Ratio Analysis

1. RATIO ANALYSIS
Is used to interpret , assess the weakness and strength of a business
when assessing the performance of a business, we will normally use the financial data to make this
assessment. profits are the main yardstick used to assess whether a firm has performed well or
poorly. however, profits alone is not enough

2. TYPES OF COMPARISONS -USES A RATIOS
•Used to compare results from year to year ie trends analysis – establish the firm
trends Comparison of present performance with previous year's performance will
tell us a lot about the direction the firm is moving in - is it improving worsening or
maintaining performance ; sometime referred to as time series analysis
•Compare one `s year results with those of other companies within the same industry
, using the industry average ratios to evaluate the firm `s individual performance
This is called cross-sectional analysis
•Evaluate the firm `s performance and provide information for the interested
stakeholders

3. STAKEHOLDERS INTERESTED IN A
BUSINESS
• Managers/Directors
• Investors
• Lenders
• Employees
• Suppliers and other trade creditors
• Customers
• Governments and their agencies
• They will assess performance, prepare budgets
• Performance; They also want to assess the ability of the
business to pay dividends.
• to determine whether their loans and interest will be paid
when due
• the stability and profitability of their employers to assess
the ability of the business to provide remuneration,
retirement benefits and employment opportunities
• any supplier wants to know if his customers are going to
pay their bills!
• determine taxation policies and as the basis for national
income and similar statistics

4. PROFITABILITY RATIOS
•

5. GP % CONTINUES
•A Business may reduce selling price of its products because of following
•1. Due to seasonal sales
•2. Launch a new product
•3. fight against competitors
•4. increase in demand

6. •This ratios shows how much profit is generated for every dollar of revenue
•It indicates how well the business is able to control its expenses
•A high profit margin indicates good control of expenses hence good performance
•An increase in % maybe due to the following
•1. Good control of expense, Increase in SP, increase in GP
•2. Increase in other income
•The opposite is true for a decrease is profit margin.

7. • Capital Employed= Equity + NCL
• Equity = Ordinary share capital +All the reserves
• Or =NCA+CA-CL
• Or =Total Assets –CL
• This ratios shows how much profit before interest (in cents) is being generated for every dollar invested
• The ratios shows how efficiently or effectively the managers are using capital invested to generate profit, the
higher the ROCE the better
• Profit from operation is the profit before interest

8. ROCE CONTINUES
• The % of ROCE is increasing because:
1. The business is making more profit
2. The business has less capital employed
3. The business is using its resources more effectively
• The% of ROCE decreasing because:
1. The business is making less profit
2. The business has more capital employed that it has not put to maximum use
3. The business is using its resources less effectively

9. •There is an inverse relationship between profit margin and asset turnover
•An increase in selling price will result in an increase in profit margin but may
result in a decline in the volume of sales.
• Therefore, an improvement in profit margin may be offset by worsening
asset turnover. Leaving ROCE unchanged or even causing it to decline.
•Thus a high profit margin will not on its own lead to an increase in ROCE
because the level of sales is also very important.

10. •Profit for the year is the profit after interest and tax and Equity is the
Ordinary share capital plus all reserves ie excluding NCL
•Again it is used to measure how effectively or efficiently the business is
using the owner`s capital to generate profits ; Increasing ratio is a strength
and decreasing is a weakness

11. •It helps to show whether or not the managers or directors have been able to
control the operating expenses.

12. LIQUIDITY RATIOS
•Liquidity is the amount of cash available to meet business debts when they
fall due. Bothe current ratio and quick ratio or acid test give an indication a
business liquidity position.

13. •This ratio assesses the company`s ability to meet its short term debts- liabilities
• A ratio of 2: 1 or 2,5 :1 or 3:1 means the business has sufficient current assets to
cover current liabilities
•A low ratio means a firm has difficulties to meet its short term obligations e.g. 0.75
: 1 i.e the business has only 75 cents of CA available to pay CL, suggesting
liquidity problems
•A high ratio; e.g. 5 : 1 indicates that the firm has resources that are not being used
efficiently or lying idle in the business in the form of cash, inventory, trade
receivables

14. •This ratios measures the ability of business to pay its short term debts without
selling inventories
•Quick ratios shows the proportion of liquid assets ( trade receivables , bank and
cash ) that is available to pay current liabilities
•A result of 2:1 shows that there is £2 of liquid assets for every £1 of CL. This
means debts can be covered twice over (assuming trade receivables can be collected
quickly and so turned into cash.
• A result of 0.5:1 shows that there is twice the amount of CL than liquid assets can
cover, suggesting liquidity problems.

15. QUICK RATIO CONTINUES
• The liquid (acid test ) ratio is more immediate measure of liquidity , where as the current ratios looks further
ahead
• If the two ratios are increasing
• 1. it mean the business will find it easier to pay its debts (this is strength )
• 2. it could also means that business has too many resources tied up as currents assets or liquidity assets( this a
weakness)
• If the two ratios are decreasing :
• 1. The business will find more difficult to pay its short term debts (weakness)
• 2. the business has reduced the resources tied up as current or liquid assets and so it is making more effective
of these resources ( strength)

16. LIQUIDITY / WORKING CAPITAL
•Ways to improve working capital position
•1. Introduction of additional capital by the owners
•2. Obtaining Non Current Asset loans ie bank loan
•3. Selling surplus non current assets
•4. Reducing drawings by the owners or reduction of dividends
•5. Delaying capital expenditure on Non Current Assets

17. • Also known as Average collection period . It is the average length of time (days, weeks ,
or months) a business takes to collect its debts ( normally credit terms is 30 days)
• An increase in collection period is an indication that the firm is poorly managing its credit
control policy
• When the customers are slow to pay , it has an adverse effect on business liquidity and
there is also a higher risk of irrecoverable bad debts
• A decrease in collection period means customers are paying faster which help the cash
flow . It may also be due to cash discounts.
• NB Answer should always be rounded up eg 35.18 days round up to 36 days

18. •It as known as Average payment period – It is the average of time , a firm
takes to pay its suppliers
•A decrease in the ratio indicates that a firm is paying its suppliers faster or
earlier , which is good for relations with suppliers but not good for cash flow
•An increase in the ratio , help to improves the liquidity and cash position but
might worsen the relationship with suppliers

19. •

20. • It indicates the number times Inventory is sold during the year
• The higher the number of times ( which is good) suggests either low levels of Inventory
are held, and perhaps an effective Inventory management system such as ‘JIT’ is being
employed as Inventory does not stay in the business for long periods of time- greater
efficiency – better cash position . If the business is able to accurately judge sales (demand
is predictable or constant for long periods) stock levels should be low, therefore stock
turnover high.
• A low number of times means a high value of Inventory is held., may indicates slowdown
in trading – piling up of inventories – lead to liquidity crisis and additional storage costs
and high risk of inventory being obsolete

21. •It measures how effectively the non current are being used to generate sales
( Revenue)
•When a firm `s Non Current Asset is significantly lower , it suggests that
there may be over investment in Non Current Asset
•A Higher value indicates better utilisation of resources

22. OVERTRADING
•It occurs when a business increases its turnover rapidly with the results that
its inventories, trade receivables, and trade payable also increases but
adversely affect its liquidity
•The business may become insolvent – unable to pay its suppliers and might
close.

23. LIMITATION OF RATIOS
• The ratios if different company can not be properly compared because different business use different bases or policies
• Ratios analysis use historical data and therefore give no indication of future performance, or the causes of the ratios changes
, only indicate areas of concern
• Financial statements non financial aspects of the business such as the staff morale , quality of management , staff strength
and weakness
• Ratios can only be used to compare like with like
• Ratios tend to ignore the time factor in seasonal business eg widely fluctuating inventory level and trade Receivables levels
• Ratios ignore inflation , hence they could be misleading
• Ratios are not definite measure , they only give clues to the a company performance or situation