CHAPTER 3

RATIO ANALYSIS
Chapter outline
Introduction
Requirements for financial ratios
Norms of comparison
Types of ratios
Profitability ratios
Profit margins
Turnover ratios
Liquidity ratios
Solvency ratios
Cash flow ratios
Investment ratios
Financial gearing
DuPont Analysis
Conclusion
Learning outcomes

By the end of this chapter, you should be able to:

discuss the requirements for financial ratios
identify the norms of comparison used to evaluate
ratios
identify the different types of ratios
define, calculate and interpret profitability, liquidity,
solvency, cash flow and investor ratios
explain financial gearing
apply the DuPont Analysis system to evaluate return
ratios.
Introduction
Information provided in financial statements is used to
calculate financial ratios
Ratios attempt to provide more information in format
that is comparable over time, between companies and
between industries/countries
Ratios are more understandable than the financial
figures in financial statements
Meaningful relationships between items from the
financial statements are investigated with ratios
Requirements for financial ratios

Primary objective:
Simplify the evaluation of the financial performance
and position of a company
Meaningful
Logical comparison between items from financial
statements
Relevant
True indication of financial situation
Comparable
Ratio calculated in a consistent manner
Norms of comparison

Conventions
Norms developed over time
May differ between firms/industries
Comparison over time
Determine if financial situation improved or declined
Determine trends in the values of the ratios
Comparison between companies
Determine the competitive position of the company
relative to its competitors
Types of ratios

Profitability ratios
Profit margins
Turnover ratios
Liquidity ratios
Turnover times
Solvency ratios
Coverage ratios
Cash flow ratios
Cash coverage ratios
Investment ratios
Profitability ratios

Evaluates efficiency with which a company

utilises its capital to generate turnover
Small investment in assets generates large income
company is highly profitable
Large investment in assets generates small income
assets are not utilised efficiently
Possible to calculate the profitability of different
capital items
Ensure relevant comparison between capital
item and corresponding income/profit
Return on assets (ROA)

Measures how efficiently total assets are

utilised to generate turnover
Compares profit after tax with total assets

Profit after tax

ROA =
Average total assets
In order to improve ROA:
Improve profit figure, reduce amount of assets, or
combination
Return on equity (ROE)

Indicates return generated on total equity

Total equity includes ordinary shareholders equity,
preference share capital and minority interest
Profit after tax represents profit available to equity
providers

Profit after tax

ROE =
Average equity
Return on shareholders equity
(ROSE)
Return generated on shareholders equity
Shareholders equity includes ordinary shareholders
equity and preference share capital
Profit after tax minus non-controlling interest
represents profit available to shareholders equity
providers

Profit after tax Noncontrol ling interest

ROSE =
Average shareholde rs' equity
Return on ordinary shareholders
equity (ROSHE)
Return generated on ordinary shareholders
equity
Ordinary shareholders equity includes ordinary
share capital and reserves
Profit after tax minus non-controlling interest and
preference share dividends represents profit
available to ordinary shareholders
ROSHE =
Profit after tax Noncontrol ling interest PSDividends
Average ordinary shareholde rs' equity
Profit margins

Indication of the percentage of turnover that

shows as profit after certain deductions are
made
Profit margins could influence profitability ratios
Higher profit margins should increase profitability
levels
Gross profit margin (GP)

Portion of turnover that is realised as gross

profit after cost of sales has been subtracted

Gross profit
GP =
Turnover
Operating profit margin (OP)

Portion of turnover that is realised as operating

profit after operating expenses have been
subtracted

Operating profit
OP =
Turnover
Earnings before interest and tax
margin (EBIT)
Profit made before taking any finance cost and
tax into consideration
Operating profit Investment income
EBIT =
Turnover
Net profit margin (NP)

Portion of turnover available after tax is paid

Important to the equity providers
Indication of portion of the turnover that belongs to
non-controlling interest holders, which can be paid
out as ordinary or preference dividends or can be
reinvested as part of the companys reserves

Profit after tax

NP =
Turnover
Turnover ratios

Indicates speed with which an investment in

assets is converted into turnover
Higher the value of the ratio the more times per year
the investment is utilised to generate turnover, and
the higher the total profit should become
Influences the profitability of a company
Higher turnover ratios should increase profitability
levels
Total asset turnover ratio

Indicates efficiency with which total assets are

utilised to generate turnover
The higher the value of TA turnover ratio, the more
times per year the investment in total assets is
converted into turnover
If a company is able to improve TA turnover ratio
while maintaining same profit margins, its return on
assets should increase

Turnover
TA turnover =
Average total assets
Property, plant and equipment
turnover ratio
Evaluates the utilisation of a companys
investment in PPE
PPE at carrying value

Turnover
PPE turnover =
Average PPE @ carrying value
Current asset turnover ratio

Indicates the number of times per year that the

investment in the current assets is converted
into turnover
Turnover
CA turnover =
Average current assets
Trade receivables turnover ratio

Shows number of times per year that

investment in trade receivables is converted
into turnover

Turnover
TR turnover =
Average trade receivable s
Inventory turnover ratio

Focuses on investment in inventory

Cost of sales is determined by the amount of
inventory that is sold so INV ratio does not
focus on the value of the companys turnover
Cost of sales figure is used instead

Cost of sales
INV turnover =
Average inventory
Trade payables turnover ratio

Evaluates efficiency with which company

utilises trade payables to finance its purchases
When the TP turnover ratio is calculated,
purchases of inventory during the year are
required
Purchases
TP turnover =
Average trade payables
Liquidity ratios

Liquidity refers to ability to honour short-term

obligations
Adequate liquidity: sufficient current assets are
available to cover current liabilities
If companys liquidity is consistently at insufficient
levels, it may eventually result in problems with
solvency in the long term: could threaten the survival
of the business
Current ratio

Compares current assets and current liabilities

Conventional norms of comparison: value of 2:1 if
company maintains acceptable levels of liquidity
Value less than one: indicates that there is less than
R1 of current assets to cover R1 of current liabilities
this could indicate insufficient liquidity

Current assets
Current ratio =
Current liabilities
Quick ratio

Focuses on current assets and liabilities

Unlike current ratio, not all current assets are
included:
Takes time to sell inventory
Prepayments cannot be reclaimed
Value of quick ratio more conservative estimate of
current assets available to cover current liabilities
Quick ratio =
Cash short - term investment s receivable s
Current liabilities
Cash ratio

Focus is placed solely on cash and cash

equivalents available
Cash ratio indicates if sufficient cash is available to
cover current liabilities

Cash
Cash ratio =
Current liabilities
Turnover time ratios

Turnover times of current assets provide indication

of time it takes to convert investment into turnover
Longer turnover times: weaker liquidity
Turnover times of current liabilities provide an
indication of average period of time before liability
is redeemed
Shorter turnover times: liabilities are paid earlier;
negative effect on liquidity
Turnover times influence cash conversion cycle
More efficient management of working capital
components could result in improved liquidity
Trade receivables turnover time

Average time it takes to convert investment in

TR into turnover
Represents average collection period of trade
receivables (i.e. how long customers that purchase
items on credit take on average to pay accounts)
Increase in value of ratio over time could be
sign of decreased liquidity; could also be
indication that credit terms are too lenient
Average trade receivable s 360
TR turnover time = Turnover
x
1
Inventory turnover time

Calculates average time it takes to convert

inventory into turnover
Provides average age of inventory (i.e. how long an
item of inventory has been in the business before it
is sold)
Average inventory 360
INV turnover time = x
Cost of sales 1
Trade payables turnover time

Indicates average period it takes before trade

payables are repaid
If TP turnover time decreases: trade payables are
repaid earlier; negative effect on liquidity
Increase in TP turnover time: improved liquidity

Average trade payables 360

TP turnover time = x
Purchases 1
Cash conversion cycle

Indication of the time that elapses from when

cash is spent on purchase of inventory until it is
received back again
Inverse relationship between CCC and
profitability; could improve profitability by reducing
CCC

TR turnover time INV turnover time

CCC =
TP turnover time
Solvency ratios

Solvency refers to a companys ability to cover

all its obligations when it eventually closes
down its operating activities
Comparison between total assets and total
debt capital
If value of assets exceeds the value liabilities:
solvency level would most probably be sufficient
If this is not the case: long-term survival of the
company may be at risk
Debt : assets ratio

Relationship between debt capital and total

assets
Provides indication of the portion of the total
capital requirement that is financed by means
of debt capital
The higher the value of this ratio, the weaker the
solvency position

Total debt
Debt : assets ratio =
Total assets
Debt : equity ratio

Compares amount of debt capital with equity

capital
The higher the value of this ratio, the weaker the
solvency position

Total debt
Debt : equity ratio =
Total equity
Financial leverage ratio

Amount of total assets is compared with

amount of equity capital included in the
companys capital structure
The higher the value of this ratio, the weaker the
solvency position

Average total assets

Financial leverage ratio =
Average total equity
Coverage ratios

Consider ability to meet certain obligations

when evaluating solvency
If a company is unable to cover some
obligations could result in solvency problems
To determine if sufficient profits are available to
cover obligations calculate coverage ratios
Coverage ratios focus on obligations company are
legally bound to consider compares it with profit
available to pay the obligation
Finance cost coverage

Finance cost payable on debt capital usually

represents legally enforceable obligation
If finance cost is not paid debt capital providers can
take legal action to collect it
Finance cost coverage ratio indicates if sufficient
profits are available to pay finance cost

EBIT
Finance cost coverage = Finance cost
Fixed payments coverage

Fixed payments: obligations that company

always needs to honour
Obligations not honoured may result in termination
of companys activities
Usually consist of finance cost and lease payments
Profit available calculated by adding finance cost
and lease payments to profit before tax
Fixed payments coverage =
EBIT Lease payments
Finance cost Lease payments
Preference dividends coverage

Indicates if sufficient profits are available to pay

preference dividends
Relevant profit figure: profit after tax and minority
interest
Preference dividends can only be paid after
provision has been made for all other obligations
Preference dividend coverage =
Profit after tax N oncontroll ing interest
Preference dividends
Cash flow ratios

Important to consider if sufficient cash flows are

generated to cover a companys expenses and
liabilities
Also necessary to investigate a companys
sources of cash flows, and how these cash
flows are utilised
Cash flow to turnover ratio

Quantifies portion of companys turnover that is

converted into CFO
Higher value indicates that turnover is converted into
cash flow more efficiently

CFO
Cash flow to turnover ratio =
Turnover
Cash return on assets

Indicates how efficiently companys assets are

utilised to generate operating cash flows
Higher value indicates that assets are utilised more
efficiently to generate CFO

CFO
Cash return on assets =
Average total assets
Cash return on shareholders
equity
Determines the cash return that the
shareholders of a company received
Higher value indicates that shareholders received a
higher cash return on their investment
Cash return on shareholders equity =

CFO
Average shareholde rs' equity
Cash flow to operating profit

Important to determine what portion of profit is

eventually converted into cash flows
Cash flow to operating profit ratio provides an
indication of the percentage of the operating profit
that is converted into operating cash flows

CFO
Cash flow to operating profit =
Operating profit
Cash coverage ratios

When evaluating a companys ability to meet

obligations also possible to focus on cash flows
rather that profit figures
Cash coverage ratios should provide analysts with
an indication of whether the company has sufficient
cash available to cover obligations
Since most obligations need to be paid with cash,
these ratios are of great importance
Finance cost cash coverage

Determines cash flow available to pay finance

cost obligations
Finance cost cash coverage =
CFO Finance expenses paid Tax paid Dividends paid
Finance expenses paid
Dividend cash coverage

Determines cash flow available to pay

dividends
If insufficient cash flows are available to cover
dividends company needs to obtain external cash
flows

CFO Dividends paid

Dividend cash coverage = Dividends paid
Reinvestment coverage

Determines if sufficient cash flows are

generated to cover reinvestment in fixed assets
Reinvestment coverage =
CFO
Cash paid for long term assets
Debt repayment coverage

Determines if sufficient cash flows are

generated to repay long-term debt capital
Debt repayment coverage =
CFO
Cash paid for long term debt repayment
Investing and financing coverage

Determines if sufficient cash flows are

generated to cover companys investing and
financing cash flows
If company is unable to generate sufficient operating
cash flows to cover these activities, they will have to
obtain additional cash flows from its capital
providers to meet the cash demand
Investing and financing coverage =
CFO
Cash flow from investing and financing activities
Investment ratios

One of the most important groups of users of

companys financial statements are the
shareholders both existing and potential
Are interested in potential benefits that investment
will provide
Also interested to find out if investment in the shares
of the company is expected to increase or decrease
in value over time
Earnings per share

Indication of the distributable profit that was

earned per ordinary share during the year
Attributable to the ordinary shareholders of the
company
EPS =
Profit after tax N oncontroll ing interest Preference dividends
Number of ordinary shares
Dividend per share

Indicates the amount that investors receive per

share in the form of ordinary dividends
Usually only a portion of the EPS is declared as an
ordinary dividend
Portion not paid out reinvested as retained earnings

Ordinary share dividend

DPS =
Number of ordinary shares
Price : earnings ratio

Indication of how many Rands investors are

prepared to pay for each R1 EPS that is earned
by the company
If P : E ratio is greater than one, it is usually an
indication that investors expect company to continue
to grow in future

Market price per share

P : E ratio =
EPS
Dividend payout ratio

Represents portion of attributable earnings that

is paid to investors
Remaining portion is reinvested as part of retained
earnings

Ordinary dividends
Dividend payout ratio =
Attributab le earnings
Ordinary dividend coverage

Ordinary shareholders have last claim on

profits
When ordinary dividend coverage is calculated,
focus is placed on attributable earnings
Usually dividends only declared if sufficient profits
are available
If ordinary dividend coverage ratio is less than one,
reserves from previous years used or additional debt
capital obtained
Attributab le earnings
Ordinary dividend coverage = Ordinary dividends
Market-to-book value

Compares market capitalisation of shares with

book value of shareholders equity
Market capitalisation calculated using current market
price: incorporate investor expectations about future
financial performance
Book value of ordinary shareholders equity: total
capital ordinary shareholders contributed
Comparison between the values provide indication
of price investors are prepared to pay relative to
investment at book values
High value for ratio sign that investors are expecting
high future earnings from the company
Market-to-book value

Market-to-book value =

Market capitalisation of ordinary shares

Book value of ordinary shareholde rs' equity
Financial gearing

Effect that use of debt capital has on ROSE

If company is able to utilise debt capital efficiently
may result in increased ROSE
If utilisation of debt capital is not efficient use of debt
capital will have a negative effect on ROSE
Two important factors taken into consideration
when evaluating financial gearing:
ROA
Cost associated with debt capital (RD)
Financial gearing

If company is able to generate ROA in excess

of RD:
Return on capital higher than its cost; surplus profit
will be transferred to shareholders increasing ROSE
Company experience positive financial gearing
Also possible that opposite situation occur:
If ROA is lower than RD: company is earning less on
debt capital than its cost; deficit will be transferred to
shareholders and the use of debt capital will result in
decrease in ROSE.
Classified as negative financial gearing
DuPont analysis

Used to obtain a breakdown of return ratios

Possible to identify individual components that
contribute to overall value of the return ratio
Also possible to evaluate changes in the values
of the ratios over time to determine where
possible problem areas exist
Can also compare the ratios of similar firms to
investigate where value is created
 ROE:

Profit after tax

Average equity

ROA: Leverage:

Profit after tax Average total assets

Average total assets Average equity

Net profit margin: Total asset turnover:

Profit after tax Turnover

Turnover Average total assets

Tax burden: Interest burden: EBIT Margin:

Profit after tax Profit before tax EBIT

Profit before tax EBIT Turnover
Conclusion

The main requirements for financial ratios are to

provide meaningful comparisons between items in the
financial statements; that only relevant amounts must
be included in their calculations; and that they need to
be comparable over time.

When evaluating financial ratios it is important to

compare the values of the ratios to conventional norms,
the value of the ratio calculated for the company over a
period of time or to the values of the ratio obtained for
similar companies.
Conclusion (cont.)

The main categories of ratios are profitability, liquidity,

solvency, cash flow and investment ratios.

Profitability ratios evaluate the efficiency with which a

company utilises its capital to generate turnover.

Liquidity ratios refer to a companys ability to cover

current liabilities by means of its current assets.

Solvency ratios investigate the relationship between a

companys debt capital and its total assets.
Conclusion (cont.)

Cash flow ratios determine if sufficient cash flows are

generated to cover the companys obligations.

Investment ratios are calculated to determine the

benefits that the investors of the company earned.

DuPont Analysis provides a breakdown of the

components that contribute to a companys ROE in
order to evaluate changes in the ratio.