Ratios Flashcards
Gross profit margin
(Gross profit/
Sales revenue) ×100%
operating profit margin
(Profit from operations /
Sales revenue) ×100%
Return on capital employed (ROCE)
ROCE =
(Profit/
Capital employed) × 100%
ROCE shows the ability of the entity to
turn its long-term financing into profit.
Profit is measured as:
operating (trading) profit, or
the profit before interest and taxation (PBIT), i.e. the profit before taking
account of any returns paid to the providers of long-term finance.
Similar to ROCE is return on equity (ROE):
ROE =
(Profit after tax/
Equity)
× 100%
ROE can be used to show
the return made for the year on the total equity in the
business. Pre-tax ROE can also be calculated using profit before tax rather than
profit after tax.
net asset turnover
(Sales revenue/
Capital employed) = times pa
the higher the asset turnover, the greater the efficiency.
Note that asset turnover can be subdivided into:
non-current asset turnover (by making non-current assets the
denominator) and
working capital turnover (by making net current assets the denominator)
ROCE can be subdivided into profit margin and asset turnover.
Profit margin × Asset turnover = ROCE
PBIT/
Sales revenue
×
Sales revenue/
Capital employed
=
PBIT/
Capital employed
Low-margin businesses (e.g. food retailers) usually have a high
Asset turnover
Capital-intensive manufacturing industries (e.g. electrical equipment
manufacturers) usually have relatively
low asset turnover but higher margins
Two completely different strategies can achieve the same ROCE.
Sell goods at a high profit margin with sales volume remaining low (e.g.
designer dress shop).
Sell goods at a low profit margin with very high sales volume (e.g. discount
clothes store).
There are two ratios used to measure overall working capital:
the current ratio
the quick or acid test ratio.
Current or working capital ratio:
Current assets/
Current liabilities : 1
The current ratio measures
the adequacy of current assets to meet the liabilities as they fall due
A high or increasing figure may appear safe but should be regarded with
suspicion as it may be due to:
high levels of inventory and receivables (check working capital
management ratios)
high cash levels which could be put to better use (e.g. by investing in noncurrent
assets).
Traditionally, a current ratio of 2:1 or higher was regarded as
appropriate for most businesses to maintain creditworthiness. However,
more recently a figure of
1.5:1 is regarded as the norm.
Quick ratio (also known as the liquidity or acid test) ratio:
Quick ratio =
Current assets – inventory /
Current liabilities :1
The quick ratio is also known as the acid test ratio because by eliminating
inventory from current assets it provides the acid test of whether the company
has sufficient liquid resources (receivables and cash) to settle its liabilities.
Inventory holding period
Inventory/
COS × 365 days
Receivables collection period is normally expressed as a number of days:
Trade receivables/
Credit sales × 365 days
Payables payment period is usually expressed as:
Trade payables/
Credit purchases × 365 days
Working capital cycle (cash cycle)
Inventory turnover period (days)
+ receivables collection period – payables payment period
In highly geared businesses:
a large proportion of fixed-return capital is used
there is a greater risk of insolvency
returns to shareholders will grow proportionately more if profits are
growing.
Low-geared businesses:
provide scope to increase borrowings when potentially profitable projects
are available
can usually borrow more easily.
There are two methods commonly used to express gearing.
Debt/equity ratio:
Percentage of capital employed represented by borrowings:
Debt/equity ratio:
Loans + Preference share capital/
Ordinary share capital + Reserves + Non-controlling interest
Percentage of capital employed represented by borrowings:
Loans + Preference share capital/
Ordinary share capital + Reserves + Non-controlling interest
+ Loans + Preference share capital
Interest cover
Profit before interest and tax/
Finance costs
interest cover of less than
two is usually considered unsatisfactory
low interest cover indicates to shareholders that their
dividends are at risk
Price / Earnings (P/E) ratio
P/E ratio =
Current share price/
Latest EPS
Dividend yield
Dividend per share/
Current share price
