1. Ratio Analysis…

2. Types of ratios…  Performance Ratios: Return on capital employed. (Income Statement and Balance Sheet) Gross profit margin (Income Statement) Operating Profit Margin (Income Statement)  Activity Ratios: Asset turnover. (Income Statement and Balance Sheet) Inventory / Stock turnover. (Income Statement and Balance Sheet) Receivables Days / Debtors Days (Income Statement and Balance Sheet) Payables Days / Creditors Days (Income Statement and Balance Sheet)  Liquidity Ratios: The current ratio. (Balance Sheet) Acid test ratio. (Balance Sheet)  Gearing Ratio: The gearing ratio (Balance Sheet)  Shareholders Ratios: Dividend Per Share. (Income Statement and additional information) Dividend Yield. (Income Statement and additional information)

3. Performance / Efficiency Ratios  Return on Capital Employed (ROCE),  Gross Profit Margin,  Operating Profit Margin.

4. What are performance ratios Performance ratios help show how well a business is doing. They tend to focus on profit, capital employed and turnover. Stakeholders such as owners, managers, employees and potential investors are all likely to be interested in profitability and efficiency of a business. Competitors might also use performance ratio’s to make comparisons of performance.

5. Return on Capital Employed… ROCE measures the return on capital (money) that has been invested by the business. It looks at how efficiently management is able to use the capital tied up in the business to generate profits. It can be calculated using the following formula: Operating Profit ROCE = * 100 Total Equity + Non Current Liabilities (The result is a percentage figure) The ROCE will vary between different industries but generally the higher it is, the better. The ROCE can only be increased by increasing the profitable, efficient use of the assets owned by the business which were purchased out of the businesses equity. If the ROCE is below current interest rates, then this can put off potential investors.

6. Gross Profit Margin… The Gross Profit Margin the percentage of turnover that is left as gross profit. It is calculated using the following formula: Gross Profit Gross Profit Margin =* 100 Revenue (The result is a percentage figure) An improved gross profit margin may be a result of an increase in revenue relative to the cost of sales or a fall in the costs of sales as a percentage of revenue. Higher gross profit margins are preferable to lower ones. However, they vary significantly according to industry type. If you had a gross profit margin of 75% this shows that out of every £1 revenue made by the company 75p is left as gross profit.

7. Operating Profit Margin This ratio shows what percentage of turnover is left as net profit. This ratio helps to measure how well a business controls its overheads. If overheads are low then there will be less difference between the gross profit margin and the operating profit margins. The net profit margin can be calculated using the following formula: Operating Profit Operating Margin = * 100 Revenue (The result is a percentage figure) Again higher profit margins are better than lower ones. A figure of 31% would show that out of every £1 sales revenue, 31p is left as operating profit.

8. Activity Ratios  Asset Turnover  Inventory / Stock Turnover  Receivables / Debtor Days  Payables Days / Creditor Days

9. What are Activity Ratios? Activity Ratios or asset usage ratios allow a business to measure how effectively it uses some of its resources.

10. Asset Turnover Asset Turnover ratio measures the productivity of assets. It looks at how efficiently assets are being used to generate sales revenue. It shows the value of sales generated by every £1 of net assets. It can be calculated using the following formula: Revenue Asset Turnover = Net Assets (Total assets – total liabilities) Higher ratios show assets are more productive i.e. assets are being used more effectively. The rate of turnover will vary substantially between industries depending on the degree of capital intensity. It is very useful for inter-firm comparisons.

11. Inventory / Stock Turnover This ratio measures the number of times during the year that a business sells the values of its stocks. It can be calculated using the following formula: Cost of Sales Stock Turnover = Stocks / Inventory An answer of 13.5 would mean that the business is selling it’s stock 13.5 times a year. I.e. on average it holds it stock for less than one month. High stock turnovers are preferred. A higher stock turnover ratio means that profit on the sale of stock is earned more quickly. Thus, businesses with high stock turnovers can operate on lower margins. A declining stock turnover ratio might indicate higher stock levels, a large amount of slow moving or obsolete stock, a wide range of products being stocked or a lack of control over purchasing.

12. Receivables Days / Debtors Days This measures the average number of days it takes to collect debts. It is calculated using the following formula: Trade Receivables / Debtors Debt Collection Period = * 365 Revenue (The result is in days) A business would prefer a shorter debt collection period, but the figure will be affected by credit periods given by different industries and businesses. A debt collection period of 60 days for a small business could cause cash flow problems. Even for a larger business it may indicate a need to improve credit control.

13. Payables Days / Creditors Days This measures the average number of days it takes on average for a business to pay for its supplies purchased on credit. It is calculated using the following formula: Trade Payables/ Creditors Debt Collection Period = * 365 Cost of sales / Credit Purchases (The result is in days) Businesses will often try to negotiate long credit payments terms in able to help with their own cash flow. Some firms however will set themselves targets to pay all debts within a set period of time. Suppliers will be interest in this figure to see whether a potential customers pays within the payment terms stipulated.

14. Liquidity Ratios  Current Ratio  Asset Test Ratio

15. What are Liquidity Ratios? Liquidity ratios illustrate the solvency of a business – whether it is in a position to pay its debts. They focus on short term assets and liabilities. Creditors are likely to be interested in liquidity ratios to assess whether they will receive the money they are owed.

16. The Current Ratio / Working Capital Ratio The Current Ratio shows the relationship between the current assets and the current liabilities. It can be calculated using the following formula: Current Assets Current Ratio = Current Liabilities The ratio shows us a businesses ability to pay its short term debts out of what it owns in the short term. It is suggested that a business should aim for a ratio between 1:1.5 and 1:2. A business operating below 1:1.5 may face working capital problems. For example, a business might be overtrading or over borrowing which could result in difficulties when paying immediate bills. Operating above 1:2may suggest that to much money is tied up unproductively.

17. The Acid Test Ratio The Acid Test Ratio (or quick ratio) is a more severe test of liquidity. This is because it does not treat stocks as a liquid asset. Stocks are not guaranteed to be sold, they may become obsolete or deteriorate. They are therefore excluded from the current assets in the calculation. It can be calculated using the following formula: Current Assets - Stock Acid Test Ratio = Current Liabilities An Acid Test Ratio of 1:1 is desirable.

18. Gearing Ratio

19. What are Gearing Ratios? Gearing ratios shows the long term financial position of the business. They are used to show how dependent the business is on long term borrowing.

20. Gearing Ratio The gearing ratio is a measure of the percentage of a firms capital that is financed by long term loans – or compulsory interest bearing sources that the company has to pay interest on regardless of profit. The following formula can be used to calculate the gearing ratio: Non Current Liabilities Gearing Ratio =* 100 Total Equity + Non-current liabilities (The result is a percentage figure) If the ratio is less than 50% then the company is said to be low geared. This means the majority of the capital of a business is likely to be raised from shareholders. If the ratio is more than 50% then the company is said to be highly geared. This means the majority of the capital of a business is likely to have been raised through long term loans and borrowing. Gearing ratios are important, as the higher the level of gearing the more susceptible the business is to changes in the interest rate. Also creditors prefer lending to lower geared companies as there is less risk.

21. Shareholders Ratios  Earnings per share  Return on Equity  Dividend Cover Ratio

22. Shareholders Ratios The owners of limited companies will take an interest in these ratios as it will help them measure the return on their shareholding. Potential investors will also be particularly interested in these ratios.

23. Dividend per Share The dividend per share ratio is a calculation of how much per share a shareholder can expect in dividends. It is calculated using the following formula: Total Dividends Dividend Per Share = Number of issued (ordinary) shares

24. Dividend Yield Dividend Yield is a measure of the dividend received as a rate of return compared to the current market share price. It can be calculated using the following formula: Dividend per share Dividend Cover Ratio = *100 Market Share Price (The result is a percentage figure) This ratio allows for a more meaningful comparison of the value of the investment in relation to alternative investments. A yield of 7.5% means that if a dividend of £1 was received, the expected value of the share would be £7.50. A shareholder could compare this to other share dividend yields and also to the rate of interest that could be achieved if the shares were sold and the money invested in the bank.

25. Benefits of Ratio Analysis Ratio analysis is often used by external and internal stakeholders of a business. It is often used to help make decisions on:  Whether to invest in the business.  Whether to lend money to the business.  Whether the profitability of the business is rising or falling.  Whether the management of the business are using resources efficiently. However as with all analytical tools, ratio analysis needs to be applied with some caution and there are quite a few significant limitations to its effectiveness.

26. Limitations  One ratio result is not very helpful – to allow meaningful analysis to be made a comparison needs to be made between this one result and either other businesses or other time periods.  Inter-firm comparisons need to be used with caution and are most effective when companies in the same industry are being compared. Financial years end at different times for businesses and a rapid change in the economic environment could have an adverse impact on a company publishing its accounts in June compared to a January publication for another company.  Trend analysis (comparing ratios from different time periods) needs to take into account changing circumstances over time which could have affected the ratio results. These factors may be outside of the company’s control, such as an economic recession.  Some ratios can be calculated using slightly different formulas and care must be taken to only make comparisons with results calculated using the same ratio formula.  Companies can value their assets in rather different ways, but depreciation methods can lead to different capital employed totals which affect certain ratio results.  Ratios are only concerned with accounting items to which a numerical value can be given. Increasingly, observers of company performance and strategy are becoming more concerned with non numerate aspects of business performance such as environmental policies and approaches to human rights in developing countries that firms might operate in. Indicators other than ratios must be used for these assessments.