3.4 Ratio Analysis

Aims to judge a firm’s financial performance.

Based on assumption that firms want to make a profit

Syllabus

Candidates should be able to:(1)Conduct ratio analysis – current and acid

test, ROCE, asset turnover, stock turnover, creditor and debtor days, gearing, DPS and dividend yield.

(2)Interpret ratios(3)Assess the value and limitations of ratio

analysis

How can a firm succeed financially?

In order to succeed a firm must(1)make a profit (____________________

ratios)(2)manage cash so it can meet payments

(____________ ratios)(3)plan long-term financing (________ ratios)(4)control its financial transactions

efficiently (___________________________ ratios)

(5)be attractive to shareholders (_________________________ ratios)

Profitability / performance ratios

Profit =

Tesco make more profit than Fred’s window cleaning business but which is more profitable?

Need to compare profit and the size of a firm to see if a firm makes more profit because it is b_____ or if it is more e______

Profitability / performance ratios: ROCE

Measure size by -Either capital employed or sales revenue

ROCE = operating profit X 100total equity plus non current liabilities

Where capital employed is total equity plus non current liabilities

Profitability ratios: NPM, OPM, GPM

Sales revenue

Net profit margin = net profit X 100 revenue

Operating profit margin = operating profit X 100

revenueGross profit margin = gross profit X 100

revenueNOTE revenue = sales = turnover

Capital employed measures the value of the firm and shows where the firm got its money from (non current liabilities, share capital and retained profit).

Could compare ROCE to bank interest rates but there is no risk in putting money in a bank so the average ROCE for UK firms should be higher (13 - 15% ideally)

Capital employed

Profit marginsFirms with high rates of stock turnover will have ________ profit margins, as their profit arises from the large numbers sold.

Gross profit can be compared with:

Liquidity ratios: current ratio

Liquidity ratios compare short-term (current) assets with short-term (current) liabilities to see if a firm can pay its _____. There are two ratios:

Current ratio = current assets : current liabilities(aka liquidity ratio)

Firms want a current ratio of 1.5 or 2 as some current assets can’t be sold immediately to pay debts BUT firms with high rates of stock turnover can operate with _______ ratios

Liquidity ratios: acid test

Acid test ratio = liquid assets: current liabilities(aka quick ratio)where liquid assets = current assets –

inventoriesLiquid assets are easily changed into cash (i.e. cash and receivables)The acid test ignores inventories (_________), ideally aim for 1.1, but as low as 0.6 is ok.

Liquidity ratios: what do the numbers mean

For both ratios:Below the suggested value => Above the suggested value =>

Gearing ratios

These look at the capital structure of the firm i.e. where does the firm get its money from.Gearing = non current liabilities X 100

total equity plus non current liabilities

Or gearing = loan capital X 100 capital employed

Capital employed = loan capital + shareholders’ funds

High gearing

High gearing > 50%Problems:

Advantages of high gearing > 50%

Low gearing < 25%

Problems: high % of shareholders’ capital so:

Advantages:

Gearing ratios in the UKIn the UK the average gearing ratio in 1999 was 47.9%, by 2004 it was 60.4%

Gearing can be reduced by – Either pay off ______ (i.e. reduce the top number) or increase_________________ (i.e. increase the bottom number)

Financial efficiency ratios

These show how the firm manages its assets and liabilities. Need to compare with similar firms as industries vary.Asset turnover measures the efficiency of a firm’s net assets in generating sales

Asset turnover = revenue ÷ net assetsOR Asset turnover = sales ÷ assets employed

High financial efficiency ratios

High figure => efficient use of assets

But a capital intensive firm will have lower asset turnover than a labour intensive firm because they have higher __________________________________________________E.g. a shipbuilding firm will have a lower asset turnover than a supermarket.

A fall in the ratio can be caused by a decline in sales or an increase in assets employed.

Financial efficiency ratios: stock turnover

Inventory or stock turnover measures how quickly stock is converted into sales.

Inventory turnover = cost of sales ÷ average inventories held

This shows the number of times per year that a firm sells its stock. For example: Inventory turnover of 4 means that a firm sells its stock __ times a year (i.e. once every __ months)

Financial efficiency ratios: stock days

We can change the formula to find out how many days stock is held for:

Inventory turnover = (average inventory ÷ cost of sales) X 365

This shows the number of days inventory (stock) is held for.

Financial efficiency ratios and JIT

With the growth in JIT, inventory levels tend to be low nowadays. So inventory turnover tends to be ______

High figure is preferred but it depends on the type of industry. E.g. perishable goods and/or regular purchases will have _______ stock turnover. An increasing ratio over time generally indicates that the firm is operating with greater _________.

Financial efficiency ratios: debtors

Receivables days (debtor days) are used to show the number of days that it takes to convert debtors to cash.

Receivables collection period = receivables ÷ revenue X 365

Where receivables = debtorsMail order firms etc. offer long term credit and so have very high debtor days. Other firms e.g. ____________ will have very low debtor days.

Financial efficiency ratios: e.g. Dixons

NOTE some firms offer credit (e.g. Dixons) work in partnership with banks and so they don’t have debtors because the bank ‘factors’ the debt. Therefore the firm (e.g. Dixons) will have low debtor days even though their customers may have 6 – 12 months to pay.Ideally want a low figure UNLESS ______________________________________________Aged debtor analysis involves ranking debtors by how long they have owed money.

Financial efficiency ratios: creditors

Payables days = payables X 365 cost of sales

Payables = creditorsThis shows the number of days it takes the firm to pay their debts. Normally 30 days, ideally higher but not too high (_____________________________________________)

NOTE: firms want payable days to exceed receivable days.

Shareholders’ ratios

Shareholders’ ratios analyse the value of shareholders’ investments in the business. They are also known as investment ratios.

Dividend per share (in pence) = DPSDPS = Total dividends paid to ordinary shareholders

Number of issued ordinary shares

Shareholders’ ratios: high DPS

_______ DPS is best BUT need to look at retained profit

If DPS is low but the firm has a high retained profit then this should boost the share price (which is good for shareholders)

Shareholders’ ratios: dividend yield

Dividend yield is used to compare shares with alternative investments e.g. a bank account or other firms.

Dividend yield = DPS X 100market share price

A low figure means the business is unprofitable OR they are retaining a high proportion of the profits for reinvestment.Shareholders want _______ and hence there is

pressure for short-term profit

Limitations of ratios

Ratios are good as they “provide a rigorous, scientific basis for decision making” BUT they are very limited in isolation. They need to be compared over time and with:

Other things to consider with ratios

Also need to consider: