Interpreting
Published
Accounts
What is ratio analysis?
Analysing relationships
between financial data
to assess the
performance of a
business
Ratios can help answer Q’s like…
Profitability
Financial
efficiency
Liquidity and
gearing
Shareholder
return
Is the business making a profit? Is it growing?
How efficient is the business at turning revenues into profit?
Is it enough to finance reinvestment?
Is it sustainable (high quality)?
How does it compare with the rest of the industry?
Is the business making best use of its resources?
Is it generating adequate returns from its investments?
Is it managing its working capital properly?
Is the business able to meet its short-term debts?
Is the business generating enough cash?
Does the business need to raise further finance?
How risky is the finance structure of the business?
What returns are owners gaining from their investment?
How does this compare with alternative investments?
Profitability ratios
Gross Profit Margin *
Operating Margin *
ROCE
* Covered in BUSS2
Return on Capital Employed
ROCE (%) =
Operating profit
Capital employed
x 100
Example
Operating profit = £280,000
Capital employed = £1,400,000
ROCE = £280,000 / £1,400,000 = 20%
Evaluating ROCE
Higher % is better
ROCE
%
Watch for trend over time
Watch out for low quality
profit which boosts ROCE
Leased equipment will not be
included in capital employed
Financial efficiency ratios
Assess how
effectively a
business is managing
its assets
Financial efficiency ratios
Asset turnover
Stock turnover
Debtor days
Creditor days
* Covered in BUSS2
Asset turnover
Asset turnover =
Revenue (sales)
Net assets
Example
Revenue = £21,450k
Net assets = £4,455k
Asset turnover = 4.8 times
Evaluating asset turnover
• A rough guide to how intensively a
business uses its assets
• Some limitations of the ratio:
– Takes no account of how profitable the revenue is
– Less relevant for labour-intensive businesses
– Will vary widely from industry to industry
– Can fluctuate from year to year (e.g. major
investment in fixed assets in one year generates
increased sales in following years)
Stock turnover
Stock turnover =
Cost of sales
Average stock held
Example
Cost of sales = £13,465k
Average stock = £1,325k
Stock turnover = 10.2 times
Evaluating stock turnover
• Interpreting the number
– In general, a higher number is better
– Low number (compared with previous period or
competitors) suggests problem with stock control
• Some issues to consider:
– Stock turnover varies from industry to industry
– Holding more stock may improve customer service &
allow the business to meet demand
– Seasonal fluctuations in demand during the year may
not be reflected in the calculations
– Stock turnover is irrelevant for many service sector
businesses (but not retailers, distributors etc)
Actions to improve stock turnover
• Sell-off or dispose of slow-moving or
obsolete stocks
• Introduce lean production techniques to
reduce stock holdings
• Rationalise the product range made or sold
to reduce stock-holding requirements
• Negotiate sale or return arrangements
with suppliers – so the stock is only paid
for when a customer buys it
Debtor days
Debtor days =
Trade debtors
Revenue (sales)
Example
Revenue = £21,450k
Trade receivables = £4,030k
Debtor days = 68.6 days
x 365
Evaluating debtor days
• Interpreting the results:
– Shows the average time customers take to pay
– Each industry will have a “norm”
– Need to take account of terms & conditions of sale
– The important data is any significant change
• Look out for
– Comparisons (good or bad) v competitors
– Balance sheet window-dressing
Creditor days
Creditor days =
Trade payables
Cost of sales
Example
Cost of sales = £13,465k
Trade payables = £2,310k
Creditor days = 62.6 days
x 365
Evaluating creditor days
• Interpreting the results
– In general, a higher figure is better
– Ideally, creditor days is higher than debtor days
– Be careful: a high figure may suggest liquidity
problems
• Look out for:
– Evidence from the current ratio or acid test ratio
that business has problems paying creditors
– Window-dressing: this is easiest figure to
manipulate
Liquidity ratios
Assess whether a business
has sufficient cash or
equivalent current assets to
be able to pay its debts as
they fall due
Current ratio
Current ratio =
Current assets
Current liabilities
Example
Current assets = £6,945k
Current liabilities = £3,750k
Current ratio = 1.85
Evaluating the current ratio
• Interpreting the results
– Ratio of 1.5-2.0 would suggest efficient
management of working capital
– Low ratio (e.g. below 1) indicates cash problems
– High ratio: too much working capital?
• Look out for
– Industry norms (e.g. supermarkets operate with
low current ratios because they low debtors)
– Trend (change in ratio) is perhaps most important
Acid test ratio
Acid test
ratio =
Current assets less stocks
Current liabilities
Example
Current assets = £5,620k
Current liabilities = £3,750k
Acid test ratio = 1.50
Evaluating the Acid test ratio
• Interpreting the results
– A good warning sign of liquidity problems for
businesses that usually hold stocks
– Significantly less than 1 is often bad news
• Look out for
– Less relevant for business with high stock turnover
– Trend: significant deterioration in the ratio can
indicate a liquidity problem
Gearing ratio
Gearing (%) =
Long-term liabilities
Capital employed
x 100
Example
Long-term liabilities= £1,200k
Capital Employed = £5,655k
Gearing ratio = 21.2%
Evaluating the gearing ratio
• Interpreting the result
– Focuses on long-term financial stability of business
– High gearing (>50%) suggests potential problems in
financing (interest & capital repayments)
• Look out for
– Increased gearing & deterioration in other liquidity
and/or financial efficiency ratios
Managing Gearing
Reduce Gearing
Increase Gearing
Focus on profit improvement (e.g.
cost minimisation
Focus on growth – invest in
revenue growth rather than profit
Repay long-term loans
Convert short-term debt into longterm loans
Retain profits rather than pay
dividends
Buy-back ordinary shares
Issue more shares
Pay increased dividends out of
retained earnings
Shareholder ratios
Measure the returns
that shareholders
gain from their
investment
Dividend per share
Dividend per share (£) =
Total dividends paid
Number of ordinary
shares in issue
Example
Dividends paid = £460,000
Number of shares = 500,000
Dividend per share = £0.92
Evaluating dividend per share
• Interpreting the results
– A basic calculation of the return per share
• The problem with this ratio: we don’t
know
– How much the shareholder paid for the shares –
i.e. what the dividend means in terms of a return
on investment
– How much profit per share was earned which
might have been distributed as a dividend
Dividend yield
Dividend per share (pence)
Dividend per share (£) =
Share price (pence)
Example
Dividend paid in 2009 = 92 pence
Average share price = 1,415 pence
Dividend yield = 6.5%
Evaluating dividend yield
• Interpreting the results
– Annual yield can be compared with:
• Other companies in the same sector
• Rates of return on alternative investments
– Shareholders look at dividend yield in deciding
whether to invest in the first place
– Unusually high yield might suggest an undervalued share price of a possible dividend cut!
Main limitations of ratio analysis
• Ratios deal mainly in numbers – they don’t
address issues like product quality, customer
service, employee morale
• Ratios largely look at the past, not the future
• Ratios are most useful when they are used to
compare performance over a long period or
against comparable businesses and an industry
– this information is not always available
• Financial information can be “massaged” in
several ways to make the figures used for
ratios more attractive