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Lecture 8

Unit 6 Financial Ratio Analysis


Learning Objectives
Identify the key aspects of financial performance and financial position that are evaluated by the use of
ratios
Explain the terms profitability, efficiency, liquidity, gearing and investment
Summarise the alternative bases of comparison for ratio analysis
Present the ratio formula for the basic ratios
Calculate ratios to analyse the profitability, efficiency, liquidity and gearing of a given entitys financial
statements over several periods
Interpret basic ratios relating to profitability, efficiency, liquidity and gearing
Discuss the limitations of ratios as a tool of financial analysis

Financial Ratios

What is a ratio?
Ratios provide a quick and simple means of examining the financial health of a business
A ratio simply expresses the relationship between one figure appearing in the financial statements with
another e.g. net profit in relation to capital employed
Ratios are simple enough to calculate, and a good picture can be built up with just a few, however ratios
can be difficult to interpret
Can be expressed in various forms e.g. percentages, fractions, proportions depending on the need and
use for the information

The key aspects of financial performance / position evaluated by the use of ratios are:
Profitability
Efficiency
Liquidity
Gearing
Investment

Financial Ratio Classification


Profitability - Measure of success in wealth creation
Efficiency - Effectiveness of utilisation of resources
Liquidity - The ability to meet short-term obligations
Gearing - Measure of degree of risk to do with the amount of leverage used to finance the business
Investment - Measure of the returns and performance of shares held by a business

The alternative bases of comparison for ratio analysis

Bases (benchmarks) that may be used as a basis of comparison for ratio analysis include:
Intertemporal - Based on past performance
Budget - Based on planned performance
Intra-industry - Based on comparison of performance with other firms in the same industry

A calculated ratio on its own does not say much about a business - it is only when it is compared with some
form of benchmark that the information can be interpreted and evaluated

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The Key Steps in Financial Ratio Analysis

Step 1:
Identify which key indicators and relationships require examination
Identify who needs the information and why they need it

Step 2:
Choose the most relevant set of ratios that will accomplish the desired purposes
Calculate and record the results using the selected ratios

Step 3:
Interpret and evaluate the results

Common ratios that we will consider now follow that illustrate the name of the
ratio, a description of the ratio, the ratio formula and the terms in which the ratio
is often expressed, for example, %, times, etc.

Note that we will not be focusing on the Investment Ratios in any great detail.

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Calculation of Ratios - Profitability Ratios
Ratio Description Formula
Return on Compares the amount of Normally
shareholders' funds profit for the period available ROSF = Net profit after taxation and preference dividend (if any) x 100 expressed as
(ROSF) to the owners with the Average ordinary share capital plus reserves a percentage
owners stake in the
business

Return on total assets Compares the net profit ROA = Net profit before interest and taxation x 100 Normally
(ROA): generated by the business Average total assets expressed as
with the assets owned by the a percentage
business

Net profit margin: Relates the net profit for the Net profit margin = Net profit before interest and taxation x Normally
period to the sales during 100 Sales expressed as
that period a percentage

Gross profit margin: Relates the gross profit of Gross profit margin = Gross profit x 100 Normally
the business to the sales Sales expressed as
generated during the same a percentage
period
Gross profit represents the
difference between sales and
cost of sales

Asset turnover Examines how efficiently the Asset turnover = Average total assets x 365 Can be
period: assets of the business are Sales expressed in
being employed in terms of days
generating sales revenue
Note: 2 ways this ratio can Asset turnover = Sales Can be
be calculated Average total assets expressed in

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terms of
times

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Calculation of Ratios - Efficiency Ratios
Ratio Description Formula
Average inventory turnover Measures the average Normally
period: period inventory was Inventory turnover periods = Average inventory held x 365 expresse
held Cost of sales d in terms
of days

Average settlement period Calculates how long, Average settlement period = Average trade debtors x 365 Normally
for accounts receivable on average credit Credit sales expresse
(debtors): customers take to pay d in terms
amounts owed of days

Average settlement period Calculates how long, Average settlement period = Average trade creditors x 365 Normally
for accounts payable on average the Credit purchases expresse
(creditors): business takes to pay d in terms
its creditors of days

Asset turnover period: Examines how Average asset turnover period = Average total assets employed x 365 Normally
efficiently the assets Sales expresse
of the business are d in terms
being employed in of days
generating sales when
revenue assessing
efficiency

The Relationship Between Profitability and Efficiency


The overall return on funds employed in the business will be determined both by the profitability of sales, and by efficiency in the use of
assets

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Calculation of Ratios Liquidity Ratios
Ratio Description Formula
Current ratio: Compares the Expressed in
businesss liquid Current ratio = Current assets terms of the
assets with Current liabilities number of times
short-term the current assets
liabilities will cover the
(current current liabilities
liabilities)

Acid test (also Represents a Acid test ratio = Current assets (excluding inventory & prepayments) Expressed in
known as the more stringent Current liabilities terms of the
quick or liquid) test of liquidity number of times
ratio: than the current the liquid current
ratio assets will cover
the current
liabilities

Cash flows Compares the Cash flows from operations ratio = Operating cash flows Expressed in
from operating cash Current liabilities terms of the
operations flows with the number of times
ratio: current liabilities the operating
of the business cash flows will
cover the current
liabilities

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Calculation of Ratios Financial Gearing (Leverage)
Financial Gearing: The existence of fixed payment bearing securities (e.g. loans) in the capital structure of a company

The level of gearing, or the extent to which a business is financed by outside parties is an important factor in assessing risk
Gearing may be used both to adequately finance the business, and to increase the returns to owners - provided that the returns
generated from the borrowed funds exceed the interest cost of borrowing

Ratio Description Formula


Gearing ratio: Measures the Expressed in
contribution of Gearing ratio = Long term liabilities x terms of a
long-term 100 percentage
lenders to the Share capital + Reserves + Long-term liabilities
long-term
capital structure
of the business

Interest cover Measures the Interest cover ratio = Profit before interest and taxation Usually
ratio (times amount of profit Interest expense expressed in
interest available to terms of the
earned): cover interest number of times
expense of the
business

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Lecture Activity 1

Example 6.1 (Accounting - an Introduction 4th edition, Atrill. et al. pp. 286-288)

We will be using Example 6.1 from your textbook to calculate some of the ratios and
interpret them.

The following financial statements relate to Alexis Ltd, which owns a


small chain of wholesale/retail carpet stores.

Alexis Ltd
Balance Sheet as at 31 March

2008 2009 2010


$000 $000 $000 $000 $000 $000
Current assets
Bank 6.1 33.5 41.0
Trade debtors 281. 240.8 210.2
0
Inventory at cost 241. 300.0 370.8
0
528.1 574.3 622.0
Non-current assets
Fixtures and fittings at cost 107. 129.0 160.4
8
Less accumulated depreciation 37.4 70.4 64.4 64.6 97.2 63.2
Freehold land and buildings at cost 351. 451.2 451.2
2
Less accumulated depreciation 65.0 286.2 70.0 381.2 75.0 376.2
356.6 445.8 439.4
Total assets 884.7 1020. 1061.4
1

Current liabilities
Trade creditors 247. 221.4 228.8
0
Dividends payable 32.0 40.2 60.0
Income tax 46.4 60.2 76.0
325.4 321.8 364.8
Non-current liabilities
12% Debentures (secured) 200.0 200.0 60.0
Capital and reserves
Paid-up ordinary capital 280. 300.0 334.1
(shares all issued at 50 cents each) 0
Reserves 26.5 26.5 40.0
Retained profit 52.8 171.8 262.5
359.3 498.3 636.6
Total liabilities and shareholders 884.7 1020. 1061.4
equity 1

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Alexis Ltd
Income statement for the year ended 31 March

2009 2010
$000 $000 $000 $000
Sales 2240. 2681.
8 2
Less cost of sales
Opening stock 241.0 300.0
Purchases 1804. 2142.
4 8
2045. 2442.
4 8
Less closing stock 300.0 1745. 370.8 2072.
4 0
Gross profit 495.4 609.2
Wages and salaries 137.8 195.0
Directors salaries 48.0 80.6
Rates 12.2 12.4
Heat and light 8.4 13.6
Insurance 4.6 7.0
Interest expense 24.0 6.2
Postage and telephone 3.4 7.4
Audit fees 5.6 9.0
Depreciation
Freehold buildings 5.0 5.0
Fixtures and fittings 27.0 276.0 32.8 369.0
Net profit before tax 219.4 240.2
Less income tax 60.2 76.0
Net profit after tax 159.2 164.2
Add retained profit brought forward 52.8 171.8
212.0 336.0
Transfer to reserves - (13.5)
Dividends proposed (40.2) (60.0)
Retained profit carried forward 171.8 262.5

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Alexis Ltd
Cash flow statement for the year ended 31 March

2009 2010
$000 $000 $000 $000
Cash flows from operations
Cash receipts from customers 2281 2711.8
Cash paid to suppliers and employees (2050) (2460.4
)
Interest paid (24) (6.2)
Tax paid (46.4) (60.2)
Net cash provided by operating 160.6 185
activities
Investing activities
Purchase of non-current assets (121.2 (31.4)
)
Net cash used in investing activities (121.2 (31.4)
)
Financing activities
Dividends paid (32.0) (40.2)
Proceeds from issuance of share capital 20.0 34.1
Repayment of long-term loan - (140.0)
Net cash used in financing activities (12) (146.1
)
Increase in cash and cash 27.4 7.5
equivalents

The company employed 14 staff in 2009 and 18 in 2010


All sales and purchases are made on credit
The market value of the shares of the company at the end of each
year was $2.50 and $3.50 respectively. The issue of equity shares
during the year ended 31 March 2010 occurred at the beginning of the
year.

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Profitability Ratios Alexis Ltd
Ratio Description Formula

Return on Compares the ROSF = Net profit after taxation and preference dividend (if any) x 100 Normally
shareholders' amount of profit expressed as
Average ordinary share capital plus reserves
funds (ROSF) for the period a percentage
available to the
owners with the
owners stake in = 159.2 x 100 = 37.1% (for year ended 31/3/2009)
the business (359.3 + 498.3) / 2

= _______________________________________(for year ended 31/3/2010)

Return on Compares the ROA = Net profit before interest and taxation x 100 Normally
total assets net profit expressed as
generated by the Average total assets a percentage
(ROA):
business with
the assets = (219.4 + 24.0) x 100 = 25.6% (for year ended 31/3/2009)
owned by the (884.7 + 1020.1) / 2
business

= ____________________________________ (for year ended 31/3/2010)

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Profitability Ratios Alexis Ltd (continued)
Normally
Net profit Relates the net Net profit margin = Net profit before interest and taxation x 100 expressed as
margin: profit for the a percentage
period to the Sales
sales during that
period = (219.4 + 24.0) x 100 = 10.9% (for year ended 31/3/2009)
2240.8

= (240.2 + 6.2) x 100 = 9.2% (for year ended 31/3/2010)


2681.2

Gross profit Relates the Gross profit margin = Gross profit x 100 Normally
margin: gross profit of Sales expressed as
the business to a percentage
the sales
generated during = 495.4 x 100 = 22.1% (for year ended 31/3/2009)
the same period 2240.8
Gross profit
represents the
difference
between sales = 609.2 x 100 = 22.7% (for year ended 31/3/2010)
and cost of sales 2681.2

Asset Examines how Asset turnover = Sales Can be


turnover efficiently the Average total assets expressed in
ratio: assets of the = 2240.8 = 2.4 times (for year ended 31/3/2009) terms of
business are times
being employed (884.7 + 1020.1) / 2
in generating
sales revenue = 2681.2 = 2.6 times (for year ended 31/3/2010)
(1020.1 + 1061.4) / 2 =
Analysis:
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Efficiency Ratios Alexis Ltd
Ratio Description Formula

Average Measures the Inventory turnover periods = Average inventory held x 365 Normally
inventory average period Cost of sales expressed in
turnover inventory was terms of days
period: held
= (241.0 + 300.0) / 2 x 365 = 57 days (for year ended 31/3/2009)
1745.4

= __________________________________ (for year ended 31/3/2010)

Average Calculates how Average settlement period = Average trade debtors x 365 Normally
settlement long, on Credit sales expressed in
period for average credit terms of days
accounts customers take
receivable to pay amounts
(debtors): owed
= (281 + 240.8) / 2 x 365 = 43 days (for year ended 31/3/2009)
2240.8

= (240.8 + 210.2) / 2 x 365 = 31 days (for year ended 31/3/2010)


2681.2

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Efficiency Ratios Alexis Ltd (continued)

Average Calculates how Average settlement period = Average trade creditors x 365 Normally
settlement long, on Credit purchases expressed in
period for average the terms of days
accounts business takes = (247.0 + 221.4) / 2 x 365 = 47 days (for year ended 31/3/2009)
payable to pay its
1804.4
(creditors): creditors
= (221.4 + 228.8) / 2 x 365 = 38 days (for year ended 31/3/2010)
2142.8

Asset turnover Examines how Average asset turnover period = Average total assets employed x 365 Normally
period: effectively the Sales expressed in
assets of the terms of days
business are
being
= ___________________________________ (for year ended
employed in
generating
31/3/2009)
sales revenue

= (1020.1 + 1061.4) / 2 x 365 = 142 days (for year ended 31/3/2010)


2681.2

Analysis:
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Liquidity Ratios Alexis Ltd
Description Formula

Ratio
Current ratio: Compares the Current ratio = Current assets Expressed in terms
businesss liquid Current liabilities of the number of
assets with short-term times the current
liabilities (current = 528.1 = 1.6 times (for year ended 31/3/2008) assets will cover the
liabilities) 325.4 current liabilities

= 574.3 = 1.8 times (for year ended 31/3/2009)


321.8

= _________________________________ (for year ended 31/3/2010)

Acid test (also Represents a more Acid test ratio = Current assets (excluding inventory & prepayments) Expressed in terms
known as the stringent test of Current liabilities of the number of
quick or liquid) liquidity than the times the liquid
ratio: current ratio = (528.1 - 241.0) = 0.9 times (for year ended 31/3/2008) current assets will
325.4 cover the current
liabilities
= (574.3 - 300.0) = 0.9 times (for year ended 31/3/2009)
321.8

= __________________________________ (for year ended 31/3/2010)

Cash flowsCompares the operating cash Cash flows from operations ratio = Operating cash flows Expressed in terms
from operations flows with the current Current liabilities of the number of
ratio: liabilities of the = 160.6 = 0.5 times (for year ended 31/3/2009) times the operating
business 321.8 cash flows will cover
the current liabilities
= 185 = 0.5 times (for year ended 31/3/2010)
364.8
Analysis:

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Financial Gearing (Leverage) Alexis Ltd

Ratio Description Formula


Gearing ratio: Measures the Expressed in terms
contribution of Gearing ratio = Long term liabilities x 100 of a percentage
long-term lenders Share capital + Reserves + Long-term liabilities
to the long-term
capital structure of
the business
Gearing ratio = _____________________________(for year ended 31/3/2009)

Gearing ratio = 60.0 x 100 = 8.6% (for year ended 31/3/2010)


(60 + 636.6)

Interest cover Measures the Interest cover ratio = Profit before interest and taxation Usually expressed in
ratio (times amount of profit Interest expense terms of the number
interest earned): available to cover of times
interest expense of Interest cover ratio = (219.4 + 24.0) = 10.1 times (for year ended
the business
31/3/2009)
24.0

Interest cover ratio ___________________________ (for year ended


31/3/2010)

Analysis:
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Trend Analysis
Trends may be identified by plotting key ratios on a graph, giving a visual representation
of changes happening over time
Intra-company trends may be compared against industry trends
Key financial ratios are often published in companies annual reports as a way to help
users to identify important trends

Ratios and Prediction Models


Ratios are often used to help predict the future however the choice of ratios and
interpretation of results depend on the judgment of the analyst
Researchers have developed ratio-based models which claim to predict future financial
distress as well as vulnerability to takeover
The future is likely to see further ratio-based prediction models developed to predict
other aspects of financial performance

Limitations of Ratio Analysis


The quality of the underlying financial statements determines the usefulness of the ratios
derived from them
Ratios only offer a restricted view of relative performance and position - not the full
picture
No two businesses are identical and the greater their differences, the greater the
limitations of ratio analysis as a basis for comparison
Any ratios based upon balance sheet figures will not be representative of the whole
period because the balance sheet is a snapshot of a moment in time

Index or Percentage Analysis


Index or Percentage analysis simply allows monetary figures to be replaced with an
index or a percentage as an alternative to ratio analysis
There are three alternative index or percentage methods:
1. The common size reports (also known as vertical analysis)
2. Trend percentage
3. Percentage change (also known as horizontal analysis)

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Summary of Unit 6
Try summarising what we have covered in Unit 6

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