Financial ratio classification Categories Profitability Efficiency Liquidity Gearing

Financial ratio classification Categories Profitability Efficiency Liquidity Gearing Investment © Pearson Education 2002�

The key steps of financial ratio analysis Identify users and their information needs Select and calculate appropriate ratios Interpret and evaluate the results © Pearson Education 2002�

Profitability ratios Formula Return on ordinary shareholders’ funds Net profit after taxation and preference dividend (if any) x 100 Ordinary share capital + Reserves Return on capital employed Net profit before interest and taxation x 100 Share capital + Reserves + Long-term loans Net profit margin Net profit before interest and taxation Sales Gross profit margin Gross profit Sales x 100 © Pearson Education 2002�

Efficiency ratios Formula Average stock turnover period Average settlement period for debtors Average settlement period for creditors Average stock held Cost of sales Trade debtors Credit sales x 365 Trade creditors x 365 Credit purchases Sales to capital employed _______ Sales_____ Long-term capital employed Sales per employee _______Sales_______ Number of employees © Pearson Education 2002�

The main elements comprising the ROCE ratio Net profit before interest and taxation sales multiplied by Sales______ Long-term capital employed equals Return on capital employed © Pearson Education 2002�

Liquidity ratios Formula Current ratio Current assets________ Current liabilities (creditors due within one year) Acid test ratio Current assets (excluding stock) Current liabilities Operating cash flows to maturing obligations Operating cash flows Current liabilities © Pearson Education 2002�

Average current ratio and average acid test ratio for UK listed companies in various industrial sectors Source: Datastream data, February 2001 2. 0 Current ratio 1. 8 Acid test ratio 1. 6 1. 4 1. 2 1. 0 0. 8 0. 6 0. 4 0. 2 0. 0 Chemicals Food Electricity Food and drugs producers retailers Household goods and textiles Information Technology Hardware Water © Pearson Education 2002�

Gearing ratios Formula Gearing ratio Long-term liabilities _______ Share capital + Reserves + Long-term liabilities Interest cover ratio Profit before interest and taxation_ Interest payable © Pearson Education 2002�

The effect of financial gearing © Pearson Education 2002�

Investment ratios Formula Dividend per share Dividend payout ratio Dividend yield ratio Dividends announced during the period Number of shares in issue Dividends announced for the year x 100 Earnings for the year available for dividends Dividend per share/(1 -t) Market value per share x 100 Earnings per share Earnings available to ordinary shareholders Number of ordinary shares in issue Operating cash flow per share Operating cash flows – preference dividends Number of ordinary shares in issue Price/earnings ratio (P/E) Market value per share Earnings per share © Pearson Education 2002�

Average dividend yield ratios 6. 62 4. 19 5. 82 6 5. 35 5 3. 79 4 3 3. 77 2. 85 2. 53 2. 84 2. 22 Banks Water Electricity Food and drug retailers Restaurants and pubs Distribution Tobacco Pharmaceuticals Engineering and machinery 0 1. 54 Chemicals 1 Oil and gas 2 Construction and building materials 1. 95 Source: Constructed from information in Financial Times, 8 December 2000 © Pearson Education 2002�

Average P/E ratios 41. 50 40 35 30 26. 84 25 22. 51 17. 93 20 12. 11 11. 60 Banks Water Electricity Food and drug retailers Restaurants and pubs 9. 89 Distribution 8. 53 Tobacco 0 13. 38 Pharmaceuticals 5 Oil and gas 10 Construction and building materials 10. 21 Engineering and machinery 13. 91 Chemicals 15 16. 83 Source: Constructed from information in Financial Times, 8 December 2000 © Pearson Education 2002�

Graph plotting current ratio against time Current ratio XYZ Ltd Industry average 1997 1998 1999 2000 2001 Time © Pearson Education 2002�

Mean ratios of failed and non-failed businesses Failed firms Non-failed firms Cash flow Total debt Net income Total assets Total debt Total assets 0. 79 +0. 1 +0. 45 0. 78 +0. 35 0. 0 +0. 25 0. 65 0. 58 +0. 15 0. 51 -0. 1 +0. 05 0. 44 -0. 05 0. 37 -0. 2 -0. 15 1 2 3 4 5 © Pearson Education 2002�

Mean ratios of failed and non-failed businesses Failed firms Non-failed firms Working capital Total assets Current ratio 0. 42 No credit interval 3. 5 +0. 15 3. 0 +0. 05 2. 5 -0. 05 2. 0 -0. 15 0. 36 0. 30 0. 24 0. 18 0. 12 0. 06 1 2 3 4 5 © Pearson Education 2002�

Scatter diagram showing the distribution of failed and non-failed businesses Failed businesses Non-failed businesses Current ratio ROCE ratio © Pearson Education 2002�