RATIO ANALYSIS

Ratio analysis is the most widely used technique for interpreting company
reports. It involves comparing one figure with another and judging whether the
resulting ratio indicates a strength or a weakness in the company.

Profitability and Return (Performance)

1. Gross Profit Margin

Gross profit x 100

Turnover
This is a key measure of profitability. Margins vary widely between products and
between industries. However, within the same industry sector, there should be
similarity, and thus comparison can be made with competitors. A high profit
margin indicates that either costs are being controlled or that selling prices are
high. Changes in the ratio occur because of changes in selling price or cost of
sales or because of changes in the company’s product range. The size of gross
profit depends on the gross profit margin and also on the volume of sales.

2. Net Profit Margin (Operating Profit Margin)

Profit before interest and tax x 100

Turnover
This ratio is an indicator of efficiency after all revenues and expenses have been
considered. Comparison of the gross profit margin and the net profit margin will
allow judgement on the control over expenses. Analysis can also be made of the
trend in individual expenses through the ratio:
Individual expenses x 100
Turnover

3. Return on Capital Employed

Profit before interest and taxation x 100

Total assets minus current liabilities

The profit figure is before interest and tax in order to :

- allow more meaningful comparisons between firms with different amounts of
debt (gearing)

- avoid the distortions which can result from unusual variations in tax from year
to year which are not caused by changes in performance.

Owing to the crucial importance of this ratio, it is often referred to as the

primary ratio. It can be analysed into its two components:

Turnover and Net Profit x

100
Capital Employed Turnover

which indicates that performance in this area is dependent on:

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- the turnover generated by the capital employed in the company
- the profitability on turnover.
The above 2 ratios can be further subdivided. Analysis of performance will be
made by comparing one year with another, and also the ROCE of other
companies, if available. Comparison may also be made with the current rate of
borrowing in the market to identify:

- whether the company’s ROCE means it is getting value for money from its
current borrowing

- how the cost of additional borrowing compares with potential future profits as
indicated by the ROCE.

Long Term Solvency and Stability (Risk)

These ratios consider how much the company owes in relation to its size and
whether its debt position and the burden of debt is worsening or improving.

4. & 5. Gearing Ratios

This ratio reflects the structure of the company’s long term capital - its
distribution between the shareholders’ funds and long term debt capital.
The gearing ratio can be calculated in two ways:

Long term loan capital + preference share capital

Ordinary share capital plus reserves

Long term loan capital + preference share capital

Long term loan capital + preference share capital + ordinary share capital plus
reserves

What constitutes “high” gearing will differ between companies (companies with
stable earnings can support higher levels of borrowing) but a ratio in excess of
50% would be considered high. The trend in this ratio is also scrutinised by
potential lenders.
The level of gearing provides an indication of the level of risk in terms of:

a) the company’s ability to stay in business - a high geared company is required

to pay large amounts of interest (assuming debt is not in the form of preference
shares). If profits fall, the company may be unable to do so and could be forced
by its creditors to liquidate its assets.
b) the level of dividends - as gearing increases, the higher the potential volatility
of returns to the ordinary shareholders. A percentage change in profits for a
highly geared company will result in a larger percentage increase/decrease in
the return to ordinary shareholders.

6. Interest Cover

Profit before interest and tax

Interest charges

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This ratio shows the ease with which a company can pay its interest charges. If
interest charges were high in relation to profits, a fall in profits would then
significantly affect the return available to ordinary shareholders. All interest
payments are included, even those relating to short term debt.

Short Term Solvency (Liquidity)

Liquid assets consist of :
Cash Trade receivables
Short term investments for which there is a Fixed term deposits with a
bank/building
ready market. society.

Liquid assets can be derived other than from sales (e.g. via share issues, sale of
fixed assets, borrowing); these options are not always available, and in general,
long term solvency depends on the ability to make profits.

7. Current Ratio

Current assets
Current liabilities

This shows the extent to which the company can meet its current obligations
(current liabilities) through its current assets which are constantly being
converted into cash.
Analysts will tend to look for the current ratio to fall within acceptable limits for
the company’s particular sector. For example, a company in retailing would
usually operate with a much lower ratio than a company engaged in
manufacturing.

8. Liquidity Ratio (quick ratio or acid test ratio)

Current assets minus inventories

Current liabilities

This ratio looks more closely at the liquidity of the items that make up the
current assets. It identifies that companies are sometimes unable to convert all
their assets into cash quickly - this may apply, for example, to stocks of raw
materials and work in progress where the conversion into saleable goods and
the receipt of cash from sales may take a long time. The ratio gives a guideline
on whether the company could meet its current liabilities from its liquid assets
(trade receivables, cash, short term investments) - if the ratio is less than 1 it
would be unable to do so.
However, it is not always the case that stocks are unavailable to provide short
term funds - this may be the case for a manufacturing company but not for a
food retailer. The ratio ignores the importance of cash being generated from
current operations. Also, the emphasis on the importance of cash and trade
receivables may encourage inefficiencies. As with the current ratio target levels
(textbooks often quote a ratio of 1:1) may be unhelpful.

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Efficiency
9. Stock Turnover Period
This indicates the average number of days that items of stock are held for.
Although it can only provide an approximation, it is useful to identify the trend
from year to year.

Average inventory x 365 or Cost of sales

Cost of sales Average inventory

The ratio is only a crude measure for comparing different companies:

- different marketing situations face different industries (luxury goods compared
with food retailing)
- methods of stock valuation may differ between companies
- stock holding may be distorted by seasonal variations.

However, it is useful for assessing performance of an individual company over

time. A fall in the ratio may indicate greater competition, a more difficult
marketing situation or the possibility of obsolescence in the company’s product
range. Companies operating in similar markets can be expected to have
comparable stock turnover ratios and thus, despite its limitations, it may be a
useful means for investors to differentiate companies.

10. Debt Collection Period

Average trade receivables x 365

Credit Sales
This ratio indicates the number of days on average that debts are outstanding.
This has an important effect on the liquidity of the company - cash flowing from
debtors is vital to the company’s ability to pay its way.
The estimate of debtor days is only approximate. For example the debtors
figure may be abnormally high at balance sheet date compared to the normal
level at other times of the year. A lengthy collection period compared with the
normal credit period allowed may indicate inefficient management, but could
also be the result of an attempt to win customers, or the fact that the company
sells overseas.

11. Creditors’ Turnover

Average trade payables x 365

Credit Purchases

This ratio can be used to indicate liquidity - an increase in the period that
amounts are owing to creditors could signify a lack of long term finance or poor
management of current assets. This in turn results in the use of extended credit
from suppliers, increased bank overdraft and so on.

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Stock Market Ratios
These ratios are used by shareholders (current and potential) to assess the
performance of companies in terms of share prices and yields. They will indicate
the value and quality of an investment in the ordinary shares of a company.

12. Dividend Cover

Profit after interest, tax and preference dividends

Dividends paid and proposed

This ratio indicates the number of times the actual dividend could be paid out of
the current year’s profits. It indicates:
 the ability of the company to pay current dividend levels in the future. A
low ratio would indicate the risk in future years, if earnings fall, of the
company being unable to maintain the same dividend payments.
 the company’s policy on profit retention to finance future growth - e.g. a
dividend cover of 3 times indicates the company has paid 25% of its
distributable profits as dividends and has retained 75% to finance future
operations.

Changes in dividend cover over time may be indicative of changes in profit

performance or of the company’s dividend policy.

13. Dividend Yield

This measures the return a shareholder is currently receiving on a company’s
shares (though return is also received in the form of capital growth – the
increase in the company’s share price.

Dividends per share x 100

Current market price of the share

14. Dividend Payout Ratio

Total dividend paid to ordinary shareholders x 100

Earnings after tax and preference dividends

The payout ratio is often used in the analysis of dividend policy. For example,
some companies may decide to pay out a fixed percentage of earnings every
year and finance any investment needs that cannot be covered by retained
earnings from external sources.

15. Earnings Per Share (EPS)

Earnings is the profit attributable to equity shareholders (after interest and tax)
after deducting preference dividends. This is then divided by the number of
ordinary shares in issue. EPS is important for comparing company performance
over several years. A company must continue to generate earnings in order to
pay dividends and re-invest in the business to achieve further growth. In using
EPS to judge performance:

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  investors will compare performance over time – is EPS growing and at
what rate?
 Investors must consider if EPS could be diluted (reduced) in future as
more ordinary shares are issued (e.g. if share options are exercised or
loan stock is converted into shares)
 If used to compare performance over time or between one company and
another, the method of calculation must be consistent
 When comparing different companies, it is preferable to use other ratios
which incorporate EPS, for example the price earnings ratio

Profit after interest, tax and preference dividends

Number of shares in issue

16. Price Earnings Ratio (P/E ratio)

This is the ratio of the current share price to the earnings per share. Share price
tends to reflect opinion on future earnings potential and thus the P/E ratio
can be thought of as a measure of the market’s expectations about future
earnings compared with its current performance. It thus serves as a measure of
the confidence that the stock market has in the company - a high or increasing
ratio indicating a belief that earnings will increase in the future. Riskier
companies would normally have lower P/E ratios. The ratio can be compared
with other companies in the same business sector and companies in general.

Current market price of the share

Earnings per share

Changes in the P/E ratios of companies in general will be affected by:

 Interest rate changes – if interest rates increase, investors will move out
of shares into debt capital. Share prices and thus P/E ratios will fall.
 The prospects for company profits. Share prices depend on expectations
of future earnings not past earnings. A change in prospects (e.g. the
threat of recession) will affect share prices and P/E ratios.
 Investor confidence – this may result from a range of factors e.g. the
prospect of greater exchange rate stability between countries

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