Ratio analysis Ratio analysis is used to help

Ratio analysis

Ratio analysis is used to help interpret a firm’s financial data. The five main types of ratios are: Profitability ratios Liquidity ratios Efficiency ratios Gearing ratios Shareholder ratios

Benefits of using ratio analysis Ratios allow for easier comparison of sets of data e. g. from different years or between different organisations Ratios can be used to assess the current ‘health’ of an organisation Ratios can be used to help make decisions and plan for the future

Limitations of ratio analysis Ratios are calculated using historical data. Historical data is useful, however, its use may be limited when making decisions about the future ‘Window dressing’ of financial information can occur which will then affect the financial ratios Qualitative factors are not taken into account

Profitability ratios These ratios are used to assess whether organisations are making enough profit: Gross and net profit margins – compare levels of profit with sales revenue (gross profit/revenue x 100) Return on capital employed (ROCE) – compares profits with the amount of capital invested (operating profit/capital employed x 100)

Liquidity ratios are concerned with an organisation’s ability to pay its short term debts: Current ratio – compares current assets with current liabilities (current assets/current liabilities) Acid test ratio – compares current assets minus stock with current liabilities (current assets-inventories)/current liabilities

Efficiency ratios are concerned with how effectively firms are using their resources: Receivables days = (receivables x 365 days) / revenue Payables days = (payables x 365 days) / credit purchases Asset turnover = sales / net assets Stock turnover = cost of sales / inventory

Gearing ratios Gearing is concerned with how much of the assets invested in a firm come from long term borrowing e. g. loans. The more highly geared a firm is, the greater risk it faces. Gearing ratio = non current liabilities / (total equity + non current liabilities) x 100

Shareholder ratios can be used by current or potential shareholders: Dividend per share (DPS) – the value of dividends paid out each year per share (total dividends paid/total number of shares) Dividend yield – compares the dividends paid with the market value of a share (DPS/market price of shares x 100)