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RATIO ANALYSIS

Categories of Ratios
I) Profitability Ratios

a) Net Profit to Sales = Net Profit % = Net Profit x 100%


Sales

This reflects a measure of management’s success in earning profits from trading


operations. A low margin could be caused by low selling prices, high costs or both.

b) ROCE = Profit Before Interest & Tax x 100%


Capital Employed

This ratio indicates the level of profitability earned based on the resources invested.
It is essentially a measure of the efficiency with which a business uses the funds at its
disposal. One has to be consistent in defining ROCE, otherwise comparability issues
arise.

NB. Capital Employed: Ord. Share Capital + Reserves + Long-term Liabilities

c) Gross Profit % = Gross Profit x 100%


Sales

The GP% is indicating how well management has been able to control the costs
associated with procuring the goods/services integral to generating revenues.
Margins could be affected by price discounts (given & received), bulk buying
etc.

d) Asset Turnover
This ratio measures the efficiency with which the business is utilizing its assets in the
generation of sales.

Asset Turnover = Sales


Capital Employed
This ratio, when combined with the Net Profit % ratio, gives the ROCE as follows:

Sales X Net Profit = ROCE


Capital Employed Sales
Situations that need to be adjusted for include calculating net sales and defining
capital employed. In addition, inflation will improve this ratio over time, as sales

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normally incorporate these price adjustments. Comparability is normally limited as
a consequence to 2- 3 years.

The general interpretation is that the higher the asset turnover ratio, the harder or
more efficiently are the assets being used and as a result, the greater the profit.
(Remember the argument, small profit and large volumes).

If the ratio is low or decreasing, the implication is that there is an underutilization of


the entity’s assets. Further analysis can be done using the fixed asset turnover and
the working capital ratios

II). Liquidity & Activity /Working Capital Ratios

A) Liquidity Ratios:

a) Current Ratio = Current Assets


Current Liabilities

This ratio provides an indication of the entity’s ability to settle its current liabilities
as they fall due. Too high a ratio may indicate idle capacity in the form of excess
cash or stock which may reduce future rates of return.

b) Quick Ratio / Acid Test Ratio

= Current Assets – Closing Stock


Current Liabilities

This ratio focuses on identifying assets which can be quickly converted into cash to
meet its obligations to creditors.

Activity / Working Capital Ratios

i) Stock Turnover = _____ Sales ___


Average Stock
A high or rising ratio indicates any or all of the following:
• low investment in stock
• a healthy cash flow position
• or if too high, possibility of stock shortages.

The ratio will be affected by:


- purchasing factors such as delivery times & reorder quantities
- production cycle time
- the level of finished goods needed to be held

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Alternate to Stock Turnover

ii) Stock Turnover Period (STP) = Average Stock x 365 days


Sales (or Cost of Sales) P.A.
The information detailed in (i) above is particularly relevant. In addition, a rising
period could also indicate
• a possible slackening over stock levels; and
• the possibility of stock obsolescence

iii) Debtors Turnover Period (DTP)

DTP = Average Debtors x 365 days


Sales

A rising trend is indicative of:


• debtors taking longer to pay
• the possibility of future losses via the bad debt route; and
• possibly bad credit control

iv) Creditors Turnover Period (CTP)

CTP = Average Creditors x 365 days


Purchases
An increasing payment period is potentially indicating the entity’s inability to
pay. This has implications for further supplies and overall credit worthiness.

NB. For Working Capital purpose, the Net Trading or Operating time is

Stock turnover period = X days


+ Debtors “ “ = A days
- Creditors “ “ = (B days)
Net op. cycle C days

v) Stocks to Net Current Assets

If this ratio is too high, the cause could be any of the following:
• poor stock control; and/or
• stock obsolescence; and/or
• tight control of cash and debtors

Working Capital management is critical to the survivability of a business.


Over-capitalization is an indication that the company has too much resources for its
current level of operations.

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Overtrading, on the other hand, is where an entity carries on a level of operation in
excess of that for which it is capable of financing. Some consequences include
a). using short term borrowings to finance long term investments
b). facing liquidity problems
Other symptoms include
a. poor current & quick ratio due to excessive creditors or overdrafts or high
stock levels
b. a high overdraft level usually at its full limit
c. acquisition of new assets using HP financing
d. lower profit margins caused by discount offered to collect
e. a high stock to net current asset ratio.

III) Gearing Ratio

Usually one of the following ratios could be used.

Gearing = Fixed Interest Capital


Equity Capital + Reserved

NB. Fixed interest Capital = Preference share capital + loans

or Gearing = Fixed Interest Capital


Total Capital
Other variants include:

Gearing = Market value of debt


Market value of equity
It indicates the entity’s ability to take on further debt but ignore asset values, which
could be used to secure further financial advances.

Interest cover = Profits Before Int. & Tax.


Interest

Indicates the extent to which profits can decline before the business is unable to
meet current interest out of current profits.

Financial Gearing

= Profit Before Interest & Tax.


Profit before Int.
Profit before interest = Tax less interest charges – Preference dividends

or % change in EPS
% increase in earnings before int. & Tax

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IV). Investment Ratios

Dividend Yield = Gross dividend per share x 100


Market value per share

Its relevance is that it allows investors to make a direct comparisons with interest
from loan stock and government securities.

Earnings Per Share (EPS)

EPS = Profit available to Equity Shareholders


Equity Shares in Issue & Ranking for Dividends

Price / Earnings Ratio (P/E)

P/E = Market Price


EPS

A higher P/E indicates to investors either that:


• the entity expects its earnings to increase faster than others
• consider that the investment is less risky or is in a more secure industry

Dividend Cover (DC)

This is the number of times the actual dividend could be paid out of current profits.

DC = Maximum Earnings Payable


Actual Dividend

This indicates that:


• the proportion of earnings retained by an entity
• the level of risk, in the face of a decline in future earnings, in maintaining the
same dividend payments

Earnings Yield

EPS x 100
Market Value per Share

This measure is allied to the EPS ratio above and indicates the level of return
achieved in the stock market.