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

• 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
Return on shareholders’ equity
(ROSE)
Return on ordinary
shareholders’ equity (ROSHE)
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)
Operating profit margin (OP)
Earnings before interest and tax
margin (EBIT)
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 company’s
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
Property, plant and equipment
turnover ratio
Current asset turnover ratio
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 company’s 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 company’s 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  receivables
Current liabilitie s
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 receivables 360

• TR turnover time = x
Turnover 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 company’s 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
company’s 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 company’s 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 company’s
expenses and liabilities
• Also necessary to investigate a company’s
sources of cash flows, and how these cash
flows are utilised
Cash flow to turnover ratio

• Quantifies portion of company’s turnover that

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

CF
• Cash flow to turnover ratio =
Turnover
Cash return on assets

• Indicates how efficiently company’s assets

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

CF
• 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 =

CF
Average shareholders' 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

CF
• Cash flow to operating profit = Operating profit
Cash coverage ratios

• When evaluating a company’s 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 =
CF  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

CF  Dividends paid
• Dividend cash coverage =
Dividends paid
Reinvestment coverage

• Determines if sufficient cash flows are

generated to cover reinvestment in fixed
assets
• Reinvestment coverage =
CF
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 =
CF
Cash paid for long term debt repayment
Investing and financing coverage

• Determines if sufficient cash flows are

generated to cover company’s 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 =
CF
Cash flow from investing and financing activities
Investment ratios

• One of the most important groups of users of

company’s 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  Noncontrolling 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
Attributable 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 shareholders' 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 company’s ability to cover

current liabilities by means of its current assets.

• Solvency ratios investigate the relationship between

a company’s debt capital and its total assets.
Conclusion (cont.)

• Cash flow ratios determine if sufficient cash flows

are generated to cover the company’s 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 company’s ROE in
order to evaluate changes in the ratio.