This document provides an overview of ratio analysis for financial decision making. It defines various types of ratios including profitability, liquidity, gearing, efficiency, and investor ratios. It explains how to calculate and interpret these ratios to evaluate the financial performance and position of a business. The document also provides examples of calculating specific ratios like return on capital employed, current ratio, gearing ratio, and asset turnover ratio.
This document provides an overview of ratio analysis for financial decision making. It defines various types of ratios including profitability, liquidity, gearing, efficiency, and investor ratios. It explains how to calculate and interpret these ratios to evaluate the financial performance and position of a business. The document also provides examples of calculating specific ratios like return on capital employed, current ratio, gearing ratio, and asset turnover ratio.
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This document provides an overview of ratio analysis for financial decision making. It defines various types of ratios including profitability, liquidity, gearing, efficiency, and investor ratios. It explains how to calculate and interpret these ratios to evaluate the financial performance and position of a business. The document also provides examples of calculating specific ratios like return on capital employed, current ratio, gearing ratio, and asset turnover ratio.
This document provides an overview of ratio analysis for financial decision making. It defines various types of ratios including profitability, liquidity, gearing, efficiency, and investor ratios. It explains how to calculate and interpret these ratios to evaluate the financial performance and position of a business. The document also provides examples of calculating specific ratios like return on capital employed, current ratio, gearing ratio, and asset turnover ratio.
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Ratio Analysis
BUS608 Financial Decision
Making 16 th April 2013 Amanda Byrne Lesson Objectives At the end of this session you should be able to: Explain the principles of interpretation of financial information, Calculate and interpret profitability, liquidity, gearing, efficiency and investor ratios and be aware of their significance Explain the limitations of ratio analysis Introduction to ratios Terminology Profitability ratios are used to compare profits with the size of the business. These ratios are often called performance ratios because the primary aim of most businesses is to make a profit. Gearing ratios focus on the long term liquidity of a business. It allows a business to determine whether a business will be able to keep up with interest payments on borrowed capital and whether it will be able to pay any long term borrowing. Liquidity ratios are a measure of whether a business would be able to meet any short term liabilities it may have. Businesses need to ensure they have enough liquidity to avoid any problems with paying debts. Efficiency ratios look at how a business manages its working capital. They are used to measure and evaluate how efficiently a firm manages its assets and short term liabilities. Investors ratios are used to determine whether shareholders would be likely to financially benefit from owning shares within the business. Ratio Analysis The process 1. In order for ratios to be beneficial, the process has to be selected carefully and well organised. To ensure that a business can take full advantage of ratio analysis, the following process should be followed: 2. Determine the reason for the analysis. 3. Conduct research on which ratios will be most relevant in the situation. 4. Collect all the information required to calculate the ratios. 5. Make an interpretation of the ratios. 6. Compare the ratios in an appropriate way in an attempt to understand the significance of the ratios. 7. Plan appropriate action in accordance with the results of the ratio analysis and implement any action Steps to Ratio Analysis Identify users and their information needs Select and calculate appropriate ratios Interpret and evaluate the results
Note: You need to compare ratios with a benchmark which could be past performance, industry performance or projected performance A few rules Always be aware of the context in which the business operates Compare like with like Findings should always be double checked. Do not base your interpretations on the result of one fact only To interpret effectively, the statements of more than one accounting period should be analysed to give an idea of the trend. You can gain an initial overall impression of a business just by looking at the figures. Profitability Ratios Profitability Ratios Gross Profit Margin = Gross Profit Sales Revenue Net Profit Margin = Net Profit Before Interest and Taxation Sales Revenue X 100 X 100 Return on Capital Employed = Net Profit Before Interest and Taxation Capital Employed X 100 Note: Capital Employed = Share capital + Reserves + Long term loans A measure of profitability in buying (or producing) and selling goods, before other expenses Expresses the relationship between net profit generated and long term capital investment Represents profit from trading operations before ant interest and taxation. Often seen as most appropriate measure of operational performance Profitability ratios Balance Sheet m Non-current assets 19550 Stock 2375 Debtors 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235
Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 ROCE Operating profit x 100 total equity + non-current liabilities
4580 x 100 11235 + 6000
4580 x 100 = 27% 17235
Income Statement m Revenue 35400 Cost of sales (30100) Gross profit 5300 Expenses (720) Operating profit 4580 Finance income 300 Finance cost (260) Profit before tax 4620 Taxation (1109) Profit for the year 3511
For every 1 of capital employed in the Business how much is being generated in profit?
Why would it be meaningful to compare this to the current rate of interest? Liquidity Ratios Liquidity Ratios Current Ratio = Current Assets Current Liabilities Acid Test Ratio = Current Assets - Stock Current Liabilities The higher the ratio, the more liquid the business is considered to be The minimum level is often stated as 1:1; that is current assets (less stock) equals current liabilities Liquidity ratios Balance Sheet m Non-current assets 19550 Stock 2375 Debtors 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235
Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Current Ratio Current Assets : Current Liabilities
5845 : 8160 = 0.716 : 1 For every 1 of CL the firm owes it owns 0.716 in CA
Do you think this business has enough short term assets to meet its short term debts?
Liquidity ratios Balance Sheet m Non-current assets 19550 Stock 2375 Debtors 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235
Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Acid Test Liquid Assets : Current Liabilities
1170 + 2300 : 8160 = 3470 : 8160 = 0.425 : 1 For every 1 of CL the firm owes it owns 0.425 in CA
Why is the acid test a more demanding measure? Comparison Significant level of inventories; the other companies are service industries Comparison Tesco does not sell on credit; very few of BA sales are on credit Comparison Tescos trade payables are much higher than its inventories; so, on average, they have the cash from sales before they need to pay for the goods concerned Gearing Ratios Gearing Ratios Capital Gearing Ratio = Long-Term Loans Share Capital + Reserves + Long-Term Loans X 100 Debt/Equity Ratio = Long-Term Loans Share Capital + Reserves X 100 Interest Cover Ratio = Profit Before Interest and Taxation Interest Payable Measures the contribution of long term lenders to long term capital structure of the business Measures the amount of profit available to cover the interest payable. The lower the figure, the greater the risk to lenders, and shareholders Gearing ratio
Balance Sheet m Non-current assets 19550 Stock 2375 Debtors 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235
Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Gearing
Non-Current Liabilities x 100 total equity + non-current liabilities
6000 x 100 (11235 + 6000) = 6000 x 100 17235 = 35% For every 1000 invested in this business how much of it is from long term loans?
Why might a high gearing be more of a concern to a business with small profit margins? Income Statement m Revenue 35400 Cost of sales (30100) Gross profit 5300 Expenses (720) Operating profit 4580 Finance income 300 Finance cost (260) Profit before tax 4620 Taxation (1109) Profit for the year 3511
Efficiency Ratios Efficiency Ratios Average Stock Turnover Period = Average Stock Cost of Sales X 365 Average Debtors Settlement Period = Trade Debtors Credit Sales Revenue X 365 Average Creditors Settlement Period = Trade Creditors Credit Purchases X 365 Asset Turnover Ratio = Sales Revenue Capital Employed A business will prefer a short stock turnover, as funds tied up in stock cannot be used for other purposes Speed of payment can have a significant effect on the businesss cash flow Represents a free source of finance A higher asset turnover is preferred to a lower one, as it indicates assets are being used more productively in generating revenue Financial Efficiency ratio Balance Sheet m Non-current assets 19550 Stock 2375 Debtors 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235
Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Asset Turnover
Revenue Net assets
35400 11235 = 3.15 times Income Statement m Revenue 35400 Cost of sales (30100) Gross profit 5300 Expenses (720) Operating profit 4580 Finance income 300 Finance cost (260) Profit before tax 4620 Taxation (1109) Profit for the year 3511
For every 1 of net assets in the business how much is being generated in revenue?
Why might asset turnover help a business assess operational efficiency between factories? Financial Efficiency ratio
Balance Sheet m Non-current assets 19550 Stock 2375 Debtors 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235
Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Stock Turnover
Cost of sales Stock
30100 2375 = 12.67 times Income Statement m Revenue 35400 Cost of sales (30100) Gross profit 5300 Expenses (720) Operating profit 4580 Finance income 300 Finance cost (260) Profit before tax 4620 Taxation (1109) Profit for the year 3511
On average for how long does this business hold stock?
What type of business might have this level of inventory turnover? Justify your answer
Financial Efficiency ratio
Balance Sheet m Non-current assets 19550 Stock 2375 Debtors 1170 Cash & cash equivalents 2300 Total current assets 5845 Current liabilities (8160) Net current liabilities (2315) Non-current liabilities (6000) Net assets 11235
Share capital 6000 Reserves & retained earnings 5235 Total equity 11235 Receivables (Debtors) days
Receivables x 365 Revenue
1170 x 365 35400 = 12 days Payables are compared to cost of sales and receivables to revenue.
What might be the expected debtor days of a) A high street coffee chain b) A commercial print company Income Statement m Revenue 35400 Cost of sales (30100) Gross profit 5300 Expenses (720) Operating profit 4580 Finance income 300 Finance cost (260) Profit before tax 4620 Taxation (1109) Profit for the year 3511
Investment Ratios Earnings Per Share = Earnings Available to Ordinary Shareholders Number of Ordinary Shares in Issue Dividend Cover Ratio = Earnings Available for Dividend Dividend for the Year Dividend Yield Ratio = Dividend per share before tax Market Value per share Price/Earnings Ratio = Market Value per Share Earnings per share Many investors regard this as a fundamental measure of share performance The higher the ratio, the greater the confidence in future earning power Ratio Analysis - Shareholders Shareholder Dividend per share (in pence) Total dividends number of issued ordinary shares The return paid to shareholders for their investment Money paid in dividends reduces retained profit Will be influenced by financial objectives
If a dividend of 600m was paid out to a total of 750 shareholders the dividend per share would be: 600m / 750 = 0.80p For every 1 share owned the shareholder would receive 80p in dividends Ratio Analysis - Shareholders Shareholder Dividend yield Ordinary share dividend (in pence) x 100 current market price (in pence) o Measures the return on the investment as a percentage of current market price o Market price fluctuates on a regular (constant basis) o Allows for a more accurate comparison of the value of the shareholders investment compared to other investment opportunities
If dividend per share is 80p and the current market share price 15 the dividend yield is: 0.80 / 15.00 x 100 = 5.3% Do you consider this to be a good return? How does this compare to savings accounts, ISAs, other share options? Value and Limitations of Ratio Analysis Value Provides a tool for the interpretation of accounts Structure from which comparisons can be made Aids decision making Internally Externally by investors
Limitation Quality of financial statements- It must always be remembered that ratios are based on financial statements, and the results of ratio analysis are dependent on the quality of these underlying statements The restricted vision of ratios. It is important not to rely exclusively on ratios, thereby losing sight of information contained in the underlying financial statements. It can be difficult to find a suitable benchmark (for example, another business) to compare with. Some ratios could mislead due to the snapshot nature of the balance sheet. any ratios based on balance sheet figures, such as the liquidity ratios above, may not be representative of the financial position of the business for the year as a whole.