Ratio Analysis

Ratio’s & What They MeasureInterpretation of Financial StatementsNicola Pennygar

PROFITABILITY

Measure Calculation Details

Gross Profit % Gross Profit/Revenue x 100 This % should be similar from year to year. A significant change, particularly a drop should trigger investigation into buying & selling prices. An increase is an improvement, a decrease is a deterioration

Expense/Revenue % Specified Expense/Revenue x 100 A large expense or overhead item can be expressed as % of revenue, eg if Marketing is calculated at 10% last year and now works out at 20%, it could show that increased spend on marketing didn’t generate any increased revenue. An increase is a deterioration, a decrease is an improvement.

Operating Profit % As with Gross Profit % this is usually similar from year to year. An increase each year indicates that that overheads etc are being kept under control and that the business is generating more profit from its revenue. Any decrease should be investigated as maybe a particular expense might have increased. The movement in % from Gross Profit % should be similar, if not, a scenario like the one described for Expense/Revenue % might have occurred. An increase is an improvement, a decease is a deterioration

AAT Level 4 (Tech) Ratio’s & What They MeasureInterpretation of Financial Statements


Return on Capital Employed (ROCE)

Profit from Operations/Total Equity + Non-Current Liabilities x 100

This measures the relationship between profits & equity + non current liabilities and compares it to the return that you might have got from a bank, had you invested your money in a bank not a business. So a person setting up a business, investing a sum of money in that business and the profit is the return achieved on his investment. It should be higher than the return from a bank for example because of the extra risks involved. An increase shows that the business is generating more profit from the available capital than before. An increase is an improvement, a decrease is a deterioration

Return on Shareholders Funds

Profit after Tax/Total Equity x 100 This ratio provides important information to shareholders as it shows the return that the company is making from their funds. They may decide to move if they get a better return elsewhere. An increase is an improvement, a decrease is a deterioration



LIQUIDITY


Current Ratio(sometimes called working capital ratio)

Current Assets/Current Liabilities= ??? : 1

This uses figures from the SFP to measure the relationship between current assets & current liabilities. It is thought that an acceptable ratio is about1.5:1 or 2:1 eg £2 of current assets to every £1 of current liabilities though some cash businesses can operate on less as it doesn’t have as many Trade Receivables. If the ratio is too high, investigation is needed, it maybe you have too much stock, too many trade receivables etc

Acid Test Ratio Current Assets-Inventories/Current Liabilities = ??? : 1

This ratio again uses figures from SFP without inventories for a comparison between trade receivables and cash to current liabilities. No less than 1 : 1. that is £1 of liquid assets to every £1 of current liabilities. (Liquid assets can be turned into cash quickly) If a lower result than 1:1 this may mean that the business would have trouble meeting its trade payables.



USE OF RESOURCES


Inventory Holding Period Inventories/Cost of Sales x 365 days

This calculation shows, on average, the number of days that inventories are held. The lower the amount of days the better but varies from different types of business. (No good for service businesses)

Inventory Turnover (times per year)

Cost of Sales/Inventories This calculation gives you the number of times that Inventories were turned over in a year. The higher the better (No good for service businesses)

Trade Receivables Collection Period

Trade Receivables/Revenue x 365 days

This indicator will show, on average, how many days it takes a customer to pay for goods/services. Most businesses have payment terms of 30 days. A figure close to payment terms shows good credit control

Trade Payables Payment Period

Trade Payables/Cost of Sales x 365

This shows how long on average your company is taking make payments to suppliers. Being as long as possible is not necessarily a good thing as it may cause problems with future suppliers etc. Being too short generally isn’t good for cash flow



Working Capital Cycle Inventory Days + Receivable days – Payable Days

Measures the time between goods received into stock and the collection of payment from customers in respect of the sale. If the time has reduced it is a better position. If the time has increased it is a worse position

Asset Turnover(total asset) Ratio

Revenue/ Non current Assets = how many times

Both this ratio and the one below measure efficient use of assets in generating revenue. An increase from one year to the next indicates greater efficiency. A falling result might be caused by a drop in revenue or an increase in assets. You may have increased stock or more trade receivables because of poor credit control, so an increase is an improvement, a decrease is a deterioration

Asset Turnover(net Assets) Ratio

Revenue/Total Assets-Current Liabilities = how many times

See above



FINANCIAL POSITION


Interest Cover Profit from Operations/Finance Costs = how many times

This gives an indication of the safety margin of profit over the finance costs. Eg If the Profit from Ops was £10,000 and the finance Costs were £5,000, this would give interest cover of 2 times. (quite low) Ten times is better showing that the profit from Ops can cover the finance costs, so an increase is an improvement, a decrease is a deterioration

Gearing Non-Current Liabilities/Total Equity + Non-Current Liabilities x 100

This ratio gives a picture of longer term financial stability. It measures how much the company is financed by debentures & loans. The higher the gearing % the less secure the company will be. Debt is very expensive in finance costs. It is thought that most investors or lenders would not want to see a gearing % of more than 50%. A high gearing % may also mean that the business will find it difficult to attract further financing. So an increase is a deterioration, a decrease is an improvement


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Ratio Analysis