Session 2: Ratio Analysis Technique http://cbdd.wsu.edu/kewlcontent/cdoutput/TR505r/page38.

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Financial Analysis revised

Page 38 of 54 pages. Chapter: 8: Module 1.4: Financial Statement Analysis

Session 2: Ratio Analysis Techniques

Session Learning Outcome
Learners will understand and be appreciative on the use of the time series analysis technique while
analysing the financial statements information, its application and interpretation

Important Learning Terms

Ratio
Types of Ratios
Liquidity Ratios
Asset management/Activity ratios
Financial Leverage/Gearing ratios
Profitability ratios
Market valuation ratios
Ratio limitations

A ratio: Is the mathematical relationship between two quantities in the form of a fraction or
percentage.

Ratio analysis: is essentially concerned with the calculation of relationships which after proper
identification and interpretation may provide information about the operations and state of affairs of a
business enterprise.

The analysis is used to provide indicators of past performance in terms of critical success factors of a
business. This assistance in decision-making reduces reliance on guesswork and intuition and
establishes a basis for sound judgement.

Note: A ratio on its own has little or no meaning at all.

Consider a current ratio of 2:1. This means that for every 1 monetary value of current liabilities there
are 2 of assets. However each business is different and each has different working capital
requirements. From this ratio, we cannot make any comments about the liquidity of the business,
whether it carries too much or too little working capital.

Significance of Using Ratios

The significance of a ratio can only truly be appreciated when:

1. It is compared with other ratios in the same set of financial statements.

2. It is compared with the same ratio in previous financial statements (trend analysis).
3. It is compared with a standard of performance (industry average). Such a standard may be
either the ratio which represents the typical performance of the trade or industry, or the ratio
which represents the target set by management as desirable for the business.

Types of Ratios
Note that throughout this section, ratios are derived from Exhibit one in Session 1 of
this chapter

A: Liquidity Ratios

Liquidity refers to the ability of a firm to meet its short-term financial obligations when and as
they fall due.
The main concern of liquidity ratio is to measure the ability of the firms to meet their short-term
maturing obligations. Failure to do this will result in the total failure of the business, as it would

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be forced into liquidation.

Current Ratio
The Current Ratio expresses the relationship between the firm’s current assets and its current
liabilities.
Current assets normally includes cash, marketable securities, accounts receivable and inventories.
Current liabilities consist of accounts payable, short term notes payable, short-term loans, current
maturities of long term debt, accrued income taxes and other accrued expenses (wages).

The rule of thumb says that the current ratio should be at least 2, that is the current assets should
meet current liabilities at least twice.
What does the calculated ratio tells us? In 2000, the company only had 85 cents worth of current
assets for every dollar of liabilities. This grew to 92 cents in 2002 indicating increasing trend on
liquidity, however the company is still unable to support its short-term debt from its currents assets.

Quick Ratio
Measures assets that are quickly converted into cash and they are compared with current liabilities.
This ratio realizes that some of current assets are not easily convertible to cash e.g. inventories.
The quick ratio, also referred to as acid test ratio, examines the ability of the business to cover its
short-term obligations from its “quick” assets only (i.e. it ignores stock). The quick ratio is calculated
as follows

insert

Clearly this ratio will be lower than the current ratio, but the difference between the two (the gap)
will indicate the extent to which current assets consist of stock.

B: Asset Management/Activity Ratios

If a business does not use its assets effectively, investors in the business would rather take their
money and place it somewhere else. In order for the assets to be used effectively, the business needs
a high turnover.

Unless the business continues to generate high turnover, assets will be idle as it is impossible to buy
and sell fixed assets continuously as turnover changes. Activity ratios are therefore used to assess
how active various assets are in the business.

Note: Increased turnover can be just as dangerous as reduced turnover if the business does not have
the working capital to support the turnover increase. As turnover increases more working capital and
cash is required and if not, overtrading occurs.

Asset Management ratios are discussed next.

Average Collection Period

The average collection period measures the quality of debtors since it indicates the speed of their
collection.

The shorter the average collection period, the better the quality of debtors, as a short collection
period implies the prompt payment by debtors.
The average collection period should be compared against the firm’s credit terms and policy to
judge its credit and collection efficiency.
An excessively long collection period implies a very liberal and inefficient credit and collection
performance.
The delay in collection of cash impairs the firm’s liquidity. On the other hand, too low a

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collection period is not necessarily favourable, rather it may indicate a very restrictive credit
and collection policy which may curtail sales and hence adversely affect profit.

Inventory Turnover
This ratio measures the stock in relation to turnover in order to determine how often the stock turns
over in the business.
It indicates the efficiency of the firm in selling its product. It is calculated by dividing he cost of goods
sold by the average inventory.

The ratio shows a relatively high stock turnover which would seem to suggest that the business deals
in fast moving consumer goods.

The company turned over stock every 24 days in 2000 and every 28 days in 2002.
The trend shows a marginal increase in days which indicates a slow down of stock turnover.
The high stock turnover ratio would also tend to indicate that there was little chance of the firm
holding damaged or obsolete stock.

Total Assets Turnover

Asset turnover is the relationship between sales and assets

The firm should manage its assets efficiently to maximise sales.

The total asset turnover indicates the efficiency with which the firm uses all its assets to
generate sales.
It is calculated by dividing the firm’s sales by its total assets.

Generally, the higher the firm’s total asset turnover, the more efficiently its assets have been
utilised.

Fixed Asset Turnover

The fixed assets turnover ratio measures the efficiency with which the firm has been using its fixed
assets to generate sales.
It is calculated by dividing the firm’s sales by its net fixed assets as follows:

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Generally, high fixed assets turnovers are preferred since they indicate a better efficiency in
fixed assets utilisation.

From the above calculations:

It appears that the activity of the business is relatively constant, with a slight upward trend.
The ratio also confirms that the business places a much greater reliance on working capital than
it does on the fixed assets as the fixed assets (2001 and 2002) turned over more quicker than
stock turnover.

C: Financial Leverage (Gearing) Ratios

The ratios indicate the degree to which the activities of a firm are supported by creditors’ funds
as opposed to owners.
The relationship of owner’s equity to borrowed funds is an important indicator of financial
strength.
The debt requires fixed interest payments and repayment of the loan and legal action can be
taken if any amounts due are not paid at the appointed time. A relatively high proportion of
funds contributed by the owners indicates a cushion (surplus) which shields creditors against
possible losses from default in payment.
Note: The greater the proportion of equity funds, the greater the degree of financial strength.
Financial leverage will be to the advantage of the ordinary shareholders as long as the rate of
earnings on capital employed is greater than the rate payable on borrowed funds.
The following ratios can be used to identify the financial strength and risk of the business.

Equity Ratio
The equity ratio is calculated as follows:

This indicates that only 32.1% of the total assets in 2002 is supplied by the ordinary stockholders and
this has shown a slight decrease from 32.8% in 2000.

A high equity ratio reflects a strong financial structure of the company. A relatively low equity
ratio reflects a more speculative situation because of the effect of high leverage and the greater
possibility of financial difficulty arising from excessive debt burden.

Debt Ratio
This is the measure of financial strength that reflects the proportion of capital which has been funded
by debt, including preference shares.

This ratio is calculated as follows:

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With higher debt ratio (low equity ratio), a very small cushion has developed thus not giving creditors
the security they require. The company would therefore find it relatively difficult to raise additional
financial support from external sources if it wished to take that route. The higher the debt ratio the
more difficult it becomes for the firm to raise debt.

Debt to Equity ratio

This ratio indicates the extent to which debt is covered by shareholders’ funds. It reflects the relative
position of the equity holders and the lenders and indicates the company’s policy on the mix of capital
funds. The debt to equity ratio is calculated as follows:

The debt to equity ratio shows that for every 1 dollar of shareholders funds in 2002 there was
2.12 dollars of debt. This compares to 2.05 dollars in 2000. This ratio is extremely high and
indicates the financial weakness of the business.

Times Interest Earned Ratio

This ratio measure the extent to which earnings can decline without causing financial losses to the
firm and creating an inability to meet the interest cost.

The times interest earned shows how many times the business can pay its interest bills from
profit earned.
Present and prospective loan creditors such as bondholders, are vitally interested to know how
adequate the interest payments on their loans are covered by the earnings available for such
payments.
Owners, managers and directors are also interested in the ability of the business to service the
fixed interest charges on outstanding debt.

The ratio is calculated as follows:

The company’s major forms of credit are non-interest bearing (trade creditors) which results in
the business enjoying very healthy interest coverage rates. In 2002 the company could pay
their interest bill 16.5 times from earnings before interest and tax. However this is a massive
drop from 51.5 times in 2001 and 37.7 times in 2000.

D: Profitability Ratios
Profitability is the ability of a business to earn profit over a period of time. Although the profit figure is
the starting point for any calculation of cash flow, as already pointed out, profitable companies can
still fail for a lack of cash.

Note: Without profit, there is no cash and therefore profitability must be seen as a critical success
factors.

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A company should earn profits to survive and grow over a long period of time.
Profits are essential, but it would be wrong to assume that every action initiated by
management of a company should be aimed at maximising profits, irrespective of social
consequences.

The ratios examined previously have tendered to measure management efficiency and risk.

Profitability is a result of a larger number of policies and decisions. The profitability ratios show the
combined effects of liquidity, asset management (activity) and debt management (gearing) on
operating results. The overall measure of success of a business is the profitability which results from
the effective use of its resources.

Gross Profit Margin

Normally the gross profit has to rise proportionately with sales.

It can also be useful to compare the gross profit margin across similar businesses although there
will often be good reasons for any disparity.

The ratio above shows the increasing trend in the gross profit since the ratio has improved from
15.2% in 2000 to 20.3% on 2002. This indicates that the rate in increase in cost of goods sold
are less than rate of increase in sales, hence the increased efficiency.

Net Profit Margin

This is a widely used measure of performance and is comparable across companies in similar
industries. The fact that a business works on a very low margin need not cause alarm because there
are some sectors in the industry that work on a basis of high turnover and low margins, for examples
supermarkets and motorcar dealers.
What is more important in any trend is the margin and whether it compares well with similar
businesses.

The net margin ratio shows that the margin is fairly stable over time with slight improvement to
1.73% in 2001. However, to know how well the firm is performing one has to compare this ratio with
the industry average or a firm dealing in a similar business.

Return on Investment (ROI)

Income is earned by using the assets of a business productively. The more efficient the production,
the more profitable the business. The rate of return on total assets indicates the degree of efficiency
with which management has used the assets of the enterprise during an accounting period. This is an
important ratio for all readers of financial statements.

Investors have placed funds with the managers of the business. The managers used the funds to
purchase assets which will be used to generate returns. If the return is not better than the investors
can achieve elsewhere, they will instruct the managers to sell the assets and they will invest
elsewhere. The managers lose their jobs and the business liquidates.

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The ratio indicates that there is increase in the ROI from 8.38% in 2000 to 8.95% in 2002.

Return on Equity (ROE)

This ratio shows the profit attributable to the amount invested by the owners of the business. It also
shows potential investors into the business what they might hope to receive as a return. The
stockholders’ equity includes share capital, share premium, distributable and non-distributable
reserves. The ratio is calculated as follows:

Again, the profitability to ordinary shareholders is strong and showing an upward trend. Note that the
return in 2002 as in all the years is after tax and the shareholders should be extremely comfortable
with these returns.

Earning Per Share (EPS)

Whatever income remains in the business after all prior claims, other than owners claims (i.e.
ordinary dividends) have been paid, will belong to the ordinary shareholders who can then make a
decision as to how much of this income they wish to remove from the business in the form of a
dividend, and how much they wish to retain in the business. The shareholders are particularly
interested in knowing how much has been earned during the financial year on each of the shares held
by them. For this reason, an earning per share figure must be calculated. Clearly then, the earning
per share calculation will be:

Exercises

1. Reconsider the ratios which have been calculated for analysis on profitability. In your
own words, analyse the trends in these ratios and discuss the linkage between ROI and
ROE.
2. How will the gross margin ratio assist you in determining the profitability of a business?
3. In your own words, explain the calculation used for ROI.
4. When calculating EPS, explain how we should deal with preference shares dividends.

E: Market Value Ratios

These ratios indicate the relationship of the firm’s share price to dividends and earnings. Note that
when we refer to the share price, we are talking about the Market value and not the Nominal value as
indicated by the par value.

For this reason, it is difficult to perform these ratios on unlisted companies as the market price for
their shares is not freely available. One would first have to value the shares of the business before
calculating the ratios. Market value ratios are strong indicators of what investors think of the firm’s
past performance and future prospects.

Dividend Yield Ratio

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The dividend yield ratio indicates the return that investors are obtaining on their investment in the
form of dividends. This yield is usually fairly low as the investors are also receiving capital growth on
their investment in the form of an increased share price. It is interesting to note that there is strong
correlation between dividend yields and market prices. Invariably, the higher the dividend, the higher
the market value of the share. The dividend yield ratio compares the dividend per share against the
price of the share and is calculated as:

Notice a healthy increase in the yield from 2000 to 2002. The main reason for this is that the dividend
per share increased while at the same time, the price of a share dropped.

This is fairly unusual because share prices usually increase when dividends increase. However there
could be number of reasons why this has happened, either due to the economy or to mismanagement,
leading to a loss of faith in the stock market or in this particular stock.

Normally a very high dividend yield signals potential financial difficulties and possible dividend payout
cut. The dividend per share is merely the total dividend divided by the number of shares issued. The
price per share is the market price of the share at the end of the financial year.

Price/Earning Ratio (P/E ratio)

P/E ratio is a useful indicator of what premium or discount investors are prepared to pay or
receive for the investment.
The higher the price in relation to earnings, the higher the P/E ratio which indicates the higher
the premium an investor is prepared to pay for the share. This occurs because the investor is
extremely confident of the potential growth and earnings of the share.

The price-earning ratio is calculated as follows:

1. High P/E generally reflects lower risk and/or higher growth prospects for earnings.
2. The above ratio shows that the shares were traded at a much higher premium in 2000 than
were in 2002. In 2000 the price was 26.8 times higher than earnings while in 2002, the price
was only 12 times higher.

Dividend Cover

This ratio measures the extent of earnings that are being paid out in the form of dividends, i.e.
how many times the dividends paid are covered by earnings (similar to times interest earned
ratio discussed above).
A higher cover would indicate that a larger percentage of earnings are being retained and
re-invested in the business while a lower dividend cover would indicate the converse.

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Dividend pay-out ratio

This ratio looks at the dividend payment in relation to net income and can be calculated as follows:

Note: Even though the dividend yield has increased, the dividend payout ratio has reduced, showing
that a lower proportion of earnings was paid out as dividend. The ratio has only reduced slightly,
however, from 50.7% in 2000 to 49.4% in 2002. Generally, the low growth companies have higher
dividends payouts and high growth companies have lower dividend payouts.

Exercise:
1. In your own words, comment on the market value ratios in our example. In your answer,
assume the following industry average for 2002
Dividend yield: 3.2%
P/E Ratio: 12.8 times.
2. What is the purpose of calculating the market value ratio?
3. What actions can directors take to ensure a stable dividend yield growth over time?
4. The P/E ratio indicates the premium an investor is prepared to pay for a share. Discuss?
5. Explain what activities can cause the dividend payout ratio to change.

Relationship Among Ratios

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