Analyzing Your Financial Ratios
Overview
Any successful business owner is constantly evaluating the performance of his or her company,
comparing it with the company's historical figures, with its industry competitors, and even with
successful businesses from other industries. To complete a thorough examination of your
company's effectiveness, however, you need to look at more than just easily attainable numbers
like sales, profits, and total assets. You must be able to read between the lines of your financial
statements and make the seemingly inconsequential numbers accessible and comprehensible.
This massive data overload could seem staggering. Luckily, there are many well-tested ratios out
there that make the task a bit less daunting. Comparative ratio analysis helps you identify and
quantify your company's strengths and weaknesses, evaluate its financial position, and
understand the risks you may be taking.
As with any other form of analysis, comparative ratio techniques aren't definitive and their results
shouldn't be viewed as gospel. Many off-the-balance-sheet factors can play a role in the success
or failure of a company. But, when used in concert with various other business evaluation
processes, comparative ratios are invaluable.
Profitability and Efficiency Ratios (Ordinary and Higher level)
Return on
Capital
Employed
Indicates the efficiency and profitability of a
company’s capital investments i.e. an indicator of how
well the company is using capital to generate revenue
_____________
Should normally be higher than the rate the company
borrows at, otherwise any increase in borrowings will
reduce shareholders earnings.
Return on
Shareholde
rs’ Funds (
Owners’
Equity)
%
Capital Employed
Return on Shareholders’ Funds reveals how much
profit a company earned in comparison to the total
amount of shareholder equity found on the balance
sheet. Shareholder equity is equal to total assets minus
total liabilities. It’s what the shareholders “own”.
Shareholder equity is a creation of accounting that
represents the assets created by the retained earnings of
the business and the paid-in capital of the owners.
A business that has a high return on equity is more
likely to be one that is capable of generating cash
internally. For the most part, the higher a company’s
return on equity compared to its industry, the better.
Net Profit +I & T (
operating profit)
Net Profit – I & T
______________
%
Shareholders’ Funds
Shareholders’ Funds =
Issued Ordinary Cap+
retained earnings
(reserves)
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Or =
Total Assets – Total Liabs
Gross
Margin
/Profit %
Indicates what the company's pricing policy is and
what the true mark-up margins are. The gross margin is
not an exact estimate of the company's pricing strategy
but it does give a good indication of financial health.
Without an adequate gross margin, a company will be
unable to pay its operating and other expenses and
build for the future. A company that boasts a higher
gross profit margin than its competitors and industry is
more efficient. Investors tend to pay more for
businesses that have higher efficiency ratings than their
competitors, as these businesses should be able to make
a decent profit as long as overhead costs are controlled
[overhead refers to rent, utilities, etc.]
Gross Profit
___________
%
Sales
● Results may skew if the company has a very
large range of products.
●
It is a very useful ration when comparing
with previous years.
●
A 33% gross margin means products are
marked up 50% etc.
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Percentage The percentage of the cost of sales accounted for by
Mark-up on the Gross profit
Cost
Gross profit
___________ %
Cost of sales
Net Margin
/ Profit %
This ratio tracks how the company has integrated sales
efforts, prices, and costs. The ratio is an indication of
how effective a company is at cost control. The higher
the net margin is, the more effective the company is at
converting revenue into actual profit. The net margin is
a good way of comparing companies in the same
industry, since such companies are generally subject to
similar business conditions. However, the net margins
are also a good way to compare companies in different
industries in order to gauge which industries are
relatively more profitable.( also called net profit
margin).
Net profit
_______________ %
Sales
Total
Expenses /
Sales ratio
Expenses to sales ratio gives an indication of the
efficency of the cost structure of your business.
Expenses
____________ %
Sales
Can be further analysed by
using different categories
of expenses, such as
administration, selling etc.
Working
Capital
Current assets minus current liabilities. Working
capital measures how much in liquid assets a company
has available to build its business. The number can be
positive or negative, depending on how much debt the
company is carrying. In general, companies that have a
lot of working capital will be more successful since
they can expand and improve their operations.
Companies with negative working capital may lack the
funds necessary for growth.( also called net current
assets or current capital.)
Current Assets – Current
Liabilities
Working capital management involves the
relationship between a firm's short-term assets and its
short-term liabilities. The goal of working capital
management is to ensure that a firm is able to continue
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its operations and that it has sufficient ability to satisfy
both maturing short-term debt and upcoming
operational expenses. The management of working
capital involves managing inventories, accounts
receivable and payable, and cash.
Liquidity / Solvency ratios (Ordinary and Higher level)
Liquidity
The ability of an asset to be converted into cash
quickly and without any price discount.
Liquidity Ratios are ratios that come off the Balance
Sheet and hence measure the liquidity of the company
as on a particular day i.e the day that the Balance
Sheet was prepared. These ratios are important in
measuring the ability of a company to meet both its
short term and long term obligations.
Solvency
The financial ability to pay ALL its debts when they
become due. The solvency of a company tells an
investor whether a company can pay its debts.
Current
Ratio
This ratio is obtained by dividing the 'Total Current
Assets' of a company by its 'Total Current Liabilities'.
The ratio is regarded as a test of liquidity for a
company. It expresses the 'working capital'
relationship of current assets available to meet the
company's current obligations.
C. Assets : C Liabilities
This ratio is obtained by dividing the 'Total Quick
Assets' of a company by its 'Total Current Liabilities'.
Sometimes a company could be carrying heavy
inventory as part of its current assets, which might be
obsolete or slow moving. Thus eliminating inventory
from current assets and then doing the liquidity test is
measured by this ratio. The ratio is regarded as an
acid test of liquidity for a company. It expresses the
true 'working capital' relationship of its cash, accounts
receivables, prepaids and notes receivables available
to meet the company's current obligations.
Liquid assets : CL
Quick ratio
Acid Test
Liquid ratio
Norm 2 : 1
If higher, it could indicate
an inefficient use of
resources and a build-up of
stock
Liquid assets = Current
Assets – Stock and
Prepayments
Also = Debtors and Bank /
Cash
If this ratio goes above
1: 1, then there may be too
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much cash lying around
idle, which could be
generating profits
When a business has insufficient finance to sustain its
Overtrading level of trading. A business is said to be overtrading
when it tries to engage in more business than the
investment in working capital will allow. This can
happen even in profitable circumstances
Avoiding overtrading
Effective debt management and
credit control can help you avoid
overtrading, by ensuring that you
get paid more efficiently and
Definition O`ver`trad´ing
have the cash to pay suppliers
and staff.
n. 1. The act or practice of buying goods beyond
the means of payment; a glutting of the
market.
● Set new payment terms
Overtrading is a common problem, and it often
happens to recently started businesses and to rapidly
expanding businesses. Cash often has to leave the
business before more cash comes into it. For example,
wages and salaries are usually payable weekly or
monthly, and there may also be other expenses that
need to be met promptly, such as telephone bills and
rent.Although you may pay suppliers on credit,
your customers may also pay you on credit. It doesn't
● Offer discounts for
prompt payment
● Encourage automated
payments
● Use factoring or invoice
discounting
take much to upset the balance.It is also possible to
run out of cash, even if your customers pay cash and
● Negotiate payment
do not have credit accounts. For example if you have
terms with your
suppliers
to pay suppliers quickly, perhaps even in advance, or
if you have to hold stock for a long time. What
matters is the amount of working capital and the
timing of cash coming in and going out.
● Improve your stock
control
● Lease your assets or
buy them on hire
purchase.
● Inject new capital
● Reduce the money
taken out
● Cut costs and be more
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efficient
Activity Ratios (Ordinary and Higher Level)
Activity ratios measure the operating characteristics of the firm. Activity ratios include the stock
turnover rate, average collection period, average payment period. ( Asste Turnovers may also be
included here)
Stock
Turnover
Ratio
The STOCK TURNOVER RATIO shows how
many times over the business has sold the value of its
stocks during the year. The higher the stock turnover
the better, because money is then tied up for less time
in stocks. A quicker stock turnover also means that
the firm gets to make its profit on the stock quicker,
and so the firm should be more competitive.
However, it will vary between industries and so it is
important to compare within an industry.
Cost of Sales
__________ ( times)
Average Stock
NB Average Stock =
Opening S + Closing S
2
Debtors’
Average
period of
Credit
Indicates the average time taken to collect trade
debts. For example, when the average collection days
lengthen it could be the result of economic factors,
such as a recession. It could be that a particular
industry sector is hardening with the result cashflow
and margins are tighter for all companies involved.
Monitoring average collection is also a great way of
monitoring credit control performance; if you stop
chasing the debts for a month then you can expect the
average collection days to increase. For start-ups it is
all about cashflow and not paper profits and average
collection days helps put credit control into focus
rather than it being a blur.
Trade Debtors x 365
_________________ (days)
Credit sales
For months, use 12 instead
of 365 in the fraction
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Creditors
Average
Period of
Credit
This ratio is much the same as the debtor ratio. It
expresses the relationship between credit purchases
and the liability to creditors. It can be stated as the
number of days that credit purchases are carried on
the books.
There is no need to pay creditors before payment is
due. The company’s objective should be to make
effective use of this source of free credit, while
maintaining a good relationship with creditors.
Trade Creditors x 365
______________ (days)
Credit Purchases
For months, use 12 instead
of 365 in the fraction
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Gearing Ratios ( Higher level only)
Gearing
Gearing is the relationship between long term
liabilities and capital employed.
Shareholders ought to have the upper hand because if
they don't that could cause them problems as follows:
●
●
Shares earn dividends but in poor years dividends may
be zero: that is, businesses don't always need to pay
any!
Fixed Interest Capital x 100
Capital Employed
(Fixed Interest Capital = Loans +
Debentures + Preference Shares)
Long term liabilities are usually in the form of loans
and they have to be paid interest; even in bad years the
interest has to be paid
Fixed Interest Capital x 100
●
Equity shareholders have the voting rights at general
meetings and can make significant decisions
Equity Capital
●
Long term liability holders don't have any voting rights
at general meetings but they have the power to override
the wishes of the shareholders if there are severe
problems over their interest or capital repayments
(Equity capital = OSC+Reserves)
Low
Gearing
If Fixed Interest Capital is < 50% of the Total
Capital, or if it is < the Equity Capital
High
Gearing
If the Fixed Interest Capital is > than 50% of the
Total Capital or is > the Equity Capital
A highly geared company is one
where there is a high proportion
of debt to equity, and can be
considered a risky investment as
there is a higher likelihood of the
company being unable to pay its
large debts
Interest
A ratio used to determine how easily a company can
pay interest on outstanding debt. The ratio is
PBIT
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Cover
calculated by dividing a company's earnings before
interest and taxes (PBIT) of one period by the
company's interest expenses of the same period
The lower the ratio, the more the company is
burdened by debt expense. When a company's
interest coverage ratio is 1.5 or lower, its ability to
meet interest expenses may be questionable. An
interest coverage ratio below 1 indicates the company
is not generating sufficient revenues to satisfy interest
expenses, and may be having solvency problems.
Interest Charges for the
Year
( expressed as number of
times)
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Investment Ratios (Higher Level only)
Earnings
Per Share
(EPS)
The portion of a company's profit allocated to each
ordinary share. EPS serves as an indicator of a
company's profitability.
Net Profit ( after Pref Div)
Earnings per share is generally considered to be the
single most important variable in determining a
share's price. It is also a major component of the P/E
ratio.
Number of Ord. Sh. Issued
An important aspect of EPS that's often ignored is the
Capital that is required to generate the earnings (net
income) in the calculation. Two companies could
generate the same EPS , but one could do so with less
equity (investment) - that company would be more
efficient at using its capital to generate income and,
all other things being equal, would be a "better"
company. Investors also need to be aware of earnings
manipulation that will affect the quality of the
earnings number. It is important not to rely on any
one financial measure, but to use it in conjunction
with statement analysis and other measures.
Price
earnings
ratio
(P/E)
The market price of an ordinary share divided by its
earnings per share for 12 months.
Market Price of one Ord Sh
The ratio indicates the number of years it would take
to recover the share price, based on the current
earnings of the company.
Earnings Per Share (EPS)
The P/E ratio of a share is used to measure how
cheap or expensive share prices are. It is probably the
single most consistent red flag to excessive optimism
and over-investment. It also serves, regularly, as a
marker of business problems and opportunities. ...
Expressed as a number of
years.
However, the P/E ratio doesn't tell us the whole story
by itself. It's usually more useful to compare the P/E
ratios of one company to other companies in the same
industry, to the market in general or against the
company's own historical P/E
Dividend
Per
Ordinary
Share
DPS shows how much the shareholders were actually
paid by way of dividends.
Dividend x 100
( Be careful not to confuse this with EPS)
Number of Ord Sh Issued
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(DPS)
Dividend
Cover
(Dividend
Payout)
( expressed in cents)
It is called the dividend 'cover' because it shows us
literally how many times over the profits could have
paid the dividend. For example, if the figure is 3, this
means that the firm's profits (or earnings) were three
times the level of the dividend paid out. So is this
good news or bad news? It depends.
EPS
DPS
For investors looking for an income from their
shares, it is probably bad news as it implies that the
firm could have paid a considerably higher dividend
from the level of profits earned. However, for an
investor who is looking for future growth in the
capital value of their investment it is probably good
news as it implies that the firm has kept 2/3 of the
profit back to re-invest in the business.
Or
Net Profit (ATPD)
Ordinary Dividend
Generally speaking, a ratio of 2 or higher is
considered safe (in the sense that the company can
well afford the dividend), but anything below 1.5 is
risky. If the ratio is under 1, the company is using its
retained earnings from a previous year to pay this
year's
dividend.
Dividend
Yield
The dividend yield ratio allows investors to compare
the latest dividend they received with the current
market value of the share as an indictor of the return
they are earning on their shares. Note, though, that
the current market share price may bear little
resemblance to the price that an investor paid for
their shares. Take a look at the history of a business's
share price over the last year or two and you will see
that today's share price might be a lot higher or a lot
lower than it was a year ago, two years ago and so
on.
Dividend per Ordinary
Share
x100
Market price per Ordinary
Share
We clearly need the latest share price for this ratio
and we can get that from newspapers such as the
Financial Times, The Irish Times, The Irish
Independent. We can also find the share prices on the
Internet at http://www.londonstockexchange.com and
www.ise.ie
Period to
recoup
Indicates how long it will take an ordinary
shareholder to get back his/her investment
Market price of Ord Share
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Price at
payout rate
(Price
Dividend
payout
ratio)
based on the dividend payout policy of the
company
DPS
Expressed as number of
years
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Debenture Holders
[2010, 2006, 2001]
Key Questions and concerns
Key Ratios
Debentures are loans that are usually secured and are said to have
either fixed or floating charges with them.
A secured debenture is one that is specifically tied to the financing
of a particular asset such as a building or a machine. Then, just like
a mortgage for a private house, the debenture holder has a legal
interest in that asset and the company cannot dispose of it unless
the debenture holder agrees. If the debenture is for land and/or
buildings it can be called a mortgage debenture.
Debenture holders have the right to receive their interest payments
before any dividend is payable to shareholders and, most
importantly, even if a company makes a loss, it still has to pay its
interest charges.
If the business fails, the debenture holders will be preferential
creditors and will be entitled to the repayment of some or all of
their money before the shareholders receive anything.
How well is the company managing to cover the
interest payments out of profits?
Interest Cover
Is the company liquid? Is it managing its working
capital properly? What’s in the bank account?
Current Ratio, Acid Test, Credit to
Drs, Credit from Crs.
Is the company profitable? Is it controlling its
margins?
Return on Capital Employed;
Margins
Will their loan be fully redeemed (repaid) at the
end of its term?
How highly geared is the company? Are there
other loans for repayment and / or redemption?
What reserves has the company?
Gearing
Is there a Debenture Redemption
Reserve
What is the company’s Dividend Policy? Does it
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pay out large dividends
Dividend Payout Rate, DPS,
Are the Debentures secured on e.g. Fixed Assets?
Ordinary Shareholders
2007,2005,1999,1998]
[2009, 2008,
Prospective Shareholders [ 2004,2003,2002,2000]
Key Questions and Concerns
Key Ratios
How profitable is this company? What is the
Return on Capital Employed? Return on
Shareholders’ Funds?
Return on Capital Employed
How is the company managing its margins?
Gross / Net Margin
Is the company liquid? Is it managing its working
capital effectively? Can it pay short-term
creditors? Is it collecting debts effectively?
Current ratio; Acid Test; Credit to
Debtors; Credit from Creditors?
Is the company highly geared? Is there a large
interest liability or pref. dividend liability which
has first call on profits before ordinary dividend?
How well are the company’s profits covering the
interest?
Gearing
How much return is there on one ordinary share?
What is the actual dividend payout on one share?
How does this compare with returns and payouts
in other companies in the same sector, or if the
Return on Shareholders’ Funds
Interest Cover
EPS, DPS
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money was invested in a high-earning deposit
account? How long would it take to get back the
market price of one share at the current payout
rate?
What length of time will it take to recover the
share price based on current earnings? Are these
shares cheap or expensive? What are the
comparative P/E’s for other companies?
Dividend Payout Rate
P/E
What dividend yield was there from one share at
its current market price?
Dividend Yield
Company has applied for a loan : Advising the
Bank Manager [2011, 2007, 1999]
Key Questions and Concerns
Sector :What type of business is the company in?
Are there any issues to be aware of? ( seasonality,
exposure to downturn in the economy, export, etc)
What is the purpose of the loan? Purchasing a
Fixed Asset (land, building etc)? For Working
Capital (purchasing stock, paying creditors)
Key Ratios
Check the Question for any details
given which you can use in your
answer
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Is the company liquid? Is it managing its cash
Current ratio, Acid Test, Credit to
flow and working capital effectively? How will the Debtors, Credit from Creditors
new loan ( repayments of interest + capital) affect
liquidity?
How profitable is the company? What is the
return on Capital Employed? Is the company
generating enough profits and cash to pay back
existing debts and prospective debts?
Can the company pay existing loans, if any? How
well can the company cover interest out of profits?
How will the new loan affect this?
Is the company highly geared? What effect would
granting the loan have on the solvency of the
company in the event of profits declining? How
sure is the bank that it will be repaid the capital
sum + interest on time?
Return on Capital Employed,
Interest Cover
Interest Cover, Acid Test
( Do a calculation of the potential
repayments )
Gearing
Dividend Policy – how much of earnings are being
distributed to shareholders? Will there be enough
to repay the loan?
Dividend Cover
Security – will there be security on the loan ?
Fixed assets? Investments? Maybe they are already
secured on the Debentures or other loans?
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Reasons why a Gross Margin may have declined [2005, 1998]( Tyrrell)
Has Sales volume fallen or price per unit or both?
Has there been an increase in the cost of sales that has not been passed on to the
customers by increasing the selling price?
Has the buyer been purchasing stock that cannot be sold at a profit causing stock losses?
Has there been a substantial theft of goods causing lower closing stock?
Has there been incorrect stock valuation? Has closing stock been undervalued or opening
stock overvalued, causing higher cost of goods sold, and therefore lower Gross Profit?
Has there been a change in the Sales mix? Have there been more sales of lowprofit/mark-up type goods and lower sales of high-profit type goods?
Has there been a reduction in selling price – a price mark-down during sales without
corresponding drop in cost of sales?
Has there been theft of cash from cash registers causing drop in sales figures?
Has there been extra competition because of opening up of markets?
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Having assessed Watson plc what actions would you advise the company to take?
[2009]
The company has a liquidity problem. The Acid Test Ratio is only 0.74:1, which has
dropped from 0.98 :1 in 2007.
I would advise the company to take the following action:
Raise cash and improve liquidity by:
1. Paying out lower or no dividends
2. Selling investments rather than issuing debentures.
3. Issuing the remaining 50,000 shares.
4. Improving Gross Profit percentage of 19.9% by reducing cost of sales or by
passing on the increased costs.
5. Diversifying into other areas.
6. Collection of debts more quickly.
7. Sale and Leaseback
A rising liquidity ratio is a sign of prudent management. Briefly discuss. [ 2008]
A rising liquidity ratio is not always a sign of prudent management.
A rising liquidity ratio could be a sign of prudent management because it indicates that it
is easier for the firm to pay its short-term debts on time and thus avoid paying interest or
enables to avail of cash discount.
However, if the liquidity ratio rises significantly above 1:1, it could mean that too much
of the company’s resources are tied up in liquid assets when they could be used to earn
more profits. Management may be leaving cash resources idle.
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Ratios Higher Level
Section (a) 1999 – 2009
● Dividend Yield
● Opening Stock if Stock Turnover is 10 (based on average stock)
● Earnings per Ordinary Share in 2007
● How long would it take one ordinary share to recoup its 2007 market price based
on present dividend payout rate?
● Cash Purchases if the period of credit received from Trade Creditors is 2.4
months.
● Interest Cover
● Dividend Yield ( check year that is being asked)
● How long would it take one ordinary share to recover its value at present payout
rate.
● The projected market value of one ordinary share in 2007
● Cash Sales if the average period of credit given to Debtors is 2 months
● Return on Capital Employed in 2004
● Ordinary Dividend Cover in 2004
● Market value of one ordinary share in 2003 if P/E ratio is 9
● Price / Earnings Ratio
● How long it would take one ordinary share to recoup its value at present rate of
earnings.
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