Introduction to ratio analysis by Owusu Attakorah HND Automotive Engineering, BSc (Hons) Mechatronics Engineering, MBA.

1. Financial Accounting
Introduction to Ration Analysis

2. Financial Ration definition
• Ratio analysis is the use of accounting ratio to
evaluate a company’s operating performance and
financial stability.
• In conducting an analysis, comparisons will be
made with:
– other companies and,
– with industrial average over a period of time
• The analysis of ratios can indicate:
– how well a company is run,
– the risks of financial insolvency and,
– the financial returns provided.

3. Purpose of Ratio Analysis
• The purpose of ratio analysis is to evaluate
financial stability of a business using accounting
ratios.
• The result of the analysis provide additional
information that helps investors, creditors and
other users of financial statements to make
different economic decisions.
• A ratio describes a quantitative relationship
between two data items and is usually presented
as 𝑥% or 𝑥: 1. In some cases it is represented in
monetary terms, such as 𝑥 pence per share.

4. Purpose of Ratio Analysis cont.
• A ratio is useful measure because it can be
compared with:
– Budgets and plans for the period (internal users
only).
– Previous periods for the same business.
– Other businesses in the same sector (inter-firm
comparison)
– Industry benchmarks (published averages for the
sector).

5. Four Main Types of Ratios
• There are four main types of ratio and each type
has a specific purpose:
– Investment ratios are used for evaluating
shareholders’ return.
– Profitability ratios are used for assessing the operating
performance of business.
– Liquidity and efficiency ratios are used for evaluating
the solvency, financial stability and management of
working capital of the business.
– Gearing ratios are used for examining the financial
structure of the business and assessing financial risk.

6. Four Main Types of Ratios cont.
• Any number of ratios can be calculated and
the choice depends on the needs of the user
and the availability of relevant data.

7. Four Main Types of Ratios cont.
Investment ratios
• Dividend per
share
• Yield gross
• Earnings per
share
• Price-earnings
Profitability ratios
• Return on equity
• Return on capital
employed
• Capital turnover
• Operating profit
margin
• Gross profit
margin
Liquidity and
efficiency ratios
• Acid test
• Inventory holding
period
• Trade receivables
collection period
• Trade payables
payment period
Gearing ratios
• Debt/equity
• Interest cover

8. Ratio Analysis
• Ratios can be applied to the financial
statement of any size and type of business.
• As an example, I am going to apply them to
the financial statement of Ted Baker PLC, a
group of company that is listed on the London
Stock Exchange (SLE).
• Extracts from the group’s financial statement
are attached.

9. Investment Ratios
• Potential investors are the first of the primary
user groups.
• Investment ratios are widely used to evaluate
shareholders’ return and aid investment
decision.
• Dividend per share measures the amount of
dividend paid on one ordinary share during
the year.
Activity: calculate Ted Baker’s dividend per share
for the ordinary shareholders for 2015 and
compare it with 2013.

10. 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
=
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠
× [100𝑝]
2014
14,708,000
43,497,126
× 100p = 33.81𝑝
The dividend per share increased by 6.15p compared with 2014. This reflects the increased
proportion of total dividends to the number of ordinary shares. This is good news for existing
investors and will help attract new investors.
2015
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
17,679,000
44,245,396
× 100p
= 39.96p
The data need for this ration are given in notes 4 and 9 in the financial statement.
Dividend yield
Dividend yield builds on the dividend per share and measures the dividend yielded on one
ordinary share in relation to the average share price over the year.
Dividend yield= (𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒) × 100%
Activity
Calculate Ted Bakers’ dividend yield for 2015 and compare it with 2014.

11. 2015
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
39.96p
1,351.2
× 100% = 2.96%
We’ve calculated the dividend per share and you can obtain the average share price from note
20
2014
33.81𝑝
1.090𝑝
× 100% = 3.1%
This result shows a slight decrease in dividend yield in 2015 compared with 2014, but it is due to
the large increase in average price, which reflected rising optimism in the stock market.
Earnings per share
Note: Total profit for the period = Dividend + retained earnings.
Earnings per share (EPS) measures the shareholders’ total return on the ordinary share.
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠
[× 100𝑝]
Activity
Calculate Ted Baker’s earnings per share for the ordinary shareholder for 2015 and compare
with 2014.

12. 2014
28,852,000
43,497,126
× 100𝑝 = 66.33𝑝
2015
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
35,870,000
44,245,396
× 100p = 81.07p
The figure we need are the profit for the period, which is the profit after interest and tax, and
the average number of ordinary shares.
EPS is a measure on which many shareholders place considerable weight. The results show as
increase of 14.74p in 2015 compared with 2013, which reflected the increased profitability.
EPS is a measure of the entity’s performance and not the amount of money distributed to
shareholders.
Price-earnings ratio
The price-earnings ratio (P/E) compares the amount invested in one share with the EPS and
reflects the stock market’s view on how long the current level of EPS will be sustained.
𝑃/𝐸 =
𝑆ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒
Earnings per share
Activity
Calculate Ted Baker’s P/E ratio for 2015 and compare with 2014.

13. 2015
𝐸 𝑃 1,351.2p 81.07𝑝 = 16.67 𝑦𝑒𝑎𝑟𝑠
2014
1,090.7
66.33
= 16.44 𝑦𝑒𝑎𝑟𝑠
There is slight increase P/E in 2015 compared to 2014 but still indicates the stock market was
more confident about how long the current level of EPS would be sustained, and slightly higher
than 2014. The P/E for 2015 did not increase much compared to 2014 due to higher increase in
average share price which reflects the general optimism in the stock market as many economies
moved out of the economic recession.
The increase in 2015 shows that the shareholders were still optimistic about the future and
therefore they might be willing to pay more for the Group’s shares than was justified by the
current level of earnings.

14. Profitability Ratios
• Profitability ratios are used by internal and
external users to assess how effective the
directors have been managing the business in
terms generating income and controlling
costs.
• Not only investors, lenders and creditors
interested in the profitability of the business,
employees, major suppliers and customers.

15. Return on Equity (ROE)
The ROE is of particular interest to investors because it focuses on the profit generated on the
investment on shareholders’ fund.
This helps them assess the stewardship of management.
𝑅𝑂𝐸 =
𝑃𝑟𝑜𝑓𝑖𝑡 𝑓𝑜𝑟 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠
E𝑞𝑢𝑖𝑡𝑦
[× 100 𝑓𝑜𝑟 %]
Activity
Calculate Ted Baker’s ROE for 2015 and compare with 2014.
The two figures needed are the profit for the period, which represent the profit after interest
and tax, and the total equity.
2015
ROE =
35,870,000
140,574,000
× 100% = 25.52%
2014
28,852,000
112,064,000
× 100% = 25.75%
The results shows there was a slight decrease in profit in 2015 (about 0.23%) which may not be
good news for investor considering how much money was invested in the business. But overall
it is not when expressed £25.52 for every £100 of equity. Also, the return in 2015 is
considerably higher than the maximum risk free interest rate of 2.77% shown in note 20.

16. Return on Capital Employed (ROCE)
The ROCE measures the percentage return on the total funds used to finance the business.
This provides useful information about management’s effectiveness in generating income from
all the resources and controlling costs.
For this ratio we will define ‘return’ as the operating profit, which is the profit before interest
and tax, and ‘capital employed’ as equity plus non-current liabilities.
𝑅𝑂𝐶𝐸 =
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑗𝑔 𝑝𝑟𝑜𝑓𝑖𝑡
E𝑞𝑢𝑖𝑡𝑦 + 𝑁𝑜𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
× 100 𝑓𝑜𝑟 %]
Activity
Calculate Ted Baker’s ROCE for 2015 and compare with 2014.
Capital employed = equity + total non-current liabilities, ignoring the negative on the total non-
current liabilities.
2015
ROCE =
49,779,000
140,574,000
× 100% = 35.41%
2014
39,588,000
112,064,000 × 100% = 35.33%
Note: There were no non-current liabilities in both 2015 and 2014 for Ted Baker.

17. The increased capital in 2014 did not really give a proportional increase in profits as
profit 2015 was approximately the same as 2014. This means the directors may have
relaxed in the effective use of the entity’s resources to generate income or they may
not have controlled costs.
ROCE should reflect the element of risk in the investment and can be compared with
interest rates for the investments where there is barely any risk, such as bank deposit
rates.
In the is case, the return in 2015 is well above the maximum risk free interest rate of
2.77% shown in note 20.
Capital turnover
Capital turnover measures the number of times capital employed was used during the
year to achieve the revenue.
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑅𝑒𝑣𝑒𝑛𝑢𝑒
E𝑞𝑢𝑖𝑡𝑦 + 𝑁𝑜𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Activity
Calculate Ted Baker’s capital turnover for 2015 and compare with 2014.

18. 2015
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
387,584,000
140,574,000
= 2.76 times
2014
321,921,000
112,064,000
× 100% = 2.87 times
The level of activity should be as high as possible for the lowest level of investment. In
this case, the capital employed in the business was turned over more than 2½ times in
both years to achieve the revenue. The lower ratio for 2015 suggests less efficient use
of capital employed or the management could not control cost effective although
there was huge increase in sales in 2015. It is also worth noting that total equity
increased which may be mainly due to retained earnings from the previous years and
there was no non-current liabilities both years.
Operating profit margin
The operating profit margin measures the percentage return on revenue based on the operating
profit.
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =
𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡
Revenue
[× 100 𝑓𝑜𝑟 %]
Activity
Calculate Ted Baker’s operating profit margin for 2015 and compare with 2014.

19. 2015
Operating profit 𝑚𝑎𝑟𝑔𝑖𝑛
=
49,779,000
387,584,000
× 100% = 12.84%
2014
2.87% × 12.30% = 35.30% times
The results show a slight improvement in operating profit margin in 2015 when it represented
an operating profit of £12.84 on every £100 of revenue. The improvement in 2015 suggest
higher selling price/or more products being sold.
The last three ratios we have looked at are interrelated:
Capital turnover × Operating profit margin = ROCE
2015
2.76 × 12.84% = 35.44%
2014
39,588,000
321,921,000
× 100%
= 12.30% times
This can be tested by inserting the ratios we calculated for Ted Baker (minor differences are due
to rounding):

20. A business can improve ROCE (the prime ratio) by reducing costs and/or raising selling prices if
that is feasible, and this will improve its operating profit margin.
Alternative, it can increase its sales volume and/or reduce its capital employed, which will
improve its capital turnover.
Gross profit margin
For business in the retail sector in particular, the gross profit is considered to be an essential
feature of management control and a guide to pricing and purchasing policies.
The gross profit margin measures the percentage on revenue based on the gross profit.
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑔𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡
Revenue
[× 100 𝑓𝑜𝑟 %]
Activity
Calculate Ted Baker’s gross profit margin for 2015 and compare it with 2014.
2015
𝐺𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑔𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛
=
235,225,000
387,584,000
× 100 = 60.69%
2014
198,470,000
321,921,000
× 100 = 62.38%

21. The gross profit margin for 2015 (£60.69 on every £100) was slightly lower than that of
2014 as you can see. This suggests lower selling prices and/or weaker control over the
cost of sales.

22. Liquidity and Efficiency Ratio
• Liquidity ratios are used to evaluate the solvency and financial
stability of a business and are therefore relevant to all users
who an interest in whether the business is a going concern.
• The liquidity of the business is of a particular importance to
lenders and creditors who need to assess whether the
business is able to service loans and pay for goods and
services bought on credit.
• Efficiency ratios (also known as funds management ratios) are
used to assess how effectively the directors have managed
the working capital (the current assets and current liabilities)
of the business

23. Current ratio and the Acid test
The current ratio is liquidity ratio that measure the relationship between current assets and
short-term liabilities.
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
Cu𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
The acid test is more stringent and measures the relationship between the liquid assets and
short-term liabilities.
𝐴𝑐𝑖𝑑 𝑡𝑒𝑠𝑡 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠
Cu𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Activity
Calculate Ted Baker’s current ratio and acid test for 2015 and compare with 2014.
The figures needed are disclosed in Ted Baker’s balance sheet.

24. 2015
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
£159,593,000
£91,088,000
= 1.75: 1
2014
£144,409,000
£89,546,000
= 1.62: 1
2015
𝐴𝑐𝑖𝑑 𝑡𝑒𝑠𝑡 =
£159,593,000 − £111,114
£91,088,000
= 0.53: 1
2014
£144,409,000 − £80,432,000
£89,546,000
= 0.71: 1
In 2015 Ted Baker had £1.75 of current assets and £0.53 of liquid for every £1 of current
liabilities. Although the acid ratio is slightly lower in 2015, the Group would have no difficulty in
paying all their creditors in the unlikely that they all demand immediate payment.
These assures users that the business is a going concern.

25. Inventory holding period
The inventory holding period is an efficiency ratio that measures the average period between
purchase and sale (or use) of inventory over the year.
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
C 𝑜 𝑠 𝑡 𝑓𝑜 𝑠𝑎𝑙𝑒𝑠
[× 12 𝑓𝑜𝑟 𝑚𝑜𝑛𝑡ℎ𝑠]
Activity
Calculate Ted Baker’s inventory holding period for 2015 and compare it with 2014.
The inventory can be identified in the Group’s balance and the cost of sales in the income
statement.
2015
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 ℎ𝑜𝑙𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑
=
£111,114,000
£152,359,000
× 12 = 8.75 𝑚𝑜𝑛𝑡ℎ𝑠
2014
£80,432,000
£123,451,000
× 12 = 7.82 months

26. In general , the shorter the period of time that inventories are held the better to keep
storage costs to the minimum and reduce risk of damage, theft, wastage,
obsolescence.
The result show a slight decline in improvement in 2015 compared with 2014 which
may due to slow movement of inventory.
In both years, one worth noting is that, it took more than 6 months (one fashion
season) to sell (or use) the inventories. However, this is not a major cause for concern
as sales of some products may straddle the seasons.

27. Trade receivables collection period
The trade receivables collection period is an efficiency ratio that measures the average
time customers took to pay for goods and services bought on credit over the year.
Trade receivables collection period =
𝑇𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑒
Revenue
[× 12 𝑓𝑜𝑟 𝑚𝑜𝑛𝑡ℎ𝑠]
Activity
Calculate Ted Baker’s trade receivables collection period for 2015 and compare it with
2014.
The trade receivables data are found in the extracts from note 15.
2015
Trade receivables collection period=
£25,823,000
£387,584,000
× 12 = 0.8 𝑚𝑜𝑛𝑡ℎ𝑠
2014
£23,105,000
£321,921,000
× 12 = 0.86 months
The results demonstrate the ratios are stable and the average period customers took
to settle their debts was just under 1 month. If the Group’s policy is to give customers
1 month’s credit, then this suggest management has an efficient system of credit
control. However, we would need to confirm this assumption before drawing firm
conclusion.

28. Trade payables payment period
The trade payables payment period is an efficient ratio that measures the average time the
business took to pay for goods and services purchased on credit from trade suppliers over the
year.
Trade payables payment period =
𝑇𝑟𝑎𝑑𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠
Cost of sales
[× 12 𝑓𝑜𝑟 𝑚𝑜𝑛𝑡ℎ𝑠]
Ideally we should use purchases, but as this is not disclosed we will use cost of sales.
Activity
Calculate Ted Baker’s trade payables payment period for 2015 ad compare it with 2014.
The data needed for this will be found in note 18.
2015
Trade payables payment period=
£32,241,000
£152,359,000
× 12 = 2.54 𝑚𝑜𝑛𝑡ℎ𝑠
2014
£22,049,000
£123,451,000
× 12 = 2.14 months

29. The interpretation to the results depends on the length of credit period agreed with
trade suppliers. A shorter payment period indicates prompt payments to creditors. If
the Group had an average credit period of 3 months, then the result demonstrate
good funds management because the Group is making use of the time allowed to pay
and there is no risk of having to pay interest on the late payments or jeopardising
relationships with suppliers. Again, here too, it is difficult to draw firm conclusions
without details of the average length of time agreed with suppliers.

30. Gearing Ratios
• Gearing (or leverage) refers to the relationship between
equity and long-term finance in the business.
• The financial structure of a business can have an impact on its
financial performance and gearing ratios are used by investors
and lenders to assess financial risk when a business has an
obligation to service and repay long-term debt(s).

31. Debt/equity ratio
This focuses on the statement of financial position and describes the financial
structure of the business in terms of the proportion of long-term debt to shareholders’
funds.
There are a number of ways in which debt can be defined, but we defined it as non-
current liabilities.
Debt/equity 𝑟𝑎𝑡𝑖𝑜 =
Noncurrent liabilities
Equity
[× 100 𝑓𝑜𝑟 %]
Activity
Calculate Ted Baker’s debt/equity ration for 2015 and compare it with 2014.
The data needed for this is shown in the Group’s balance sheet.

32. 2015
𝐷𝑒𝑏𝑡 𝑒𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜 =
£0
£140,574,000
× 100% = 0%
2014
£0
£112, 064,000
× 100% = 0%
The interpretation is that the higher the gearing, the higher the risk that business will
be unable to pay the cost of financing the business (loans) make repayments of loans
when they are due more especial when profits are low. Also, higher gearing may
cause lenders and investors to demand more interest on their investments as they
may see the business as risk.
On the other hand, the higher the gearing, the higher the returns will be to
shareholders in strong economic conditions. 0% gearing for both years takes the
business out of any financial distress which is very good for the shareholders and the
management.

33. Interest Cover
It assess the relative safety of interest payments by measuring the number of times interest
payable on long-term debt is covered by available profits.
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑣𝑒𝑟 =
Operating profit
Interest payable
Activity
Calculate Ted Baker’s interest cover for 2015 and compare it with 2014.
Interest payable is one of the finance expenses and this will be found in the extract from note 4.
2015
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑣𝑒𝑟 =
£49,779,000
£1,184,000
= 42.02 𝑡𝑖𝑚𝑒𝑠
2014
£39,588,000
£1,279,000
= 30.95 𝑡𝑖𝑚𝑒𝑠

34. As shown in the results interest payable in higher in 2015 than in 2014. Interest
payable in 2015 was covered by operating profit approximately 42 times, which is very
safe.
This means there is low risk to lenders and/or long-term creditors that the Group
would be unable to service its long-term debts.

35. Conclusion
• Ratio analysis is a technique for analysing financial
statements that is widely used by investors, lenders,
creditors and others to evaluate the financial performance
and stability of the business. There are four main types:
– Investment ratios are used to evaluate shareholders’ return.
– Profitability ratios are used to assess the operating performance
of the business.
– Liquidity and efficiency ratios are used to evaluate the solvency,
financial stability gearing ratios are used to examine the
financial structure and assess financial risk.
– Gearing ratios are used to examine the financial structure and
assess financial risk.

36. Reference
Jill Collis (2016) Financial Accounting. Palgrave Publishers, London.
Ted Baker (2015) Annual Reports. Available on: www.tedbakerplc.com. Accessed: 04/01/2017