Accounting - Financial ratios

• Compares two related figures, usually both from the same set of financial statements

• Is an aid to understand what the financial statements really mean

• Is an inexact science so results must be interpreted cautiously

• Past periods, the performance of similar businesses and planned performance are often used to provide benchmark ratios

• A brief overview of the financial statements can often provide insights that may not be revealed by ratios and/or may help in the interpretation of them

- Return on ordinary shareholders' fund (ROSF)

- Return on capital employed (ROCE)

- Operating profit margin

- Gross profit margin

- Average inventories turnover period

- Average settlement period for trade receivables

- Average settlement period for trade payables

- Sales revenue to capital employed

- Sales revenue per employee

- Current ratio

- Acid test ratio

- Cash generated from operations to maturing obligations ratio

- Gearing ratio

- Interest cover ratio

- Dividend payout ratio 

- Dividend yield ratio

- Earnings per share

- Cash generated from operations per share

- Price/earnings ratio

Individual ratios can be tracked (i.e. plotted on a graph) to detect trends

- Univariate analysis - looking at just one ratio over time in an attempt to predict financial failure

- Multiple discriminate analysis - looking at several ratios, put together in a model, over time in an attempt to predict financial failure - Z scores

- Ratios are only as reliable as the financial statements from which they derive

- Inflation can distort the information

- Ratios have restricted vision

- It can be difficult to find a suitable benchmark (i.e. another business) as comparator

- Some ratios could mislead due to the 'snapshot' nature of the statement of financial position