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Benefits of Ratios Summary statistic Enable comparison of:

one company’s performance over time different companies in same industry sector different divisions within one company company performance with industry average

A ratio is a relationship between two or more items in the financial statements

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Categories of Ratios

Profitability Liquidity Efficiency Gearing Investment

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Profitability Ratios – Gross Profit Margin

Gross profit x 100

Turnover (Sales)

Measures the profitability in buying and selling goods before any other expenses are taken into account.

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Profitability Ratios – Net Profit Margin

Profit before interest & tax x 100Turnover (Sales)

Can vary considerably between types of businesses. For example, a supermarket will often have low profit margins to stimulate sales. A jeweler, on the other hand, will have a high profit margin but much lower sales volume.

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Efficiency Return on Capital Employed (ROCE)

Profit before interest & tax x 100Capital employed Measures the efficiency with which

capital employed has been utilized. Capital employed usually means long-

term funds so it includes equity and long-term (non-current) liabilities.

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Key ratios: Liquidity and debt

Liquidity (Solvency) Current ratio Liquidity (acid test) ratio

Debt Long term (Investment risk) Gearing ratio

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Solvency Ratios –Current Ratio

Current assets Current liabilities

A ratio less than 1:1 might give cause for concern because it would indicate that liquid resources are insufficient to cover short term payments (but depends on type of business).

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Solvency Ratios –Liquidity Ratio (Acid Test)

Current assets – StockCurrent liabilities

Stock may be slow to convert into cash, thus this ratio excludes stock. There is no ideal ratio here but a long term downward trend in the quick ratio might give some cause for concern.

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Gearing Ratio (Debt/capital employed) x 100

Long term liabilities x 100

Capital Employed Measures the relationship between debt

and capital employed and it should be compared with the return of other investments such as the risk free interest of the savings accounts, the return from Government and corporate bonds ,dividends and value appreciation of stock, price increase of gold etc

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EFFICIENCY ROCE

Turnover to Capital Employed= Turnover

Capital employed*

(* Total assets – current liabilities)

Examines how effective the long term capital employed has been in generating sales revenue.

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Efficiency Stock Turnover Period

Stock x 365 daysCost of sales

The stock turnover period measures the average number of days for which stock was held before being sold.

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Efficiency Debtors’ Collection Period

Trade debtors x 365 daysCredit sales

Shows how long it takes for customers to pay the amounts owing.

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Efficiency Creditors’ Payment Period

Trade creditors x 365 daysCredit purchases

Shows how long the business takes to pay its trade creditors.

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Limitations of Ratios Reliability of financial statements Balance sheet figures may not reflect

normal position, e.g. seasonal business Different accounting practices make

inter-company comparisons difficult, e.g. Use of different measurement bases Use of off-balance sheet finance Use of different commercial practices

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Limitations of Ratios

Different accounting practices (cont.) Use of different accounting policies Judgement - based adjustments Definitions of ratios

Finding appropriate comparator companies

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Finally … Although ratios have

their limitations, a number of previous studies have reported the importance of ratios to financial analysts.

The P/E ratio and dividend yield were found to be very important in valuation of companies.