Ratio analysis

Analysing and Interpreting Financial Statements

- The objective of accounting is to provide relevant and timely
information to support the decision-making needs of financial
statement users.
- Bankers, creditors, and investors rely on financial statements to
provide insight into a company’s financial condition and performance.
- General-purpose financial statements are distributed to a wide range of
potential users, giving each group valuable information about a
company’s economic performance and financial condition.
Analysing and Interpreting Financial Statements
- Financial analysis based on accounting information consistently
involves comparison.
- Financial ratios can help describe the financial condition of an
organisation, the efficiency of its activities, its comparable
profitability, and the perception of investors as expressed by their
behaviour in financial markets.
- They tell a story about where an organisation has come from, its
current condition and its possible future (incomplete though it may
be).
Analysing and Interpreting Financial Statements
- The ease with which ratios can be manipulated and the danger in using
them as criteria lead many analysts to concentrate on trends in ratio
measurement rather than on the absolute value or proportion expressed
by the ratio itself.
- Questions can be raised about why the trend is occurring.
- Answers to such questions provide new information not necessarily
contained in financial reports (relevant and useful to the decision-
makers)
Analysing and Interpreting Financial Statements
- Financial statements provide quantitative information relating to a
firm’s activities over a fiscal period
- This information can be used to assess the firm’s performance and the
risk of its operation
- However, before it can be interpreted, the financial information needs
to be contextualised
- Ratio analysis is the interpretation of financial information by
comparing one piece of financial data to another (calculating a ratio),
and then comparing these ratios to one or more benchmarks
Benchmarks
Ratios must be compared with benchmarks:
- Pre-determined targets for ratios set by the company;
- Ratios of companies of similar size who are engaged in similar
business activities;
- Average ratios for the business sector in which a company operates,
i.e. with industrial norms;
- Ratios for the company from previous years.
Benchmarks
Both analytical methods and ratios can be used to compare a company’s
financial performance over time or to another company.
- Comparisons Over Time: The comparison of a financial statement
item or ratio with the same item or ratio from a prior period often
helps the user identify trends in a company’s economic performance,
financial condition, liquidity, solvency, and profitability;
- Comparisons Among Companies: The comparison of a financial
statement item or ratio to other companies in the same industry can
provide insight into a company’s economic performance and financial
condition relative to its competitors.
Ratio analysis
4 Categories of ratios:
- Profitability: how well is the firm employing the funds it has
available, and to what extent does it control its operating costs?
- Efficiency: How well is the firm managing its day to day operations?
- Liquidity: Is the firm capable of meeting its short-term commitments?
- Financing & Investment: Can the firm meet its long-term
commitments? What level of return is the firm generating for its
investors?
Profitability ratios
- Asset Turnover ratio
- Gross profit margin
- Operating profit margin
- Net profit margin
- Return on Equity (ROE)
- Return on Assets (ROA)
- Return on Equity Employed (ROCE)
Asset Turnover ratio
The asset turnover ratio measures how effectively a company uses its
assets. Long-term investments are excluded in computing asset turnover.
It is computed as follows:
Sales
Asset Turnover =
Average Total Assets (excluding long-term investments)
Gross Profit Margin
This ratio, which gives a rate of return on sales, relates two statements
of income measurements to each other. It indicates income sensitivity to
price changes or changes in cost structure.

Gross Profit
Gross Profit Margin = x 100%
Sales

- GPM shows % of sales left over after taking away the costs of buying
materials and costs relating to processing the materials
- A constant or increasing figure is good. It shows that firms control
quantity, selling price, and cost of raw materials.
Operating profit margin
- The operating margin represents how efficiently a company can
generate profit through its core operations.
- It is expressed per-sale after accounting for variable costs but before
paying any interest or taxes (EBIT).
- Higher margins are considered better than lower margins and can be
compared between similar competitors but not across different
industries.
operating profit
Operating profit margin = ∗ 100%
sales or revenue
Net profit margin
- Net profit margin measures how much profit a company makes as a
percentage of its revenue.
- Net profit margin helps investors assess if a company’s management is
generating enough profit from its sales and whether operating costs
and overhead costs are under control.
- Net profit margin is one of the most important indicators of a
company’s overall financial health.
net profit
Net profit margin = ∗ 100%
sales or revenue
Return on Equity
- ROE is a gauge of a corporation's profitability and how efficiently it
generates those profits.
- The higher the ROE, the better a company is at converting its equity
financing into profits.
- ROE will vary based on the sector a company is in, so it provides the
most information when it's used to compare companies in the same
industry.
Net Profit
Return on Equity = ∗ 100%
Total Equity
Return on Assets
- Return on assets is a profitability ratio that provides how much profit a
company can generate from its assets.
- Return on assets (ROA) measures how efficient a company’s
management is in generating profit from the total assets on their
balance sheet.
- ROA is shown as a percentage, and the higher the number, the more
efficient a company’s management is at managing its balance sheet to
generate profits.
Net Profit
Return on Assets = ∗ 100%
Total Assets
 Return on Capital Employed
- Return on capital employed is a financial ratio that measures a
company’s profitability in terms of all of its capital.
- ROCE is similar to return on invested capital.
- It's always a good idea to compare the ROCE of companies in the
same industry because those from differing industries usually vary.
- Higher ratios tend to indicate that companies are profitable

Profit before interest and tax

Return on Capital Employed = ∗ 100%
Total Equity + Long term liability
Liquidity ratios
- Working capital
- Current ratio
- Quick ratio
Working capital
- Working capital, also called net working capital (NWC), is the
difference between a company’s current assets and current liabilities. It
measures a company’s liquidity and short-term financial health,
indicating the ability to fund operations and respond to financial stress
or opportunities.
- Negative working capital occurs when current liabilities exceed
current assets, suggesting potential liquidity issues. Positive working
capital shows a company can support ongoing operations and invest in
future growth.
- A company’s working capital is computed as follows:
Working Capital = Current Assets – Current Liabilities
Working capital
How much working capital to hold
Too Much:
- Overstocking or Overcapitalization,
- Funds tied up that could be used more productively elsewhere
(opportunity cost) and incur the cost of funding.
Too Little:
- the firm cannot pay bills as they fall due
- May have to borrow on short notice
- May be forced to sell other assets
Current ratio
- The current ratio compares a company’s assets to its current liabilities.
- The current ratio helps investors understand a company’s ability to
cover its short-term debt, which can be used for comparisons with
competitors and peers.
- Industries will have different expected or average current ratios, so it
can't easily be used to compare companies across different industries.
- It is often said that the current ratio should be around two, but what is
normal will vary from industry to industry.
Current Assets
Current ratio =
Current Liability
Quick ratio
- The quick ratio measures a company’s capacity to pay its current
liabilities without selling its inventory or obtaining additional
financing.
- The quick ratio is considered a more conservative measure than the
current ratio, which includes all current assets as coverage for current
liabilities.
- The higher the ratio result, the better a company’s liquidity and
financial health; the lower the ratio, the more likely the company will
struggle with paying debts.
Current Assets − Inventory
Quick ratio =
Current Liability
Efficiency ratios
- Receivable Turnover rate
- Receivable collection period
- Inventory Turnover rate
- Inventory holding period
- Payable Turnover rate
- Payable payment period
- Cash conversion cycle (working capital cycle)
Receivable Turnover rate
- The receivables turnover ratio measures the efficiency with which a
company is able to collect on its receivables or the credit it extends to
customers.
- The ratio also measures how many times a company's receivables are
converted to cash in a certain period of time.
- The receivables turnover ratio is calculated on an annual, quarterly, or
monthly basis.

sales
Receivable Turnover rate =
receivables
 Receivable collection period
- The average collection period refers to the length of time a business
needs to collect its accounts receivables.
- This period indicates the effectiveness of a company’s account
receivable management practices.
- A low average collection period indicates that an organization collects
payments faster.
Receivable 365
Receivable collection period = ∗ 365 =
sales Rececivable Turnover rate
Receivable level trade-off
Costs of low debtors
- Lower sales as customers prefer more time to pay

Costs of high debtors

- Administration of debtors
- Losses due to bad debts
- Opportunity cost of cash tied up in debtors
Inventory Turnover rate
- Inventory turnover ratio measures how efficiently a company uses its
inventory. Inventory turnover ratios are only useful for comparing
similar companies and are particularly important for retailers.
- A relatively low inventory turnover ratio may indicate weak sales or
excess inventory, while a higher ratio signals strong sales but may also
indicate inadequate inventory stocking.
- Accounting policies, rapid cost changes, and seasonal factors may
distort inventory turnover comparisons.
Cost of sales
Inventory Turnover rate =
Inventory
 Inventory holding period
- Inventory holding period shows how long it takes the firm to process
its raw materials and sell finished goods (days in inventory)
- It provides some measure of liquidity and the ability of the company
to convert inventories to cash quickly if that were to become necessary

Inventory 365
Inventory holding period = ∗ 365 =
Cost of sales Inventory Turnover rate
Inventory level trade-off
Costs of too little stock
- High ordering costs from frequent ordering
- Loss of sales and lower profits and customer goodwill
- Disruption to the production process
Costs of too much stock
- Opportunity cost of cash tied up in stock
- Warehousing costs
- Risk of obsolescence (out-dated or out of fashion)
- Risk of deterioration
Payable Turnover rate
- The accounts payable turnover ratio is a short-term liquidity measure
used to quantify the rate at which a company pays what it owes in the
short term.
- The ratio shows how many times a company pays off its accounts
payable during a period.

Cost of sales
Payable Turnover rate =
Payables
 Payable payment period
- Payable payment period computes the average days a company needs
to pay its bills and obligations.
- Payable payment period is a turnover ratio that calculates how
efficiently a company operates and uses resources.

Payable 365
Payable payment period = ∗ 365 =
Cost of sales Payable Turnover rate
Payable level trade-off
Costs of high creditors
- Loss of discounts for early payment
- Loss of supplier goodwill

Costs of low creditors

- Harder to offer credit to customers
- Greater need for access to cash or short-term debt
Cash conversion cycle
- The cash conversion cycle (CCC) is a metric that expresses the
number of days it takes for a company to convert its inventory into
cash flows from sales.
- The shorter the cash conversion cycle, the less time cash is in accounts
receivable or inventory.
- CCC will vary by industry sector based on the nature of business
operations.

Cash conversion cycle = Inventory holding period

+ Receivable collection period − Payable payment period
Financing & investment ratios
- Earnings per share
- Price earnings ratio
- Interest cover ratio
- Gearing ratio
- Dividend yield
- Dividend payout ratio
Earnings per share
- EPS indicates how much money a company makes for each share of
its stock and is a widely used metric for estimating corporate value.
- A higher EPS indicates greater value because investors will pay more
for a company's shares if they think the company has higher profits
relative to its share price.
- Like other financial metrics, earnings per share is most valuable when
compared against competitor metrics, companies of the same industry,
or across a period.
Net profit
Earnings per share =
Number of share issued
Price earnings ratio
- A high P/E ratio could mean that a company's stock is overvalued or
that investors expect high growth rates.
- Companies with no earnings or are losing money don't have a P/E
ratio because there's nothing to put in the denominator.
- P/E ratios are most valuable when comparing similar companies in the
same industry or for a single company over time.

Share price
P / E ratio =
Earnings Per Share
Interest cover ratio
- The interest coverage ratio measures how well a firm can pay the
interest due on outstanding debt.
- The ratio is found by dividing a company's earnings before interest
and taxes (EBIT) by its interest expense during a given period.
- The interest coverage ratio helps lenders, investors, and creditors
determine a company's riskiness for future borrowing.

Profit before interest and tax

Interest cover ratio =
Interest expense
Gearing ratio
- Gearing ratios are a group of financial metrics that compare
shareholders' equity to company debt in various ways.
- The goal of gearing ratios is to assess the company's amount of
leverage and financial stability.
- Gearing measures how much of a company's operations are funded
using debt versus the funding received from shareholders as equity.

Long term liability

Gearing ratio = * 100%
Long term liability+Equity
Dividend yield
- The dividend yield is the amount of money a company pays
shareholders for owning a share of its stock divided by its current
stock price.
- Companies in the utility and consumer staple industries often have
relatively higher dividend yields.
- Higher dividend yields don't always indicate attractive investment
opportunities because the dividend yield of a stock may be elevated as
a result of a declining stock price.
Dividend per share
Dividend yield =
share price
Dividend payout ratio
- The dividend payout ratio is the proportion of earnings paid to
shareholders as dividends.
- Some companies pay out all their earnings to shareholders, some only
pay out a portion of their earnings, while others don't pay any
dividends to shareholders at all.
- The portion of earnings that isn't paid is called the retention ratio.

Dividend
Dividend payout ratio = ∗ 100%
Net profit
Steps in Ratio Analysis
4 steps in analysing ratios

1. Observation: Identify the figures you need

2. Calculation: Calculate the ratios you need to analyse
3. Analysis: Put into context i.e. compare with previous years, other
companies
4. Interpretation: Conclude firm performance from the ratios