Financial ratios

Overview

An alternative means of reporting performance

Identified more with finance than accounting

•       ratio analysis

Makes heavy use of accounting information

Represent performance using simple numbers

•       as a percentage

•       as a proportion (decimal)

•       as a single number

An open ended exercise - experimentation

All ratios computed in many different ways

Allow comparisons between operating units

•       overcome size differentials

Useful in identifying trends over time

•       health (or otherwise) trends

Require to be used with caution – interpretation

Categories of financial ratio

Text identifies 5 different categories

•       profitability

•       efficiency

•       liquidity

•       (financial) gearing

•       investment

A largely universal taxonomy

Profitability ratios

Accountants state profit as a number

Such a figure has relatively limited value

Takes no account of scale of operations

Profit serves as the numerator in a ratio

Various denominators can be identified

Can derive a ratio to use in comparisons

•       takes into account the scale of activity

ROCE

Return on Capital Employed

Seen as most fundamental profitability ratio

Compute operating profit against capital

What constitutes capital varies

•       share capital + reserves

•       non-current liabilities

A percentage will be determined

ROSF

Return on Shareholder Funds

•       strip out ‘other’ sources of funds

•       preference shares

Adjust profit for preference dividends

Why would you do this?

Because not all entities are funded the same

Any resulting return percentage becomes robust

OPM

Operating Profit Margin

View profit in terms of turnover

Compute operating profit and sales revenue

•       how much profit per £ of turnover

Express as a percentage

The Gross Profit Margin provides an alternative

Compute the gross profit against turnover

What would comparing these tell you?

Efficiency ratios

Efficiency of working capital management

Working capital viewed here as

•       stock and work in progress

•       debtors

•       creditors

Cash/bank/short term investments excluded

Provide interesting insights on (in)efficiencies

Stock turnover ratio

How long it takes you to move your stock

Many different variations on basic computation

•       cost of average stockholding

•       total cost of sales

Resultant decimal  multiplied by 365 – days

Over time turnover days has fallen

Why – high stock ties up your cash (and space)

Debtors’ turnover ratio

How long it takes to collect your debts

Similar variations in ratio

•       average level of outstanding debtors

•       total level of credit sales

Ratio again stated in terms of days

Too long to turnover is a problem

Loss of use of cash (overdraft charges)

Creditors’ turnover ratio

The complementary ratio

The number of days taken to pay creditors

•       average level of creditors

•       total credit purchases

An early sign of ill-health is a rising CTR

Deferring payments to trading partners

•       use them as cost free lenders of funds

Sales revenue ratios

Two are identified in the module text

•       sales revenue/capital employed

•       sales revenue/employee

The former tells you about use of assets

•       is this a good way to deploy your resources?

The latter tells you about employee effort

•       no comment………

ROCE again

ROCE can be viewed in a different way

Linking two key ratios

•       operating profit margin

•       sales revenue to capital

The sales revenue figure falls out to leave

•       operating profit to capital - ROCE

Basis for DuPont model of ratio analysis

Liquidity ratios

Probably the easiest to remember

Fortunately as these are two crucial ratios

Closely related to efficiency ratios

Again focus on working capital

Tells you something about immediate health

No liquidity, no business

Hence the situation of going into liquidation

Current ratio

Makes a comparison between

•       current assets

•       current liabilities

Capacity to meet short term financial obligations

Logically you should have a figure of 1+

Beyond this its all relative

The higher the better – not quite so easy?

Acid test ratio

Alternatively simple the quick ratio

A more refined numerator

•       basically cash/near cash  (not inventory)

Again reference to a desirable 1 ratio

In practice many successful companies fail test

Trust overrides a lack of liquidity

But when trust is diminished then problems

Gearing ratios

Refer to financial gearing

A technical term deriving from finance

Concerned with relationship between

•       borrowings or loans

•       equity or shareholder investment

With borrowings come financial commitments

Equity doesn’t bring these commitments

But if you have no more funds you borrow

In principle pretty simple

Compute the levels of

•       long term liabilities (loans)

•       equity + long term liabilities

Interpreting a specific level of gearing is complex

It very much depends on specifics

Increasing financial gearing is a worry generally

Interest cover ratio

Gearing commitments mean interest payments

•       bank loans and personal loans

•       preference shares

Legally required to cover these commitments

The ratio computes

•       interest payments

•       operating profit

Investment ratios

These have assumed increased significance

Of more interest/immediacy to shareholders

Inform them of the health of their investments

Provide a basis for moving funds

Although questionable if this actually occurs

•       institutional investors

•       investment advisors

Dividend payout ratio

How much is to be paid out as dividends

As a percentage of available earnings

Sometimes you might seek a high yield

Sometimes you want it to be low

•       retained earnings growth

•       storing up value for the future

A core topic within corporate finance theory

A variation on dividend payout ratio

A different denominator

•       (stock) market value

•       the ‘informed’ assessment of value of shares

This is a core topic for (some) accountants

•       relationship between market and book values

•       the intangibles panic of the mid/late 1990s

Earnings per share

This is almost an everyday idea nowadays!

Expresses health of an investment per share

Computes

•       earnings available to ordinary shareholders

•       number of ordinary shares

Strips out other complications, back to basics

Desirable to see the EPS on an upward trend

Price/earnings ratio

Often seen as the key indicator of health

Identifies EPS in terms of market value

Axiomatically high market value means health

Resultantly very high PE ratios are common

Also the self-fulfilling prophecy

•       high P/E ratio, greater demand for shares

•       higher market value

In summary

A few ratios can take you a long way

If only it was so easy…….

This is definitely not a mechanical exercise

A moment’s thought should tell you that

In practice analysts devise their own models

And obviously charge you for their expertise

Plus there is the whole informal side