131128 ratio analysis

At the end of this presentation every student will be able to ……..

• recall and use the 16 ratios that are included in the presentation

• Compare ratios and explain the consequences of the increase or decrease in any one of those ratios

• Contextualise ratios with the aid of the process with the mnemonic “COPIED”

• Inter-relate ratios to bring out more meaning

Sources for Ratio Calculation (The three P’s)

Sources for Ratio

Calculation

Financial Performance over a period

(Usually a year) – P&L

Financial Position at the

end of that year - BS

Market Perception at the end of the

period or at present

Context in which Ratios can be studied can be remembered by the mnemonic COPIED

Context

1.

Competition

2. Organisation

Type

3. PESTEL

4. Industry

5. Extracts

6.

Data Age

1. Competition context

• What is the structure of the market? • Is the company competing with many others

in the market or does the market have only a few other players?

2. The Organisational type context

• Is it a sole trader, a partnership, a private limited company, a public limited company, a corporation (like the BBC), a club or a charity?

3. PESTEL context• Political, Economic, Social, Technological, Environmental and

Legal • Is the country in a boom or a recession? • What is the impact of exchange rates if the company buys or

sells abroad? • What is the impact of unemployment, interest rates, inflation

balance of payments etc? • Is the company environmentally friendly or are there social

pressures in this context? • Is the company technologically sound? • Does it function in accordance with the expectations of society?

4. Industry Context

• This refers to the type of industry being considered. Clearly technological companies have a different profile to say a company involved in mining for example.

5. Extracts Context

• This refers to extracts from the published financial statements,Newspaper articles, magazine articles and the Internet.

6. Data Age Context

• “Historical Accounts are getting too old to be meaningful. In a time of crisis, you can’t rely on performance figures on a period two years in the past” (Start of Chapter 10 Dyson, J.R. (2010) Accounting for Non-accounting Students, 8th Edition, Harlow: FT Prentice Hall)

• Is the data available rather old and as a result less relevant?

How do we compare ratios......

Compare with one of four ways.......

Previous periods of the same organisation

Budget of the organisation for the same period

Other organisations

The industry taken as a whole

Profitability RatiosRatio Description Answer

formatWhat it measures Implications of increase

Return on Capital Employed (ROCE)

Profit before interest and taxation X 100 / (Shareholder's funds + long-term loans)

x% The degree of profitability in relation to the amount it needed to finance it

The funds required to finance the business are being used more efficiently and more effectively.

Gross Profit Ratio (sometimes also called the Gross Profit Margin)

Gross Profit X 100 / Sales

x% This shows the amount of profit made for every £100 of sales before overheads are deducted

It could be that the organisation has gone upmarket or managed to reduce the cost of sales by more competitive buying of more competitive manufacturing

Mark-up Ratio Gross Profit X 100 /

Cost of Goods soldx% This shows the amount

that is added to the cost of sales for every £100 of cost of sales

It could be that the organisation has gone upmarket or managed to reduce the cost of sales by more competitive buying of more competitive manufacturing

Net Profit Ratio Net Profit before taxation X 100 / Sales

x% This shows the profit before taxation that has been made for every £100 of sales

It could be that the mark up has increased and or a reduction in overheads.

Liquidity RatiosRatio Description Answer


Current Ratio Current Assets /

Current Liabilities

x:1 the amount of current assets available for every pound of liabilities

less risk of non-payment particularly if the stock is a small proportion of current assets.

Acid Test (Current Assets less Stock) / Current Liabilities

x:1 The amount of more liquidatable assets available for every pound of liabilities

A healthier liquidity position of the organisation

Efficiency RatiosRatio Description Answer


Stock Turnover Ratio Cost of goods sold /

Closing Stockx times the speed of the cycle of

stock purchase and stock sales

The greater the turnover of stock the greater is the efficiency of the sales force and the greater the effectiveness of the purchasing and or manufacturing departments.

Fixed Asset Turnover Ratio

Sales / Fixed Assets at Net Book Value

x times The degree of efficiency in using fixed assets

The fixed assets are being used more efficiently

Trade Debtor Collection Period

Closing Trade Debtors X 365 / Credit Sales

x days The average number of days the debtors take to pay the amounts due by them

Credit control function is less efficient

Stock Period Closing Stock X 365 / Cost of sales

x days The average number of days between purchase of stock and the sale of stock

There may be ineffective buying or inefficient selling

Trade Creditor Payment Period

Closing Trade Creditors X 365 / Total Credit Purchases

x days The average number of days the organisation has taken to pay its creditors

This shows that the organisation may be experiencing difficulties in paying their suppliers unless credit terms have been renegotiated.

Investment RatiosRatio Description Answer


Dividend Yield Dividend per share

X 100 / market price per share

x% The rate of return an investor gets when shares are bought

The investor gets a higher return

Dividend Cover (net Profit less

taxation less preference share dividend) / ordinary dividend

x times The number of times the current dividend can be paid from the profit attributable to ordinary shareholders

The risk of the non-payment of an ordinary share dividend decreases.

Earnings per share (EPS)

(Net Profit less taxation less preference share dividend) / number of ordinary shares

x pence The earnings attributable to ordinary shareholders per share held by them

The higher the earnings attributable to shareholders the more likely is the increase in dividends and more likely is the growth in the company

Price Earnings Ratio

Market price per share / Earnings per share

x Informs as to how many times the market price of a share is as compared with the EPS

A high P/E ratio indicates that the market believes that the current earnings are sustainable for many years.

GearingRatio Description Answer


Capital Gearing Ratio

(preference shares + long term loans) X 100 / (Shareholders funds + long term loans)

x% The degree to which the company is financed by non-ordinary shares

A high level of gearing brings a higher risk of failure although a moderate level of gearing can be healthy and useful.

Profitability Ratios

Financial Performance Financial Position Market Perception

Return on Capital Employed (ROCE)

✔ ✔

Gross Profit Ratio (sometimes also called the Gross Profit Margin)

✔ ✔

Mark-up Ratio ✔ ✔

Net Profit Ratio ✔ ✔

Liquidity Ratios


Current Ratio ✔

Acid Test ✔

Efficiency Ratios


Stock Turnover Ratio✔

Fixed Asset Turnover Ratio ✔

Trade Debtor Collection Period ✔

Stock Period

✔

Trade Creditor Payment Period ✔

Investment Ratios


Dividend Yield ✔

Dividend Cover

✔

Earnings per share (EPS) ✔

Price Earnings Ratio

✔

Dividend Yield ✔

Gearing


Capital Gearing Ratio ✔ ✔

Interrelationships between Ratios• There are, of course, an infinite number of combinations

of ratios which may help understand one or more characteristics of the organisation that is being analysed.

• A good knowledge of the functions of the ratios will help you to spot these combinations.

• The identification of the interrelationships of ratios is always a source for high marks.

• It is up to the student to attempt as many examples as possible in order to develop the skills required to interrelate ratios.

An example – Working Capital Cycle

Pay suppliers

Store stock until sold

Sell stock on credit

to customers

Receive cash from debtors

Purchase stock on

credit from suppliers

Trade creditor payment period

Stock turnover ratio

Trade Debtor collection period

Stock period

How to reach Excellence in Ratio Analysis

Excellence in Ratio Analysis

Comparison of Ratios

Context of Ratios

Interrelating Ratios

131128 ratio analysis

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