Ratio Analysis Use of Ratio Analysis To analyse

Ratio Analysis

Use of Ratio Analysis To analyse • Performance • Liquidity • Shareholder Investment

Performance Ratios • ROCE • Gross profit margin • Net profit margin

ROCE Return On Capital Employed - relates a firms profitability in relation to the investors capital investment ROCE = profit before tax + finance costs + pref. dividends x 100% (Total Assets-Current Liabilities)

Gross Profit Margin The ‘mark-up’. This shows the gross profit made on sales turnover. Gross profit margin = gross profit x 100% Sales revenues A large range of profit may affect the true results Useful when comparing against the margins of previous years.

Net Profit Margin This shows how well a business controls its overheads Net profit margin = Net profit x 100% Sales Revenue

Liquidity Ratios Current ratio Acid test ratio • Measure a firm’s ability to meet shortterm obligations, collect receivables, and maintain a cash position • How well is the organisation able to meet its short-term obligations?

Current Ratio • Measures a company's ability to pay short-term obligations. • Current ratio = current assets/current liabilities Current ratio = x: 1 • Suggested Rule of thumb 2: 1

Acid Test Ratio/ Quick Ratio • Determines risk undetected by the Working Capital ratio • Acid test ratio = (Current Assets–Closing Inventory) Current Liabilities • Acid test ratio = x: 1 • An extreme version of the working capital ratio because it only uses cash and equivalents. • The ratio excludes inventory, which for some companies can make up a large portion of its assets. • Suggested Rule of thumb 1: 1

Gearing Ratio Compares owner's equity (or capital) to borrowed funds. Shows how risky a company is financially Gearing ratio = Non-current Liabilities (Debt) x 100% = x% (Equity Capital + Reserves + Debt Capital)

Shareholders Ratios • Earning per share • Return on equity

Earning per Share (EPS) This measure expresses how many pence the company is earning for every share held. Earnings per Share = Profit for the year No. of ordinary shares in issue = x pence

Return on Equity A measure of how well a company used reinvested earnings to generate additional earnings ROE = (Net profit for the year – preference dividend) x 100% Ordinary Share Capital + Reserves

Advantages of Ratio Analysis • Can assist in interpreting and evaluating income statements and balance sheets by reducing the amount of data contained in them to a workable amount • Can make financial data more meaningful • Help to determine relative magnitudes of financial quantities • Help managers or business analysts make effective decisions about the firm's credit worthiness • Can assist with predicting potential business earnings • Can assist in seeing financial business strengths • Can assist in spotting business weaknesses

Disadvantages of Ratio Analysis • Comparing the ratios with past trends and with competitors may not give a correct picture as the figures may not be easily comparable due to the difference in accounting policies, accounting period etc. • It gives current and past trends, but not future trends. • Impact of inflation is not properly reflected, as many figures are taken at historical numbers, several years old. • There are differences in approach among financial analysts on how to treat certain items, how to interpret ratios etc. • The ratios are only as good or bad as the underlying information used to calculate them.

Factors Affecting Ratio Analysis • • Inflation External factors eg pollution Management changes Yearly comparisons Performance State of the economy Performance of competitors

Difference between cash and profit • Cash is considered cash and cheques • It’s a liquid asset of the business • Cash is the inflow of money into the business bank account (actual money received, rather than what is ‘promised’) • Cash also flows out of the business – e. g. paying suppliers bills. • Not all bills are paid by cash – many are on credit terms

Profit • This is measured by taking the costs away from the sales revenue • It’s different from cash because profit is the money earned by the business, and is represented on paper (in the accounts) • Because sales can be made on credit terms, not just cash, then it’s different to cash flow