Financial Ratio Analysis

INTRODUCTION

• Financial ratio analysis is a tool used to conduct a quantitative analysis of information in a company’s financial statement.

• Ratios are calculated from current year numbers and then compared to previous years, other companies, the industry or even the economy to judge the performance of the company.

• As a BENCHMARKING tool.

USERS OF RATIO

• There are vast number of parties interested in analysing financial statements, including shareholders, lenders, customers, suppliers, employees, government agencies and competitors. Yet, in many respects, they will be interested in different things.

• Ratio analysis is a first step in assessing an entity. • The table below shows some categories of ratios

and indicates some of the stakeholder groups that would be interested in them:

..

Ratio Category Examples of interested groups

Profitability Shareholders, management, employees, creditors, competitors, potential investors

Liquidity Shareholders, suppliers, creditors, competitors

Efficiency Shareholders, potential purchasers, competitors

Shareholder Shareholders, potential investors

Capital Structure Shareholders, lenders, creditors, potential investors

CATEGORIES OF RATIOProfitability Ratios1. Return on capital

employed (ROCE)• One of the most important

profitability ratios, as it encompasses all the other ratios, and because an adequate return on capital employed is why people invest their money in a business at the first place.

• We will look further from both perspectives of sole traders and companies.

a) Sole trader We will use average of the

capital account as the figure for capital employed, calculated as (op. bal. + cl. bal.) / 2

Example: business C and D have made the same amount of net profit, but the capitals employed are different.

.

BALANCE SHEET Business C Business D

RM RMFixed+CA-CL 100,000 100,000Capital Accounts

Op Bal 80,000 140,000Add Net profit 36,000 36,000

116,000 176,000Less Drawings (16,000) (16,000)

100,000 160,000

Therefore,Business C Business D 36,000 x 100 =40% 36,000 x 100 = 24% (80,000+100,000)/2 (140,000+160,000)/2

The ratio illustrates that what is important is not simply how much profit hasbeen made but how well the capital has employed. Business C has made far better use of its capital, achieving of RM40 net profit forevery RM100 invested, whereas D has received only a net profit of RM24 per RM100.

Return on capital employed (ROCE) = Net Profit x 100 Capital Employed

b) Companies• The main ones used for:i. Return on capital employed sourced from ordinary shareholders In a company, this is known as Return on Owner’s Equity (ROOE), or more

commonly Return on Shareholders’ Funds (ROSF). “return” = Net profit for the period. “shareholders’ funds” = book value of all things in the balance sheet that

describe the owners’ capital and reserves.

ii. Return of capital employed sourced from all long-term suppliers of capital Known as ROCE “return” = net profit + any preference share dividends + debenture and

long term loan interest. “capital” = Ordinary Share Capital + Reserves including Profit and Loss

account + preference share dividends + debenture and long term loan interest.

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Balance Sheet as at 31 DecP Ltd Q Ltd

RM RM RM RM 2007 2008 2007 2008

Fixed assets 520,000 560,000 840,000 930,000Net Current assets 280,000 340,000 160,000 270,000

800,000 900,000 1,000,000 1,200,00010% Debentures - - (120,000) (120,000)

800,000 900,000 880,000 1,080,000

Share Capital (ord.) 300,000 300,000 500,000 500,000Reserves 500,000 600,000 380,000 580,000

800,000 900,000 880,000 1,080,000

.Profit and Loss Accounts for year to 31 Dec 2008P Ltd Q Ltd

RM RMNet Profit 220,000 380,000Dividends (120,000) (180,000)

100,000 200,000i) ROSF

P Ltd Q Ltd 220,000 x 100 = 25.9% 380,000 x 100 = 38.8%

(800,000+900,000)/2 (880,000+1,080,000)/2ii) ROCE

P Ltd (note 1) Q Ltd (note 2)

Same as ROSF = 25.9% 380,000+12,000 x 100 = 35.6% (1,000,000+1,200,000)/2

note 1: The return on capital employed by all long-term sources of capital (in Q Ltd’s case, the shareholders’ funds and the debentures) is the same as the ROSF in the case of P Ltd, as it has no debentures)

Note 2: The debenture interest )i.e. 10% of RM120,000 = RM12,000) must be added back, as it was an expense in calculating the RM380,000 net profit.

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2) Gross Profit as percentage of sales

3) Net Profit as percentage of sales

Gross Profit x 100 Sales

Net Profit x 100 Sales

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Liquidity ratios• In a business, profitability is not the only thing that is

desirable. Accounting is used, not just to calculate profitability, but also to provide the information that indicates whether or not the business will be able to pay its creditors, expenses, loans falling due, etc. at the right time.

• Being able to pay one’s debts as they fall due is known as being ‘liquid’.

• When it comes to the liquidity of a business, both its own ability to pay its debts when due and the ability of its debtors to pay the amount they owe to the business are very important.

• Ratio analysis that focuses upon liquidity (or solvency) of a business are current ratio and acid test ratio

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1) Current Ratio• Compares assets which will become liquid

within approximately twelve months with liabilities which will be due for payment in the same period and is intended to indicate whether there are sufficient short term assets to meet short term liabilities.

• When calculated, the ratio may be expressed as:

i. A ratio to 1, with current liabilities being set to 1 , or

ii. As a ‘number of times’, representing the relative size of the amount of total current assets compared with total current liabilities

• You need to contextualise every ratio you calculate when you are trying to understand what the result means, such as:

What is the norm in this industrial sector (for example, retailers are often below 1:1)

Is this company significantly above or below that norm?

If so, can this be justified after an analysis of the nature of these assets and liabilities, and of the reasons for the amounts of each held?

2) Acid test ratio• This shows that, provided creditors and debtors are

paid at approximately the same time, a view might be made as to whether the business has sufficient liquid resources to meet its current liabilities.

• Stock is omitted as it is considered to be relatively illiquid, because it depends upon prevailing and future market forces and may be impossible to convert to cash in a relatively short time.

• Example: E Ltd F Ltd

Note: Sales for both E and F amounted to RM144,000. GP for E and F were identical at RM48,000

Current ratio = Current Assets Current Liabilities

Acid test ratio = Current Assets - Stock Current Liabilities

RM RM RM RM

Fixed Assets 40,000 70,000

Current Assets

Stock 30,000 50,000

Debtors 45,000 9,000

Bank 15,000 1,000

90,000 60,000

Less : Current Liabilities (Creditors)

(30,000) (30,000)

60,000 30,000

100,000 100,000

Capital

Opening capital 80,000 80,000

Add : Net profit 36,000 36,000

116,000 116,000

Less : Drawings (16,000) (16,000)

100,000 100,000

.• Profitability is the same for both businesses. However, there is a vast difference in the liquidity for the two businesses.

• Current ratios :

E = 90,000 = 3 F= 60,000 = 2 30,000 30,000

this looks adequate on the face of it, but let’s look at the acid test ratio:

• Acid test ratios:

E = 60,000 = 2 F = 10,000 = 0.33 30,000 30,000

• This reveals that F may be in trouble, as it will probably find it difficult to pay its current liabilities on time.

• No matter how profitable a business is, unless it is adequately liquid it may fail.

• However, it is also not very healthy to have too high ratio; ie. Too many resources being held as current assets – could have been used for more profitability.

Efficiency Ratios1. Stock turnover• Measured how efficient a business is at

maintaining an appropriate level of stock.• When it is not being as efficient as it used to

be, or is being less efficient than its competitors, this may indicate that control over stock levels is being undermined.

E = 96,000 F = 96,000 (34,000+30,000)/2 (46,000+50,000)/2 = 96,000 = 96,000 32,000 48,000 = 3 times = 2 times

2. Debtor/Sales ratio

E = 45,000/144,000 F = 9,000/144,000 = 1 : 3.2 = 1 : 16

• The relationship between debtor and sales is often translated into the length of time a debtor takes to pay

Stock turnover= Cost of Sales Average Stock

Debtors Sales

.E = 365 x 1 = 114 days 3.2

F = 365 x 1 = 22.8 days 16

• Why company E should have allowed so much time for its debtors to pay is a matter for investigation. i.e. hard to sell the products, thus giving longer credit term to customer. Or it could be that E has no proper credit control system, whereas F has an efficient one.

• When the ratio is rising, this may signal liquidity problems.

3) Creditor/purchases ratio• Assuming that purchases for E amounted to

RM92,000 and for F RM100,000 then the creditor/purchases ratio can be calculated as:

E = 30,000 = 1:3.07 F = 30,000 = 1:3.3 92,000 100,000

• This also is often translated into length of time we take to pay our creditors.

E = 365 x 1 = 118.9 days 3.07

F = 365 x 1 = 110.6 days 3.3

Creditors Purchases

.Shareholders’ Ratios• ‘price’ = price of the shares on the Stock

Exchange

1) Earnings per share (EPS)

• This gives the shareholder a chance to compare one year’s earnings with another. Many people consider EPS to be the most important ratio that can be calculated from the financial statements.

2) Price/Earnings ratio (P/E ratio)

• This puts the price into context as multiple the earnings. The greater the P/E ratio, the greater the demand for the shares.

3) Dividend yield

• This measures the real rate of return by comparing the dividend paid to the market price of a share.

4) Dividend cover

• This gives the shareholder some idea as to the proportion that the ordinary dividends bear to the amount available for distribution to ordinary shareholders.

EPS= Net Profit aft. Interest and tax and preference dividend No. of ordinary shares issued

P/E ratio= Market price per share EPS

Div. yield= Market price per share EPS

Div. Cover= NP aft. Tax and preference dividends Ordinary dividends paid and proposed