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Lecture 4 - Ratio Analysis - JJ

The document discusses ratio analysis, which assesses a company's financial performance and health using ratios calculated from its financial statements. It covers various types of ratios that can be classified into liquidity, profitability, efficiency, financing/gearing, and investment categories. Specific ratios discussed include current ratio, quick ratio, gross profit margin, return on capital employed, debt-to-equity, interest coverage, earnings per share, and dividend yield. Calculating and interpreting these ratios provides insights into a company's operations, profitability, use of assets/liabilities, and returns.

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Tariq Khan
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37 views

Lecture 4 - Ratio Analysis - JJ

The document discusses ratio analysis, which assesses a company's financial performance and health using ratios calculated from its financial statements. It covers various types of ratios that can be classified into liquidity, profitability, efficiency, financing/gearing, and investment categories. Specific ratios discussed include current ratio, quick ratio, gross profit margin, return on capital employed, debt-to-equity, interest coverage, earnings per share, and dividend yield. Calculating and interpreting these ratios provides insights into a company's operations, profitability, use of assets/liabilities, and returns.

Uploaded by

Tariq Khan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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PDE4232 : LECTURE 4

Introduction to Ratio Analysis


Rewind
• Last week, spent a lot of time looking at putting
financial statements together – Income Statements
and Balance Sheets.

• This week, focus is on assessing the financial


performance and financial health of a company
using primarily ratios.
Learning Objectives
• Understand ‘interpretation of accounts’
• Why we need to interpret accounts
• How do you interpret accounts
• Usefulness of interpreting accounts
Why is it important?
• It tells us about a company’s performance and
financial position

• Gives us an indication about whether the company


has done well

• It can be used as a basis for comparing with previous


years, budgets, competitors

• What about the future


Ratios
Ratio can be classified into 5 categories:
• Liquidity ratios
• Profitability ratios
• Efficiency ratios
• Financing/ Gearing ratios
• Investment ratios (Shareholder’s return)
Liquidity/Solvency ratios
• Liquidity ratios are calculated using Balance sheet
items.

• These ratios are important to measure the ability of


the company to meets its short-term and long-term
obligations.
Liquidity/Solvency Ratios (cont’d)
• Two types :

 Current Ratio

 Quick Ratio (also known as acid test)


Current Ratio
Formula:
Total Current Assets = No. of times
Total Current liability

Examples
Current assets: Current liabilities:
Inventory (stock) Bank overdraft
Bank (+) Short-term loan
Cash Payables (creditors)
Receivables (debtors) Accruals
Prepayments
Current Ratio (cont’d)
• Example:
Total current assets = 150
Total current liability 50

• Current Ratio = 3:1

• The Interpretation:
The company has £3.00 of Current Assets to meet £ 1.00
of its Current Liability
Quick Ratio
• The formula:
Quick Ratio = Total Quick Assets
Total Current Liabilities

• Total Quick Assets = Total Current Assets (minus


Inventory)
Quick Ratio (cont’d)
• Example:
Total current assets = £200
Inventory = £50
Total current liabilities = £100

• Quick ratio = (200 – 50)


100
= Quick Ratio = 1.50 : 1

• The Interpretation:
The company has £ 1.50 of Quick Assets to meet £ 1.00 of its
Current Liabilities
Exercise
Calculate the Liquid Ratios for 21st century question
Profitability Ratios
• Profitability ratios show how successful a company is
in terms of generating profits on the investment.

• Generally, if a business is liquid and efficient it


should also be profitable.
Profitability Ratios (cont’d)
• Gross Profit Margin

• Operating Profit Margin

• Net Profit Margin

• Return on Capital Employed

• Return on ordinary shareholders’ funds


Gross profit margin
• Formula:
Gross Profit x 100
Sales Revenue

• Gross profit = Sales – Cost of sales

• Cost of sales = Opening Inventory + Purchases –


Closing Inventory
Gross profit margin (cont’d)
£
Sales 100
Cost of sales 50
Gross profit 50

Gross profit margin = 50 = 50%


100

The Interpretation:
The company makes 50 pence gross profit on every
£1.00 of sale
Operating profit margin
• Operating profit margin = Operating Profit x
100 Sales revenue

• The Interpretation:
An apt measure of operational performance as
differences in the way the business is financed do not
influence operating profits
Net profit margin
• Formula:
Net profit x 100
Sales

• Net profit = profit after interest and tax


Net profit margin (cont’d)
£
Sales 200
Cost of Sales (50)
Gross profit 150

Less:

Operating expenses (80)


Operating profit 70
Interest (10)
Tax (5)
Net Profit 55
Net profit margin (cont’d)
• Net profit margin
= 55 x 100
200

= 27.5%

• The Interpretation:
The company makes nearly 28 pence net profit on every
£1.00 of sale
Return on capital employed
• Return = Operating profit/ Capital employed

• Capital Employed = Total Equity (or Shareholders


funds) + Non-current liabilities (long-term loans)

• Total Equity = Share capital + Retained profit +


Reserves
Return on capital employed (cont’d)
Income Statement
£
Sales 200
Cost of Sales (50)
Gross profit 150

Less:

Operating expenses (80)


Operating profit 70
Interest (10)
Tax (5)
Net Profit 55
Return on capital employed (cont’d)
Balance Sheet
£
Non-current assets 100
Current assets 100
Non-current liability (50)
Current Liability (50)
Net Asset 100

Equity 100
Return on capital employed (cont’d)
• Operating profit = £70 x 100
Capital Employed £150
= 46.67%

• Capital employed = Equity + non-current


liabilities/long term loans

• Interpretation
 The capital had generated 46.47% of operating profit
 This ratio focuses on the profit attributable to both
shareholders and long term providers of capital
Return on ordinary shareholders’ funds (ROSF)
• Net Profit (less any pref dividend) X 100
Shareholders funds (= Ord share cap + reserves)

• The profit figure is the net profit after interest and


after tax and represents profit attributable to the
owners.

• This focuses on the return (after tax) to Ordinary


Shareholders specifically.
Exercise
Calculate the profit ratios for 21st century question
Efficiency Ratios
This ratio outlines how efficient the company is in
running the company
Receivable days
• Formula:
Trade receivables* x 365
(Credit sales) (or Sales)**

• *Trade receivables = debtors (Average)


• ** Credit Sales not always available, so use sales figure
Receivable days (cont’d)
• Examples:
Trade Receivables* x 365 = 200 x 365
Credit Sales 260

• Receivable days = (200/260) x 365 = 281 days

• Interpretation:
It takes on average 281 days to receive money from
trade debtors. Reduction in receivable days implies that
less cash is tied up in debtors for every £1 of sale

* Average
Creditors Payment Period
• Formula:

Trade Creditors (Trade Payables)* x 365

Credit purchases (Cost of Sales)

* Average
Creditors Payment Period (cont’d)
• Example

Trade Payables x 365 = £800 x 365


Credit purchases £1500
(Cost of Sales)
= 195 days
• Interpretation:
It takes on average 195 days for the company to pay its
creditors
Inventory turnover days
• Formula
Inventory* x 365
Cost of Sales

= Inventory days, e.g. 30 days

• Interpretation
It takes 30 days for the company to turn its inventory to
sales

* Average
Exercise
Calculate the efficiency ratios for 21st century
question
Financing Ratios
• Debt/Equity

Long term liabilities + Preference shares


Ordinary shareholders funds (Equity)

• Measures the relationship between debt and equity. The


higher the ratio, the more perceived risk
Financing Ratios (cont’d)
• Gearing ratio

Long term liabilities + Preference shares


Shareholders Funds + L-T Liabilities + Pref Shares

• Measures the relationship between debt as a proportion


of total funds invested in the company on a long term
basis. The higher the ratio, the more perceived risk
Financing Ratios (cont’d)
• Interest cover
Profit before interest and tax (Operating Profit)
Interest payable

Or

Profit before interest and tax + Interest receivable


Interest payable

• Measures the amount of profit available to cover


the interest payable
Investment Ratios (cont’d)
• Earnings per share (EPS)

Profit after interest & tax - minority interests - pref. dividends


Number of ordinary shares

• This ratio is regarded as the fundamental measure of


share performance. The trend in this ratio is used to
assess the investment potential of a company’s shares.
Earnings Per Share (EPS)
• Diluted EPS
Profit after interest & tax - minority interests - pref.
dividends

• The weighted average number of ordinary shares +


The weighted average number of potential ordinary
shares

• Potential ordinary shares exist as a result of the share


option schemes for executives and employees.
Investment Ratios (cont’d)
• Price/earnings ratio (PER)
Market price per ordinary share
EPS
• Reflects the expectations of the market concerning the
future earnings of a company. It indicates whether the
company is highly or lowly rated.
Investment Ratios (cont’d)
• Dividend cover =

Profits available to ordinary shareholders


Ordinary dividends

• Similar to interest cover. It examines the amount by


which profits could fall before leading to a reduction in
the current level of dividends.
Investment Ratios (cont’d)
• Dividend yield
 Dividend per share/(1-t*)
Market price per share
 Measures the return to shareholders in relation to the shares’ current
valuation
• Dividend payout (another way of calculating dividend
cover)
 Ordinary dividends
Profits available to ordinary shareholders
 Measures the proportion of earnings that a company pays out
to shareholders

*t = dividend tax credit; to gross up dividend (i.e. compute the pre-tax value)
Exercise
• Calculate the financial and investment ratios for 21st
century question (note that it will be impossible to
calculate some of the ratios!)

• Hint: Make reasonable assumptions regarding


market prices!
Exercises for the week
Atrill & McLaney, Chapter 6
1. Self-Assessment Question 6.1
2. Review questions 6.1 to 6.4
3. Exercises 6.1 to 6.5

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