Concept/Stages of Ratio Analysis
Ratio Analysis: a method of assesing a firm's financial situation by comparing two sets of linked data.
Stages in using ratio Analysis
- Identifying the reason for the investigation, is the info needed to decide wether to become an investor,customer or supplier or is it being used by the organisation to improve efficiency.
- Decide on relevent ratio to achive purpose of the user.
- Gather info required and then calculate the ratio.
- Interpret the ratio. what is the meaning of the results?
- Make appropriate comparisions in order to understand significance of ratio.
- Take appropriet actions then reevaluate with same proccess after implementation.
Ratios alone are meaningless therefore we compare them with other results.
- Inter-firm Comparisons - Between 2 companies, a company should compare to rival competitors, in order to assess its relative performance. these should be selected as the ones with the most in common in order to take into external factors which should effect the both.
- Intra-firm Comparisons - Within a company. the efficiency of different divisions or areas of a company can be compared. Should also be between similar areas.
- Comparisons to a Standard - Certain levels are seen as efficient, a company can compare to these standards to assess objectively
- Comparisons Over Time - Whatever basis is used, a company ratio should be compared over time to see trends in efficiency and to allow for exceptional events.
Types of Ratio
- Profitability Ratio - These compare profits with the size of the firm. as profit is often primary aim of a company (ROCE)
- Liquidity Ratios - These show whether a firm is likely to be able to meet its short-term liabilites. although profit shows long-term success its vital to hold sufficient liquidity to avoid difficulties in paying debts. (Current Ratio & Acid Test Ratio)
- Gearing - Focuses on long-term liquidity and shows whether a firm's capital structure is likly to be able to continue to meet intrest payments on, to repay long term debts. (Gearing Ratio)
- Financial Efficiency Ratio - Focuses on management of working capital, used to asses the efficiency of firm in managing assets and short-term liabilities. (Asset turnover, Inventory turnover,Payables days & Receivables days)
- Shareholders Ratios - Focus on drawing conclusions about financial shareholder benefits from their company shares. (Divided per Share & Divided Yield)
Users of ratios
- Managers - Identify efficiency of the firm and its different areas, to plan ahead and see effectiveness of policies
- Employees - Whether the firm can afford wage rise and to see if profits are being fairly distributed
- Government - To review success of its economic policies and find ways to improve efficiency overall.
- Competitors - To compare their performance against rival firms and discover their relative strengths and weaknesses.
- Suppliers - To know the sort of payment terms that are being offered to other suppliers, and can they afford to pay.
- Customers - Know the future and make sure guaranties and after sale services are secure
- Shareholders - Compare financial benefits with other investments.
Return On Capital Employed
The capital employed is a measure of the value of the resources used by a business and is an excellent guide to its size. Profit targets are often expressed as a ROCE which uses the formula below:
- ROCE = Operating Profit /Capital Employed x 100
Two liquidity ratios - Current ratio & Acid test ratio used in order to assess the abillity of an organisation to meet its short-term Liabilities.
Current Ratio: In order to meet liabilities a firm can draw on its current assets,bank balance,debtors and stock that is sold.
Current ratio = Current assets:current liabilities = ?:1
Company should aim to be between 1.5:1 and 2:1 as an ideal ratio
Acid Test Ratio: Firms cannot be sure the their inventories will sell quickly so acid test is used as an alternative. Acid test ignores inventories in its calculation considering only cash, bank balances and receivables.
ATR= (Current assets - Inventories):current liabilities
The ideal Acid Test Ratio is between 0.75:1 and 1:1
- Gearing examines the capital structure of a firm and its likely impact on the firm's ability to stay solvent.
Gearing (%) = Non-current Liabilities/
(Total equity + Non-current liabilities) X 100
- Non-current liabilities normally take the form of loans, such as debentures or long-term loans from the bank
- High Gearing is greater than 50%. High gearing ratio shows that a business has borrowed a lot of money in relation to its total capital.
- Low Gearing is below 25%. Low gearing ratio indicates that a firm has raised most of its capital from shareholder, in the form of share capital and retained profit.
Benefits of High Gearing
- There are relatively few shareholders, so it is easier for existing shareholders to keep control of the company.
- The company can benefit from a very cheap source of finance when interested.
- In times of high profit, interest payments are lower than share holders' dividend requirements, allowing greater retained profit.
Benefits of Low Gearing
- Is permanent share capital avoids creditors pushing them into liquidation.
- A low gearing company avoids the problem of having to pay high levels of interest on borrowed capital when interest rates are high.
- The company avoids the pressure facing highly geared companies that must repay their borrowing at some stage.
Financial Efficiency Ratios
Asset Turnover: This ratio measures how well a company uses its assets in order to achieve sales revenue.
Asset Turnover = Revenue / Net Assets
- High AT shows the business is using assets efficiently to achieve sales.
- Low AT shows the business is not using assets efficiently to achieve sales.
- Capital intensive firms will have lower asset turnover than labour intensive firms, because capital owned is included in net assets where a labour is not.
Inventory Turnover: This measure of financial efficiency shows how quickly stock is converted to sales.
IT = Cost of Goods Sold/Avg Inventories Held
the inventory turnover figure represents the number of times in a year that a firm sells the value of its stock. 3 time a year = once every 4 months
Factors influencing the rate of Stock Turnover
- The Nature of the Product - Perishable products or products that become dated (newspapers) have high stock turnover.
- The Importance of Holding Stock - Clothes retailers need to hold high levels of stock to encourage shoppers
- The Length of the Product Life Cycle - Fashionable products are expected to sell quickly and products with short life cycles must also have a rapid turnover.
- Stock Management System - Just-In-Time stock control = low levels of stock so stock turnover is faster.
- Quality of Management - Poor market research may lead to inappropriate stock levels = low stock turnover.
- The Variety of Products - Company with 20 products will hold greater levels of stock than a company with 1.
Financial Efficiency Ratios
Receivables Days: shows the number of days that it takes to convert receivables into cash.
Receivable Days = Receivables(debtors)/RevenueX365
Fthat provide long-term credit to customers, may expect a high figure, but companies that deal mainly in cash transactions will have low figure for receivables days.
Payables Days: shows the number of days that it takes to pay back any payables owed by a business.
Payables Days = payables / cost of sales X 365
Firms that receive long-term credit from suppliers may expect a high figure for payables days, but companies that pay suppliers in cash will have a low figure. in general a firm will want high a value as possible meaning payables are not paid quickly, in effect this means that the business is holding another organisations money
Dividend Per Share:
DPS =Total Dividends Paid/No Shares Issued
The ratio lacks context e.g it does not reveal how much the shares cost to buy 15p is good for a 30p share but **** for a £30 share
Dividend yield: The dividend yield builds on the dividend per share by expressing it as a percentage of the current market price.
DY =Dividend per share / Market price X100
Shows the annual percentage return on the money needed to purchase the share. this allows the opportunity cost to be calculated to see if its a better investment than elsewhere.