Accounting Ratios Flashcards
Limitations of Accounting Ratios
They are based on historic data
Using ratios in isolation can be misleading – they need to be compared to the ratios of companies in the same sector
Ratios take no account of “soft” qualitative factors such as management style
Accounting data can be manipulated and, by definition, ratios based upon such data will be false / misleading
Operating Profit
Operating profit is the profit after operating and administration costs. It excludes effects of investments, interest expenses, and tax. Operating profit is also referred to as EBIT (earnings before interest and tax) in accounts.
Net Profit
Net profit is what’s left to distribute to shareholders once interest and tax has been paid.
Profit Margin
We can work out our Operating Margin, or our Net Margin, by dividing Operating Profit or Net Profit by total sales.
Margin is a useful fundamental because it provides an indication of profitability from one year to the next (growth/fall in sales).
Assets
Non-current assets (NCAs) are the long-term assets of a company with a life of longer than one year). Current assets are the short-term assets of a company. They are held for conversion into cash, usually within one year of the statement of financial position date.
Liabilities
Current liabilities are the opposite of current assets. They are amounts of money owed by a company and due for payment within one year of the statement of financial position date.
Interest & Tax
If a company has debt finance it will be required to service that finance by paying interest and Interest is paid out of operating profit. Corporation tax is paid out of operating profit less interest.
Dividends
If a company has profit remaining after the payment of interest and tax, it can reward shareholders by paying out dividends. Dividends paid and proposed in relation to an accounting period will be included in the income statement for that period. If a company has preference and ordinary shares, both types of dividend will be included in this line.
Return on Equity
ROE = Net profit / Shareholders’ funds
The ability to earn consistent above average ROE is the most fundamental characteristic of a good company.
ROE is most effectively used when comparing equities with other asset classes such as property or bonds / fixed interest.
It indicates how efficiently a company’s management has utilised the shareholders’ funds.
Return on Capital Employed
ROCE = Operating profit / Capital employed
Capital employed includes ALL capital. It is defined as total assets less current liabilities, AKA shareholders’ funds + long-term
creditors.
It is a common means of evaluating a company’s profitability over time, and comparing the profitability of different companies; widely recognised as the best ratio for measuring overall
management performance.
ROCE is most effectively used when making comparisons between individual specific companies.
Asset Turnover
Asset turnover is calculated as sales as a percentage of capital employed. It is THE key indicator of how efficient the company is at using its assets to generate profit. It measures
how much of the ROCE is from good asset utilisation.
Financial Leverage
(Long-term loans + preference shares) / (total equity – preference shares)
Financial leverage is known as the debt-to-equity ratio. Ratios of more than 100% are generally considered high in the UK, but what is acceptable will vary between industries. High gearing exaggerates changes to return on equity. When profits are high, gearing boots return on equity. When profits fall, they fall faster than in a non-geared company.
Gearing
Gearing is a measure of the amount of debt a company has. It can be measured as a percentage of the total long-term capital available to a business (debt and equity capital), or
as a percentage of the funds provided by the ordinary shareholder.
The debt capital refers to the preference shares, loan stock, debentures, bank loans, mortgages and any other long-term borrowing, such as an overdraft for more than one year.
Operating Leverage
Fixed costs / variable costs
Higher operating leverage (high fixed costs compared to variable costs) indicates more volatility around the break-even point, with profits increasing/falling more quickly after this point.
Lower operating leverage indicates lower volatility around the breakeven point, and a lower breakeven point. However, over the longer term, particularly in boom, the company is likely to have higher total costs.
Analysis of Break-even Point
Analysis of the break-even point is known as break-even analysis. Fixed costs above 80% are considered high.
