Slide 28.1
Chapter 28
Review of Financial Ratio Analysis
Slide 28.2
Objectives
By the end of the chapter, you should be able to:
calculate operating, liquidity and activity ratios
from an annual report;
discuss the implication of the ratios;
describe and draft a report using inter-firm and
industry comparative ratios;
critically discuss the strengths and weaknesses
of ratio analysis;
calculate EBITDA and EBITDA margins for
management control purposes.
Slide 28.3
Initial impressions
Impact of economic conditions
 Is liquidity likely to be under pressure?
 Are debt covenants likely to be broken?
 Will assets need to be sold to reduce debt?
Slide 28.4
Initial impression of the sector
• Possible risk of:
– A significant fall in revenue
– Plant closures
– Redundancy costs
Slide 28.5
Initial impressions –
misrepresentation?
What are the pressures on management to:
–
–
–
–
–
Understate liabilities
Overstate inventories
Overstate trade receivables
Overstate bank balances
Understate impairment losses.
Slide 28.6
Initial look as prelude to more
systematic look
Need for an extremely inquisitive and enquiring
frame of mind
Some issues will be quickly evident, e.g.
 A company has made losses in the past 2 years or
 It has a declining sales turnover or
 A large overdraft or
 A greatly increased accounts payable figure.
Slide 28.7
Ratio analysis – main strength
 Ratios:
 Direct the user’s focus of attention
 Identify and highlight areas of good and bad
performance
 Identify areas of significant change.
 For a ratio to be useful, there must be a significant
relationship between the two items being compared.
 A ratio focuses attention on the relationship.
 Ratios require additional investigation of the
underlying data being used.
Slide 28.8
Caveat
Beware creative accounting
View that:
 Every company in the country is fiddling its profits
 It is a myth that the financial statements are an accurate
reflection of the company’s trading performance for the
year
 Accounts are little more than an indication of the broad
trend.
Slide 28.9
Compare like with like
Comparing current financial ratios with:
Financial ratios for a preceding period
Budgeted financial ratios for the current period
Financial ratios for other profit centres within
the company
Financial ratios for other companies within the
same sector (industry).
Slide 28.10
Importance of uniformity
Comparison is possible only if there is:
• Uniformity in the preparation of accounts
– IFRS helping to achieve this
• An awareness of any differences in international
accounting policies
– US SEC still has not adopted IFRSs.
Slide 28.11
Need to understand how ratios are
defined
Implications of any given ratio requires a clear
definition of its constituent parts
 Which profit is being used?
 EBIT?
EBITDA?
NOPAT?
Definitions of ratios may vary from source to
source, e.g. concepts and terminology are not
universally defined
 How is capital employed defined?
Slide 28.12
Awareness of underlying trends
How to interpret a constant ROCE?
 ROCE remains a constant 10% over the years 20X7–
20X9
 Net profit and capital employed increased by 50% in both
20X2 and 20X3
 This trend is not ascertainable in the ROCE ratio.
20X1
20X2
20X3
Net profit Capital employed
£
£
100,000
1,000,000
150,000
1,500,000
225,000
2,250,000
Return on
capital employed
10%
10%
10%
Slide 28.13
Review ratio analysis
• Three primary ratios:
– Investment ratios
– Operating ratios
– Liquidity ratios.
Slide 28.14
Primary investment level ratios
Return on equity:
Earnings before interest and tax
Shareholders’ funds
Measures the return available to the shareholders.
The objective of management is to generate the
maximum return on shareholders’ investment.
This ratio serves as an indicator of management
performance, but should be used in conjunction with
other indicators.
Slide 28.15
Return on equity
 A high return, normally associated with effective
management, could indicate an undercapitalised company.
 A low return, usually an indicator of poor
management performance, could reflect a highly
capitalised, conservatively operated business.
 Net profit after taxes and preference dividend is
used because this is the amount available for
distribution to the ordinary shareholders.
Slide 28.16
ROE driven by
• Financial leverage multiplier
Capital employed
Shareholders’ funds
• Return on capital employed
• where capital employed = total assets
Slide 28.17
Primary operating level ratios
Return on capital employed
Earnings before interest and tax
Capital employed
• No single definition of capital employed
• Often used for strategic planning.
• Also known as:
• Return on total assets, or
• Return on investment
Slide 28.18
Return on capital employed
 Measures the return to shareholders and
lenders on the total investment they have in the
business. It is a measure of the overall
effectiveness of management in employing the
resources available to the business.
 Heavily depreciated plant and equipment, large
amounts of intangible assets, or unusual
revenue or expense items can cause distortions
to the ratio.
 Is also known as return on investment.
Slide 28.19
Use of ROCE as a target
The Royal Mint’s financial performance
improved for the second consecutive year in
2007–08, with a pre-exceptional operating profit
of £9.6m
The return on capital employed of 11.5% was
substantially above the financial ministerial
target of 7.2%.
Slide 28.20
Calculation of ROCE
2003
2002
Return on capital employed
9.19% 8.95%
Financial leverage multiplier
2.56
2.53
Return on equity
23.5
22.6
Slide 28.21
Calculation of ROCE (Continued)
ROCE is calculated as the product of:
 the % return on sales and
 the asset turnover.
Slide 28.22
Asset turnover
 The asset turnover ratio measures the number of
times that ₤1 of assets results in a ₤1 of revenue
 If asset turnover increases, then either the total
value of revenue is increasing or the capital asset
base is decreasing, or both
 Has increased sales been achieved at the
expense of the profit margin?
 Has a reduction in the capital asset base
adversely affected productive capacity?
Slide 28.23
Primary operating level ratios
Primary utilisation ratio (asset turnover)
Sales
Capital employed
 Improved by:
 Sales increasing
 Assets decreasing
• Fixed asset replaced?
• Inventory falling?
Slide 28.24
Sales/capital employed increasing
Sales increasing
 Volume increase
 Price increase
 Possible Effect on profits

Price reductions

Sales promotions.
Slide 28.25
Sales/capital employed increasing
(Continued)
Assets decreasing
• Non-current assets
– Disposal?
– Impairment?
• Inventory
– Run down of inventory?
– Possible stock outs?
Slide 28.26
Current ratio
a short-term measure of a company’s liquidity
position comparing current assets with current
liabilities.
no rule of thumb measure, such as 2:1, that
can be applied.
appropriate ratio depends on the industry
sector and each individual company’s
experience.
Slide 28.27
Current ratio – what if it increases?
– Good reasons
Growth:
Inventory buildup expecting sales growth
Expansion:
Permanent increase in scale.
Slide 28.28
Current ratio – what if it increases?
(Continued)
Poor reasons:
 Decline:
 Inventory buildup result of falling sales
 Inefficiency:
 Poor control over working capital.
Slide 28.29
Subsidiary ratios
Gearing ratios
Liquidity ratios
Asset utilisation ratios
Investment ratios
Profitability ratios.
Slide 28.30
Subsidiary ratios – gearing (leverage)
 Analysing long-term financial stability – to indicate a company’s
capacity to meet long-term obligations (solvency)
Slide 28.31
There are a number of different formulae
used to express the gearing ratios
(a) Long-term debt to Capital employed ratio
(b) The debt ratio
– (total debt / total assets)
(c) The debt-to-equity ratio
– (total debt / total equity)
(d) The equity ratio
– (equity / assets).
Slide 28.32
Definition of gearing for text
For the purposes of illustrations in this
chapter we are defining gearing as long-term
debt to Capital employed.
A number of companies report the debt/equity
ratio as their preferred choice and include
total debt rather than long-term debt if a
company relies heavily on overdraft facilities.
Slide 28.33
Subsidiary ratios – gearing (leverage)
 Leverage (debt) ratios
 Leverage ratios measure the extent to which:
borrowed funds are used to finance the business, and
earnings can decline before the business is unable to
meet its fixed charges.
 Leverage ratios measure the business’s longterm solvency – the ability of the business to
meet all of its liabilities
 Leverage ratios are calculated by comparing
fixed charges and earnings from the Income
Statement, or by relating debt and equity items
in the Balance Sheet
Slide 28.34
Subsidiary ratios – gearing (leverage)
 Creditors use them to see whether the business’s profit
can support interest and other fixed charges and
whether there are enough assets available to pay off
debt if the business fails. Shareholders are interested
because the higher the debt, the higher the interest
expense and, therefore, the less profit available to them.
If borrowing and interest are excessive, the business
may become insolvent.
 The various types of leverage ratios are:
 • debt to total assets ratio
 • debt to equity ratio
 • times interest earned
 • cash flow to debt ratios.
Slide 28.35
Subsidiary ratios – gearing (leverage)
 Debt to total assets ratio
 Measures the percentage of funds provided by creditors,
and shows the protection provided by the shareholders
for the creditors. It is calculated as follows:
 The higher the ratio, the greater the risk being assumed
by the creditors. A lower ratio suggests long-term financial
stability. A company with a low ratio also has greater
flexibility to borrow in the future.
Slide 28.36
Subsidiary ratios – gearing (leverage)
 Creditors prefer low-to-moderate ratios because
these indicate greater safety for their claims on
the company.
 Shareholders may seek higher leverage
because this increases the return on their
investment.
 A highly leveraged company can also affect the
shareholders’ returns unfavourably. If profits are
not enough to cover interest expenses,
shareholders will not receive any dividends and
the company could become insolvent and be
liquidated.
Slide 28.37
Subsidiary ratios – gearing (leverage)
 Debt to equity ratio
 The debt to equity ratio is calculated as follows:
 Debt may be defined as either total debt or longterm debt. Most analysts tend to use long-term
rather than total debt for this ratio.
Slide 28.38
Subsidiary ratios – gearing (leverage)
Long-term creditors prefer to see a low-tomoderate debt to equity ratio. Why?
This means that there is greater protection
for them and more at stake for the
shareholders. There is, therefore, greater
motivation for the owners to ensure the
business operates profitably.
Slide 28.39
Subsidiary ratios – gearing (leverage)
 Times interest earned (Interest cover)
 A measure of the degree of protection creditors have from default on
interest payments. It shows the business’s ability to meet its interest
payments. The ratio is calculated as follows:
 Net operating profi t is earnings before interest and taxes (EBIT).
EBIT is used because the ability of the business to pay interest is not
affected by the company’s tax liability.
 What does a low times interest earned ratio suggest?
 The business may have difficulty in raising additional finance if the
need arises.
Slide 28.40
Subsidiary ratios – gearing (leverage)
 If debt is bad, why have any?
 Despite its riskiness, debt is a flexible means of financing
certain business operations.
 Because it has a fixed interest charge, it limits the cost of
financing and presents a situation where leverage can
be used to advantage.
 Eg, if the business can earn more than the interest cost,
it will make an overall profit. In times of inflation, debt
(which is a fixed dollar amount) is repaid with ‘cheaper’
dollars than the ones originally borrowed. The dollars
used to repay the debt are worth less in buying power
than the ones originally borrowed. But, if the business
does not earn a return on its assets equal to the cost of
interest, it operates at a loss.
Slide 28.41
Subsidiary ratios – gearing (leverage)
 Cash flow to debt ratios
 A measure of the ability of a business to service its debt is
the relationship of annual cash flows to the amount of
debt outstanding. The ratio is calculated as follows:
 Cash flow is defined as the cash generated from the
operations of the business that is shown in the Cash Flow
Statement
 The cash flow to long-term debt ratio can also be used
for evaluating the long-term solvency of a company
Slide 28.42
Subsidiary ratios – liquidity
 analysing stability – to indicate a company’s capacity to meet shortterm obligations
Slide 28.43
Subsidiary ratios – liquidity
 Liquidity ratios
 Liquidity ratios look at the relationships between
the components of working capital.
 The most commonly used ratios are:
 1 working capital
Working capital = Current assets – Current liabilities
 2 current ratio
a measure of immediate ability to pay debts.
 3 liquidity (quick or acid test) ratio.
the ratio of liquid assets to current liabilities.
Slide 28.44
Subsidiary ratios – liquidity
 Working capital
Working capital = Current assets – Current liabilities
 used as a measure of a business’s ability to meet
its short-term commitments.
 Which company has the better working capital?
Slide 28.45
Subsidiary ratios – liquidity
 The current ratio is the ratio of current assets to
current liabilities.
 The make-up and quality of the current assets is a
crucial factor in using this ratio as an indicator of the
business’s liquidity.
 Consider the following two companies.
Slide 28.46
Subsidiary ratios – liquidity
 Company B is more able to meet its current obligations. It does not
have to convert inventories to cash. It must still collect its receivables,
but this is easier than converting inventories into sales to create
receivables that must then be collected as cash.
Slide 28.47
Subsidiary ratios – liquidity
 What can cause the current ratio to increase?
Decrease?
 Increases could indicate
 poor inventory management,
 poor credit control,
 unfavourable prices for purchases,
 poor production planning and increases in sales due to high
discounting leading to increased accounts receivables.
 Decreases could indicate
 improved inventory control,
 Increases in cash sales, and
 improved production planning.
Slide 28.48
Subsidiary ratios – liquidity
 Liquidity (quick or acid test) ratio
 Liquid (or quick) assets are cash, marketable
securities, and accounts receivable – the assets
that can be turned into cash quickly
 It shows a business’s ability to meet its current
obligations promptly.
 When the ratio is less than 1, it implies
dependency on inventories and other current
assets that have been excluded from the formula
to liquidate short-term debt
Slide 28.49
Subsidiary ratios – liquidity
 The formula is:
 Should all current liabilities be included, or just those that
could be termed ‘quick’ liabilities (i.e. those liabilities that
require to be met immediately)?
 Bank overdraft, Taxes payable, Dividends payable?
 When must these be paid?
Slide 28.50
Subsidiary ratios – liquidity
 Current and liquidity ratios of seven New Zealand companies
(2006 figures)
 Company
Current ratio Liquidity ratio
 Cavalier Corporation Ltd
2.97
1.42
 Michael Hill International Ltd1
3.80
0.43
 Nuplex Industries Ltd
1.99
1.21
 Provenco Group Ltd
1.64
0.98
 Steel and Tube Holdings Ltd
2.29
1.14
 Trustpower Ltd2
1.02
1.02
 The Warehouse Group Ltd1
1.93
0.46
 1 These companies purchase their inventories on credit, but the majority of
their sales are cash sales. Consequently, they are able to operate
satisfactorily with a low liquidity ratio
 2 Because of the nature of this company’s’ business, it does not hold any
inventories, hence the current and liquid ratios are identical.
Slide 28.51
Subsidiary ratios – liquidity
 What is an acceptable current ratio or liquidity ratio?
 Factors that need to be considered when evaluating
short-term solvency include:
 the size of operating costs – the financial statements
do not usually show how much cash is needed for
operating expenses such as salaries, rent and expenses
other than those required to be disclosed. If these
expenses are large and the liquid assets are few, the
business could have problems meeting them.
 bank credit – if the business has an excellent credit
record and facility with its banker, lower current and
liquidity ratios can be carried. The Warehouse Group
would fall into this category – hence its ability to operate
with a liquidity ratio of 0.45 : 1.
Slide 28.52
Subsidiary ratios – liquidity
 seasonal trade patterns –ratios can be distorted through the
seasonal build-up, or run-down, of inventories and accounts
receivable to meet sales demands when they peak. As
retailers, The Warehouse and Briscoe Groups will carry much
larger inventories over the Christmas shopping period than at
other times of the year. However, these companies also
increase certain types of inventories for other times during the
year – such as Mother’s Day.
 the type of business – for manufacturers and wholesalers, a
larger ratio is needed because most of these firms’ sales are
on credit, and it will be up to 51 days from the date of sale
before cash payment is due to be received. Retailers,
however, have a considerable volume of cash sales to
supplement the credit sales and so will have a greater ability
to meet cash liabilities as they fall due. Therefore, they can
operate with a lower liquidity ratio.
Slide 28.53
Quick ratio – identify the company
norm
The following is an extract from the 2008 Annual Report of
Barloworld:
2004 2003 2002 2001 2000 1999
Quick ratio 1.0
0.8
0.7
0.8
0.9
1.1
Rule of thumb is 1:1
Consider the company norm
Slide 28.54
Activity utilisation ratios
 Asset utilisation
 Asset utilisation, or activity, ratios show how
much use the business makes of its assets in
generating sales.
 They indicate whether the business’s
investments in current and long-term assets are
too large or too small.
 These ratios also indicate the ability of the
business to turn assets, especially inventories
and accounts receivable, into cash and are,
therefore, further indicators of solvency.
Slide 28.55
Activity utilisation ratios
Activity ratios include:
inventory turnover
days’ sales in inventory
accounts receivable turnover
average collection period (or days’ sales
outstanding)
cash conversion cycle
non-current asset turnover
total assets turnover
Slide 28.56
Activity utilisation ratios
 To avoid the problems of seasonal fluctuations in
the sizes of inventories and accounts receivable,
the monthly balances of these items should be
taken and averaged when calculating ratios
relating to these.
 This is possible for internal analysis, but not
when undergoing an external analysis.
 Most external analysis uses either the end-ofyear figures available in the published financial
statements of companies, or an average of the
opening and closing figures that are provided in
the published reports.
Slide 28.57
Inventory turnover change
analysing activity – to indicate how
effectively a company is using its assets
Is it a proactive decision?
Is it reactive such as responding to economic
changes?
Has there been misrepresentation?
Refer to narrative for clues.
Slide 28.58
Inventory turnover
 Inventory turnover measures the number of times
inventory is sold and replaced during the year.
 Why is COGS used?
 Because inventories are valued in terms of their
cost. The sales figure includes the profit mark-ups
Slide 28.59
Inventory turnover










A high turnover can indicate:
better liquidity or superior merchandising
of needed inventory for sales, which in turn could mean
unhappy or lost customers
A low turnover implies:
a large investment in inventories relative to the amount
needed to service sales
poor liquidity,
possible overstocking, or
obsolete stock.
may also be an indicator of a planned inventory build-up
in the case of material shortages
Slide 28.60
Inventory turnover
 What are some problems involved with using COGS?
 For companies such as The Warehouse Group, for example,
the average turnover of the food items sold will be much
higher than the turnover of electrical appliances – yet both of
these types of goods are included in the turnover figure
 Many companies do not disclose their cost-of-sales figures
and so their sales figures are used as a surrogate for cost of
sales in this calculation. An inventory turnover figure
calculated using sales will be higher than would be calculated
if cost of sales is used.
 Another example is the Briscoe Group whose financial year is
to 28 January. It is likely to have sold down inventories after
the Christmas rush and New Year sales. Consequently, this
turnover figure is likely to be higher than would be the case if
average end-of-month inventory figures are used.
Slide 28.61
Accounts receivable turnover
 Days’ sales in inventory
 shows the length of time (in days) that it takes to sell
inventory. The formula for calculating this ratio is:
 if sales are affected by seasonal patterns, the result
 may be misleading.
 if the days’ sales in inventory is understated, the liquidity
of the inventory will be overstated.
Slide 28.62
Accounts receivable turnover
 Accounts receivable turnover
 measure of liquidity in terms of cash collection. The
formula is:
 Average collection period
 measures liquidity in terms of cash collection. The
formula is:
Slide 28.63
Accounts receivable turnover
 The higher the turnover figure (or the lower the
collection period), the more successful the
business is in collecting cash, and the better off
its operations are.
 Any large variations from month to month with
the accounts receivable figure will affect the
usefulness of this ratio
 These ratios also indicate the business’s credit
policy.
 If customers are given more time to pay, the
collection period will generally be longer.
Slide 28.64
Accounts receivable turnover
 A long collection period may also arise because
of
weaknesses in the billing procedures,
ineffective incentives to get customers to pay on time,
poor selection of customers to whom credit is extended.
 A longer collection period can only be justified
if it leads to greater sales, and
if the profit on these extra sales covers the cost of
extending the credit.
Slide 28.65
Accounts receivable turnover
 The average collection period is affected by the pattern
of sales.
 If sales are rising, the ratio is more current than if sales
are steady or falling. Why?
 Because a greater proportion of the sales are billed in
the current period.
 If sales are falling over time, the ratio will show higher
average collection periods, or older debts outstanding.
 If there is a rapid change in the pattern of sales or if
there is a fluctuating pattern to sales behaviour, the
average collection period is not a realistic portrayal of the
liquidity of receivables.
Slide 28.66
Cash conversion cycle
 measures the delay between payments for inputs
and receipts from sales.
 Average payables period is the time it takes to
pay accounts payable and is calculated as
follows:
Slide 28.67
Cash conversion cycle
 In interpreting the cash conversion cycle figure,
it is important to look at the trend in all three of
its components.
 If shorter periods in processing inventories
and/or accounts receivable are off-set by a
longer period in paying accounts payable, any
efficiencies gained from the improvement(s) in
inventory and accounts receivables ratios could
be eliminated.
Slide 28.68
Non-current (Fixed asset or property,
plant and equipment) turnover
 measures the productivity of the business’s
property, plant and equipment. The formula is:
 A low ratio indicates:
 assets are being used inefficiently, or
 there is unused capacity available.
Slide 28.69
Non-current (Fixed asset or property,
plant and equipment) turnover
 Over-investment in property, plant and equipment :
 may require the business to assume higher interest charges,
which may result in inadequate working capital.
 Under-investment in property, plant and equipment
(which can give a higher ratio) may result in:
 insufficient capacity and
 a deterioration of existing equipment
 Assets that have been depreciated to close to zero, and
labour-intensive operations, may cause a distortion of
this ratio because these factors will produce a higher
ratio (the carrying, or book, value of the assets is low) –
suggesting the assets are being used extremely
efficiently.
Slide 28.70
Non-current (Fixed asset or property,
plant and equipment) turnover
 Total assets turnover
 shows how well the business is using its total assets
to generate sales. It should only be used to compare
businesses within specific industry groups and in
conjunction with other operating ratios to determine
the effective employment of assets. The formula is:
Slide 28.71
Subsidiary ratios – investment
Slide 28.72
Earnings per share
Elliott & Elliott covered this in ch 27
We also looked at the other investment
ratios when discussing ch 27
Slide 28.73
Earnings per share – use in strategic
planning Gamma Holding NV 2002
Gamma aims to maximise shareholder value
Strives for continuous growth of EPS of 10%
while maintaining healthy balance sheet ratios
and generating positive cash flows
Aims to achieve an average ROCE of 15%.
Slide 28.74
PE – a measure of market
confidence
Market price takes into account macro events:
Political factors
– imposition of trade embargoes or sanctions
Economic factors
– downturn in manufacturing activity
Companyrelated events
– possibility of organic or acquired growth
the implication of financial indicators for future cash
flow estimates.
Slide 28.75
PE ratio – implication of financial
indicators
Statement of financial position:
Change in debt/equity ratio in relation to prior
periods
New borrowings for finance expansion
Debt restructuring following inability to meet
current repayment terms
Contingent liabilities that could be damaging if
they crystallise – non-current assets being
increased or not being replaced.
Slide 28.76
PE ratio – implication of financial
indicators (Continued)
Adequacy of working capital
Low acid test (quick) ratio in relation to prior
periods indicating possible liquidity difficulties
Change in current ratio in relation to prior
periods, i.e. higher indicating a build-up of
slow moving inventory and lower possible
stock-outs.
Slide 28.77
PE ratio – implication of financial
indicators – income statement
Income statement:
 Change in sales trend
 Limited product range, products moving out of patent
protection period
 Expanding product range
 Changes in technology beneficial or otherwise to company
 High or low capital expenditure/depreciation ratio
indicating that productive capacity is not being maintained
 Loss of key suppliers/customers, e.g. loss of longstanding
Marks & Spencer contracts
 Change in ratio of R&D to sales.
Slide 28.78
Profitability ratios
 Profitability ratios are designed to assist in the
evaluation of management performance.
 Poor performance indicates a basic failure that,
if not corrected, could result in the business
going into liquidation.
 A business’s past profitability may give a better
understanding for decision making.
 Profitability usually also affects a firm’s liquidity
position.
 A business can make a profit but not have
enough cash available to meet its liabilities.
Why?
Slide 28.79
Profitability ratios
 Measures of profitability include:
gross profit margin (or mark-up)
net operating margin
profit margin on sales
expenses as a percentage of sales
percentage change in sales
return on total assets
return on equity.
 Each of these ratios relates earnings to sales,
assets, or equity.
 Why do creditors, owners, and management pay
close attention to them?
Slide 28.80
Profitability ratios
 Answer:
 Without profits, a business could not attract
outside capital.
 If these ratios are not adequate, creditors and
owners become concerned about the
business’s future, and may withdraw their funds.
Slide 28.81
Profitability ratios
 Gross profit margin and mark-up
 Reflects the effectiveness of pricing policy and of
production efficiency. The formula is:
 Mark-up expresses the gross profit margin in terms of
the cost of goods sold, rather than in terms of sales.
Slide 28.82
Profitability ratios
 These ratios indicate managerial efficiency in selling the
company’s merchandise.
 Because there are usually wide variations between
businesses, it is the trend rather than a comparison
between businesses that is more important here –
especially if the types of activity undertaken are not very
similar.
 As listed companies do not disclose their cost of sales,
the gross profit margin and mark-up ratios normally
cannot be reliably measured. Consequently, they are
ratios used by management for internal purposes, rather
than by investors and creditors, for assessing
performance.
Slide 28.83
Profitability ratios
 Net operating margin
 Measures the effectiveness of production and sales in
generating pre-tax income. The higher this ratio is, the better.
Formula is:
 Non-operating income and expense items are excluded - these
are not directly related to the production or sales functions of
the business.
 Businesses finance their activities in different ways, so
earnings before interest and tax (EBIT) is used so that relevant
comparisons can be made.
Slide 28.84
Profitability ratios
 Profit margin on sales
 Indicates management’s ability to operate the business
well enough to recover both fixed and variable costs, and
leave a margin of reasonable profit for the shareholders.
The formula is:
 The ratio mixes the effectiveness of sales in producing
profits (reflected by the net operating margin) with the
effects of non-operating activities (included in net profit
before tax).
Slide 28.85
Profitability ratios
 Other ratios
 Compare various expenses as a percentage of
sales to ascertain whether a particular expense
has an undue effect on net profit.
 The year-on-year percentage change in sales
may be a useful indicator of sales growth.
The effect of inflation on sales price needs to be
considered when using this ratio.
A better indicator for ascertaining the change in sales
trend is the change in volume (units) sold.
Slide 28.86
Using ratios to make business decisions
 Inter-relationship of ratios
 Ratios must be evaluated together, not
individually – why?
 Because of the interactions and
interrelationships between the various items that
make up the ratios
 Eg. Short-term ratios may suggest impending
problems but long-term ratios suggest strength
and vice versa
Slide 28.87
Using ratios to make business decisions
 Reporting and the usefulness of ratio analysis
 Calculating ratios and commenting on the trends
from one period to another is not difficult.
 Interpreting the ratios – that is, explaining why the
trends have occurred, and suggesting how these
can be changed or improved is much more difficult,
and much more important
 Need to compare with standards – eg industry
averages
 Look for possible reasons for variations – good and
bad – and how interactions might have an effect
Slide 28.88
Using ratios to make business decisions
 Pitfalls
 Accounting policies applied by the company and those
with whom the ratios are being compared - are these
consistent?
 Companies of the same size in the same industry should
be used for comparison.
 Increasing diversification of company operations,
 Accelerated changes in technology, and
 Rapid changes in company sizes
 make it very hard to find a suitable company within an
industry with which valid comparisons can be made.
Slide 28.89
Using ratios to make business decisions
 Recent and past ratios should be compared. A ratio
may fluctuate considerably over time, with many reasons
for this.
 Legislation,
 international affairs,
 competition,
 scandals,
 resignation of a senior manager
 and many more factors can turn profits into losses
 Ratios should be analysed over a period of 5 – 10 years.
 A single figure, or ratios for any one year may give a
misleading indication of financial condition and company
performance.
Slide 28.90
Using ratios to make business decisions
 Limitations
 Ratios have limitations.
 A ratio may indicate something is wrong, but it
does not identify the problem.
 The figures that make up the ratio have to be
analysed to find out which items (assets and/or
liabilities) have changed.
 Each item that goes into the ratio – as well as
those that impinge on these items – must be
analysed to see what has caused the change.
Other factors, such as competitors and the state
of the economy, also need to be considered.
Slide 28.91
Using ratios to make business decisions
Ratio analysis cannot predict the future,
but knowledge gained from studying ratios
and related information can help you give
informed recommendations and make
informed decisions.
Slide 28.92
Using ratios to make business decisions
Slide 28.93
Limitations of ratio analysis
Ratios are useful flags but there are limitations that
the reader needs to bear in mind – these include
limitations:
• relating to the underlying financial statements:
– the reliability of the financial statements that are
themselves made suspect
• window dressing e.g. dispatching goods at the end
of the period knowing that they are defective, so that
they appear in the current year’s sales, and
accepting that they will be returned later in the next
period.
Slide 28.94
Limitations of ratio analysis (Continued)
– The possibility that the accounts are subject to
fundamental uncertainty which could affect the
going concern concept – there might be full
disclosure in the notes but ratios might not be
accurate predictors of earnings and solvency.
• Arising because ratios make use of the
statement of financial position figures
– The end of year figures are static and might not
be a fair reflection of normal relationships such as
when a business is seasonal.
Slide 28.95
Limitations of ratio analysis (Continued)
• E.g. a toy manufacturer might have little inventory
after supplying wholesalers in the lead up to
Christmas.
• Any ratios based on the inventory figure such as
inventory turnover could be misleading if calculated
at say a 31 December year end.
• Invalidating intercompany comparisons, such as:
– Use of different measurement bases e.g.
• Non-current assets reported at historical cost or
revaluation
• Revaluations carried out at different dates.
Slide 28.96
Limitations of ratio analysis (Continued)
– Use of off-balance sheet finance e.g.
• Structuring the terms of a lease to ensure that it is
treated as an operating lease and not as a finance
lease
• Special purpose enterprises to keep debts off the
statement of financial position.
– Use of different commercial practices e.g.
• Factoring accounts receivable, so that cash is
increased – a perfectly normal transaction but one
which could cause the comparative ratio of days
credit allowed to be significantly reduced.
Slide 28.97
Limitations of ratio analysis (Continued)
• Invalidating intercompany comparisons, such as:
– Applying different accounting policies e.g.
• Adopting different depreciation methods such as
straight line and reducing balance
• Adopting different inventory valuation methods such as
FIFO and weighted average
– Assuming different degrees of optimism/pessimism
while making judgment-based adjustments to noncurrent and current assets e.g.
• On the impairment review of intangible and tangible
non-current assets
• On writing down inventory and accounts receivable.
Slide 28.98
Limitations of ratio analysis (Continued)
• Invalidating intercompany comparisons, such as:
– Having different definitions for ratios e.g.
• The numerator for ROCE may be operating profit,
profit before interest and tax, profit before interest,
profit after tax etc
• The denominator for ROCE may be total assets, total
assets less intangibles, net assets etc
–
The use of norms can be misleading e.g.
• A current ratio of 2:1 may be totally inappropriate for
a company like Tesco which does not have long
inventory turnover periods – as its sales are for cash
it would also not produce trade receivable collection
period ratios.
Slide 28.99
Limitations of ratio analysis (Continued)
• Invalidating intercompany comparisons, such as:
– Making appropriate choice of comparator companies for
benchmarking – this is a simple idea but more difficult in
practice e.g.
• How to find companies with a similar trade?
• How to set criteria for selection?
• Should it be
– The industry average ratios – but these may be based on
many companies operating under very different economies of
scale or companies with
– Similar amount of capital employed or
– Similar amount of sales or
– Some other criteria.
Slide 28.100
Using ratios to make business decisions
 Analysing the Cash Flow Statement
 a Cash Flow Statement provides is a summary of the
company’s use of cash
 Cash Flow Statements can be investigated using
horizontal and vertical analyses, as Illustration 10.1 in
the handout shows.
 Look closely at the Anna Corporation example in the
handout
 A business cannot survive if it relies on selling assets
and/or borrowing to meet its cash flow needs
 Successful companies generate the greatest percentage
of their cash from operations, not from selling their fixed
assets or from borrowing money.
Slide 28.101
Using ratios to make business decisions
Analysts are particularly interested in an
entity’s free cash flow – the net cash flow
from operating and investing activities.
If an entity continually has positive cash
flow from these two activities combined, it
means it can pay dividends and/or repay
debt without risk – even if, like The
Warehouse Group, its liquidity ratio is
considerably less than one each year.
Slide 28.102
Review questions
1. (a) Explain the uses and limitations of ratio analysis
when used to interpret the published financial
accounts of a company.
(b) State and express two ratios that can be used to
analyse each of the following:
(i) profitability
(ii) liquidity
(iii) management control.
(c) Explain briefly points which are important when
using ratios to interpret accounts under each of the
headings in (b) above.
Slide 28.103
Review questions (Continued)
4. Discuss why a company might decide to report
EBITDA in addition to operating profit.
7. Discuss why an increasing current ratio might not be
an indicator of better working capital management.