3.6 Ratio analysis
external image ratiomap.gif

Learning Outcome

Calculate ratios.
Use the ratios to interpret and analyse financial statements from the perspective of various stakeholders.

(Ratio formulae are given in the appendices and a copy of the formulae will be provided for students in examinations.)

Evaluate possible financial and other strategies to improve the values of ratios.
When analyzing financial statements, the financial analyst is able to derive results from key items that help to provide greater insight on the finances of the business. For example, looking at a trend in financial terms helps the stakeholder to make decisions that would have been otherwise more difficult to justify.
Financial statements are in themselves designed for stakeholders to analyze. However, because of the vast amount of information found in these financial sheets, the interpretation is at time difficult to pin down. This is the advantage found in the use of ratios.
Ratio analysis involves the understanding and interpretation of simple mathematical expressions. The financial statements therefore provide the information and possibility of comparing the relationships of specific items that are related to each other.
Profitability ratios
Measuring profitability is done through the Income or Profit and Loss Statement. Profitability is therefore determined through the use of profitability ratios. These types of ratios serve to illustrate the performance success of the business since they focus on sales revenue, profit and cost of sales. Being that profit maximization is the objective of the business, these ratios are of keen interest to stakeholders.

Gross Profit Margin
The Gross Profit Margin or Profit Rate is expressed as a percentage of net sales. Generally this rate of return is calculated in order to draw a comparison with businesses in similar industries as well as charting the trend from one accounting period to another. Gross Profit Margins are usually low for high volume low cost items (e.g. pencils) and high for low volume high cost items (e.g. laptop computers). The gross profit is arrived at by subtracting the direct costs or costs of production from Sales revenue.
Sales Revenue - Cost of Sales (production costs) = Gross Profit

external image clip_image002.pngx 100 = Gross Profit Margin

ABC Republic Store Inc.’s Gross Profit in June 2011 was $150,000 with Sales Revenue of $100,000
external image clip_image004.png x 100 = 150%

The higher the Gross Profit Margin the better. However, a business with a fast stock turnover is likely to have a low Gross Profit Margin if the sales price is reduced. If turnover is increased and the Costs of Sales is maintained, the Gross Profit Margin ratio can be improved. In addition by reducing cost of sales, the Gross Profit Margin ratio would also increase.

Net Profit Margin

In order to calculate Net Profit Margin indirect costs must be subtracted from Gross Profit. Therefore all costs that do not directly relate to production would be classified as overheads and therefore subtracted from Gross Profit.
Gross Profit - Indirect Costs (Overhead) = Net Profit
The Net Profit Margin is a measure of overheads and how well the business is able to control its indirect costs as they relate to Sales Revenue. In other words, if the executives in a business are spending an excessive amount on lavish offices and salaries, the difference between the Gross and Net Profit Margin will be very wide.
external image clip_image006.png x 100 = Net Profit Margin

ABC Republic Store Inc.’s Net Profit in June 2011 was $135,000 with Sales Revenue of $100,000
external image clip_image008.png x 100 = 135%

Once more, higher Net Profit Margins are better than lower ones. Similar to the Gross Profit Margin, if turnover is increased and the level of assets (Cost of Sales) are maintained, the Net Profit Margin ratio can also be improved. By reducing Cost of Sales, the Net Profit Margin ratio would also increase.
Liquidity ratios
We examined the role of Working Capital earlier in the chapter. Your understanding of liquidity and working capital is therefore almost complete. In order to meet day-to-day operating costs, a business must have enough cash or assets that can be quickly converted into cash in order to meet the operating expenses. These expenses would include rent, salaries and electricity costs and as you can imagine, being unable to pay for these would mean shutting down the business.
The liquidity ratios therefore determine the solvency of the business in its day-today operations.
Current ratio
Measuring liquidity is done through the balance sheet. The current ratio is calculated by first determining what the current assets and current liabilities are in the balance sheet. This ratio is the Working Capital that we examined earlier in the form of a ratio. Therefore, we determine the value of all assets that can be converted into liquid cash within the current year of operations relative to the dues and obligations the business has that must also be met within the one year period of operation.
external image clip_image010.png= Current Ratio

What this ratio tells us is the value of Current Assets the business has at its disposal for every $1 of debt. A ratio of 2:1 will suggest to us that for every $1 of Current Liabilities the business is able to meet it with $2 of Current Assets. Therefore the business has a very healthy liquidity and will most certainly remain in operation in the year accounted.
However, a ratio of 0.5:1 would suggest that for every $1 of Current Liabilities or debt that needs to be met in the year of operation, the business has only 0.50Cents to meet the expenses. Because of the potential of not being able to meet its obligations, this ratio may raise concerns when examined by stakeholders such as suppliers and creditors.
ABC Republic Stores, Inc.’s June 31st 2011 balance sheet has Current Assets of $50,000 and Current Liabilities of $20,000
external image clip_image012.png = 2.5 Current Ratio

This therefore means that for every $1 of Current Liabilities or debt within the current year of operation, ABC Republic Stores has $2.5 to meet the obligation. Therefore the business has sufficient liquid resources. A business may improve its ratio of Current Assets to Current Liabilities by improving stock or credit control.
Although a ratio at 1:1 or higher is assumed to mean that the business is able to meet its operating expenses, a ratio of 5:1 would suggest that the business has too much sitting Current Assets and the opportunity cost of what could have been done with the resources would need to be considered. Some bankers and creditors believe that a business should have a Current ratio of 2:1 to qualify as a good credit risk.
In order to improve the Current Ratio stock control is an option, as is reducing current liabilities through short term credit reductions.

Acid test ratio

Although the Current Ratio is able to indicate the ability of the business to meet its day-to-day expenses, the inclusion of Stock (inventory) raises some uncertainty. Market forces are determined by supply and demand meaning that inventory turnover could slow down during slow periods. This in turn implies that a business may not be able to sell enough stock in order to raise the liquidity needed within the year of operation. Therefore by eliminating the inclusion of stock in the calculation of current assets, a more precise measure of liquidity is possible. The Acid Test Ratio or Quick ratio serves this purpose of comparing only the most liquid of Current Assets.
external image clip_image014.png= Acid Test Ratio

ABC Republic Stores, Inc.’s June 31st 2011 balance sheet has Current Assets of $50,000, stock of 25,000 and Current Liabilities of $20,000
external image clip_image016.png =
external image clip_image018.png = 1.25 Acid Test Ratio

This ratio now means that in terms of cash or assets that can be turned into cash very quickly for every $1 of debt the business has $1.25 of very liquid assets.
In reality, it is important to take note the some businesses with a liquidity ratio below 1:1 may operate quite effectively. In order to improve tye ratio stock control is not longer an option as it is omitted, however reducing current liabilities through short term credit reductions is an option.

Efficiency ratios

The measure of the ability of management to successfully use the assets at their disposal through is the purpose of these ratios.
Stock turnover

As the name implies stock turnover is a measure of how quickly a business sells or uses its inventory.
external image clip_image020.png = Stock Turnover

This formula will indicate to the analysis how many time per year a business sells of uses its inventory.
ABC Republic Stores, Inc.’s June 31st 2011 balance sheet has stock of 25,000 and its Profit and Loss statement for the same period has Cost of Sales of $50,000
external image clip_image022.png = 2.0 Times

A different method used in determining stock turnover is through the number of days that a business needs to sell its stock.
external image clip_image024.png x 365 = Stock Turnover
external image clip_image026.png x 365 = 182.5 days

The higher the Stock Turnover the better, therefore the shorter the days in the ratio, the better. When the number of days needed increases this would imply that inventory is building up and cuts would need to be made on re-purchasing stock, which would in turn would improve this ratio.
Return on capital employed (ROCE)
This ratio is Return on Capital Employed or ROCE which indicates how efficiently the management is able to use the company's capital investments. By utilizing Capital investments to generate revenue the higher the ROCE the better.
In order to calculate the Return on Capital Employed the profit that has been earned before interest and tax (EBIT is Earnings Before Interest and Tax) is divided by the Long Term Capital Employed (the total of all Assets minus all Liabilities or alternatively Shareholders Funds plus Long Term Liabilities; Shareholders equity is the retained profit plus share capital plus long term loans).
external image clip_image028.png x 100 = ROCE

ABC Republic Inc’s Net Profit in June 2011 was $135,000 with Capital Employed being $230,000
external image clip_image030.png x 100 = 58.69% ROCE

Since ROCE measures the profit earned as a percentage of long-term capital employed it raises the question of whether the profit is sufficient considering the amount of capital invested. Nevertheless, ROCE should always be more than the rate the company borrows, if this is not the case any increase in borrowing will reduce shareholders' earnings. Therefore to improve ROCE a business could reduce costs and the amount of capital employed.
HL Extension
For the Higher Level students an additional understanding has to be demonstrated in the calculation and interpretation of ratios. The ratios here are means of determining efficiency in the business’s credit control system and in shareholder value.

Debtor days

This ratio measures the average number of days that it takes the business to collect of debt that it has outstanding.
external image clip_image032.pngx 365 = Debtor Days

ABC Republic Stores, Inc.’s June 31st 2011 balance sheet has Debtors (Accounts Receivable) of $10,000 and Sales Revenue (Turnover) of $100,000
external image clip_image034.png x 365 = 36.5 days

The shorter the debt collection period the more working capital the business has available. Business credit usually extends for periods ranging from 30 – 120 days. This of course depends on the type of business and other factors that are subjective. Nevertheless, because a business requires liquidity, one way to ensure that the business is not cash-strapped is to reduce the number of creditors outstanding or the period in which the accounts receivable are outstanding. Improving the sales revenue relative to accounts receivable will also improve the debt collection period while reducing the number of creditors through credit control will also do the same.

Creditor days

The credit payment period is the opposing side of debt collection.
external image clip_image036.png x 365 = Creditor days ratio

Most businesses will at one point or another need to ensure adequate working capital by seeking an extension of credit. This is a regular feature of business activity. Although the business enterprise seeks out credit facilities, if there is an extended amount of time taken to repay creditors, this can raise questions on the ability to repay. Consequently, this ratio measures the length of time it takes a company to pay its creditors, and the longer the better. If creditors are paid back by the business more quickly than they are able to complete their collection of debt, a higher working capital will be required.
ABC Republic Stores, Inc.’s June 31st 2011 balance sheet has Creditors (Accounts payable) of $20,000 and Total Credit Purchases of $50,000 (we assume Cost of Sales).
external image clip_image038.png x 365 = 146 days
Again, not paying back creditors within 100 days may raise questions on why the business is unable to meet its debts, in addition to jeopardizing access to future credit facilities. This ratio can be improved by reducing the amount of debt outstanding.

Shareholder ratios

Shareholder or Investment ratios are concerned with the Return on Investment (ROI) for shareholders. They are also concerned with the return and value of investment in a business that is publicly traded.

Earnings per share

The earnings per share only apply to common stock or ordinary shares as opposed to preferred shares. EPS shows how much each ordinary share is worth after taxes.
external image clip_image040.png = Earnings per share

Only when the EPS is compared with an industry standard or a similar business can there be a determination as to the value of the EPS. In order to improve the ratio a business could decrease the number of shares that are outstanding. Increasing the shares outstanding would dilute current shareholders; as well as lower the EPS. In addition, the business could buy-back outstanding stock.

Dividend yield

The dividend yield measures the dividend issued for an ordinary share as a percentage of the current market share price. The current market share price usually increases over time but because there are fluctuations in the market share price an increase in the dividend yield may be because the dividend per share increased while at the same time, the price of a the share market price falls.
In other words, the dividend yield is calculated to determine how much dividends a stock is paying out for the price of the stock.
external image clip_image042.png x 100 = Dividend Yield

Share prices usually increase when dividends increase. However there could be number of factors that influence the dividend yield, such as the state of the economy or internal mismanagement. This would in turn negatively influence the stock price.
The business must strive to balance the amount of dividend paid to shareholders and the retained profit. If a business pays out a high dividend yield it may be considered as risky because it means that the business will not have enough liquidity to meet operational costs.

Gearing ratio

Gearing ratios indicate the extent to which the business’ economic activity is being supported by the creditor through the provision of loans as opposed to the shareholders funds. This will indicate the financial stability of the business whereby the greater the proportion of shareholder funds the greater the financial strength.
external image clip_image044.png x 100 = Gearing Ratio

A business with a high gearing ratio that is over 50% is said to be financed from external loans and creditors and is therefore highly geared. This is not a positive attribute, meaning that the financial strength and risk of the business is in question. Because this ratio invariably tells us that the greater the proportion of equity funds, the greater the degree of financial strength, it is in the interest of the business to decrease its leverage by doing away with the high level of debt.
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