# 1 Ratio Analysis LIQUIDITY RATIOS: Liquidity ratio measures a company's ability to pay short-term obligations

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1 Income Statement for the year ending..: Sales/Revenue/Turnover Less: Cost of Sales Gross profit Less: Expenses Operating profit Less: Finance cost/interest expense Profit before tax (PBT) Less: Tax Profit after tax (PAT)/Profit for the year/net profit Less: Preference dividend Profit attributable to ordinary shareholders Less: Ordinary dividend Retained profit for the year () () () () () () Balance Sheet/Statement of Financial Position as at..: Assets: Non-current assets Current assets: Cash Receivables Closing Inventory Total assets Shareholders capital: Ordinary share capital Reserves Preference share capital* Long-term liabilities Current liabilities *Preference share capital will be treated as a long-term liability where it is redeemable; in that case its dividend will be treated as interest. LIQUIDITY RATIOS: Liquidity ratio measures a company's ability to pay short-term obligations 1. Current ratio = :1 - Current ratio is mainly used to give an idea of the company's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). - The higher the current ratio, the more capable the company is of paying its obligations. - A current ratio of 1.5:1 to 2:1 can mean sufficient current asset to cover current liabilities. - A current ratio of above 2:1 may mean over investment in working capital (i.e. current asset). Surplus asset can be reinvested to expand the business operation or to increase capacity or to repay debt or can be distributed to shareholders. - A current ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point. Current ratio can be improved by selling of unused non-current assets, by taking long-term loan, by speeding up the receivables collection, and/or by slowing payables payment - A weak current ratio shows that the company is not in good financial health, but it does not necessarily mean that it will go bankrupt as there are many ways to access financing; but it is definitely not a good sign. - Companies that have trouble getting paid on their receivables or have long inventory turnover can run into liquidity problems 2. Quick or Quick asset or Acid test ratio = = :1 - The quick ratio measures a company's ability to meet its short-term obligations with its most liquid assets (as it excludes inventory). - Inventory is excluded because some companies have difficulty turning their inventory into cash. - The higher the quick ratio, the better the position of the company. - A quick ratio of 1:1 is normally most appropriate. For manufacturing businesses, where high level of inventory is held, a lower quick ratio may be appropriate. - If quick ratio is too low than the current ratio; this could mean that high amount of working capital is tied up in inventory. High amount of inventory means high inventory holding costs. 1 Ratio Analysis

2 PROFITIBALITY RATIO: 1. Return on capital employed (ROCE) = 100% = % - Better to use average Capital Employed ( ) where possible. Capital employed = Total asset Current liabilities = Share Capital + Reserve + Long-term liability - There is a lot other contexts to define capital employed. This is basically the capital required for a business to function. - This ratio indicates how efficiently a business (i.e. managers) is using the funds available (equity and long-term debt). It measures how much is earned per \$1 invested. - ROCE increase from previous year or above industry average means a good sign and reflects the fact that the company (i.e. managers) has managed to increase sales without a proportionate increase in costs. - ROCE decrease from previous year or below industry average shows problem with controlling of costs. Level of dividend may also fall as a consequence. - The value of capital employed is lower where company mainly uses rented assets (i.e. thorough operating lease) rather owning or finance lease. This is also possible where assets carrying value is lot less than the cost (remember in this case assets need replacement). These may result a higher ROCE. - ROCE should always be higher than the rate at which the company borrows; otherwise any increase in borrowing will reduce shareholders' earnings. 2. Return on equity (ROE), or Return on Shareholders Capital (ROSC) = 100% = % - Normally use book values rather market values of shares (if market values used remember to exclude Reserve) - Better to use average of Shareholders Capital( ) where possible, specially when closing balance significantly differs form opening balance. - Return on equity (ROE) indicates to ordinary shareholders how well their investments has performed measuring how much profit the company has generated with their money 3. Asset turnover or Asset utilisation ratio = = :1 - Use of Non-Current Asset instead of Capital Employed is also correct (then interpretation has to change!) - This shows the turnover (i.e. sales) that is generated from each \$1 worth of Capital (or asset) employed. The higher the turnover per \$1 invested the more efficient use of the capital was. 4. Net profit margin = 100% = % - A higher percentage than last year or industry average indicates costs are being controlled better; sales prices were high compared to costs. - Company can sell at a discount to retain market share during economic downturn (and/or because of intense competition). If costs remain at same level this will result a lower Net Profit Margin. Companies trading cheap products can gain during economic downturn when customers generally stop buying luxury products and turn to cheap ones. - In large companies, where higher level of economies of scale can be achieved (i.e. lower level of per unit cost) the net profit margin can be higher as a result. - Multinational companies can gain or loss from favourable or adverse exchange rate movements. 2 Ratio Analysis

3 5. Gross profit margin = 100% = % - High gross profit margin may mean effective purchasing strategy; and/or concentration on low volume-high margin sales - Low gross profit margin may be an indication of selling products cheaply (i.e. at discount) in order to generate high volume of sales. 6. Operating profit margin = 100% = % - Operating margin gives analysts an idea of how much a company makes (before interest and taxes) on each dollar of sales. - A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. - If a company's margin is increasing, it is earning more per dollar of sales. The higher the margin, the better. EFFICIENCY RATIOS: 1. Average receivables collection period = 365 = days - An alternative of using Average Receivables is using year-end receivables figure where amount of receivables not significantly changed from year beginning to end. In that case, comparison figures have to be derived from same approach. - Provision for bad & doubtful debts (if any) should not be deducted while arriving to Average Trade Receivables figure. - An approximate measure of the length of time customers take to pay what they owe - Average Receivables Collection Period similar as Average Payables Payment Period may be an indication of better credit control policy - Collection Period of less than 30 days may seem normal. Significantly in excess of 30 days might be representative of poor management of funds of a business. However, some companies such as exporting companies must allow generous credit terms (may be 60 days) to win customers; whereas retailer may sell only or mainly on cash (may be collection period of not more than 10 days). - A high or increasing collection period may mean poorly managed credit control function, and increased risk of bad debts. This also may mean over investment in receivables. - However, increase in collection period might be a deliberate policy to increase sales by offering better credit terms than competitors. - Decreasing or low collection period may mean tighten credit control policy; which may cause declining customer numbers (i.e. reduction of sales) 2. Average payables payment period = 365 = days - Increasing or long payment period may indicate liquidity problem; and also may mean loosing of prompt payment discounts. - A longer payment period may also mean company has succeeded in obtaining very favourable credit terms from its suppliers; contradictorily, this may also mean unethical business practice. - Declining or short payment period may indicate business has sufficient cash to meet payables. A short payment period may put company s credit ratings in higher position. - If collection period is higher than payment period than it can cause cash flow difficulties 3 Ratio Analysis

4 3. Inventory turnover/holding period = 365 days = days Or, = Times - Better to use Average Inventory figure to take account of variation between beginning of the year to the end. But, instead of Average Inventory the year end inventory figure can be used where opening inventory level cannot be determined; in that case comparable figure has to derive from same approach. - This ratio is an estimate of the average time that inventory is held before it is used or sold. If average inventory period is 30 days, this means that the inventory is turned over (i.e. used) on average times (= 365/30) in a year - A low turnover implies poor sales and, therefore, excess inventory. - A high ratio implies either strong sales or ineffective buying. - High inventory levels are unhealthy because they represent an investment with a rate of return of zero. It may also put company at a great loss if prices start to decline (think about technological products) 4. Working capital cycle, or, Cash operating cycle (in days) = Inventory holding period + Receivables collection period Payables payment period - This cycle is the length of time between cash payment to suppliers and cash received form customers. This measured how long a firm will be deprived of cash. - A company could even achieve a negative cycle by collecting from customers before paying suppliers. This policy of strict collections and delay payments is not always sustainable or appreciable by customers and suppliers. INVESTMENT RATIOS: 1. Earnings per share (EPS) = = \$ Or, = \$ - The best way is to use weighted average number of ordinary shares - EPS is generally considered to be the single most important variable in determining a share s price. This is a key measure of company performance from ordinary shareholders point of view. - EPS shows the amount of profit attributable to each ordinary share. But, it does not represent actual income of the ordinary shareholders. - Increase in EPS generally indicates success; whereas a decrease is not welcomed by shareholders. - A constant growth in EPS may result in favourable movements (i.e. increase) in share price. - Both right issue and bonus issue of shares result in a fall of EPS. So, care must be taken while interpreting. - EPS often ignore the capital is required to generate the earnings. Two companies could generate the same EPS, but one could do so with less investment; this could mean that this company was efficient at using its capital to generate income. 2. Dividend per share (DPS) = = \$ - DPS is important for shareholders who are seeking income from shares rather capital gain - Company may have a policy of achieving steady growth in dividend pay-out per share; this normally creates positive market reaction (i.e. increase in share price) 4 Ratio Analysis

5 3. Dividend pay-out ratio = 100% = % Or, 100% = % - Dividend pay-out ratio is the percentage of earnings paid to shareholders as dividends. This shows how well earnings support the dividend payments. - High dividend pay-out ratio may mean company confidence on future earnings. But, where majority of shares are held by a small number of shareholders, it may also mean that shareholders are taking out as much profit as they can; and this not necessarily serve company s long-term interest. - Low dividend pay-out ratio may mean company is expecting difficulties in the future; so now interested in retaining earnings. But, it can also mean expansion (by reinvesting the retained earnings) of business in the future. - More mature companies tend to have a higher pay-out ratio. 4. Dividend cover = = Times Or, = Times - Dividend cover represents how many times dividend could have paid from the profit attributable to ordinary shareholders. - Dividend cover is a measure of the ability of a company to maintain the level of dividend paid out. The higher the cover, the better the ability to maintain dividend pay-out if profits drop. - Typically, a ratio of 2 or higher is considered safe in the sense that the company can well afford the dividend; but dividend cover below 1.5 may seem risky. - If the dividend cover is below 1 then the company using its retained earnings from previous years to pay current year s dividend - A low level of dividend cover might be acceptable in a company with very stable profits, but the same level of cover at company with volatile profits would indicate that dividends are at risk. 5. Price/Earning (P/E) ratio = = Times Or, = Times - P/E ratio also knows as Price Multiple or Earnings Multiple ratio - P/E ratio is a basic measure of company performance from the market s point of view. - P/E ratio shows how much money investors are willing to pay for per dollar of earnings. It gives an indication of the confidence that investors have in the future prosperity (i.e. earnings) of the business. - A P/E ratio of 1 shows very little confidence on the company s future prosperity; whereas, a P/E ratio of 20 expresses a great deal of optimism about the future of a company. Market can over-value of under-value company share depending of information available. - In a very basic term, a P/E ratio of 20 may mean investors are paying equivalent of 20 years earnings (at current EPS level) to own a share in the company. 5 Ratio Analysis

6 6. Dividend yield = 100% = % - Dividend Yield is a financial ratio that shows how much a company pays out in dividends each year relative to its share price. - In the absence of any capital gains, the Dividend Yield is the return on investment for a stock. - Investors can secure a minimum stream of cash flow from their investment portfolio by investing in shares which is paying relatively high and stable dividend yields. - Mature and well-established companies tend to have higher dividend yields; while young and growth oriented companies tend to have lower yield. Many fast growing companies do not have a dividend yield at all because they do not pay-out dividends at all. DEBT RATIOS: 1. Gearing (UK term)/ Leverage (US term) ratio = 100% = 100% = % Or, 100% = 100% = % - This gearing ratio is known as Financial Gearing - Values for Gearing ratio can be either book value or market value; for financial management purpose generally market values are used - While using market values remember market value of ordinary shares take account of reserves (i.e. do not add reserve amount with total market value of ordinary shares) - Preference share capital generally deemed not as part of equity - A gearing level of more than 50% (where Debt Capital to Total Capital used) or more than 100% (where Debt Capital to Equity Capital used) means company is high geared - Risk is high for investors in a high geared company because of obligation to pay the interest and repaying capital on time. - The standard level of gearing depends on industry; and some companies can be zero geared (i.e. 100% equity financed). Sometimes lander (i.e. bank) can put a covenant on highest level of gearing (i.e. debt). - A relatively higher gearing may mean company adopted an aggressive strategy to expand its operation. This has to be justified with sales and profit growth. A higher gearing may also mean company is having financial difficulties; so may be a going concern. - A low or declining gearing may mean company is getting stronger financially and confident on future earnings. - Where gearing is high, a high EPS may not be appreciated by the investors because of high risk; their required rate of return will increase. 2. Interest cover = = Times - Interest cover is a measure of the adequacy of a company's profit relative to interest payment on its debt. - A high interest cover ratio means that the business is easily able to meet its interest obligations from profits. Similarly, a low level of interest cover ratio means that the business is potentially in danger of not being able to meet its interest obligations. - Interest Cover of more than 2 is normally considered reasonably safe. But, companies with very volatile earnings may require an even higher level of Interest Cover. - Interest Cover of less than 1 means the company did not earn sufficient earning (i.e. profit) to meet its interest charge; and this may trigger going concern. 6 Ratio Analysis

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