Ratio Analysis Financial ratios can be used to examine various aspects of the financial position and performance of a business and are widely used for planning and control purposes. They can be used to evaluate the financial health of a business and can be utilised by management in a wide variety of decisions involving such areas as profit planning, pricing, working-capital management, financial structure and dividend policy. Ratio analysis provides a fairly simplistic method of examining the financial condition of a business. A ratio expresses the relation of one figure appearing in the financial statements to some other figure appearing there. Ratios enable comparison between businesses. Differences may exist between businesses in the scale of operations making comparison via the profits generated unreliable. Ratios can eliminate this uncertainty. Other than comparison with other businesses, it is also a valuable tool in analysing the performance of one business over time. However useful ratios are not without their problems. Figures calculated through ratio analysis can highlight the financial strengths and weaknesses of a business but they cannot, by themselves, explain why certain strengths or weaknesses exist or why certain changes have occurred. Only detailed investigation will reveal these underlying reasons. Ratios must, therefore, be seen as a ‘starting point’. Financial ratio classification The following ratios are considered the more important for decision-making purposes: Ratios can be grouped into certain categories, each of which reflects a particular aspect of financial performance or position. The following broad categories provide a useful basis for explaining the nature of the financial ratios to be dealt with. Profitability.Businesses come into being with the primary purpose of creating wealth for the owners. Profitability ratios provide an insight to the degree of success in achieving this purpose. They express the profits made in relation to other key figures in the financial statements or to some business resource. Efficiency.Ratios may be used to measure the efficiency with which certain resource have been utilised within the business. These ratios are also referred to as active ratios. Liquidity.It is vital to the survival of a business that there be sufficient liquid resources available to meet maturing obligations. Certain ratios may be calculated that examines the relationship between liquid resources held and creditors due for payment in the near future. Gearing.This is the relationship between the amount financed by the owners of the business and the amount contributed by outsiders, which has an important effect on the degree of risk associated with a business. Gearing is then something that managers must consider when making financing decisions. Investment.Certain ratios are concerned with assessing the returns and performance of shares held in a particular business. Profitabi ...

1. Ratio Analysis
Financial ratios can be used to examine various aspects of the
financial position and performance of a business and are widely
used for planning and control purposes.
They can be used to evaluate the financial health of a business
and can be utilised by management in a wide variety of
decisions involving such areas as profit planning, pricing,
working-capital management, financial structure and dividend
policy.
Ratio analysis provides a fairly simplistic method of examining
the financial condition of a business.
A ratio expresses the relation of one figure appearing in the
financial statements to some other figure appearing there.
Ratios enable comparison between businesses.
Differences may exist between businesses in the scale of
operations making comparison via the profits generated
unreliable.
Ratios can eliminate this uncertainty.
Other than comparison with other businesses, it is also a
valuable tool in analysing the performance of one business over
time.
However useful ratios are not without their problems.
Figures calculated through ratio analysis can highlight the
financial strengths and weaknesses of a business but they
cannot, by themselves, explain why certain strengths or

2. weaknesses exist or why certain changes have occurred.
Only detailed investigation will reveal these underlying reasons.
Ratios must, therefore, be seen as a ‘starting point’.
Financial ratio classification
The following ratios are considered the more important for
decision-making purposes:
Ratios can be grouped into certain categories, each of which
reflects a particular aspect of financial performance or position.
The following broad categories provide a useful basis for
explaining the nature of the financial ratios to be dealt with.
Profitability.Businesses come into being with the primary
purpose of creating wealth for the owners. Profitability ratios
provide an insight to the degree of success in achieving this
purpose. They express the profits made in relation to other key
figures in the financial statements or to some business resource.
Efficiency.Ratios may be used to measure the efficiency with
which certain resource have been utilised within the business.
These ratios are also referred to as active ratios.
Liquidity.It is vital to the survival of a business that there be
sufficient liquid resources available to meet maturing
obligations. Certain ratios may be calculated that examines the
relationship between liquid resources held and creditors due for
payment in the near future.
Gearing.This is the relationship between the amount financed by
the owners of the business and the amount contributed by
outsiders, which has an important effect on the degree of risk
associated with a business. Gearing is then something that
managers must consider when making financing decisions.

3. Investment.Certain ratios are concerned with assessing the
returns and performance of shares held in a particular business.
Profitability ratios
1. Return on ordinary shareholders’ funds (ROSF)
The return on ordinary shareholders’ funds compares the
amount of profit for the period available to the ordinary
shareholders with the ordinary shareholders’ stake in the
business.
Net profit after taxation and preference dividend (if any) X 100
Ordinary share capital plus reserves
The net profit after taxation and any preference dividend is used
in calculating the ratio, because this figure represents the
amount of profit available to the ordinary shareholders.
2.
Return on capital employed (ROCE)
The return on capital employed is a fundamental measure of
business performance. This ratio expresses the relationship
between the net profit generated by the business and the long-
term capital invested in the business. Expressed as a
percentage.
Net profit before interest and taxation x 100
Share capital + reserves + long-term loans
Note, in this case, the profit figure used in the ratio is the net
profit before interest and taxation. This figure is used because
the ratio attempts to measure the returns to all suppliers of
long-term finance before any deductions for interest payable to

4. lenders or payments of dividends to shareholders are made.
ROCE is considered by many to be a primary measure of
profitability. It compares inputs (capital invested) with outputs
(profit). This comparison is of vital importance in assessing the
effectiveness with which funds have been deployed.
3.
Net profit margin
The net profit margin ratio relates the net profit for a period to
the sales during that period.
Net profit before interest and taxation x 100
Sales
The net profit before interest and taxation is used in this ratio as
it represents the profit from trading operations before any costs
of servicing long-term finance are taken into account.
This ratio compares one output of the business (profit) with
another output (sales).
The ratio can vary considerably between types of business.
For example, a supermarket will often operate on low prices
and, therefore, low profit margins in order to stimulate sales
and thereby increase the total amount of profit generated.
A jeweller, on the other hand, may have a high net profit margin
but have a much lower level of sales volume.
Factors such as the degree of competition, the type of customer,
the economic climate and industry characteristics (such as the
level of risk) will influence the net profit margin of a business.
4.
Gross profit margin
The gross profit margin ratio relates the gross profit of the
business to the sales generated for the same period.

5. Gross profit represents the difference between sales value and
the cost of sales.
The ratio is therefore a measure of profitability in buying (or
producing) and selling goods before any other expenses are
taken into account.
As cost of sales represents a major expense for retailing,
wholesaling and manufacturing businesses, a change in this
ratio can have a significant effect on the bottom line (that is,
the net profit for the year).
Gross profit x 100
Sales
Efficiency ratios
Ratios used to examine the efficiency with which various
resource of the business are managed include the following:
1.
Average stock turnover period
Stocks often represent a significant investment for a business.
For some types of business (for example, manufacturing),
stocks may account for a substantial proportion of the total
assets held.
The average stock turnover period measures the average number
of days for which stocks are being held.
Average stock held x 365

6. Cost of sales
The average stock for the period can be calculated as a simple
average of the opening and closing stock levels for the year.
A business will normally prefer a low stock turnover period to a
high period as funds tied up in stocks cannot be used for other
profitable purposes.
2.
Average settlement period
A business will usually be concerned with how long it takes for
customers to pay the amount owing.
Trade debtors x 365
Credit sales
A business will normally prefer a shorter settlement period.
3.
Average settlement period for creditors
The average settlement period for creditors tells us how long,
on average, the business takes to pay its trade creditors.
Trade creditors x 365
Credit purchases
Referred to as ‘free’ source of finance for the business, not

7. surprising that some businesses attempt to increase their
average settlement period for trade creditors.
4.
Sales to capital employed
The sales to capital employed ratio examines how effective the
long-term capital employed of the business has been in
generating sales revenue.
Sales
Share capital + reserves + long-term loans
Generally a higher ratio for sales to capital employed is
preferred to a lower one. A higher ratio will normally suggest
that the capital (as represented by total assets minus current
liabilities) is being used more productively in the generation of
revenue. However, a very high ratio may suggest that the
business is undercapitalised – that is, it has insufficient long-
term capital to support the level of sales achieved.
Liquidity ratios
1.Current ratio
The current ratio compares the ‘liquid’ assets (cash and those
assets held that will soon be turned into cash) of a business with
the current liabilities (creditors due within one year).
Current assets
Current liabilities
The ideal is often expressed as 2: 1 meaning that the business
can meet its short-term liabilities twice over.
2.
Acid test ratio

8. The acid test ratio represents a more stringent test of liquidity.
It can be argued that, for many businesses, the stock in hand
cannot be converted into cash quickly. As a result, it may be
better to exclude this particular asset from any measure of
liquidity.
Current assets (excluding stock)
Current liabilities
Gearing ratio
Financial gearing occurs when a business is financed, at least in
part, by contributions from outside parties. An important factor
in assessing risk. Where a business borrows heavily, it takes on
a commitment to pay interest charges and make capital
repayments. This can be a significant financial burden and can
increase the risk of a business becoming insolvent.
One particular effect of gearing is that returns to ordinary
shareholders become more sensitive to changes in profits. For a
highly geared company, a change in profits can lead to a
proportionately greater change in the returns to ordinary
shareholders.
The gearing ratio measures the contribution of long-term
lenders to the long-term capital structure of a business
Long-term liabilities x 100
Share capital + reserves + long-term loans
Interest cover ratio
The interest cover ratio measures the amount of profit available
to cover the interest payable.

9. Profit before interest and taxation
Interest payable
The lower the level of profit coverage, the greater the risk to
lenders that interest payments will not be met.
Investment ratios
1.
Dividend per share
The dividend per share ratio relates the dividends announced
during a period to the number of shares in issue during that
period.
Dividends announced during the period
Number of shares in issue
Factors that influence the amount that a company is willing or
able to issue in the form of dividends include:
i) The profit available for distribution to investors
ii) The future expenditure commitments of the company
iii) The expectations of shareholders concerning the level of
dividend payment.
iv) The cash available for dividend distribution
2.
Dividend payout ratio
The dividend payout ratio measures the proportion of earnings
that a company pays out to shareholders in the form of
dividends.

10. Dividends announced during the period x 100
Earnings for the year available for dividends
The earnings available for dividends, in the case of ordinary
shareholders, would normally be net profit after interest and
taxation and after any preference dividends announced during
the year.
3.
Earnings per share (EPS)
The earnings per share (EPS) relates the earnings generated by
the company during the period and available to shareholders to
the number of shares in issue. For ordinary shareholders, the
amount available will be represented by the net profit after tax
(less any preference dividend where applicable).
Earnings available to ordinary shareholders
Number of ordinary shares in issue
Many investment analysts regard the EPS as a fundamental
measure of share performance. The trend in earnings per share
over time is used to help assess the investment potential of a
company’s shares.
4.
Price/earnings (P/E) ratio
This ratio relates the market value of a share to the earnings per
share.
Market value per share

11. Earnings per share
The ratio is, in essence, a measure of market confidence in the
future of a company. The higher the P/E ratio, the greater the
confidence in the future earning power of the company and,
consequently, the more that investors are prepared to pay in
relation to the earnings stream of the company
Price/earnings ratios provide a useful guide to market
confidence concerning the future.
Limitations of ratio analysis
Although a useful tool ratios do have limitations.
Quality of financial statements.
Ratios are based on financial statements and the results of ratio
analysis are dependent on the quality of those statements.
One important issue when making comparisons between
businesses is the degree of conservatism that each business
adopts in the reporting of profit.
Therefore any review of the financial statements should include
an examination of the accounting policies that are being
adopted.
There are some businesses that may adopt particular accounting
policies or structure particular transactions in such a way that
portrays a picture of financial health that is in line with what
those who prepared the financial statements would like to see
rather than what is a true and fair view of financial performance
and position.
This practice is referred to as creative accounting and has been
a major problem for accounting rule-makers.
Inflation

12. A persistent problem in most Western countries is that the
financial results of a business are distorted as a result of
inflation.
One effect of inflation is that the values of assets held for any
length of time may bear little relation to current values.
Generally the value of assets will be understated in current
terms during a period of inflation as they are usually recorded at
their original cost (less any amounts written off for
depreciation).
The basis of comparison
Ratios require a basis of comparison in order to be useful.
Moreover, it is important that the analyst compares like with
like.
When comparing businesses, however, no two businesses will
be identical, and the greater the differences between the
businesses being compared, the greater the limitations of ratio
analysis.
Balance sheet ratios
Because the balance sheet is only a ‘snapshot’ of the business at
a particular moment in time, any ratios based on balance sheet
figures such as the liquidity ratios, may not be representative of
the financial position of the business for the year as a whole.