potential investment opportunities.
15. Shareholder ratios: help measure the value of
the return received by a shareholder.
Dividend per share: the number of pence per share received by shareholders
Dividend per share= total dividends/ number of shares issued
Example: 300/ 500= 60p per share
An investor may be willing to accept a lower dividend per share in the short run if profits are being
reinvested for the long-term good of the business
16. Shareholder ratios: help measure the value of
the return received by a shareholder.
Dividend yield: a measure of the return received on an investment, expressed as a percentage of the
current market price of the share.
Dividend yield= (dividend per share/market share price) X 100
Example: (0.60/9.33) X100= 6.4% this means that a yield of 6.4% means that if a
dividend of ยฃ1 was received, the expected value of the share would be ยฃ6.40
Allows for a more meaningful comparison of the value of the investment in relation to alternatives.
Dividend yield will go up or down in relation to the share price on the stock exchange.
17. Value and limitation of ratio analysis
โข Ratios provide a structure and put figures into context
โข provide a framework from which we can make meaningful comparisons
between a firmโs performance from one year to the next, between branches
within a firm or between firms within the same industry
โข provide management with a tool to compare performance and set targets
โข financial documents may have been โwindow dressedโ/manipulated to
improve the picture they show. This will affect the ratios calculated
โข the balance sheet is a โsnapshotโ and as such only true on the day it is drawn
up
โข ratio analysis only takes into account the financial performance of a firm
