Financial Ratios

1. Accounting for Business Decision Making
AC570
Session 3
Interpretating Financial Performance

2. Learning Objectives
• Identify the major categories of ratios that can be used for analysis purposes
• Calculate important ratios for determining financial performance and position of a business
• Explain the significance of the ratios calculated
• Discuss the limitations of ratios as a tool of financial analysis

3. Financial Ratios
• Provide quick and relatively simple means of examining the financial position/performance of a
business
• Ratio – expression of the relationship of one figure to another, e.g.
Net profit : sales
Sales per employee
• Ratio – can be expressed as %, time (e.g. days), proportion
• Usually easy to calculate – sometimes difficult to interpret (skill)
• Use of ratios can build up picture of the financial performance

4. Financial Ratio Classification
• Profitability
• Determine the wealth creation (ability to generate profits) in business
• Efficiency
• Relates to resources used – called activity ratios – measure of management
performance.
• Liquidity
• Measures the ability to pay short term debts as they fall due
• Gearing/Risk
• Relationship between finance provided by owners vs that of outside parties (% of
equity vs debt financing)
• Investment
• Measures the returns available to shareholders

5. Similar businesses during the same periods
Planned performance (i.e. Vs Budget)
Past periods
Ratios may be compared with:
Ratios Benchmarks
NB: Crucial to compare or benchmark, ratios in isolation are meaningless. E.g. consider
a sports analogy, how can a Olympic sprinter know their performance is good enough
without comparing to their competition/rivals?

6. Liquidity Ratios:
Current Ratio
Current Assets (£300) Expressed as a factor
Current Liabilities £100
e.g. 3 : 1
• usually expect more current assets than current liabilities
• but may depend on the type of business
Acid Test Ratio (or Quick Ratio)
Current Assets - Inventory also as a factor
Current Liabilities
• More specific than the current ratio
• Most applicable for a manufacturing business, where inventory is not readily
turned into cash 6

7. Efficiency ratios:
Inventory Turnover
Cost of Goods Sold = No of Times
Closing inventory
• The greater the inventory turnover the more efficient the business
• Obviously varies from business to business
• Particularly applicable to retail businesses
Net Asset Turnover Ratio
Sales = No of Times
Capital Employed (Total Assets-Current Liabilities)
• Indicates how effectively the capital employed has been used to generate revenue
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8. Efficiency ratios:
Asset turnover
Sales/Revenue = No of Times or € revenue per € of Assets
Total Assets
• The greater the turnover the more efficient the business at generating sales from its assets
• Obviously varies from business to business
Working Capital Turnover Ratio
Sales = No of Times
Working Capital (Current Assets-Current Liabilities)
• Indicates how effectively the business generates sales for every € of working capital used
8

9. Efficiency ratios:
Receivables Collection Period
Trade receivables x 365 = No of days
Sales
• Faster collection indicates efficiency in debt collection-cash conversion
• Very much dependent on the type of business involved
• Need to establish a trend
Payables Collection Period
Trade Paybables x 365 = No of days
Cost of sales
• Strike balance between paying on time, but using credit period (cash conversion)
• NB to maintain good relations with suppliers, part of supply chain
• Need to establish a trend
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10. Risk ratios:
The more long term debt, the more interest has to be paid before the shareholders
can receive a return
• Gearing is also known as leverage
• There are many ways of calculating this*
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How easy is it for the company to pay its interest charges out of operating profit
Debt to Capital
Total Debt (short & long term)
Total Capital (debt & equity)
Debt to Equity
Total Debt
Total Equity

11. Risk ratios: Interest cover
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Operating profit
Interest charges
How easy/comfortable is it for the company to pay its interest charges out
of operating profit

12. Profitability Ratios
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Gross Profit Ratio/Margin
Gross Profit x 100 = X%
Sales
• Measures how much profit has been earned from the main trading activity
• Indicates how successful the business is at trading.
Operating Profit Ratio
Operating profit x100 = X%
Sales
• Mostly used for internal comparison because the differing accounting policies
applied by different businesses make external comparison difficult
• Useful for establishing trends

13. 13
Return On Capital Employed (ROCE)
Operating Profit x 100 = X%
Capital employed (Total Assets- Current Liabilities)
• HOW much profit is meaningless, unless the size of the business in known
• Useful as a comparator within and between businesses
Return on equity
• The ultimate profit that is available to shareholders expressed
as a percentage of the value they have invested in the business
Profit after tax
Total equity
´100 = X%
Profitability Ratios

14. ROCE
Interrelationships of ratios
Operating profit Operating profit Sales
Capital employed Sales Capital employed
 
ROCE Profitability
ratios
Efficiency
ratios

15. Investment ratios: Dividend Yield
Dividend per Share X 100 = X%
Market price per Share
• Measures the rate of return and investor gets by comparing the cost
of his shares with the dividend he receives
Note: Dividend are usually declared as a % of the nominal (face) value of
the shares
15

16. Dividend Cover
• Profit after tax.
Paid & proposed ordinary Dividends = Number of Times
• This shows the number of times the dividend could be paid out of
ordinary earnings
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17. Investment ratios: Earnings per Share (EPS)
Profit after tax
No. of Ordinary Shares in issue in year = X cent
• EPS enables a fair comparison to be made between one year’s earnings
and another by relating the earnings to the number of shares in issue
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18. Investment ratios: Price / Earnings Ratio (P/E)
Market price per Share = X
Earnings per Share
• The P / E ratios allows a comparison between the EPS and the market
price.
• It tells you that the market price is X times earnings
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19. Other Analyses Techniques
• Using multi year P & L data ( 5 years)
• Horizontal Analysis
• Identifies the annual % change in individual items, e.g. sales, gross margins, net
margins – to view performance year by year
• Trend Analysis
• Starts with a base year and measures subsequent performance against base year
values which are given a base value of 100 – to view performance over a period from
a base line
• Vertical Analysis
• Expresses individual expense categories as % of sales (IS) or % of capital employed
(BS) – to spot trends in expenditure levels

20. Other Considerations
Analysts should also consider non-financial factors:
● the nature and size of the business
● the riskiness of the business
● quality of management and staff morale
● a company's future development plans
● geographical location
● the prevailing economic, political and social environment
● industry trends…performance of key competitors
● the impact of technological changes
• Combined these help ‘set the scene’ for any subsequent financial
analysis

21. Limitations of Ratio Analysis
• Quality of Financial Statements – should
• Be prudent, conservative in presentation
• Not use creative / false accounting / manipulate profits
• Inflation – impacts profits, values of assets.
• Measures relative performance – ignores scale, size
• Basis for Comparison – inter company comparison may not be on same basis due to accounting
policies, year end date, financing policies
• Balance Sheet Ratios – may not be representative of business over full year , e.g. seasonality
• Should only be used as a guide, they do not provide the answers, only the starting point for further
analysis/investigation.
• Be careful about being dogmatic when making any decision based on any analysis you may do.

22. Ratio Grid
https://docs.google.com/spreadsheets/d/1vpL93GtoyrS2aQzD2bf
uwSoEnmW34ia3gvoCVymKtV0/edit#gid=0

23. Reading
Recommended
Atrill, P. and McLaney E. (2019). Accounting and Finance for
Non-Specialists
• This session: Chapter 6 Analysing & Interpreting Financial
statements
or
● Collier - Chapters 6 and 7
● O’Regan - Chapter 8

24. Questions?