Ratio Analysis

● A ratio is simply a mathematical expression of

an amount or amounts in terms of another or
others.
● A ratio may be expressed as a percentage, a
fraction, or a stated comparison between two
amounts.
 Ratio Analysis…

● Ratios focus attention on relationships which

are significant but the full interpretation of a
ratio usually requires, further investigation of
the underlying data.
● Ratios are an aid to analysis and interpretation
and not a substitute for sound thinking.
 Classification of Ratios
(i) Short-term Liquidity Ratios.
(ii) Drivers Of Liquidity/Working Capital
Management Ratios
(iii) Capital Structure/Leverage/Debt
Management Ratios
(iv) Operating Efficiency/Profitability
Management Ratios
(v) Investment Management Ratios
 Short-term Liquidity Ratios

● Liquidity refers to an enterprise’s ability to meet

its short-term debts as and when they fall due.
● Liquidity ratios are used to assess a firm’s
ability in meeting its short-term obligations as
and when they fall due.
Short-term Liquidity Ratios Include…
I. Working Capital Ratio
II. Current Ratio
III. Acid-test Ratio
 Working Capital

● Current Assets – Current Liabilities

● Represents that portion of current assets

financed by long term funding not requiring
immediate payment
 Working Capital

● ASSETS = Shareholders Equity

(SE) + Liabilities

● Non Current Assets + Current Assets = Equity

+ Non Current Liabilities + Current Liabilities
 Working Capital

Non Current Assets + Current Assets –

Current Liabilities = Equity + Non –Current
Liabilities
 Working Capital

Non Current Assets + Working Capital =

Equity + Non – Current Liabilities
Working = Equity + Non - Non
Capital Current Current
Liabilities Assets
 Working Capital Ratio
A&B X&Y

Current Assets E.175,00 Current Assets E.92,000

Current Liabilities (100,000) Current Liabilities (50,000)
75,000 42,000
 Current Ratio

● It measures the amount of liquid and near

liquid resources available to meet short-term
debts. (short-term debt paying ability)

● A high current ratio is assumed to indicate a

strong liquidity position while a low current
ratio is assumed to indicate a relatively weak
liquidity position.

● The rule of the thumb is that current assets

should be twice current liabilities.
 Current Ratio…
● The ratio is computed as follows:

Current Ratio= Current Assets

Current Liabilities
 Current Ratio
A&B X&Y

175,000 92,000
100,000 50,000
= =
1.75 : 1 1.84 : 1
Quick Ratio or Acid Test Ratio

● This ratio tests the short-term debt paying ability of

an enterprise without having to rely on inventory
and prepayments.

● The ratio concentrates on more readily realizable

or liquid assets available to meet short-term debts.

● The rule of the thumb is that for every shilling of

current liability owed, the enterprise should have at
least a shilling of quick assets available to meet it.
 Quick Ratio or Acid Test Ratio

● It is given by;

Current Assets-Inventories- Prepayments

Current Liabilities
 Quick Ratio
A&B X&Y

175,000 -100,000 92,000 - 40,000

100,000 50,000
= =
0.75 : 1 1.04 : 1
Working Capital Management Ratios
● These ratios assess the efficiency with
which the firm manages the individual
components of working capital to
Drive/Bring about Liquidity.
● Liquidity does not come by itself ,
rather it is a consequence of the
efficiency of management of both
current assets and current liabilities
(working capital)
 Working Capital Management Ratios
include…
I. Average Collection Period
II. Debtors /Accounts Receivable Turnover
III. Average Payment Period
IV. Accounts Payable Turnover Ratio
V. Age of Inventory/Average Sale Period
VI. Inventory Turnover Ratio
 Average Collection Period Ratio

● The ratio measures the average number of days

taken by an enterprise to collect its trade
receivables.
● The ratio measures the efficiency with which
receivables/debtors are managed to create
cash/liquidity.
Average Collection Period Cont…

● The ratio is computed as follows:

Average Trade Receivables X 365 Days

Annual Credit Sales
Average Collection Period Computation

Company A&B X&Y

Average Trade 40,000 + 20,000 30,000 + 38,000

Receivables 2 2
= 30,000 = 34,000
Credit Sales 1/3 *450,000 1/3 * 810,000
= 150,000 = 270,000

Average Collection 30,000 *365 days 34,000 * 365 days

Period 150,000 270,000
= 73 days = 46 days
 Accounts Receivable Turnover Ratio

● The ratio measures the number of times an

enterprise has turned over (converted) its trade
receivables into cash

● The ratio measures efficiency of collection

efforts adopted by a firm.
● The higher the number of times, the more
efficient an enterprise is assumed to be in
collecting its trade receivables
 Accounts Receivable Turnover Ratio…

● The ratio is computed as follows:

Annual Credit Sales

Average Trade Receivables
Or
365
ACP
 Accounts Receivable Turnover Ratio
Computation
Company A&B X&Y

Accounts 150,000 270,000

Receivable 30,000 34,000
Turnover Ratio = 5 times = 8 times
Average Collection Period Cont…

● Alternative formula for computation

ACP = 365 Days

Accounts Receivable
Turnover Ratio
 Average Collection Period
Company A&B X&Y

Average 365 days 365 days

Collection Period 5 8
= 73 days = 46 days
Average Payment Period

● This ratio measures the average number of

days taken to pay an accounts payable. It is
computed as follows:-

Average Trade Payables X 365 Days

Annual Credit Purchases
 Average Payment Period Ratio…

●Cost of sales:
Beginning Inventory XX
Purchases XX
Goods Available for Sale XX
Ending Inventory (XX)
Cost of Sales XX
 Average Payment Period
Company A&B X&Y

Average Accounts 100,000 50,000

Payables

Credit Purchases:
Beginning Inventory 92,000 45,000
Purchases (Balancing) 253,000 400,000
Goods For Sale 345,000 445,000
Ending Inventory (100,000) (40,000)
Cost Of Sales 245,000 405,000
 Average Payment Period
Company A&B X&Y

Average 100,000 *365 days 50,000 * 365 days

Payment 253,000 400,000
Period = 144 days = 46 days
 Accounts Payable Turnover Ratio

● The ratio measures efficiency of payment

● The higher the number of times, the more

efficient an enterprise is assumed to be in
paying its trade payables
 Accounts Payable Turnover Ratio…

● The ratio is computed as follows:

Annual Credit purchases

Average trade payables
Or
365/APP
Accounts Payable Turnover Ratio
Company A&B X&Y

Accounts Payable 253,000 400,000

Turnover Ratio 100,000 50,000
= 2.53 times = 8 times
Average Sales Period
● This ratio measures the average number of
days taken to sell inventory one time.

● It is given by;

Average Inventory X 365 Days

Cost of Sales
 Average Sales Period
Company A&B X&Y

Average 92,000 + 100,000 45,000 + 40,000

Inventory 2 2
= 96,000 = 42,500

Cost of Sales = 245,000 = 405,000

 Average Sales Period
A&B X&Y

Average Sales 96,000 *365 days 42,500 * 365 days

Period 245,000 405,000
= 143 days = 38 days
 Inventory Turnover Ratio

● The ratio measures efficiency with which

inventory is sold.

● The higher the number of times, the more

efficient an enterprise is assumed to be in
selling its inventory
 Inventory Turnover Ratio…

● The ratio is computed as follows:

Cost of Sales
Average Inventory
OR
365
ASP
 Inventory Turnover Ratio
Company A&B X&Y

Inventory Turnover 245,000 405,000

Ratio 96,000 42,500
= 2.55 times = 9.5 times
Long-term Solvency (Debt Management)
Ratios
● Also referred to as Leverage/Gearing/
Capital Structure Ratios
● A firm is said to be leveraged whenever it
finances a portion of its assets by debt.
● Debts commit a firm to payment of interest and
repayment of capital.
● Borrowing increases the risk of default and it is
only advantageous to shareholders if the return
earned on the funds borrowed is greater than
the cost of the funds.
 Long-term solvency ratios
include …

i. Debt to Equity Ratio

ii. Proprietary (Equity) Ratio
iii. Debt to Total Assets Ratio
iv. Times Interest Earned Ratio (Interest Cover)
 Debt to Equity Ratio

● This ratio measures the amounts of assets

provided by creditors for each shilling of
assets provided by the shareholders.
● It is computed as follows:
Total Liabilities
Total Stockholders’ Equity
Debt to Equity Ratio Computation
Company A&B X&Y

Total Liabilities:
Accounts Payable 100,000 50,000
Long Term Debt 60,000 70,000
Total 160,000 120,000
 Debt to Equity Ratio…
Company A&B X&Y

Total Stockholders
Equity
Capital Stock 150,000 500,000
Share Premium 30,000 110,000
Retained Earnings 60,000 70,000
240,000 680,000
 Debt to Equity Ratio…
Company A&B X&Y

Debt to Equity Ratio 160,000 120,000

240,000 680,000
= 0.67: 1 = 0.18 :1
 Proprietory (Equity) Ratio
● This ratio measures the proportion of assets
financed by the owners.

● It is calculated as follows:

Total Stockholders’ Equity X 100%

Total Assets
 Proprietory Ratio
Company A&B X&Y

150,000+30,000 500,000+110,000+
Total Shareholders’ +60,000 70,000
Equity =240,000 =680,000

Total Assets = 400,000 = 800,000

 Proprietory Ratio
Company A&B X&Y

Proprietory Ratio 240,000 X 100% 680,000*100%

400,000 800,000
= 60% = 85%
Debt to Total Assets Ratio
● This ratio measures the proportion of assets
financed by outsiders.

● It is calculated as follows:

Total Liabilities X 100%

Total Assets
 Debt to Total Assets Ratio
Company A&B X&Y

100,000 + 60,000 50,000 +70,000

Total Liabilities = 160,000 = 120,000

Total Assets =400,000 =800,000

 Debt to Total Assets Ratio
Company A&B X&Y

Debt To Total 160,000 X 100 120,000 X 100

Assets Ratio 400,000 800,000

= 40% = 15%
The Times Interest Earned Ratio

● This is also known as the interest cover

ratio.

● This ratio measures the ability of a firm to

meet its interest expense/payment out of
the current earnings.

● It reflects the likelihood that creditors will

continue to receive their interest payments
by calculating the number of times the
interest payable is covered by profits
available for such payments.
The Times Interest Earned Ratio cont

● It is computed as follows:-

● Profit Before Interest and Tax (PBIT)

Interest Expense
The Times Interest Earned Ratio…

● Note:
◦ The question has provided information on
net income for both entities. The net
income represents profit after interest and
tax. There is therefore need to derive the
figure of profit before interest and tax.
◦ The steps to follow to derive the same are
as follows:
⚫ Derive the figure of profit before tax
⚫ Add interest expense to the above figure
 Times Interest Earned Ratio…

1. Given that the income tax rate is 30%, the

profit after tax is therefore 70% of the
profit before tax

2. Profit after tax = Profit before – 30% profit

tax before
tax
Profit before tax = Profit after tax
70%
 Times Interest Earned Ratio…
Company A&B X&Y

Profit Before Tax 45,000 90,000

0.7 0.7
= 64,286 = 128,571
Interest Expense 60,000 *10% 70,000*10%
= 6,000 = 7,000
Profit Before Interest 64,286 + 6,000 128,571 + 7,000
And Tax = 70,286 = 135,571
 Times Interest Earned Ratio cont…

Company A&B X&Y

Times Interest 70,286 135,571

Earned Ratio 6,000 7,000

= 11.7 times = 19.4 times

Profitability Ratios and Operating
Efficiency Ratios
● Profitability analysis consists of tests used
to evaluate a firm's earnings performance
during the year.

● The ratios are of importance to long term

creditors, shareholders, suppliers,
employees and their representative groups.

● All these parties are interested in the

financial soundness of an enterprise.
 Profitability Ratios and Operating
Efficiency Ratios…

The ratios commonly used to measure

profitability include:-
 Profit Margin (Return On Sales Ratio)
 Total Assets Turnover
 Return on Total Assets (ROA)
 Return on Common Stock Holders’
Equity(ROE)
Profit Margin (Return on Sales) Ratio

● This ratio describes the company's ability to

earn income.
● It is a measure of the proportion of sales
that contribute to profit.
● The ratios are computed as follows:-
Net Profit Margin= Net Income X 100%
Net Sales
Or
Gross Profit Margin=Gross Profit *100%
Net Sales
 Gross/Net Profit Margin Ratios…
Company A&B X&Y

Net Profit Margin 45,000 X 100 90,000 X 100

Ratio 450,000 810,000
= 10% = 11.1%

Gross Profit 205,000*100% 405,000

Margin 450,000 810,000
=46% = 50%
 Total Assets Turnover

● This ratio describes the ability of an

enterprise to use its assets Efficiently to
generate sales.

● Measures the efficiency with which assets

have been used to generate sales

● It is computed as follows:

Net Sales
Average Total Assets
 Total Assets Turnover Ratio…
Company A&B X&Y

Total Assets 450,000 810,000

Turnover Ratio 400,000 800,000

= 1.125 times = 1. 0125 times

 Return on Total Assets

● This ratio measures how well management has

employed assets to generate profits/returns.

● It is given by

Net Income x 100%

Average Total Assets
 Return on Total Assets…
Company A&B X&Y

Return On Total 45,000 X 100% 90,000 X100%

Assets Ratio 400,000 800,000

= 11.25% = 11.25%
Return on Ordinary Stock Holders’ Equity

● This ratio measures the ability of an enterprise to

generate income for its owners (common
Shareholders).

● It is computed as follows:

Net Income – Preference Dividend(if Any)x 100%

Average Common Stock Holders Equity

● Where, Common Stockholders’ Equity=

Total Equity-Preference Share Capital
 Return on Common Stockholders’
Equity Ratio…
Company A&B X&Y

Return on Common 45,000 X 100% 90,000 X100%

Stockholders’ Equity 240,000 680,000
Ratio
= 18.75% = 13.235%
 Investment Management Ratios (Market
Test Ratios)

● These ratios help equity shareholders and other

investors to assess the value and quality of an
investment in the ordinary shares of a company.

● The value of an investment in ordinary shares in a

listed company is its market value

● Investment ratios must have regard not only to

information in the company’s published accounts,
but also the current market price.
 Investment Ratios…

The ratios commonly used to assess value and

quality of investments include:-

(i) Earnings Per Share (IAS 33)

(ii) Dividend Pay Out Ratio
(iii) Dividend Yield Ratio
(iv) Earnings Yield Ratio
(v) Price Earning Ratio
 Earnings Per Share (EPS)

● This ratio represents or reflects the amount of

shillings or cents earned (lost) per ordinary share.

● It is given by

Net Income – Preference Dividends(if any) .

The Weighted Average Number of Ordinary Shares Outstanding.
 Earnings Per Share cont…

Company A&B X&Y

Earnings Per Share 45,000 90,000

15,000 50,000

= Sh 3 per share = Sh. 1.8 per share

Dividend Pay-out Ratio

● This ratio reflects a company’s

dividend policy.
● It is computed as follows:

Dividends Per Share X 100%

Earning Per Share
Or Total Common Dividend Paid X 100%
Earnings Available to Common
 Dividend Per Share

● This ratio reflects the amount of dividend

paid per share

● It is computed as follows:

Total Ordinary Dividends

Number of Ordinary Shares
Outstanding
 Dividend Pay-out Ratio

Company A&B X&Y

Dividends Per 36,000,000 15,000,000

Share 15,000,000 50,000,000
= Sh 2.4 per share = Sh. 0.30 per share

Dividends Pay-out 2.4 X 100 % 0.3*100%

Ratio 3.0 1.8
= 80% =17%
 Dividend Yield Ratio

● This shows the dividend return being

provided by the share.

● It is given by

Dividends Per Share X 100%

Market Price Per Share
 Dividend Yield Ratio

Company A&B X&Y

Dividends Yield 2.4 X 100 % 0.3 X 100%

Ratio 18.0 15

= 13% =2%
 Earning Yield Ratio

● This shows the earning return being provided by the share.

● It is given by

Earnings Per Share X 100%

Market Price Per Share
 Earning Yield Ratio

Company A&B X&Y

Earning Yield Ratio 3.0 X 100 % 1.8 X 100%

18.0 15

= 16.7% =12%
Price Earnings Ratio (The P/E Ratio)

● This ratio is used in comparing stock

investment opportunities.

● It is an index of determining whether shares

are relatively cheap or relatively expensive.
It is given by

Market Price Per Share

Earnings Per Share
Price-earning Ratio Computation

Company A&B X&Y

Price -Earning 18.0 15

Ratio 3.0 1.8

= 6 Times = 8.3 Times