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Accounting Ratios • A financial ratio is a relationship between two quantities on a company’s • financial statements, which is derived by dividing one quantity by another. • The purpose of using ratios is to reduce the amount of data to a workable • form and to make it more meaningful. • This goal is defeated if too many ratios are calculated. There are hundreds of ratios which could be calculated. • A manager must learn which combination of ratios is most appropriate in a specific situation, remembering that ratios seldom provide conclusive answers; • Ratios lead the manager to ask the right questions and sometimes give clues as to possible areas of corporate strength or weakness.
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Accounting Ratios • Liquidity Ratios Liquidity ratios are designed to measure a company’s ability to meet its maturing Short-term obligations. • Profitability Ratios Profitability ratios are designed to measure management’s overall effectiveness: Does the company control expenses and earn a reasonable return on funds committed? • Capital Structure Ratios Capital structure ratios are divided into two groups which are: (a) those that examine the asset structure of the company; and (b) those that analyse the financing arrangements of the company’s total assets, in particular the extent to which the company relies on debt, known as the gearing ratios. • Efficiency Ratios Efficiency ratios give an indication of how effectively a company has been managing its assets.
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Accounting Ratios • Ratios produce performance measures which relate to the efficiency with which resources are allocated, appropriate measures must be used for: – Revenues / Costs / Assets – Assets appear in the bottom line of most of the measures, • The following ratios are typically encountered in company accounts: – ROI (Return on Investment) = ROE (Return on Equity) – ROTA Return on Total Assets – Gearing ratio – ROCE Return on Capital Employed
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Profitability Ratios 1- Profit Margin=Profit/Sales • If low then we need to check pricing structure (too low?). • If prices are in line with competitors’, then a detailed analysis of costs and overheads should be analysed. 2-Return on Total Assets (ROTA)=Profit/total Assets • Profit is not only a function of sales, it is also closely related to the assets employed by the company to produce the profit. • How much are we making from our investment in total assets? • If good then, Co is efficiently ‘working its assets’. If a company finds itself with a low return on total assets ratio, management could start to put things right by shedding unproductive assets. • Improvement can be achieved by an improvement in profitability or in asset management (cost, inventory…) or in a combination of both. 3-Return on Owners’ Equity=Profit/Owners Equity (=ROI) • If the company fails to earn a decent return for its shareholders, the share price will fall, thereby prejudicing the company’s chances of securing additional capital or loans on beneficial terms. It could in fact signal danger if the firm relies too heavily on debt. But, again, further analysis could indicate whether or not a disproportionate increase in debt caused the improvement in the first place.
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Profitability Ratios 4- Return on Capital Employed (ROCE)=Profit/ Capital Employed Capital employed is usually defined as the total assets of a company minus the current liabilities. Alternatively, one can add together the owner’s equity and the long-term loans and provisions. This figure for capital employed in the business is an indicator of the magnitude of resources locked up in the business and working for the benefit of the two categories of capital providers, the shareholders and the providers of loan and debt.
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Capital Ratios The first group of capital structure ratios examines the asset structure of the company: for example, has the company the correct proportion of fixed assets to total assets? Fixed to Current Asset Ratio=fixed assets/current assets If more current assets (stock?) then why? This ratio highlights the fact that for every £1 invested in current assets, ? The co invested in fixed assets. Depends on the industry.
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Capital Ratios • The second group of capital ratios analyse how the company’s assets have been financed. • Gearing ratios or leverage. • Companies with low gearing ratios have: • less risk of loss when the economy goes into a recession, but • they also have lower returns when the economy takes off again (as company would earn more on the borrowed funds than it pays in interest). • Conversely, highly geared companies are very exposed in hard times (due to a high fixed interest charge on reducing profits) but enjoy high profits in boom times. Debt ratio=Total Debt/Total Assets Total debt/Total equity*100 • If high it would be difficult to borrow additional funds without first asking shareholders to provide more capital themselves.
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Efficiency Ratios Inventory Turnover=cost of sales/inventory Inventory is an asset which companies require to invest in to act as a buffer between uncertain demand for the finished products on the one hand and uncertain supply of raw materials and the vagaries of the production cycle on the other. At the other end of the supply chain, finished goods are held to guard against a sudden surge in demand. Fixed Assets Turnover=sales/fixed assets Fixed assets are acquired by a company to produce saleable products: it is therefore not unreasonable to relate the investment in fixed assets to the level of sales generated therefrom. more efficient at ‘working its assets’ than other companies, that is, they require less assets to produce the same level of sales as others. Another reason, however, could be that the competition makes a more realistic valuation of some of its fixed assets, notably land and buildings.
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Ratio Tips • Ratios relation to BCG and PLC (prod capacity, inventory, attrition, overtime, profit, mkting cost…) • Comparing ratios or absolute no .btw products or periods or btw forecast no of dev product to actual after product launch • Difference btw op surplus (if >) and net cash flow, means that fin controls could be improved (mod 8) • Unit cost*inventory figure=cost of inventory, producing for inventory does not show in the op surplus but hits in the CF. (inventory = year end – year beginning) COSTS • Corporate OH or Corporate services as % of COGS (if low) - shows control on exp over corporate fns, also shows whether it’s a heavy structure or not; also raises the question (what parenting advantage is obtained in return?) • Hire & fire cost as % of wage bill • Marketing Exp as % of sales revenues • Development expenditure: shows potential for the future • We can assume costs falling in the future due to exp. curve (for some cases incl development products cost) • Look at inventory level, attrition rate and overtime (indication of resource allocation) ,depends on BCG • Gross profit vs. return on sales (margin) • Interest payment % from op surplus or net cash flow FINANCING • Gearing ratio – on total assets, and on owner’s equity – if high shows difficulty in future financing • Debt to net cash flow shows interest rate exposure • Exposure on ST debt vs. LT MARKETING • Orders or sales vol/mkt share=shows whether mkt is growing or not • Difference btw selling price and unit cost (%) SENSITIVITIES
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