*Ratios provide a quick and simple means of assessing the financial health of a business *Ratio relates one figure, say Net Profit, to another figure from the financial statements, say per employee *Ratios summarise quite complex data into a small number of key indicators *Ratios enable comparison of different businesses *Ratios overcome issue of difference in scale of businesses

1. Profitability
How successful a firm is at
creating wealth for it’s
shareholders
Investment
Assessment of returns &
performance of shares
Efficiency
How efficiently
resources have been
used
Liquidity
Assessment of resources
that are sufficiently liquid
to meet maturing
obligations
Financial Gearing
Assessment highlighting
the extent to which
business is using
borrowing
Financial Ratios

2. • Ratios provide a quick and simple means of assessing the
financial health of a business
• Ratio relates one figure, say Net Profit, to another figure from
the financial statements, say per employee
• Ratios summarise quite complex data into a small number of key
indicators
• Ratios enable comparison of different businesses
• Ratios overcome issue of difference in scale of businesses

3. Example
Example, Business A profit £1m and
B profit £2m only tells us that B
made more profit whereas if relate
each profit to business size a valid
comparison could be make between
A and B

4. • Ratios are also used to compare current performance with past performance
to identify trends
• Calculating ratios is easy, the hard part is interpreting the ratios and using
skill, knowledge and experience to draw valid and useful conclusions
• Ratios are expressed in various forms – percentages, proportions, number of
days (debtor and creditor days) etc
• The way the ratio is expressed depends on the needs of those using the
information
• Traditionally ratios are classified into five groups:
• Profitability; Efficiency/Activity; Liquidity; Financial Gearing and Investment
ratios

5. Ratios can be compared with
• Past Periods
They must consider that trading conditions different in the
periods compared
• Similar businesses for the same period
may have different year ends & accounting policies
• Planned performance
Compare with target – compare planed Vs. Actual performance

6. Profitability Ratios
Return on ordinary shareholders’ funds (ROSF)
Profit for the year -any preference dividend
Ordinary share capital + Reserves
x 100

7. Profitability Ratios
Return on capital employed (ROCE)
Operating profit
Share capital + Reserves + Non-current liabilities
x 100

8. Q&A
Return on capital employed (ROCE)
You are the managing director of a small restaurant chain,
Petites. You are concerned about your company’s profitability and
want to compare it with that of a major competitor, Garcon. In
previous years the ratios have been broadly comparable between
the companies in spite of their different size.
You have obtained the following information.

9. Q&A
Return on capital employed (ROCE)
Petites Garcon
£ £
Revenue 127,966 384,898
Gross Profit 65,455 182,474
Net Profit 19,356 69,282
Equity 56,302 206,036
Bank Loan 40,000 80,000
Required:
Calculate the relevant profitability ratios and comment on the results.
What additional information would you seek given the opportunity?

10. Q&A
Return on capital employed (ROCE)
Petites Garcon
GP% = GP/Revenue = 51.1% 47.4%
NP% = NP/Revenue = 15.1% 18.0%
ROCE% = NP/(Shareholders Funds + Long Term Loans) = 20.1% 24.2%
Comment: Petites have the better GP% indicating either higher selling prices
or lower Cost of Sales. Petites Overheads ( Fixed Costs ) are higher than those
of Garcon ( despite a higher GP% ) and producing a significantly lower NP% -
hence management should look at this area of expense. ROCE% is significantly
lower and a result of either a lower NP%, comparatively higher capital
employed, or both.

11. Profitability Ratios
Operating profit margin
Operating profit
Sales revenue
x 100

12. Profitability Ratios
Gross profit margin
Gross profit
Sales revenue
x 100

13. Efficiency Ratios
Average inventories turnover period
Average inventories held
Cost of sales
x 365

14. Efficiency Ratios
Average settlement period for receivables
Average trade receivables
Credit sales revenue
x 365

15. Efficiency Ratios
Average settlement period for payables
Average trade payables
Credit purchases
x 365

16. Efficiency Ratios
Sales revenue to capital employed
Sales Revenue
Share capital + Reserves + Non-current liabilities

17. Efficiency Ratios
Earnings per share
Sales Revenue
Number of employees
x 365

18. Liquidity Ratios
Current Ratio
Current assets
Current liabilities

19. Liquidity Ratios
Acid test ratio
Current assets (excluding inventories)
Current liabilities

20. Gearing Ratios
Gearing ratio
Long term (non current) liabilities
Share capital + Reserves + Long term (non current) liabilities
x 100

21. Gearing Ratios
Interest cover ratio
Operating profit
Interest payable
x 100

22. Investment Ratios
Dividend payout ratio
Dividends announced for the year
Earnings for the year available for the dividends
x 100

23. Investment Ratios
Dividend cover ratio
Earnings for the year available for dividend
Dividends announced for the year

24. Investment Ratios
Dividend Yield ratio
Dividend per share / (1-t)
Market value per share
x 100
Relates cash return to market value, -t = dividend tax rate of income tax
Dividends issued net of income tax

25. Investment Ratios
Earnings per share
Earnings available to ordinary shareholders
Number of ordinary shares in issue
Earnings Per Share can be used to help assess the investment potential of
a business’s shares, however it is not useful to compare the EPS of one
business with another.

26. Investment Ratios
Price/Earnings ratio (P/E)
Market value per share
Earnings per share
This can be used as a measure of market confidence in a business for the
future. However it should be noted that differences in accounting policies
between businesses can lead to different profit and EPS figures.