Accounting Ratios Flashcards
Introduction
- A ratio is an accounting item expressed in terms of another accounting item; e.g net profit margin expresses the net profit as a percentage of sales.
- Ratios are often used in accounting, and there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firms creditors. Security analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.
What ratios to calculate?
- Profitability ratios: ratios which indicate (i) the profit margin in sales and (ii) the long term efficiency of the company in generating profits from the funds at the firm’s disposal.
- Liquidity ratios: ratios which assess the ability of the company to meet its short term debts as and when they fall due.
- Efficiency or working capital ratios: ratios which examine the extent to which management is efficient at reducing the need for working capital.
- Gearing ratios: ratios which highlight the extent of the financial risk borne by the owners or shareholders of a business. The greater the proportion of debt capital, the greater will be the financial risk.
- Shareholders’ investment ratios: these are ratios which help equity shareholders and investors to assess the worth and viability of an investment in ordinary shares.
PROFITABILITY RATIOS
-The business must be profitable if it is to survive in the long term i.e. for the foreseeable future.
Profitability is the result of many managerial policies and decisions. Profitability ratios measure the efficiency of the business in generating profits.
1. Return on total assets (ROTA):
Profits before Interest and Tax (PBIT) divide Total Assets x 100 percent.
Total assets = FA + CA = Long term capital + short term capital
Long term capital-Owners equity + Long term loans]
short term capital-Current liabilities
-ROTA reflects the profits earned before interest and tax (i.e. before remunerating providers of capital) on all the assets employed, irrespective of how they are financed. ROTA therefore measures the efficiency with which profits are generated from total capital at the
disposal of the business, irrespective of the source of the capital.
-2. Net profit margin = Net Profit divide sales x 100
-3. Net Profit mark-up = Net Profit divide by cost of sales x 100
-4.Return on Capital employed (ROCE) =Profits before interest and tax (PBIT) divide capital employed x100
LIQUIDITY RATIOS
Managers must ensure the short-term survival of the business. In so doing, their attention is inevitably drawn to liquidity. Is the company able to meet its short term maturing obligations?
1. Current ratio (or liquidity ratio) = current assets divide by current liabilities
● Since current assets are cash or assets expected to be turned into cash within the next 12 months, and current liabilities are those that should be paid within the next 12 months, a business should presumably be in a good position to meet its current obligations if current assets exceed current liabilities by a reasonable margin having regard to the nature of the business. Traditionally the satisfactory norm was 2:1.
● However, a reasonable norm depends on the nature of the business. If the business carries lots of stocks and debtors, it is normal that the business will REQUIRE more working capital so that its current ratio may be 2:1 or even 3:1. However, if a business has rapid stock turnover and few debtors because it sells mainly for cash (e.g. a supermarket), then it can afford to have a lower liquidity ratio (say 1:1) because its REQUIREMENT for working capital is much less.
● Therefore, the level of working capital, indicated by the current ratio, must be compared with the working capital requirement. An abnormally high liquid ratio could mean that the need for working capital is high because stock is remaining in store a long time before
being sold and/or because debtors are taking too much time to settle their accounts. This is why the currant ratio must be assessed in relation to working capital or efficiency ratios.
- Quick or Acid test ratio =Current assets stocks divide by current liabilities
● Analysts recognise that current assets include inventory which is sometimes slow moving and not so readily realizable into cash as implied by the current ratio.
● The quick ratio therefore removes inventory from the calculation, thus providing a more rigorous (hence the term acid test) test of the company’s ability to pay its short-term obligations.
Cash ratio = cash and cash equivalent divide by current liabilities.
-This is the ultimate test of liquidity as it tests whether the firm currently has enough cash to meet its current liabilities.
-Interpretation: If liquidity ratios are too low, this may indicate liquidity problems and the need to raise further finance. If the ratios are too high, this could indicate poor working capital management with stock and debtor levels too high.
WORKING CAPITAL OR EFFICIENCY RATIOS
- Stock turnover (in days) = closing stock or ( average stock) divide by cost of sales x 365days
The stock turnover period shows the average number of days the stock stays in store before being sold.
2.Rate of stockturn= Cost of sales divide by Closing stock (average stock) x …times
The rate of stockturn measures the number of times, on average, when goods are bought and sold.
Interpretation:
● It is desirable to have a low stock turnover but a high rate of stockturn. This would imply that goods are being bought and sold rapidly.
● On the other hand, a low rate of stock turnover (i.e. stocks remain in store a long time before being sold) and a high stock turnover may indicate poor stock control or even obsolescence. - Debtors collection (in days)= closing debtors (or average debtors) divide by credit sales x 365 days
-Debtors collection represents the average time taken for debtors to settle their accounts.
Interpretation:
● The higher the collection period, the greater the investment in debtors and the greater the need for working capital.
● A high collection period could indicate poor credit control i.e. the credit worthiness of customers are not properly evaluated.
● The collection period should be compared with the past and with industry trading terms. - Creditors payment period (in days) = Trade creditors (or average creditors) divide by credit purchases x 365 days
This ratio shows the average time taken by the business to pay its trade creditors.
Interpretation:
● An increase in the creditors collection period could indicate that the business is finding difficulty paying its creditors or that it has obtained more favorable credit terms.
● An increase in the credit collection period represents a source of funds and reduces the need for working capital. - Cash cycle:
The cash cycle represents the length of time between paying creditors for the goods and receiving cash from debtors from the sale of goods. The cash cycle (in days) is equal to:
Stock turnover period + debtor collection period - creditor payment period = Cash cycle
Interpretation:
● A lengthening of the cash cycle will strain liquidity and will require more working capital. Compare cash cycle of business with the industry average.
GEARING RATIOS
Gearing is a measure of the extent to which the business is financed by debt. The higher the level of
gearing, the higher the financial risk. A high financial risk implies that the business has a lot of fixed interest charges which must be paid irrespective of the level of profits earned. This means that the owners or shareholders (those who are ranked last in the pay-out queue) may end up with little or no profits as expenses and fixed interest charges must be paid first.
1. Debt equity ratio (for a company)= long term loan divide by ordinary share capital + retained profit + reserves
2. Capital gearing= long term loan divide by total long termed capital employed
3. Interest cover = PBIT divide by interest
Interpretation
● An acceptable level of gearing will depend on the nature of the trade. Thus comparison with other companies and industry average is essential.
● As the level of gearing increases:
(i) The chance that there will be no earnings available to equity increases. Thus high gearing increases the financial risk.
(ii) The owners or ordinary shareholders become more vulnerable to profit fluctuations. When profits are falling, the interest remains fixed and therefore increases as a proportion of profit. However, as profits increase, interest (which is fixed) decrease as proportion of profit.
● The business can be financed by debt if its profits are stable.
Shareholders’ investment ratios
- Earnings per share= profit after tax divide by No of ordinary shares in issue.
-EPS indicates the amount of net profit that is attributable to each share. Since EPS shows the net
profit per share, it should be easier to compare the performance of the equity of one company with that of another similar company. - Dividend cover =Earnings per share divide by dividend per ordinary share.
It shows the proportion of profit for the year that is available for distribution to shareholders that has been paid (or proposed) and what proportion will be retained in the business to finance future growth. - Price earnings ratio = Market price per share divide by Earnings per share
It is a measure of market confidence in the shares of the company. Indeed, since market price = EPS x P/E, the P/E ratio is merely a multiple of earnings. If the market’s perception of the growth in the firm’s future earnings is strong, then the P/E ratio will be higher. The P/E ratio will be higher, when performance drivers drive market price upwards. These performance drivers are:
(i) Growth in earnings and dividends (the higher the growth in dividends, the higher the P/E, other factors remaining constant)
(ii) Payout ratio (the higher the payout ratio the higher the P/E ratio, other factors remaining constant)
(iii) Lower business and financial risk. - Dividend yield = Dividend per ordinary share divide by market price per share
Dividend yield is that part of the shareholder’s total holding period return that is attributable to dividends. The total holding period return is determined as follows:
