Ratio Analysis

Ratio analysis should not be taken in isolation of other aspects of a business. What type of business is it? A company's debtor day indicator (how long on average it takes debtors to settle bills) may be 29 days. This seems fine but not for fast-food business. Ratios must be seen against

• norms/benchmarks for the industry
• performance over time (previous years)
• prospects for the future and
• expectations of significant stakeholders.

As a principle, accounting policies should be applied consistently. Changes must be highlighted and the impact of changes from an original policy disclosed. This applies when calculating and interpreting ratios. Trends in a company's performance cannot be determined if published accounting data is dressed up so as to produce more favourable outcomes. Yet benchmark comparisons against other companies in a sector may be difficult given the flexible scope offered by Statements of Standard Accounting Practice (SSAPs) and Financial Reporting Standards (FRSs).

As an example of such flexibility, under SSAP 13, Research and Development, companies may within certain limits decide to capitalise development expenditure, as an alternative to charging this expense to the P&L account. One firm may do this and by-pass the P&L account in certain years whereas another may not. This will affect performance ratios and make it difficult to conclude on how the company compares against its competitors.

Key ratios

1. business performance
2. liquidity (short term and long term)
3. efficiency.

1. Performance

   Return on total capital employed.

   Used to measure overall business efficiency in employing its resources

   How to calculate

   
   
      Profit before interest and tax 
      ------------------------------ 			x 100 
    Share capital + reserves + debentures 
   
   

   Using/interpreting this ratio

   • This targets the return on capital. The figure will be set by investor expectations. Consistent failure to hit the target would indicate that it would be better selling the company and redeploying its resources elsewhere.
   • Comparisons with real interest rates in the market should account for inflation if resources could be redeployed in different economies.
   • If assets have been re-evaluated this may increase capital employed and so reduce the return ratio.
   • This ratio needs to be considered in relation to the goodwill and development expenditure of accounting policies.

   Gross profit percentage

   .... indicates the margin the company earns on its sales

   How to calculate

   Gross profit
   -----------       x 100 
     Sales 
   

   Using/interpreting this ratio

   Note the effect of changes in

   • sales prices without associated changes in costs
   • sales mix. If last year a company sold £3m of cream deserts at a 12% margin, and £170,000 of catering consultancy services at a 28% margin, pulling out of cream desert sales will reduce turnover, but improve gross profit %.
   • the calculation of closing stock. Gross profit % may show up stock valuation irregularities. Gross profit = sales - cost of sales (opening stock + purchases - closing stock).

   Net profit percentage

   - identifies the affect of fixed and variable overheads on sales.

   How to calculate

   Net profit before interest and tax    
   -----------------------------------      x 100 
           £ sales
        
   

   Using/interpreting this ratio

   It requires attention to

   • changes in the value of sales.
   • changes in the structure of overhead costs. A company that has incurred a move to newer, more costly premises will feel an adverse affect on net profit %

2. Liquidity

   Short-term Liquidity

   The following are generally expressed in N to 1 terms.

   Current ratio

   This measures a company's capacity to cover its current liabilities as they fall due.

   How to calculate

   
     Current assets 
     ------------- 
   Current liabilities
   
   

   A manufacturer normally needs a current ratio of around 2:1. More than this suggests poor resource usage and potential liquidity problems.

   Quick ratio or "acid test"

   This test/ratio excludes slower-moving item (stock) from current assets and pinpoints real short-term liquidity.

   How to calculate

   
       Debtors + cash 
     ------------------ 
   Current liabilities
   
   

   Using/interpreting this ratio

   For both current ratio and quick ratio we must be aware that

   • Low ratios may indicate liquidity problems yet some businesses/industries (supermarkets once again) operate on tight liquidity ratios.
   • high ratios look good but may pinpoint poor management of funds. Cash mountains may not offer the returns that shareholders are looking for.
   • If we examine the make-up of the ratio we may find high stock levels. This may give a healthy current ratio but stock obsolescence may be evident affecting real stock valuations.

   Long-term Liquidity

   Gearing ratio

   There are several variations but the general gearing ratio measures the relationship between a firm's borrowings and its shareholders' funds.

   How to calculate

   Fixed return capital (debentures, preference shares, loan stock
        --------------------------------------------------
           Equity capital + reserves
           
   

   Using/interpreting this ratio

   Note:

   • company cash flow stability. Strongly branded business can rely on stable cash flows. Such a company can borrow heavily against its brands/labels in order to fund acquisitions/expansion etc.
   • policies to revaluate fixed assets may improve shareholders' funds and reduce gearing are popular as they avoid breaches of covenants when raising additional debt.

3. Efficiency Ratios

   Stock turnover

   This measures a company's effectiveness in converting stock into sales. So long as a sale involves a profit then the faster the company turns its stock over, the more it makes.

   How to calculate

   cost of sales            closing stock 
    -----------     or       ------------         x 365 
   closing stock            cost of sales  
   

   Closing stock is better than average stock for comparisons unless we have data from several years.

   Using/interpreting this ratio

   • low turnover may point to obsolete stock though some businesses/industries may need high stocks or carry high-value, slow-moving items. Higher gross profit %s in these cases may compensate for lower stock turn.
   • high stock turn may indicate efficient management but stock-outs may occur affecting the quality of customer service.

   Debtor days

   This indicates the period of credit taken by the company's customers.

   How to calculate

   Closing debtors
   --------------    x 365
    Credit sales
   
   

   Using/interpreting this ratio

   • an increase over the previous year may be due to bad debt problems but it may also indicate a change in a company's change settlement terms policy.
   • the customer base may have changed, important new customers demanding longer settlement terms
   • we should evaluate whether or not year_end debtors are representative of the year as a whole? If we stock up ahead of a sales drive just before year_end, a distorted pattern may result.

   Creditor days

   This measures the credit period a company takes from its suppliers

   How to calculate

   Trade creditors
   ---------------    x 365
   Credit purchases
   
   

   Using/interpreting this ratio

   • high figures suggest liquidity problems (financing the business on the backs of its suppliers. Examine the company's overdraft position. Has it has run out of bank facilities?
   • Is a potential receivership on the cards? Are creditors losing patience?
   • Does the ratio reflect the year as a whole?

Using the Ratios

• calculate the ratios
• interpret your findings
• make suggestions.

In many cases the constituent parts of a ratio must be examined to cast light on

• movement, trends
• priorities and significant influences
• implications. Is an adverse ratio a blip or a long term, worrying trend?
• the ratio result set against the industry norms and relationships with other ratios