BISHOPS GRADE 9 EMS
In this section of work you will learn about the following concepts…
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Introduction to Ratio Analysis
The Current Ratio
Gearing ratio
Return on capital employed (“ROCE”)
Dividend per share
Dividend yield
Value and limitation of ratio analysis
Name: _____________________
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Introduction
Ratio analysis: an examination of accounting data through the comparison of two figures.
Looking at just one piece of financial information of a company might be misleading.
For example, examine the data below…
Profit before tax (R’000)
2013 - 2014
Adidas
44,051
Nike
54,100
Which company appears to
have performed better?
………………………………..
However, if we now look at another piece of financial information about the company, we get a much
clearer picture…
Profit before tax
(R’000) 2013 - 2014
Sales (R’000)
2013 - 2014
Adidas
44,051
271,414
Nike
54,100
787,100
Profit as a
percentage of sales
Now which appears to
be more successful?
………………………
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1. The Current Ratio
The current ratio indicates the short term liquidity position of the business and compares the
current assets and current liabilities shown in the balance sheet.
Liquidity: refers to how easily an asset can be turned into cash – the easier, the more liquid.
A business which doesn’t have enough current assets to pay their liabilities when they are due may
be forced into liquidation. This is a situation where the business is forced to stop trading and then
their assets are liquidated (sold to raise cash). The cash that is raised is then used to pay off the
business’ debts.
Liquidity can be improved by…
 decreasing stock levels
 speeding up the collection of receivables (debtors)
 slowing down payments to payables (creditors)
The current ratio is a simple measure that shows whether a business can pay debts due within one
year out of the current assets.
The formula for the current ratio is…
current assets : current liabilities
The answer is expressed as “x : 1”.
Using the financial statements on the last page, work out Pick ‘n Pay’s current ratio for 2013 and
2014.
Formula:
2013
2014
Working out and answer:
A current ratio of between 1.5 – 2 : 1 is considered the ‘ideal’ ratio.
It suggests that the business has enough cash to be able to pay its debts, but not too much finance
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tied up in current assets which could be reinvested to help expand the business or distributed to
shareholders.
A low current ratio (less than 1 : 1) suggests that the business is not well placed to pay its debts. It
might be required to raise extra finance or extend the time it takes to pay creditors.
For example, a current ratio of 0.8 : 1 means that a business has only 80c of currents assets for
every R1 of current liabilities.
However, a high current ratio is not necessarily a good thing for a business. A high current ratio
(above 2 : 1) represents a significant opportunity cost. The opportunity cost of holding too many
current assets is the lost opportunity to purchase more non-current assets and stimulate growth in
the business.
Opportunity cost: the cost of the next best alternative forgone.
2. Gearing ratio
Gearing: compares the amount of capital raised by selling shares with the amount raised
through long-term loans.
The gearing ratio is also concerned with liquidity. However, it focuses on the long term financial
stability of a business.
In theory, the higher the level of borrowing (gearing) the higher are the risks to a business, since
the payment of interest and repayment of debts are not "optional" in the same way as dividends
are.
For example, if a business made a loss they cannot pay out dividends whereas they have to still
pay back their long-term loans with interest.
The formula for calculating gearing is…
non-current liabilities
x 100
total equity + non-current liabilities
1
The answer is expressed as a percentage.
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Work out the gearing ratio for Pick ‘n Pay for the years 2013 and 2014…
Formula:
2013
2014
Working out and answer:
A business with a gearing ratio of more than 50% is traditionally said to be “highly geared”. A
company in this position will find itself at risk of defaulting on their loans during a low period of
profit as well as being affected by changing interest rates that will change the amount that they
will have to pay back on a monthly basis.
A business with gearing of less than 25% is traditionally described as having “low gearing”. In this
situation a business should consider borrowing more money to grow the company. As long as the
proposed investment gains a higher return that the interest that has to be paid on the borrowed
money, the business should see profits increasing.
Something between 25% ‐ 50% would be considered “normal” for a well‐established business
which is happy to finance its activities using debt.
It is important to remember that financing a business through long‐term debt is not necessarily
always a bad thing!
When long‐term debt is relatively cheap due to low interest rates, a business is able to increase
the amount of long term loans and can reduce the amount that shareholders have to invest in the
business. The more shares that you sell in a company, the more control you give up as well as
profits.
A well-established business which produces strong and reliable cash flows can handle a much
higher level of gearing than a business where the cash flows are unpredictable and uncertain.
Having a positive cash flow and working capital is crucial to be able to ensure that monthly
repayments are able to be made on time.
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3. Return on capital employed (“ROCE”)
ROCE is sometimes referred to as the "primary ratio”. It tells us what returns (profits) the business
has made on the resources available to it.
ROCE is calculated using this formula…
operating profit
x 100
total equity + non-current liabilities
1
The answer is expressed as a percentage.
Capital employed is a good measure of the total resources that a business has available to it,
although it is not perfect. For example, a business might lease or hire many of its production
capacity (machinery, buildings etc) which would not be included as assets in the balance sheet.
This would lead to the ROCE ration becoming artificially inflated.
Using the financial statements on the last page, work out Pick ‘n Pay’s ROCE for 2013 and 2014.
Formula:
2013
2014
Working out and answer:
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With ROCE, the higher the percentage figure, the better.
The figure needs to be compared with the ROCE from previous years to see if there is a trend of
ROCE rising or falling.
It is also important to look to see whether the operating profit figure used includes any one-off
items as this will make the ROCE percentage and any comparisons over time difficult.
To improve its ROCE a business can try to do two things…
 Improve the top line (i.e. increase operating profit) without a corresponding increase in
capital employed
 Maintain operating profit but reduce the value of total equity and non-current liabilities.
4. Dividend per share
Dividend / share: shows the value of the total dividend per issued share for the financial year.
The formula for dividend per share is…
total dividends
number of issued ordinary shares
The answer is expressed in cents/share
To illustrate the calculation, let us assume that Pick ‘n Pay paid out the following dividends
2013: R460,000
2014: R240,000
In both years, there were 500,000 shares issued
Work out the dividend per share for Pick ‘n Pay for both years…
Formula:
2013
2014
Working out and answer:
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A shareholder would probably be pleased with a higher dividend per share. However, the problem
with dividend per share is that the ratio lacks context. We don’t know, for example…
a) How much the shareholder paid for the shares – i.e. what the dividend means in terms of a
return on the shareholder’s original investment.
b) How much of the actual profit for the year was distributed as a dividend.
5. Dividend yield
Dividend yield: expresses dividend / share as a percentage of the current market price.
Dividend yield is a better shareholder ratio to use to get a sense for the rate of return on
investment.
The formula for dividend yield is…
ordinary share dividend (in cents)
x 100
current market price (in cents)
1
The answer is expressed as a percentage.
To illustrate the calculation, consider this information…
The average share price for 1 ordinary share of the company on the Stock Exchange during those
financial years was 1415c (2013) and 1067c (2014)
Work out the dividend yield for Pick ‘n Pay for the years 2013 and 2014…
Formula:
2013
2014
Working out and answer:
The dividend yield must be compared with the current interest rates that you could have received
from saving your money in a bank account.
A dividend yield that is higher than these rates is considered a good investment although it should
be significantly higher to account for the higher risk of buying shares.
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Value and limitation of ratio analysis
The main strength of ratio analysis is that it encourages a systematic approach to analysing
performance.
However, it is also important to remember some of the drawbacks of ratio analysis…
The historical basis of published accounts affects ratio analysis for the following reasons:
 Accounts indicate where a company has been, rather than where it is going. Past
performance is not necessarily a useful guide to the future.
 Accounts show what has happened, rather than why, and so they can only serve to point
out potential problems.
Comparisons
Ratios rely on comparisons, but they always involve difficulties because no two businesses or
department within a business face identical circumstances.
Corporate objectives
Ratio analysis only looks at financial measures, and relies on the assumption that maximising profit
is the only aim of all firms. It ignores other objectives that may be more important to a business
like customer loyalty and growth strategies.
External Factors
Company performance is very dependent on outside factors. Without taking these external factors
into account, the ratios may seem better or worse than they actually are given the prevailing
external influences. For example, you would expect to see a business that sells luxury items
struggle during a recession and this will affect their ROCE ratio negatively.
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Income Statement of Pick ‘n Pay
R Millions
2013
R Millions
2014
Balance Sheet for Pick ‘n Pay
R Millions
2013
R Millions
2014
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