This document provides an introduction to ratio analysis for financial accounting. It discusses the purpose of ratio analysis, the four main types of ratios (investment, profitability, liquidity/efficiency, and gearing), and provides examples calculating various ratios for Ted Baker PLC using data from its 2015 and 2014 financial statements. Key ratios discussed include return on equity, return on capital employed, operating profit margin, and gross profit margin. Comparing ratios across years provides insights into the company's financial performance and position over time.

1. Financial
Accounting
Introduction to Ratio Analysis
By: Owusu Attakorah (Bsc - hons Mechatronics , Mba)

2. Introduction
 Ratio analysis involves the calculation and interpretation of key
financial performance indicators to provide useful insights.
 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 or . In some cases it is
represented in monetary terms, such as 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.

10. Investment Ratios
Dividend per share:
 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 2014.


11. 2014
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
The data need for this ratio are given in notes 4 and 9 in the financial
statement.

12. Investment Ratios cont.
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
Activity: CalculateTed Bakers’ dividend yield for 2015 and compare it
with 2014

13. 2015
We’ve calculated the dividend per share and you can obtain the average
share price from note 20
2014
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.

14. Investment Ratios cont.
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.



 Activity: CalculateTed Baker’s earnings per share for the ordinary
shareholder for 2015 and compare with 2014.


15. 20142015
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.

16. Investment Ratios cont.
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.

 Activity: CalculateTed Baker’s P/E ratio for 2015 and compare with
2014.


17. 2015 2014
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 increase in earnings per share which is good for the
shareholders and can attract the public too.
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.

18. 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.

19. Profitability Ratios cont.
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.



 Activity: CalculateTed Baker’s ROE for 2015 and compare with
2014.


20. The two figures needed are the profit for the period, which represent the
profit after interest and tax, and the total equity.
2015 2014
%
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 bad 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.

21. Profitability Ratios cont.
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.

 Activity: CalculateTed Baker’s ROCE for 2015 and compare with 2014.



22. Capital employed = equity + total non-current liabilities, ignoring the
negative on the total non-current liabilities.
2015 2014
%
Note: There were no non-current liabilities in both 2015 and 2014 for
Ted Baker.

23. The increased capital in 2015 did not really give a proportional increase
in profits as profit for 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 this case, the return in 2015 is well above the maximum risk free
interest rate of 2.77% shown in note 20.

24. Profitability Ratios cont.
Capital turnover:
 Capital turnover measures the number of times capital employed
was used during the year to achieve the revenue.


 Activity: CalculateTed Baker’s capital turnover for 2015 and
compare with 2014

25. 2015 2014
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.

26. Profitability Ratios cont.
Operating Profit Margin:
 The operating profit margin measures the percentage return on
revenue based on the operating profit.



 Activity: CalculateTed Baker’s operating profit margin for 2015 and
compare with 2014.


27. 2015
2014
2.87
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
2014
This can be tested by inserting the ratios we calculated for Ted Baker (minor
differences are due to rounding):

28. 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.

29. Profitability Ratios cont.
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.



 CalculateTed Baker’s gross profit margin for 2015 and compare it with 2014.


30. 2015 2014
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.

31. 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.



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