Ratio Analysis: Interpretation of Financial Statements: 1) Profitability Ratios
Ratio Analysis: Interpretation of Financial Statements: 1) Profitability Ratios
Ratio Analysis: Interpretation of Financial Statements: 1) Profitability Ratios
1) Profitability Ratios
Measures the Profit (Return) that a business
a] ROCE (PBIT ÷ Capital Employed) n/a generates from the resources available to it (its
(Return On x 100% capital employed).
Capital
Employed)
(Net profit ÷ Sales) x 100% n/a Measures the average profit in comparison to the
b] Net Profit Sales Revenue.
Margin or %
(Operating Expenses ÷ n/a If high, the business usually has a low Net profit
d] Expenses Sales) x 100% margin, i.e. the expenses of the business are too
Ratio high.
(Sales ÷ Capital employed) n/a Measures the efficiency with which the organisation
e] Asset times uses its resources (net assets) or capital employed
turnover ratio to generate sales.
2) Liquidity Ratios
a] Current Current assets ÷ Current 2:1 Measures the ability of the entity to meet its debts
ratio liabilities when they fall due. It shows the extent to which
current liabilities are covered by cash/assets that
can be converted into cash within a reasonably
short period of time.
NB – a shorter Payables’ days than Receivables’ days may lead to cash or liquidity problems as
debtors will not be paying as much as the company is paying its suppliers.
b] Earnings (PAT – Preference dividends) Shows how much of Net Profit could have been received by
per share ÷ Number of Ordinary shares each shareholder (Equity) had the whole Net Profit been paid
(EPS) [pence] out as dividends.
For example, the P/E ratio of company [A] with a share price of
$10 and earnings per share of $2 is 5. The higher the P/E ratio,
c] Price Market price per share ÷ EPS the more the market is willing to pay for each dollar of annual
Earnings ratio earnings. Companies with high P/E ratios are more likely to be
considered "risky" investments than those with low P/E ratios,
since a high P/E ratio signifies high expectations. Comparing
P/E ratios is most valuable for companies within the same
industry.
*Ratio analysis is a powerful accounting tool, but it has its own disadvantages, among
others are the following:
-It is based on historical information, i.e. ratios are calculated from financial statements
from previous years.
- Different businesses may use different accounting conventions, e.g. depreciation methods
etc.
- Ratio analysis on its own cannot uncover the real business issues that may have caused the
trends in the ratios. It can work as a starting point for questions on what and why there
have been the manifested trends.
e.g.
A business acquires a building (asset) for P1 000 000, where P600 000 came from the
owners’ funds (Equity/ Capital and the rest of the money (the P400 000) was a loan (liability)
that was borrowed from the bank. Using the accounting equation, this transaction can be
represented as follows:
A=C+L
1) C=A–L
e.g.
C = A - L
P600 000 capital = P1 000 000 asset - P400 000 loan or
2) L = A – C.
e.g.
L = A - C
P400 000 liability/loan = P1 000 000 asset - P600 000 equity/capital