 Topics  Activities 3

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1: THE ENTERPRISING ENVIRONMENT Welcome to Business

2: OPERATIONS MANAGEMENT
Enterprise Skills
3: THE ENTERPRISE FORMULATION AND GROWTH

4: THE ENTERPRISING ENVIRONMENT

5: BUSINESS PLANNING

6: THE ENTERPRISE FORMULATION AND GROWTH

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7: PEOPLE IN BUSINESS ENTERPRISES

8: BUSINESS PLANNING

9: OPERATIONS MANAGEMENT

10: PEOPLE IN BUSINESS ENTERPRISES

11: ENTERPRISE FINANCE AND ACCOUNTING

12: OPERATIONS MANAGEMENT

13: MARKETING AND MARKETING

14: ENTERPRISE FINANCE AND ACCOUNTING

15: MARKETS AND MARKETING

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 RATIO ANALYSIS

By the end of this sub-topic, learners should be able to:

1. Define the term ratio analysis.

2. Explain the different types of accounting ra tios.
3. Calculate ratios from given d ata.
4. Evaluate the importance of ra tio analysis in e nte rpr ise .

Ratio Analysis
Ratio analysis refers to the process of determining and interpreting business numerical
relationship based on financial statements.
They help to indicate firm's financial performance in several key areas.
They are different types of accounting ratios which are grouped into profitability,
liquidity, investment and capital structure.

Profitability ratios
Measure the ability of a business to earn profit for its owners.
Profitability ratios relate to profit from sales and disposal of assets.
Important profit ratios include:

Gross profit margin

Ratio of gross profit of a business to its revenue.

It measures the proportion of revenue converted into gross profit.
It is calculated as follows:

Gross margin =
gross profit ( total revenue - Cost of goods sold )
sales revenue
x 100

Suppose Colmat enterprise earns $100 000 as revenue from

selling computer bags and incurs $50 000 as production costs.
Therefore gross margin is calculated as follows:

$ 100000 - $ 50000
Gross margin = $ 100000
x 100

Gross margin = 50%

This means that Colmat enterprise earns 50% gross profit on

every unit sold.

Gross profit mark up

It is a profitability ratio which shows gross profit earned based on cost of goods sold.
It is calculated as follows:

Gross profit
Gross profit mark-up = x 100
Cost of sales

Computer bag had a cost of $8 and it earned a gross profit of

$2.
Calculate the gross profit mark-up

$2
Gross profit mark-up = $8
x 100

Gross profit mark-up = 25%

Mark-up percentage is often expressed as a percentage of cost.

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Net Profit Margin
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It i di t h h fit i d ft ll h b d d t df
 It indicates how much profit is earned after all expenses have been deducted from
revenue.
Net profit ratio exclude earnings before interest and tax.
Formula for net profit margin:

Net profit margin =

Net profit ( or earnings before interest and tax )
x 100
Sales revenue

Colmat enterprise has a net profit of $70 000 and sales

amounting to $210 000. Therefore net profit margin is:

$ 70000
Net profit margin = x 100
$ 210000

Net profit margin = 33%

Return on capital employed (ROCE)

Return on capital ratio indicates the efficiency and profitability of a company's capital
investments.
It measures returns realised by an enterprise from its capital employed.
ROCE is calculated using formula below:

ROCE =
Operating profits ( earnings before interest and tax )
x 100
Capital employed

Capital employed refers to the value of assets employed in an enterprise for profit
acquisition.
It does not consider profit margins alone but also considers the amount of capital
utilised when earning these profits.
Higher ROCE is favourable than the cost of borrowing.
General rule states that ROCE of 20% or more is considered favourable.
Lower ROCE, means that an enterprise is using its resources inefficiently, even if its
profit margins are high.
If an enterprise increase borrowing, it will reduce shareholders' earnings.

Assume that Colmat enterprises operating profit is $4 900 and

capital employed is $12 000.
$ 4900
Therefore ROCE = $ 12000
x 100
= 40.8%

Liquidity ratios
Liquidity ratios are used to test if the enterprise has enough cash or equivalent current
assets sufficient to pay its debts as they fall due.
It shows the ability of the enterprise to meet its short term debts with its current
assets.
Liquidity ratios aid management in checking the efficient management of working
capital.
They are two liquidity ratios:

Current asset ratio

It measures enterprise's ability to pay short term obligations.

The formula for calculating enterprise's current ratio is:

( Current assets )
Current Ratio = ( current liabilities )

The general rule states the current asset ratio should be between 1.5 and 2.
Higher current asset ratio which exceeds 2 depicts that money is tied up in current
assets and not realising profits for the enterprise.
Lower ratio less than 1.5 indicates over trading and under capitalisation, therefore it
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may face difficult to meet its short term obligations.

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Acid test (or quick) ratio
 ( q )

It measures the enterprise's ability to pay its current liabilities with only liquid assets.
Not all current assets are easily converted quickly into cash, for example, stock may
take time to convert.
Acid test ratio eliminates stock which is not ready cash and cash equivalence.
The formula for calculating enterprise's quick ratio is:

( Current assets less stock )

Acid test ratio = ( current liabilities )

The general rule states that the quick ratio should be 1 (this shows that cash and cash
equivalence is equal to current liabilities)
This depicts that the business can pay it short term liabilities without facing
difficulties. and it can do it without selling stock at a discount.
When quick asset ratio is low, the enterprise may not be able to cover its current
liabilities.

Efficiency ratios
Measures how efficient an enterprise uses its assets and liabilities.
Efficiency ratio can calculate the turnover of receivables, equity usage, the repayment
of liabilities and general usage of machinery and inventory.

Stock turnover (rate of stock turnover)

Measures how efficient a business maintains an appropriate level of inventory.

It is calculated as follows:

( Cost of sales )
Stock turnover =
( Average inventory )

High stock turnover indicate that the enterprise is efficient and active in trading goods.
Stock turn depends on the quality and nature of goods.

Debtors' collection period ratio

It is also called debtors days or accounts receivable / sales ratio.

Shows average time taken by debtor to pay debts or time taken to collect trade debts.
It is calculated as follows:

Debtors
Debtors days = Total credit sales
x 365

If debtors take a long time to pay their debts, the enterprise may experience problems
in meeting its obligations.

Credit payment period

It is also called creditor days or accounts payable / purchases ratio.

It indicates the average period of time taken by an enterprise to pay its debts.
It is calculated as follows.

Average trade creditors

Creditors days = x 365
Total credit sales

The enterprise would prefer a longer payment period.

Investment/ Shareholders' ratios

Investment ratios assess the performance of enterprise's equity.
Ratios used by investors to make an assessment of the returns on investment.
They measure enterprise performance in terms of its borrowings, revenue, economic
value added, return on investment, stockholder's equity, dividends yield, gearing, etc.
They include:

Dividend yield

It shows the dividend per share expressed as a percentage of the market price of the
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share.

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It is calculated as follows:
 Declared dividend per share
Dividend yield = Market price per share
x 100

Assume that the declared dividend per share is 8.5 cents and a market price per share
$ 0 . 085
is $ 1.70, the dividend yield would be: x 100 = 5 %
$ 1 . 70

Investors would prefer high returns, however it is associated with high risk.

Dividend cover

It measures how many times the dividends could have been paid out of the profit after
tax.
( Profit after tax )
The formula for calculating dividend cover is as follows: ( Paid and proposed dividend )

For example, if enterprise had profit available for distribution after tax of $20 million
and it paid total dividends of $5million, then the dividend cover would be:
$ 20 000 000
$ 5 000 000
= 4 times

Therefore it means that the enterprise did not pay the shareholders a significant
proportion of the profit after tax in form of dividends.
The company may be keeping its profit after tax as retained profit to be used for
investment purpose.

Earnings per share

Earnings per share measures the enterprise's potential dividends that it could pay to
its shareholders.
The formula for calculating earnings per share is as follows:
Net profit available to pay shareholders
Number of ordinary shares

If an enterprise has profit after tax of $ 20 million and it has 40

million ordinary shares, then the earning per share would be:
$ 20000000
40000000
= $0. 50

This means that every ordinary share could earn a dividend of $0.5, if all profits after
tax are distributed as dividends.

Price — earnings ratio (P/E)

This measures the profitability of the share in terms of both capital value and
earnings.
Market price per share
It is calculated using the following formula: Earnings per share

For example if the current market price of an enterprise's share is $ 1.70 and earnings
$ 1 . 70
per share is $ 0.50, then the P/E ratio would be: $ 0 . 5 = 3. 4

The answer indicates that it would take an investor 3.4 years to recover the cost of
the share.

Capital structure ratios

Gearing ratio

These are ratios which make comparison between equity financing and debt financing.
Gearing is a measurement of entity's financial leverage.
It compares how the company is funded — mainly through borrowing (debt finance)
or with owner's equity.
There are more than one way of calculating gearing. The mostly widely used methods
are as follows:

The ability of company to meet its interest payments is

calculated as:
Gearing =
Loan finance ( total liabilities )
x100
total shareholders ' equity ( loan and share finance )
OR 100%
( Fixed interest capital )
Gearing = ( Fixed interst capital + equity )
x100
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 When the enterprise is highly geared, it means it mainly financed mainly through
borrowed finance.
There is a greater chance of enterprise failing to meet its interest payments leading to
insolvency.
An enterprise with a gearing ratio of less than 25% is generally described as having
‘low gearing'.
An enterprise with a gearing ratio of more than 50% is generally said to be ‘highly
geared'.
Gearing ratio between 25% - 50% would be considered as normal for a well-
established enterprise which finance its activities using debt.
The higher the gearing, the greater dividend fluctuations.

Importance of ratio analysis

To formulate forecasting and planning.

To prepare budgets.
To measure the degree of efficiency.
To compare performance and locating weakness.
To analyse financial statements.
For decision making.

Limitations of ratio analysis

It is calculated based on historical trends.

It is also affected by estimates and assumptions.
Different companies use different rules, practices and regulations in preparing financial
information.
Seasonal factors can also distort ratio analysis.
It does not show non numerical factors that affect ratios, for example, product quality.

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