ST JAGO HIGH SCHOOL

CAPE FINANCIAL ACCOUNTING UNIT 1

RATIO ANALYSIS - MODULE 3

TEACHER: Mr E. Tucker CLASS NOTES (8)

RATIO ANALYSIS

Ratio analysis is a quantitative method of gaining insight into a company's liquidity, operational
efficiency, Solvency and profitability by studying its financial statements such as the balance sheet and
income statement. Ratio analysis is a cornerstone of fundamental performance analysis.

This is one of the main form of assessing, analyzing and evaluating the performance of a business. It
is a study of the relationship of various elements of the financial statements (Trading and profit and
loss A/C & Balance Sheet). This analysis is vital in the decision making process by weighing the
options of investments or to plan for the future. However, since ratios are just ‘numbers’, the numbers
in isolation (on their own) are meaningless. That is, ratios are most useful when they are compared on
a year-to-year basis, with other companies of the same size and in the same industry. There is usually
a benchmark (standard ratio) which is acceptable, thus enable us to determine whether a ratio is high or
low.

● Ratio analysis compares line-item data from a company's financial statements to reveal insights
regarding profitability, liquidity, operational efficiency, and solvency.
● Ratio analysis can mark how a company is performing over time, while comparing a company
to another within the same industry or sector.

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 ● While ratios offer useful insight into a company, they should be paired with other metrics, to
obtain a broader picture of a company's financial health.

OBJECTIVES OF RATIO ANALYSIS

1. To prepare a report on performance

2. To formulate a trend analysis
3. To prepare statistical reports
4. To assess current credit worthiness
5. To assess liquidity, solvency, profitability and activity (operating efficiency)
6.

USERS OF RATIOS

1. Management - To analyze past results and to control a business by way of planning

for the future.

2. Investors - To make comparisons with alternative forms of investments.

3. Bankers and Finance houses – To assess the credit worthiness and payback potential.

4. Trade creditors – To assess credit worthiness of Trade Debtors.

5. Trade Unions – To use as support for bargaining on behalf of employees.

6. Financial Analyst – To prepare press (or media) financial reports.

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7. Government Statisticians – To compile National Statistics.

TYPES OR GROUPS OF RATIOS

Ratios are classified into groups or types and are as follows:

Leverage Ratios are Solvency Ratios.

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1. PROFITABILITY RATIOS : These ratios assess the performance of the business from a
profit perspective.

2. Liquidity Ratios: These ratios evaluate the level of liquidity in the business. It looks
at how well or how fast it is able to meet its current obligations, or
will it be able to cover its current liabilities in the short –run.

3. Solvency Ratios: These are similar to liquidity ratios but takes an overall view of the
company’s potential to pay off its debts in the long run. That is, it
looks at the overall business and not just the current liabilities and
short-run but long-term liabilities and the long-run. It also looks at
how dependent the business is on outside sources of finance.

4. Activity Ratios (operational efficiency/utilization ratios):

These ratios analyze the operational activities of the business. It
measures the usefulness of the assets of the business to generate
revenue or how well the fixed assets are utilized.

LIQUIDITY RATIOS:

A) The Current ratio = Current Assets = Ratio/Times

Current liabilities

This serves as a guide to see how well the company is able to cover its current liabilities, using its
current assets. A Benchmark of 2:1 is used as a guide to determine good or bad performance. Also
known as the working capital ratio but may be interpreted differently.

B) The Acid Test Ratio/Quick ratio = Current Assets - closing inventory = Ratio/Times
Current liabilities
This serves as a more thorough test of a company’s ability to cover its immediate debts. This is to say
that if all liabilities are to be paid off now, would the company be able to do so without the use of
stock. A Benchmark of 1:1 is used as a guide to determine good or bad performance.

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C) The Working Capital ratio (Research this)

PROFITABILITY RATIOS (main ones)

A) Net Profit Margin = Net profit X 100 or Net income X 100 = #%

Sales Revenue
This looks at the relationship between net profit and sales, a 30% ratio indicate that
every $100 of sales is contributing $30 of net profit.

B) Gross Profit Margin = Gross profit X 100 or Gross income X 100 = #%

Sales Revenue
This looks at the relationship between Gross profit and sales, a 40% ratio indicate that
every $100 of sales is contributing $40 of gross profit.

C) Return On Capital Employed (ROCE)/Return on Net Assets

= Profit before Interest and Tax X 100
Net Assets (capital + Reserves + LT Liab)

This looks at the contribution of the net assets to net profit before interest and taxation is taken out
(deducted), a 25% ratio indicates that every $1 of net assets has contributed $0.25 of profit.

D) Return On Investment = Profit before Interest and Tax X 100

Investment
This looks at the amount of return a company makes on its investment. It measures the amount of
return that is generated by its investment.

E) Earnings Per Share (EPS) = Profit after Tax and Preference Dividend. = $ #
Number of ordinary shares
This looks at how much is earned and available to pay as ordinary dividends for each
ordinary share.

F) Price Earning Ratio (PER) = Market price of share = A number

Earnings Per Share
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 This tells the number of years earnings an investor is willing to pay for when a share
is purchased or how many years it will take for the company to earn its market value
of the share.

G) Dividend Cover Ratio = Profit after Tax - Preference Dividend = # times

Ordinary Dividend paid
This is a measure of how well the company is able to cover its dividend expenses. A
year-to-year ratio will indicate an increase/decrease in its ability to pay dividends.

H) Dividend Yield Ratio = Rate of dividend Declared X Nominal value (Par) =

Market Price/value of share
This tells the real rate of dividends received. It tells the real percentage of the declared dividend
received.

SOLVENCY RATIOS

A) Interest Cover/Times Interest Earned Ratio = Profit before interest and Tax = #times
Interest Charges/Expense
This is a measure of how well the company is able to cover its interest expenses. It looks at how
many times the PBIT is able to cover interest expenses for the period. A year-to-year ratio will
indicate an increase/decrease in its ability to pay interest.

B) Gearing Ratio = Fixed cost capital(FCC) = Pref. Cap + Deb. + Mort. Etc. X 100% = #%
Total capital Ord. share cap + Res. + FCC
This tells how dependent the company is on outside sources of finance. A 50% ratio shows a
neutral position but lower indicate an ideal position while higher than 50% suggest too much
dependence on barrowing(too much liability).

C) Debt/Equity or DEBT-TO-EQUITY Ratio = Fixed cost capital(FCC) X 100 = #%

Equity (ordinary share cap + Res.)

This is the most current formula used to calculate Debt to Equity.

This provides a measure of the comparison between barrowed funds and funds supplied by
shareholders. It also tells how dependent the company is on outside sources of finance but
compares FCC with Equity. A 100% ratio shows a neutral position but lower indicate an ideal
position while higher than 100% suggest too much debt obligations and dependence on
barrowing(too much liability).

ACTIVITY RATIOS (OPERATIONAL EFFICIENCY RATIOS):

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A1) Stock Turn/ Turnover Ratio = Cost of Sales (Cost of goods sold) = # times
Average stock
This tells the number of times the company has sold out its stock and replenished it for the year.
The higher the turnover rate, the more prosperous the company is assumed to have been for the
period in question (year).

A2) Stock Turn/ Turnover Ratio in days = 365/stock turnover rate

B) Debtors Ratio/Debtors collection period = Debtors X 365 = # of days
Credit Sales
This tells the number of days on average it takes to collect from our debtors. The higher the
number of days, the worst it is for the company while the lower it is, the better it is for the
company since the cash will be coming in faster which could be very effective if put to good use.
The benchmark or standard number of days is 30.

C) Creditors Ratio/ Creditors payment period = Creditors X 365 = # of days

Credit Purchases
This tells the number of days on average it takes to pay our creditors. The higher the
number of days, the better it is for the company while the lower it is, the worst it is for the
company since the cash will stay in the company longer, which could be very effective in
improving its liquidity position if put to good use.The benchmark or standard number of days is 30.

D) Capital utilization Ratio = Sales X 100 = #%

Capital employed
This looks at how much each $1 of capital employed generates as sales. A 30% ratio says that each
$100 of capital produces $30 of sales.

E) Asset Usage Ratio = Sales X 100 = #%

Total Assets
This looks at how well the assets of the company have been utilized. It tells how much sales each
dollar of asset has produced.

F) Fixed Asset utilization Ratio = Sales X 100 = #%

Fixed Assets
This looks at how well the Fixed assets of the company have been utilized. It tells how much sales
each dollar of Fixed asset has produced.

F) Working Capital utilization Ratio = Sales X 100 = #%

Net working capital
This looks at how well the working capital of the company has been utilized. It tells how much
Sales each dollar of working capital has produced.

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PESTEL: Political, Environlental, Social, Technological, Economical and Legal.

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 CALCULATION OF RATIOS

RATIO FORMULA AE calculations PRESTON AE ratio PRES Ratio

calculations

Current ratio Current 498 750/281 100 442 500/295 000 1.77: 1 1.5:1
Assets/current liab

Acid Test ratio Current Assets - 498 750 – 442 500- 1.16: 1 0.85: 1
inventory/current 173250/281 100 191750/295 000
liab

Gross profit % Gross profit/sales x (1 131 750/2 625 (843 741/1 750 43.1 % 48.2 %
100 750) x 100 500) x 100

Net income % (Net income/sales) x (269 250/2 625 (268 741/1 750 10 .25% 15.35%
100 750) x 100 500) x 100

Return on (Profit before (413250/1279 (364 741/1122 32.30% 32.49%

Assets interest/Total assets) 200) x 100 500) try x 100
x 100

ROCE (Profit before (413250/1 279 (364 741/1122 41.4 % 44.07%

interest/net assets) x 200 – 281 100) 500 – 295 000) x
100 x100 100

EPS Profit after tax – (269 250 – 0)/90 (268 741 – 0)/40 $2.99 $6.72
preference Div/no. 000 000
of ordinary shares

Times Interest Profit before 413250/28 500 364 741/19 000 14.5 times 19.2 times
earned interest/interest exp.

Debt to Equity [Total [581 100/698 [785 000/ 337 83.24% 232.6 %
Liabilities/Equity] x 100] x 100 500] x 100
100 =
PER Market price/EPS $12/$2.99 $15/$6.72 4.01 2.23

843 741- 268 741 = $575 030

Operating margin = (operating / sales) x 100 = (575 030/1 750 500) x 100 = 32.85%

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1. Current Ratio = CA/CL = current Assets =cash + inventory + accounts Rec’ble = 79 000 + 53 000
+12 000 =144 000.
Current liabilities = accounts payable +income tax payable = 12 000 +13000 = $25 000.

Therefore current ratio = 144000/25 000 = 5.76:1

2. Acid Test Ratio = CA – inventory /CL = current Assets =cash + inventory + accounts Rec’ble =
79 000 + 53 000 +12 000 =144 000 – 53 000 = $91 000,
Therefore acid test ratio = 91 000/25 000 = 3.64:1

Ratio FORMULA CALCULATIONS

Net profit margin Net profit / sales x 100 [44 000/ 180 000] X 100 = 24.44%

Gross profit margin [Gross profit / sales] x [Revenue – cost of goods sold]/sales
100 [180 000 – 89 000]/180 000 } x 100 = 50.55%

Earnings per share [Net income – pref (44 000- 0)/12 000 = $3.60 per share
EPS div]/ no. of ordinary
shares

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OPENING CAPITAL + ADDITIONAL CAPITAL + NET PROFIT – DRAWINGS = CLOSING
CAPITAL.

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WRITING A RATIO REPORT

A Ratio report is an analysis of the performance of an entity over a period of time. An effective ratio
report should include the following:

1. Interpretation
2. The perspective/category of the ratio eg. Liquidity or solvency.
3. Explaination of Ratios
4. Trend of performance.
5. Comparisons
6. Significant/Drastic changes
7. Bench marks/standards
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