1. Interpretation of Accounts
Ratio Analysis

2. The need for ratios To examine the profitability of the firm.
To find out the ability of the firm to meet it’s debts (liquidity).
To see how efficiently the managers of the firm uses its resources.
So that investors in the firm can see the returns on their investment.

3. Profitability Ratios: ROCE
Return On Capital Employed (ROCE)
Net profit before tax & interest X 100
Total capital employed
Expressed as a percentage

4. Using ROCE Larger figures indicate higher profitability
Must be compared with previous year or similar firm to be meaningful.

5. Profitability Ratios: Gross Profit Margin
Shows gross profit as a percentage of sales
GPR = Gross Profit X 100
Total sales revenue
Does not show the impact of overheads on profits.

6. Profitability Ratios: Net Profit Margin
Shows net profit as a percentage of sales.
NPM = Net profit X 100
Total sales revenue
Should be compared with previous period or with similar business

7. Gross & Net profit margins
How are they linked?
If the NP margin goes down more than the GP margin what does this mean?
Remember, GO and NP are linked in the profit and loss account, and so they are linked here!

8. Liquidity Ratios Measure the indebtedness of the firm.
Current Ratio = Current Assets
Current Liabilities
Expressed as a ratio eg 3:1
Not expressed as a percentage!
Ideal value = 1.5:1 or 2:1

9. Low Current Ratio: Overtrading & over-borrowing
When the ratio is too low for the firm to meet its debts.
Overtrading.

10. High Current Ratio
Suggests the firm is not making full use of its current assets (eg cash idle in a bank a/c)

11. Limitations of Current ratio
Suggests that stocks can be liquidised quickly, and at a fair value. This is not always the case. They can become obsolete or deteriorate.
SO….

12. Acid Test Ratio Does not treat stocks as liquid assets
Acid Test Ratio = Current Assets – stocks
Current Liabilities
A value of 1:1 is considered acceptable

13. Shareholder Ratios Return on Equity =
Profit after tax, interest & pref. dividends X 100
Ordinary Share Capital

14. Shareholder Ratios (cont’d)
Earnings per Share =
Net profit (after tax and Pref. dividend)
Number of shares
This shows how much profit each share has earned for the business. The directors will use this figure to help decide dividend payments

15. Shareholder Ratios (cont’d)
Dividend Yield =
Dividend per share X 100
Market value of shares

16. Efficiency Ratios Stock Turnover
This shows how many times over the business has sold the value of its stocks during the year.
STOCK TURNOVER RATIO = Cost of Goods Sold Average Stock
(Sometimes Sales is used if Cost of Goods Sold not available)

17. Efficiency Ratios
The higher the stock turnover the better, because money is then tied up for less time in stocks. A quicker stock turnover also means that the firm gets to make its profit on the stock quicker, and so the firm should be more competitive.
However, it will vary between industries and so it is important to compare within an industry, as well as from year to year.

18. Efficiency Ratios Trade Debtor Collection Period = Trade Debtors X 365
Sales Revenue (Credit)
A low value means that the firm is managing its debtors well. A higher value indicates that debtors are taking longer to pay. The firm would need to investigate this further.

19. Efficiency Ratios Trade Creditors Payment Period =
Trade Creditors X365
Total purchases
A longer period means that it is taking the business longer to pay its debts to its creditors. This could be an advantage (ie free credit) or indicate a problem (lack of money to make payments!). It can also prove disastrous as it may force suppliers into bankruptcy.

20. Efficiency Ratios Gearing Ratio Total Capital
Loan capital (+ Preference Capital) X100
Total Capital
A higher % means that the firm must pay more interest on profits each year. Failure to do so could lead to insolvency. A lower % is preferable since shareholders will only be paid a dividend out of profits if the directors feel that the firm can afford it.