Analysing & Interpreting

Financial Statements:
RATIO ANALYSIS

Lecturer: Hadeel Cassinelli

 Objectives of Week 4 &5
Learners will be able to:
• Identify the categories of ratios;
• Calculate ratios for assessing 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.
FINANCIAL RATIO CLASSIFICATIONS
• Profitability - relationship between profit,
revenue, assets, equity and capital employed;
• Efficiency - how effectively and efficiently the
assets and liabilities are used;
• Liquidity - ability of business to stay solvent by
meeting its short-term financial obligations;
• Financial Gearing – relationship between debt
and equity financing, indication of risk;
• Investment – helping shareholders assess returns
on their investment.
 Why use ratios?
• An aid to understanding what the accounts are saying.
• Inter year comparisons - to establish a trend from past
years, to provide a standard of comparison;
• Intra firm comparisons - to compare against a similar
business in the same industry;
• Benchmark - compare against industry averages.

An inexact science, so results must be interpreted

cautiously.
One ratio may indicate something but other ratios and
data are needed to support and interpret it in order
for a meaningful evaluation.
Example – BP’s Balance sheets at 31/05/17 (£000) 2017 2016
Non-current assets 1,800 1,400
Current assets
Inventory 1,200 200
Receivables 400 800
Cash 100 100
1,700 1,100
Total assets 3,500 2,500

Equity and liabilities

Ordinary share capital (@ £0.50) 1,200 500
Share premium 600 0
Reserves 200 100
2,000 600
Non-current liabilities
10% loan notes 1,000 600
Current liabilities
Trade payables 200 500
Other payables 300 800
500 1,300
Total equity and liabilities 3,500 2,500
BP’s Income Statements (£000) 2017 2016
Revenue 2,000 1,000
Cost of sales (1,300) (700)
Gross profit 700 300
Distribution costs (260) (90)
Administration expenses (100) (60)
Operating profit 340 150
Interest (100) (60)
Profit before taxation 240 90
Taxation (50) (20)
Profit after taxation 190 70
Ordinary dividends (90) (50)
Retained profit for the year 100 20
Profit and loss b/fwd 100 80
Profit and loss c/fwd 200 100
Share price (£) 1.30 1.26
Industry information:
Industry PE ratio 22 20
Industry average growth in EPS (%) 12 8
Profitability
 Profitability
We will look at:
1.Return on Ordinary Shareholders’ Funds %
(ROSF)/Return on Equity

2.Return on Capital Employed % (ROCE)

3.Operating profit margin (PBIT) %
4.Gross profit margin %
 1. RETURN ON ORDINARY
SHAREHOLDERS’ FUNDS (EQUITY)

ROSF/ = Profit after tax and preference dividends x 100%

ROE Ordinary share capital + reserves

• Measuring how much profit a company generates for its ordinary

shareholders with the money they have invested in the company.

Example – BP:
2017 2016
ROSF = 190/2,000 70/600
9.5% 11.7%
 2. RETURN ON CAPITAL EMPLOYED
ROCE = Operating profit (PBIT) x 100%
Capital employed*
* Usually where Capital Employed = Debt & Equity,
(i.e. Share Capital + Reserves + Non-current liabilities)
• Measuring how efficiently a business is using the funds
available from all sources of long-term finance.
Example – BP:
2017 2016
ROCE = 340/3,000 150/1,200
11.33% 12.50%
 3. OPERATING PROFIT MARGIN

Operating profit% = Operating profit (PBIT) x 100%

(PBIT) Sales Revenue
• Measuring the profit from trading operations (net profit, before
interest and tax) in relation to the sales revenue for a period.

Example – BP:
2017 2016
Op Profit % = 340/2,000 150/1,000
17% 15%
 4. GROSS PROFIT MARGIN

Gross profit % = Gross profit x 100%

Sales Revenue

• Measuring the gross profit (where GP = sales revenue –

cost of sales) in relation to the sales revenue for a period.

Example – BP:
2017 2016
Gross Profit % = 700/2,000 300/1,000
35% 30%
Efficiency
 Efficiency
We will look at:
5.Inventory turnover period (days)
6.Receivables collection period (days)
7.Payables payment period (days)
8.Sales Revenue to Capital Employed/Asset
Turnover (times)
 5. INVENTORY TURNOVER PERIOD
Inventory = Closing inventories held (1) x 365
turnover period Cost of Sales

• The number of days inventory is held for. A longer inventory

turnover period indicates either a slowdown in trading, or
possible excessive investment in inventory.
(1)
Can also use average inventory [(opening + closing)/2]

Example – BP:
2017 2016
Inventory turnover=(1,200/1,300) x 365 (200/700) x365
period 337 days 105 days
6. RECEIVABLES COLLECTION PERIOD
Receivables = Trade Receivables(1) x
365
settlement period Credit Sales Revenue
(1)
Can also use average receivables [(opening + closing)/2]
• Average time taken for debtors to pay us. Useful to compare
against a benchmark. Average in UK is 30 days, but if
international trade, it will take longer. Ideally this should be
shorter than trade payables days, and the lower the period, the
better.
Example – BP:
2017 2016
Receivables period= 400/2,000 x 365 800/1,000 x 365
73 days 292 days
 7. PAYABLES PAYMENT PERIOD
Payables = Trade Payables (1) x 365
settlement period Credit Purchases(1)
(1)
Can also use average payables [(opening + closing)/2]
(1)
can use COS as an approx. to purchases
• Average time taken for business to pay suppliers. Useful to
compare against a benchmark. Ideally this should be longer
than trade receivables days, although delaying too much can
cause problems e.g. loss of goodwill.
Example – BP:
2017 2016
Payables period= (200/1,300) x 365 (500/700) x 365
57 days 271 days
 8. SALES REVENUE TO CAPITAL EMPLOYED
SR:CE ratio = Sales Revenue
Capital Employed*
*Where Cap. Employed = Share Capital + Reserves + Non-current liabilities
• Also known as Asset Turnover. Measures efficiency of the use of Net
Assets in generating Sales; year on year comparison used.
• A fall in ratio could be due to reduction in Sales or increase in Net Assets.
• Depends on company – engineering company will be low, supermarket
with few assets will be high.

Example – BP:
2017 2016
Asset turnover = 2,000/3,000 1,000/1,200
0.67 times 0.83 times
Liquidity
 Liquidity
We will look at:
9.Current Ratio – the standard liquidity test
10. Acid Test Ratio (also known as quick ratio)
 9. CURRENT RATIO
Current ratio = Current Assets : 1
Current Liabilities

• Indicates how comfortable a company’s current

assets can meet its commitments to pay its current
liabilities. Should be comfortably in excess of 1:1.
Example – BP:
2017 2016
Current ratio= 1,700/500 1,100/1,300
3.4:1 0.85:1
 10. ACID TEST RATIO
Acid Test ratio = Current Assets - Inventories : 1
Current Liabilities
Useful for companies with slow inventory turnover (and so long
cash cycles). Should ideally be at least 1:1, can be lower if fast
inventory turnover but below this indicates a business may not
be able to meet its current liabilities.

Example – BP:
2017 2016
Acid test ratio= 500/500 900/1,300
1:1 0.69:1
Financial Gearing
 Financial Gearing

We will look at:

11. Capital Gearing ratio
12. Debt: Equity Ratio
13. Interest Cover ratio
 11. FINANCIAL GEARING
Capital Gearing = Long-term (non-current) liabilities x100
Share capital + Reserves + Long-term (non-current)
liabilities

•Long-term capital structure, mix of debt & equity.

•Higher the gearing, the less secure will be the financing of the
company and therefore its future (usually)

Example – BP:
2017 2016
Gearing ratio= 1,000/3,000 600/1,200
 12. DEBT: EQUITY RATIO
Debt: Equity= Long-term (non-current) liabilities x100
Share capital + Reserves (Equity)
•Long-term capital structure, mix of debt & equity.

•Higher the gearing, the less secure will be the financing of the
company and therefore its future (usually)

Example – BP:
2017 2016
Debt to equity ratio=1,000/2,000 600/600
50% 100%
 13. INTEREST COVER RATIO
• Interest Cover = Operating profit (PBIT)
Interest payable
• Measures amount of operating profit available to cover
interest payable.
• The higher the better, as low coverage means risk to lenders
that interest payments will not be met.

Example – BP:
2017 2016
Interest cover= 340/100 150/60
3.4 times 2.5 times
Shareholders’ Investment Ratios
 Shareholders’ Investment Ratios

We will look at:

14. Earnings per share
15. P/E ratio
16. Dividend per share
17. Dividend Cover
18. Dividend yield
 14. EARNINGS PER SHARE
EPS = Profit distributable to ordinary shareholders (PAT)
Number of shares in issue
• Measuring a company’s performance from an ordinary
shareholder’s point of view.
• Usually expressed in pence
• Comparison on previous years is used.
Example – BP:
2017 2016
EPS = 190/2,400 70/1,000
7.92p 7p

The growth rate of EPS = (7.92 -7)/7 x 100% = 13%

 15. PRICE EARNINGS RATIO
P/E ratio = Share Price
EPS
• The amount the shareholders are prepared to pay
for the share as a multiple of current earnings.
• High = strong shareholder confidence.
• Can be compared against all other companies.
Example – BP:
2017 2016
PE ratio = 130/7.92 126/7
16.4 times 18 times
 16. DIVIDEND PER SHARE

DPS = Total ordinary dividend

Total no. of shares issued

• How much of the overall dividend payout

the shareholders are entitled to.
Example – BP:
2017 2016
DPS = 90/2,400 50/1,000
3.75p 5p
 17. DIVIDEND COVER
DIVIDEND COVER = Profits after tax or: Earnings per
share
Dividends Dividend per share

• Measures how many times the earnings

available for dividend cover the actual dividend.
• Inverse =dividend payout ratio.
Example – BP:
2017 2016
Dividend cover = 7.92/3.75 7/5
2.1 times 1.4 times
 18. DIVIDEND YIELD
Dividend yield = DPS x 100
Market price per share

• Measuring the wealth in terms of a return

received by the ordinary shareholders.
Example – BP:
2017 2016
Dividend yield = 3.75/130 5/126
2.9% 4%
 Question of the week

• What are the limitations of

using accounting ratios as
measurement of companies’
performance?