Week 6 Flashcards
What is Ratio Analysis and how is it used?
The technique used to describe and interpret the relationships of certain financial data in the financial statements, which would otherwise be devoid of meaning.
Ratio analysis is the most widely used technique for interpreting and comparing financial reports Ratios can be used to:
- Summarise relationships and results
- Provide an indication of firm performance
- Compare firm performance: Over time against different companies against an industry average
- Provide a prediction of future firm performance by analysing past trends
What are the primary interests of users for ratio analysis?
- The profitability of the firm
- The liquidity of the firm and its ability to exist for the foreseeable future (going concern)
- The efficiency of the firm
- The potential for investment in the firm
- The ability of the firm to increase its capital and hence its worth
What are the categories of Ratios Studied and what are they used for?
Profitability - Profitability is concerned with the generation and increase of profits.
Efficiency - Efficiency ratios examine the ways in which various resources of the business are managed
Liquidity - Liquidity ratios are concerned with the ability of the business to meet its short-term financial obligations
Financial Gearing - The firm’s level of borrowing is referred to as the level of ‘gearing’. High gearing implies high risk through interest payments and capital repayments
Investment Ratios - These ratios assist the user in ascertaining how worthwhile a firm is in terms of being an investment
Profitability calculations: Return on Capital Employed (ROCE)
One of the main ratios in accounting. An adequate return on capital employed is why people invest their money in a firm in the first place.
Net profit before interest and tax X 100%
Share capital + retained profits + long-term loans
Profitability calculations: Gross profit margin
Defines the association between gross profit and sales price
Gross profit margin (%) =
Gross profit X 100
Sales revenue
- Example: If a firm has sales of £500 and we are told the gross margin is 60%, then gross profit will be £300 (60% of £500)
- Thus, the association is as follows:
- Gross Profit + Cost of Sales = Turnover
(60%) (40%) (100%)
£300 + £200 = £500
Profitability calculations: Net profit margin
Defines the association between net profit and sales
NPM(%) =
Net profit before interest and tax X 100
Sales revenue
Example: A firm has sales of £500. Net profit was £125. Therefore the net profit margin is: £125/£500 = 25%
Profitability calculations: Turnover Growth
Measures the percentage change in turnover from period to period.
Turnover growth =
(Turnover this year-Turnover last year) X 100%
Turnover last year
Example:
Turnover for 2013 = £100,000
Turnover for 2012 = £80,000
TG for 2013 = £20,000/£80,000 X 100 = 25%
Profitability calculations: Return on Shareholder’s Funds (ROSF)
Differs from ROCE in that it measures the return made to ordinary shareholders for the investment made in the firm. ROCE measures the return made to all investors
ROSF =
Net profit after tax & preference dividend X 100%
Ordinary share capital + retained profits
Profitability calculations: Mark up Percentage
Not a ratio
A method of identifying the percentage of profit made on a product when it is sold
Compares gross profit against the buying price
e.g. Firm buys a product for £110 and sells it for £130
Mark up percentage = £20/£110 = 18.18%
Efficiency ratios: Inventory Turnover Period
This ratio measures the average period for which inventories are held.
•ITP =
(Opening inventory + Closing inventory)/2 x365
Cost of Sales
- OR Cost of Sales / 365 = Cost of sales per day
- ITP = Average Inventory / Cost of sales per day
Efficiency ratios: Trade Receivables Period
Measures the average speed of customer payments Shows the average number of days’ credit taken by customers (trade receivables)
•TRP=
Closing Trade Receivables x 365
Credit Sales
OR
Credit sales / 365 = Credit sales per day
TRP = Closing Trade Receivables / Credit sales per day
Efficiency ratios: Trade Payables Period
Indicates the average speed of payments to suppliers Shows the average number of days’ credit taken from suppliers (trade payables)
•TPP =
Closing Trade Payables x 365
Credit Purchases
OR
Credit Purchases / 365 = Credit purchases per day
TPP = Closing trade payable / Credit purchases per day
Where the average settlement period for trade receivables ratio is high compared with other firms (or against an industry average), and/or is increasing over time, this indicates inadequate credit control procedures by the firm Where the average settlement period for trade payables ratio is high compared with other firms (or against an industry average) and/or is increasing over time, this may indicate a financial weakness in the firm and may have long-term damage on the firm’s credit rating
Efficiency ratios: Sales Revenue to Capital Employed
Measures how effectively the assets of the business are being used to generate sales revenue.
SRCE =
Sales revenue
Capital employed
Also known as the “Asset Turnover Ratio”
Efficiency ratios: Sales Revenue per Employee
Measures the productivity of the company’s workforce
Sales revenue
Number of employees
Liquidity Ratios: Current Ratio
Current ratio =
Current Assets
Current Liabilities
Compares ‘liquid’ assets (i.e. cash and those assets held that will soon be turned into cash) of the firm with the short-term liabilities (creditors due within one year) The higher the current ratio, the more ‘liquid’ the business is considered to be. As liquidity is vital to the success of a firm, a higher current ratio may be regarded as more preferable to a lower ratio Textbooks often state that a benchmark is a ratio of 2:1 but this will depend on the nature of the business
