Ratio analysis
should not be taken in isolation of other aspects of a business. What type of
business is it? A company's debtor day indicator (how long on average it takes
debtors to settle bills) may be 29 days. This seems fine but not for fast-food
business. Ratios must be seen against
As a principle,
accounting policies should be applied consistently. Changes must be highlighted
and the impact of changes from an original policy disclosed. This applies when
calculating and interpreting ratios. Trends in a company's performance cannot
be determined if published accounting data is dressed up so as to produce more
favourable outcomes. Yet benchmark comparisons against other companies in a
sector may be difficult given the flexible scope offered by Statements of
Standard Accounting Practice (SSAPs) and Financial Reporting Standards (FRSs).
As an example
of such flexibility, under SSAP 13, Research and Development, companies may
within certain limits decide to capitalise development expenditure, as an
alternative to charging this expense to the P&L account. One firm may do
this and by-pass the P&L account in certain years whereas another may not.
This will affect performance ratios and make it difficult to conclude on how
the company compares against its competitors.
These offer measurements for the evaluation of
A.
business performance
B.
liquidity (short term and long term)
C.
efficiency.
Used to measure overall business efficiency in employing its resources
How
to calculate
Profit before interest and tax
------------------------------ x 100
Share capital + reserves + debentures
Using/interpreting
this ratio
o This targets the return on capital. The figure will be set by investor expectations. Consistent failure to hit the target would indicate that it would be better selling the company and redeploying its resources elsewhere.
o Comparisons with real interest rates in the market should account for inflation if resources could be redeployed in different economies.
o If assets have been re-evaluated this may increase capital employed and so reduce the return ratio.
o This ratio needs to be considered in relation to the goodwill and development expenditure of accounting policies.
.... indicates the margin the company earns on its sales
How
to calculate
Gross profit
----------- x 100 Sales
Using/interpreting
this ratio
Note
the effect of changes in
o sales prices without associated changes in costs
o sales mix. If last year a company sold £3m of cream deserts at a 12% margin, and £170,000 of catering consultancy services at a 28% margin, pulling out of cream desert sales will reduce turnover, but improve gross profit %.
o the calculation of closing stock. Gross profit % may show up stock valuation irregularities. Gross profit = sales - cost of sales (opening stock + purchases - closing stock).
- identifies the affect of fixed and variable overheads on sales.
How
to calculate
Net profit before interest and tax ----------------------------------- x 100 £ sales
Using/interpreting
this ratio
It
requires attention to
o changes in the value of sales.
o changes in the structure of overhead costs. A company that has incurred a move to newer, more costly premises will feel an adverse affect on net profit %
The following are generally expressed in N to 1 terms.
Current
ratio
This
measures a company's capacity to cover its current liabilities as they fall
due.
How
to calculate
Current assets ------------- Current liabilities
A manufacturer normally needs a current ratio of around 2:1. More than this suggests poor resource usage and potential liquidity problems.
Quick
ratio or "acid test"
This
test/ratio excludes slower-moving item (stock) from current assets and
pinpoints real short-term liquidity.
How
to calculate
Debtors + cash ------------------ Current liabilities
Using/interpreting
this ratio
For
both current ratio and quick ratio we must be aware that
o Low ratios may indicate liquidity problems yet some businesses/industries (supermarkets once again) operate on tight liquidity ratios.
o high ratios look good but may pinpoint poor management of funds. Cash mountains may not offer the returns that shareholders are looking for.
o If we examine the make-up of the ratio we may find high stock levels. This may give a healthy current ratio but stock obsolescence may be evident affecting real stock valuations.
Gearing ratio
There
are several variations but the general gearing ratio measures the relationship
between a firm's borrowings and its shareholders' funds.
How
to calculate
Fixed return capital (debentures, preference shares, loan stock
-------------------------------------------------- Equity capital + reserves
Using/interpreting
this ratio
Note:
o company cash flow stability. Strongly branded business can rely on stable cash flows. Such a company can borrow heavily against its brands/labels in order to fund acquisitions/expansion etc.
o policies to revaluate fixed assets may improve shareholders' funds and reduce gearing are popular as they avoid breaches of covenants when raising additional debt.
This measures a company's effectiveness in converting stock into sales. So long as a sale involves a profit then the faster the company turns its stock over, the more it makes.
How
to calculate
cost of sales closing stock ----------- or ------------ x 365
closing stock cost of sales
Closing
stock is better than average stock for comparisons unless we have data from
several years
Using/interpreting
this ratio
o low turnover may point to obsolete stock though some businesses/industries may need high stocks or carry high-value, slow-moving items. Higher gross profit %s in these cases may compensate for lower stock turn.
o high stock turn may indicate efficient management but stock-outs may occur affecting the quality of customer service.
This indicates the period of credit taken by the company's customers.
How
to calculate
Closing debtors
-------------- x 365Credit sales
Using/interpreting
this ratio
o an increase over the previous year may be due to bad debt problems but it may also indicate a change in a company's change settlement terms policy.
o the customer base may have changed, important new customers demanding longer settlement terms
o we should evaluate whether or not year_end debtors are representative of the year as a whole? If we stock up ahead of a sales drive just before year_end, a distorted pattern may result.
This measures the credit period a company takes from its suppliers
How to calculate
Trade creditors
--------------- x 365Credit purchases
Using/interpreting
this ratio
o high figures suggest liquidity problems (financing the business on the backs of its suppliers. Examine the company's overdraft position. Has it has run out of bank facilities?
o Is a potential receivership on the cards? Are creditors losing patience?
o Does the ratio reflect the year as a whole?
You need to be able to
In many cases the
constituent parts of a ratio must be examined to cast light on