INTRODUCTION
To judge the performance of a company or group of companies the analysis of financial statements is normally based largely on ratio analysis.
You may be expected to carry out a performance analysis on a set of company accounts. Generally, this will require you to extract the relevant figures from financial statements and notes to the statements. Having done this you must then calculate suitable trends and ratios. Finally, and most importantly, you must be able to analyse and interpret the figures, trends and ratios. This may require you to draft a report with supporting appendices.
You should be familiar with many of the important ratios from your other studies. This note is intended to pull all the ratios together and to comment on their usefulness.
The purpose of ratio analysis is:
- To appraise the performance of a business.
- To highlight significant changes.
- To reveal a company’s strengths and weaknesses.
- To illustrate underlying trends in a company’s activities.
Financial analysis is undertaken by four main groups:
- The company itself for management control.
- Current and potential shareholders in order to make investment decisions.
- Suppliers of capital (banks, trade creditors etc.).
- Financial analysts (stockbrokers, business journalists etc.).
A ratio expresses the relationship of one figure to another. A change in the ratio represents a change in the relationship. Ratios once computed should then be subjected to comparison. The two broad areas of comparison are:
- Internal – present performance is compared with past performance and with budgets.
- External – present performance is compared with similar firms in the same industry or with industry averages.
Ratio analysis has many limitations and care must be exercised in their use. Among the limitations are:
- Ratios are only a guide, they cannot be used to make absolute statements. For example, if the Debtors Collection Period is lengthening it might be concluded that there is poor credit control with additional costs incurred by the company. However, if other aspects of performance are checked it may become apparent that longer credit has been used as a marketing tool, which in turn has led to increased sales and profitability. Thus, ratios should be used to provide support for other information.
- A ratio represents the relationship between figures. Thus, both figures can alter the ratio and this should be taken into account when indicating the reason for change. Also,
note that proportionate changes in both figures will leave the ratio unaltered. For example:
= 10% As is
- For ratios to be fully comparable the figures used must be computed in like manner from year to year or from firm to firm. Changes in accounting policies or firms adopting different accounting policies will render the ratios not comparable.
- A Balance Sheet represents a company’s financial position at one particular point in time. A Balance Sheet drawn up one month, or even a day, earlier or later might reveal a sharply contrasting situation, particularly for current assets and liabilities. CATEGORIES OF RATIOS
Broadly, the basic ratios can be grouped into four categories:
- Profitability
- Debt & Gearing
- Liquidity
- Shareholders’ Investment Ratios
Profitability
To assess properly a company’s profits or profit growth it is necessary to relate them to the capital employed in producing them. The most important profitability ratio is, therefore, the Return on Capital Employed (ROCE), which shows the profit as a percentage of the amount of capital employed.
Debt & Gearing
Gearing Ratio
This is concerned with a company’s long-term capital structure. There is no absolute limit to what the gearing ratio ought to be. Many companies are highly geared but if such companies wish to borrow further they may have difficulties unless they can also boost shareholders’ capital, either with retained profits or a new share issue.
Gearing Ratio can be expressed as:
- Equity Capital (including Reserves)Prior Charge Capital
or
- Total CPrior Charge Capitalapital Employed
* Prior Charge Capital refers to long-term debt and includes Preference Shares but does not normally include Bank Overdraft.
Interest Cover
This shows the financial risk in terms of profit rather than capital values. It demonstrates whether a company is earning enough profits before interest and tax to pay its interest costs comfortably.
Interest Cover = Interest ChargesPBIT
As a general guide, an interest cover of less than 3 times is considered low, indicating that profitability is too low given the gearing of the company.
Liquidity
A company requires liquid assets in order to meet its debts as they fall due. Liquidity is the amount of cash a company can put its hands on quickly to settle its debts and possibly meet other unforeseen demands.
Current Ratio
Indicates the extent to which the claims of short-term creditors are covered by assets that are expected to be converted to cash in a period which corresponds roughly to the maturity of the liabilities.
Current Ratio = Current LiabilitiesCurrent Assets
A benchmark of 2:1 is often quoted but this should not be adopted rigidly as organisations have vastly different circumstances (e.g. operating in different industries, seasonal trade etc.).
Quick Ratio (“Acid Test”)
This is a measure of the company’s ability to pay off short-term obligations without relying upon the sale of its stocks, which may not be disposed of easily and for the value at which they are being carried.
Current Assets – Stock
Quick Ratio =
Current Liabilities
A benchmark of 1:1 is often quoted but, again, this should not be adopted rigidly.
Debtors Collection Period
This is a measure of the average length of time it takes for a company’s debtors to pay what they owe. The credit period allowed may depend on the industry in which the company operates.
Debtors
Debtors Collection Period = x 365 days
Sales
Creditors Payment Period
This is a measure of the average credit period that a company takes before paying its suppliers.
Creditors Collection Period = PurchasesCreditors x 365 days
Stock Turnover Period
This shows the number of times the stock is turned over during the year and indicates how vigorously a business is trading.
Cost of Sales
Stock Turnover Period = x times
Stock Alternatively:
Stock Period = Cost of SalesStock x 365 days
Shareholders’ Investment Ratios
These ratios help equity shareholders and other investors to assess the value and quality of an investment in the ordinary shares of the company.
Earnings Per Share (EPS)
EPS is the profit in Rwandan Francs attributable to each equity share. Following the publication of FRS 3 this is the profit after tax, minority interests and extraordinary items and after deducting preference dividends; divided by the number of equity shares in issue and ranking for dividend.
EPS on its own does not tell us too much but it is widely used to measure a company’s performance and to compare the results over a number of years.
Fully Diluted EPS can be calculated where a company has securities that might be converted into equity at some future date. A hypothetical EPS is calculated as if the options, warrants or convertible loan stock were converted and thus, the investor can appreciate by how much the EPS may change.
Price Earnings Ratio (P/E Ratio)
Market Price per Share
P/E Ratio =
EPS
All quoted companies have a P/E Ratio. It is equal to the number of years earnings needed to cover the current market price. The value of the P/E Ratio reflects the market’s appraisal of the share’s future prospects. A high P/E Ratio indicates strong shareholder confidence in the company and its future (e.g. profit growth etc.), and a lower P/E Ratio indicates lower confidence.
The P/E Ratio of one company can be compared with the P/E Ratio of other companies in the same business sector or other companies generally.
Dividend Cover
This is the number of times the actual dividend could be paid out of current earnings. A high rate of dividend cover means that a high proportion of earnings are being retained.
EPS Total Earnings
Dividend Cover = Dividend per Share or Total Dividends = x times
Dividend Yield
Gross Dividend per Share
Dividend Yield = x 100%
Market Price per Share
The gross dividend is the dividend paid plus the appropriate tax credit. The Gross Dividend Yield is used so that investors can make a direct comparison with (gross) interest yields from loan stock and Government Stocks (gilts).
Z-SCORES
One of the limitations of Ratio Analysis is that each ratio is examined in isolation and the combined effects of several ratios are based solely on the judgement of the financial analyst. Therefore, to overcome these shortcomings it is necessary to combine different ratios into a meaningful predictive model.
Professor Altman established a model for predicting bankruptcy in the U.S. Using a sample of sixty-six manufacturing firms, half of which went bankrupt, he identified five key variables which contributed most. Each ratio is given a weighting to arrive at the Z-Score.
