Financial Ratios

Ratio Analysis

Ratio Analysis

Ratio Analysis

Purpose:

To identify aspects of a businesses performance to aid decision making

Quantitative process - may need to be supplemented by qualitative factors to get a complete picture

5 main areas:

Ratio Analysis

Liquidity - the ability of the firm to pay its way

Investment/shareholders - information to enable decisions to be made on the extent of the risk and the earning potential of a business investment

Gearing - information on the relationship between the exposure of the business to loans as opposed to share capital

Profitability - how effective the firm is at generating profits given sales and or its capital assets

Financial - the rate at which the company sells its stock and the efficiency with which it uses its assets

Liquidity

Acid Test

Also referred to as the 'Quick ratio'

(Current assets - stock) : liabilities

1:1 seen as ideal

The omission of stock gives an indication of the cash the firm has in relation to its liabilities (what it owes)

A ratio of 3:1 therefore would suggest the firm has 3 times as much cash as it owes - very healthy!

A ratio of 0.5:1 would suggest the firm has twice as many liabilities as it has cash to pay for those liabilities. This might put the firm under pressure but is not in itself the end of the world!

Current Ratio

Looks at the ratio between Current Assets and Current Liabilities

Current Ratio = Current Assets : Current Liabilities

Ideal level? - 1.5 : 1

A ratio of 5 : 1 would imply the firm has Ј5 of assets to cover every Ј1 in liabilities

A ratio of 0.75 : 1 would suggest the firm has only 75p in assets available to cover every Ј1 it owes

Too high - Might suggest that too much of its assets are tied up in unproductive activities - too much stock, for example?

Too low - risk of not being able to pay your way

Investment/Shareholders

Investment/Shareholders

Earnings per share - profit after tax / number of shares

Price earnings ratio - market price / earnings per share - the higher the better generally. Comparison with other firms helps to identify value placed on the market of the business

Dividend Yield - ordinary share dividend / market price x 100 - higher the better. Relates the return on the investment to the share price

Gearing

Gearing

Gearing Ratio = Long term loans / Capital employed x 100

The higher the ratio the more the business is exposed to interest rate fluctuations and to having to pay back interest and loans before being able to re-invest earnings

Profitability

Profitability

Profitability measures look at how much profit the firm generates from sales or from its capital assets

Different measures of profit - gross and net

Gross profit - effectively total revenue (turnover) - variable costs (cost of sales)

Net Profit - effectively total revenue (turnover - variable costs and fixed costs (overheads)

Profitability

Gross Profit Margin = Gross profit / turnover x 100

The higher the better

Enables the firm to assess the impact of its sales and how much it