Financial Ratio Analysis

1. Profitability Ratios
These ratios give users a good understanding of how well the
company utilized its resources to generate profit and shareholder
value.

The long-term profitability of a company is vital for its survivability. It

is these ratios that can give insight into the all important "profit".

Return On Equity - ROE

What Does Return On Equity - ROE Mean?

The amount of net income returned as a percentage of shareholders

equity. Return on equity measures a corporation's profitability by
revealing how much profit a company generates with the money
shareholders have invested. It tells common shareholders how
effectively their money is being employed.

ROE is expressed as a percentage and calculated as:

Net profit after tax and preference dividends (if any) x 100
Average (ordinary share capital + reserves)

Net income is for the full fiscal year (before dividends paid to
common stock holders but after dividends to preferred stock.)
Shareholder's equity does not include preferred shares.

By comparing the ROE provided by the company with the return

provided by alternative investments with the same level of risk,
existing shareholders can assess the quality of their investment and
decide whether to keep their funds in the company (if ROE is higher
than the return on alternative investments) or invest elsewhere (if
ROE is lower than the return on alternative investments).

Return On Assets
This ratio indicates how profitable a company is relative to its total
assets. The return on assets (ROA) ratio illustrates how well

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management is employing the company's total assets to make a
profit. The higher the return, the more efficient management is in
utilizing its asset base. The ROA ratio is calculated by comparing net
income to average total assets, and is expressed as a percentage.

Net profit before interest and tax x 100

Average total assets

Some investment analysts use the operating-income figure instead of

the net-income figure when calculating the ROA ratio.

The need for investment in current and non-current assets varies

greatly among companies. Capital-intensive businesses (with a large
investment in fixed assets) tend to be more asset heavy than
technology or service businesses.

In the case of capital-intensive businesses, which have to carry a

relatively large asset base, the denominator of the ROA will be a
large number. Conversely, non-capital-intensive businesses (with a
small investment in fixed assets) will be generally favored with a
relatively high ROA because of a low denominator number.

It is precisely because businesses require different-sized asset bases

that investors need to think about how they use the ROA ratio. For
the most part, the ROA measurement should be used historically for
the company being analyzed. If peer company comparisons are
made, it is imperative that the companies being reviewed are similar
in product line and business type. Simply being categorized in the
same industry will not automatically make a company comparable.

As a rule of thumb, investment professionals like to see a company's

ROA come in at no less than 5%. Of course, there are exceptions to
this rule. An important one would apply to banks, which strive to
record a ROA of 1.5% or above.

Profit Margin Analysis

In the income statement, there are four levels of profit or profit
margins - gross profit, operating profit, pretax profit and net profit.

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The term "margin" can apply to the absolute number for a given
profit level and/or the number as a percentage of net sales/revenues.
Profit margin analysis uses the percentage calculation to provide a
comprehensive measure of a company's profitability on a historical
basis (3-5 years) and in comparison to peer companies and industry
benchmarks.

Basically, it is the amount of profit (at the gross, operating, pretax or

net income level) generated by the company as a percent of the sales
generated. The objective of margin analysis is to detect consistency
or positive/negative trends in a company's earnings. Positive profit
margin analysis translates into positive investment quality. To a large
degree, it is the quality, and growth, of a company's earnings that
drive its stock price.

Gross Profit Margin

What Does Gross Profit Margin Mean?

A financial metric used to assess a firm's financial health by

revealing the proportion of money left over from revenues after
accounting for the cost of goods sold. Gross profit margin serves as
the source for paying additional expenses and future savings.

Also known as "gross margin".

Calculated as:

Gross profit x 100

Sales

Where:
Gross Profit= Sales- COGS where COGS= Cost of Goods Sold

This metric can be used to compare a company with its competitors.

More efficient companies will usually see higher profit margins.

Net Profit Margin

Net profit margin or net profit ratio all refer to a measure of
profitability. It is calculated by finding the net profit as a percentage

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of the revenue and it indicates how much of each dollar of sales
revenue has been left after all expenses have been covered.

The Net Profit Margin can be calculated as:

Net profit before interest and tax x 100

Sales

The profit margin is mostly used for internal comparison. It is

difficult to accurately compare the net profit ratio for different
entities. Individual businesses' operating and financing
arrangements vary so much that different entities are bound to have
different levels of expenditure, so that comparison of one with
another can have little meaning. A low profit margin indicates a low
margin of safety: higher risk that a decline in sales will erase profits
and result in a net loss.

2. Operational Efficiency Ratios or Activity

Ratios
Are a measure of how well a company and its management uses its
assets to generate income.

These ratios look at how well a company turns its assets into revenue
as well as how efficiently a company converts its sales into cash.
Basically, these ratios look at how efficiently and effectively a
company is using its resources to generate sales and increase
shareholder value. In general, the better these ratios are, the better
it is for shareholders.

Average Inventory Turnover Period

Average inventory held x 365

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Cost of sales

This ratio should be compared against industry averages. A low

turnover r( high ratio) implies poor sales and, therefore, excess
inventory. A high turnover (low ratio) implies strong sales.

High inventory levels(high ratios) are unhealthy because they

represent an investment with a rate of return of zero. It also opens
the company up to trouble should prices begin to fall.

Average Settlement Period for Debtor/Average

Collection Period

Average trade debtors x 365

Credit sales

Average collection period measures the average length of time that a

company receives payments from its customers after the close of a
sale. Analysts should compare this ratio with the credit terms the
company offers to its customers.

The lower this ratio the better. High ratios indicate that the company
has problems collecting from its clients and might face cash flow
problems.

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 Financial Ratio Analysis

Average Settlement Period for Creditors/ Accounts

Payable Period

Average trade creditors x 365

Credit purchases

Accounts payable period measures the average length of time that it

takes the company to pay its suppliers.

If this ratio is falling from one period to another, this is a sign that
the company is taking longer to pay off its suppliers than it
was before. The opposite is true when this ratio is increasing, which
means that the company is paying off suppliers at a faster rate.

While the larger this ratio is the better as it shows that the company
has a good ability to negotiate payment terms with it suppliers one
needs to be careful. If this ratio exceeds the number of days
stipulated in the payment terms it might be an indicator that the
company is facing cash flow problems and is unable to pay its
suppliers on time.

3. Liquidity ratios
Liquidity ratios attempt to measure a company's ability to pay off its
short-term debt obligations. This is done by comparing a company's
most liquid assets (or, those that can be easily converted to cash)
with its short-term liabilities.

In general, the greater the coverage of liquid assets to short-term

liabilities the better as it is a clear signal that a company can pay its
debts that are coming due in the near future and still fund its
ongoing operations. On the other hand, a company with a low
coverage rate should raise a red flag for investors as it may be a sign
that the company will have difficulty running its operations, as well
as meeting its obligations.

The biggest difference between each ratio is the type of assets used
in the calculation. While each ratio includes current assets, the more

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conservative ratios will exclude some current assets as they aren't as
easily converted to cash.

Current Ratio
Current assets
Current liabilities

The current ratio is a popular financial ratio used to test a

company's liquidity (also referred to as its current or working capital
position) by deriving the proportion of current assets available to
cover current liabilities.

The concept behind this ratio is to ascertain whether a company's

short-term assets (cash, cash equivalents, marketable securities,
receivables and inventory) are readily available to pay off its short-
term liabilities (notes payable, current portion of term debt,
payables, accrued expenses and taxes). In theory, the higher the
current ratio, the better.

If this ratio is more than 1, then that company is generally

considered to have good short-term financial strength. However, if
the current ratio is too high (more than 2), then the company may
not be efficiently using its current assets, it could indicate that the
company has too much inventory and is not investing the excess cash
because it lacks the managerial acumen to put those resources to
work.

If current liabilities exceed current assets (Current ratio<1), then

the company may have problems meeting its short-term obligations.
Low values, however, are not always fatal. If an organization has
good long-term prospects, it may be able to enter the capital market
and borrow against those prospects to meet current obligations. The
nature of the business itself might also allow it to operate with a
current ratio less than one. For example, in an operation like Mc
Donald's, inventory turns over much more rapidly than the accounts
payable become due. This timing difference can also allow a firm to
operate with a low current ratio.

Acid Test Ratio

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Current assets minus (inventory & prepayments)

Current liabilities

The quick ratio - or the quick assets ratio or the acid-test ratio - is a
liquidity indicator that further refines the current ratio by measuring
the amount of the most liquid current assets there are to cover
current liabilities. The quick ratio is more conservative than the
current ratio because it excludes inventory and other current assets,
which are more difficult to turn into cash. Therefore, a higher ratio
means a more liquid financial position.

4. Gearing Ratios
Are financial ratios that compare some form of owner's equity (or
capital) to borrowed funds. Gearing is a measure of financial
leverage, demonstrating the degree to which a firm's activities are
funded by owner's funds versus creditor's funds.

Gearing Ratio or Net Gearing Ratio

Long term liabilities x 100

Share capital + reserves + long term liabilities
.

Investopedia explains Gearing Ratio

The higher a company's degree of leverage, the more the company is
considered risky. As for most ratios, an acceptable level is
determined by its comparison to ratios of companies in the same
industry. The best known examples of gearing ratios include the
debt-to-equity ratio (total debt / total equity), times interest earned
(EBIT / total interest), equity ratio (equity / assets), and debt ratio
(total debt / total assets).
A company with high gearing (high leverage) is more vulnerable to
downturns in the business cycle because the company must continue
to service its debt regardless of how bad sales are. A greater

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proportion of equity provides a cushion and is seen as a measure of
financial strength.

Interest Coverage Ratio/Times Interest Earned

Metric used to measure a company's ability to meet its debt
obligations. It is calculated by taking a company's earnings before
interest and taxes (EBIT) and dividing it by the total interest payable
on bonds and other contractual debt. It is usually quoted as a ratio
and indicates how many times a company can cover its interest
charges on a pretax basis. Failing to meet these obligations
could force a company into bankruptcy.

Net profit before interest and tax

Interest expense

Also referred to as "fixed-charged coverage".

Investopedia explains Interest Coverage Ratio /Times Interest

Earned - TIE
Ensuring interest payments to debt holders and preventing
bankruptcy depends mainly on a company's ability to sustain
earnings. However, a high ratio can indicate that a company has an
undesirable lack of debt or is paying down too much debt with
earnings that could be used for other projects. The rationale is that a
company would yield greater returns by investing its earnings into
other projects and borrowing at a lower cost of capital than what it is
currently paying for its current debt to meet its debt obligations.

Financial Ratio Analysis

Exam Guide
Ratios are examinable either as an entire discussion question (analysis) or
as a question involving calculations and analysis.

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 Financial Ratio Analysis
Students usually struggle to write good analysis and suggest ways of
improving financial performance. So if you want to get good marks, make
sure you practice writing!

How to write a good Ratio

Analysis?
Here are some tips on what the examiners are looking for:

1. If you are analysing Liquidity/Profitability/ Efficiency/ Gearing explain

exactly what they mean.
2. Tell your reader which ratios measure Liquidity/Profitability/Efficiency/
Gearing and which ones you will be using in your analysis.
3. Explain the meaning of each ratio and apply it to the company that
you are analysing (Company X).

E.g. The Current Ratio measures whether a company's short-term assets (cash,
cash equivalents, marketable securities, receivables and inventory) are readily
available to pay off its short-term liabilities (notes payable, current portion of
term debt, payables, accrued expenses and taxes). CompanyXs Current Ratio
was more than 1 throughout the period so the business is generally considered
to have good short-term financial strength.

4. If you have information for more than one period make sure you
analyse trends and comment on whether there is an improvement or
deterioration in the ratios.

E.g. The ratio of Days Inventory Turnover is an efficiency and activity ratio that
measures how long it takes a business to convert its inventory into sales or
revenue. Despite a slight deterioration in this ratio from 2004 to 2005(16 days to
17 days), CompanyX appears to be able to turn its inventory into revenue quite
quickly.

5. Explain how the behaviours of different ratios within a category relate

to each other.

E.g. The Acid Test Ratio is also known as quick ratio and is a more conservative
measure of liquidity than the Current Ratio because it excludes inventory and
prepayments, which are more difficult to turn into cash. The behavior of this

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ratio confirms our earlier conclusions based on the Current Ratio. CompanyX
does not appear to have any liquidity problems. The business is able to meet its
short term obligations by using its cash reserves and accounts receivable.

6. If you are given information for the industry make sure you compare
the companys performance with the industrys performance.

E.g. It appears that the companyX has been more aggressive than its
competitors in financing its growth with debt and this is reflected in its steeper
degree of leverage (Debt to Equity Ratio was 103% in 2003 and 104% in 2004
vs the industry average of 75%). As a result, the companyX is more vulnerable
to downturns in the business cycle than its peers, regardless of how bad sales
are, the company must continue to service its debt.

7. If required, suggest ways to improve financial performance.

- E.g. To improve profitability company X should reduce unnecessary costs or

find ways to save costs.

Financial Ratios

What is a ratio?

Ratios provide a quick and simple means of examining the financial

health of a business
A ratio simply expresses the relationship between one figure appearing
in the financial statements with another e.g. net profit in relation to
capital employed
Ratios are simple enough to calculate, and a good picture can be built up
with just a few, however ratios can be difficult to interpret
Can be expressed in various forms e.g. percentages, fractions,
proportions depending on the need and use for the information

The key aspects of financial performance / position evaluated by

the use of ratios are:

Profitability
Efficiency
Liquidity
Gearing
Investment

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Financial Ratio Classification

Profitability - Measure of success in wealth creation

Efficiency - Effectiveness of utilisation of resources
Liquidity - The ability to meet short-term obligations
Gearing - Measure of degree of risk to do with the amount of leverage
used to finance the business
Investment - Measure of the returns and performance of shares held by
a business

The alternative bases of comparison for ratio analysis

Bases (benchmarks) that may be used as a basis of comparison for ratio

analysis include:

Intertemporal - Based on past performance

Budget - Based on planned performance
Intra-industry - Based on comparison of performance with
other firms in the same industry

A calculated ratio on its own does not say much about a business - it is only
when it is compared with some form of benchmark that the information
can be interpreted and evaluated

The Key Steps in Financial Ratio Analysis

Step 1:

Identify which key indicators and relationships require examination

Identify who needs the information and why they need it
Step 2:

Choose the most relevant set of ratios that will accomplish the desired
purposes
Calculate and record the results using the selected ratios
Step 3:

Interpret and evaluate the results

Trend Analysis

Trends may be identified by plotting key ratios on a graph, giving a visual

representation of changes happening over time
Intra-company trends may be compared against industry trends
Key financial ratios are often published in companies annual reports as a
way to help users to identify important trends

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Ratios and Prediction Models

Ratios are often used to help predict the future however the choice of
ratios and interpretation of results depend on the judgment of the
analyst
Researchers have developed ratio-based models which claim to predict
future financial distress as well as vulnerability to takeover
The future is likely to see further ratio-based prediction models
developed to predict other aspects of financial performance

Limitations of Ratio Analysis

The quality of the underlying financial statements determines the

usefulness of the ratios derived from them
Ratios only offer a restricted view of relative performance and position -
not the full picture
No two businesses are identical and the greater their differences, the
greater the limitations of ratio analysis as a basis for comparison
Any ratios based upon balance sheet figures will not be representative of
the whole period because the balance sheet is a snapshot of a moment
in time

Index or Percentage Analysis

Index or Percentage analysis simply allows monetary figures to be

replaced with an index or a percentage as an alternative to ratio analysis
There are three alternative index or percentage methods:
1. The common size reports (also known as vertical analysis)
2. Trend percentage
3. Percentage change (also known as horizontal analysis)

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