Ratio analysis A method of assessing a firm’sfinancial situation by comparing two sets of linked data
Concept of ratio analysisA 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, 2.5:1Despite the name of this technique, most of the ratios featured in ratio analysis are actually stated as a percentage!
Ratio analysisGives 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
Types of ratio Meaning of ration typeLiquidity 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 firm’s management of its management of its working capital. They are used to assess the efficiency of the firm in it’s management of its assets and short- term liabilitiesGearing ratios Gearing focuses on long-term liquidity and shows whether a firm’s capital structure is likely to be able to continue to meet interest payments on, and to repay, long-term borrowingShareholders’ ratios These focus on drawing conclusions about whether shareholders are likely to benefit financially from their shareholding
Liquidity: a business’s 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 liabilitiesExample: Current assets=250 Current liabilities=200Ratio= 1:1.25 for every £1 of current liabilities the business has £1.25 in current assets
Liquidity: a business’s 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 liabilitiesExample: current assets= 250 Current liabilities=200 Inventories= 30 Ratio=1:1.1 for every £1 of current liabilities, the business has £1.10 in current assets less inventories
• 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• 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• 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.
Profitability: the relationship between a business’s 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 100Example: operating profit= 550 Total equity= 5000 Non-current liabilities= 2000 ROCE= 18.3% for every £1 capital invested a profit of 0.183p was generated. Thisfig. will be compared with the firm’s ROCE from previous years and other companies.
EfficiencyAsset 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 hardAsset turnover= Sales/ net assetsExample: Sales=2000 Net assets= 1500 Ratio= 1:1.33 for every £1 invested in assets, the business generates sales of £1.33 in one yearRate 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 sameindustry
EfficiencyInventory or stock turnover: a measure of how many times per year a business turns over its stockthrough salesInventory turnover= cost of sales/ inventoryExample: 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
EfficiencyPayables (creditor) days: a measure of the average number of days taken to pay suppliersPayables (creditors) days= (Payables X 365days)/ credit purchasesExample: (200 X 365)/900 = 81daysIf the figure for credit purchases is not available then cost of sales is used. Some firms set themselvesinternal targets in relation paying debts. In order to improve cash flow firms often negotiate longerpayback periods
EfficiencyReceivables(debtors) days: a measure of the average number of days taken to by a business tocollect its debts from customersReceivables days= (receivables X 365 days) / RevenueExample: (135X365) / 1390= 35days approx. takes 1 month to receive payment for sales
Gearing: refers to how much of a firms capital is financed by long-term loansGearing ratio %= non-current liabilities / ( total equity+ non-current liabilities) X 100Example: 2000/ (1500+2000) X100= 57% For every £1 invested in the business, 57p is from a long-term liabilityIf gearing is low it may indicate a firm is being cautions and could possibly be missing out onpotential investment opportunities.
Shareholder ratios: help measure the value of the return received by a shareholder.Dividend per share: the number of pence per share received by shareholdersDividend per share= total dividends/ number of shares issuedExample: 300/ 500= 60p per shareAn investor may be willing to accept a lower dividend per share in the short run if profits are beingreinvested for the long-term good of the business
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 thecurrent market price of the share.Dividend yield= (dividend per share/market share price) X 100Example: (0.60/9.33) X100= 6.4% this means that a yield of 6.4% means that if adividend of £1 was received, the expected value of the share would be £6.40Allows 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.
Value and limitation of ratio analysis• Ratios provide a structure and put figures into context• provide a framework from which we can make meaningful comparisons between a firm’s performance from one year to the next, between branches within a firm or between firms within the same industry• provide management with a tool to compare performance and set targets• financial documents may have been ‘window dressed’/manipulated to improve the picture they show. This will affect the ratios calculated• the balance sheet is a ‘snapshot’ and as such only true on the day it is drawn up• ratio analysis only takes into account the financial performance of a firm