1. Ratio Analysis

2. = Liquid Assets [current assets – stock] Current Liabilities
1) Liquidity Ratios
Firms can be vulnerable to cashflow problems, but they must be able to meet their immediate payments. Liquidity ratios concentrate on short term (current) assets and liabilities to test a firm’s ability to pay.
a) Acid Test (quick) Ratio
= Liquid Assets [current assets – stock] Current Liabilities
Firms can’t be certain to sell their stock quickly therefore stock is ignored. If a company has between £0.80 and £1 of current assets (excluding stock) for every £1 of current liabilities it is unlikely to run out of cash.
A business must pay it’s debts to survive, therefore it must hold cash. BUT if it holds too much cash it may sacrifice opportunities for greater profit.
Q: How could one improve liquidity?

3. 2) Financial Efficiency Ratios
These ratios study the efficiency with which the organisation manages its assets and liabilities. For all these ratios the firm will need to compare itself with similar firms before it can draw conclusions; as standards vary significantly between industries.
a) Asset Turnover
= Annual Sales (turnover) Net Assets
A high figure indicates efficient use of assets. Capital intensive firms will have lower asset turnovers than labour intensive firms. Many firms use the ratio for intra-firm comparisons between branches.
e.g. if the result is 3, this means a firm’s total sales are 3x the value of net assets; i.e. the net assets have been ‘turned over’ 3 times.

4. 2) Financial Efficiency Ratios (continued)
b) Stock Turnover
= Sales revenue (valued at cost) Average stock
Sales are valued at cost to provide a fair comparison (as stock values are based on cost).
The rate of stock turnover (RST) figure represents the number of times in a year that the firm sells the value of its stock.
e.g. if RST= 4, the firm sells the stock 4 times a year (i.e. once every 3 months). Thus, it will take 3 months, on average, to convert stock into cash.
If the ratio gets too low it suggests stocks are too high (and vice versa).

5. 2) Financial Efficiency Ratios (continued)
c) Debtor Days (Average age of debtors)
= [Debtors Annual Sales] x 365
This shows the number of days it takes to convert debtors into cash.
Firms who give Long Term credit expect a high figure (and vice versa). Standards vary between industries BUT in general, firms shouldn’t suffer if payments to its creditors (its suppliers) take longer than its receipts from its debtors (unless this upsets its suppliers).

6. = Long Term liabilities (borrowing) Capital Employed
3) Debt Ratios
a) Gearing Ratio
This looks at the capital structure of a firm and its likely impact.
= Long Term liabilities (borrowing) Capital Employed
N.B.- Long term liabilities include loan capital, preference shares etc. Capital employed includes shareholders funds, long term liabilities etc.
A high Gearing ratio shows a reliance on capital with which interest payments must be paid. This increases the risk when interest rates are high or profits are low, but can be advantageous if the company is highly profitable.

7. 4) Profitability Ratios
(This is a firms main objective. Performance ratios relate profit to the size of the firm.)
a) Profit Margin
Measures operating/net profit as a percentage of sales (turnover).
= Operating/Net profit (profit after tax) Sales Revenue
Firms with high rates of stock turnover will tend to have lower profit margins; as their profit arises from the large number of items sold.
This ratio measures the acceptability of selling prices and, to some extent, the efficiency of production. e.g. if the figure is 8%, then for every £1, 8p is profit.
It is unfair to compare industries. For example, nowadays supermarkets operate profit margins between 5 and 7%, whereas a construction company expects to make a margin of 20-22% on a particular project.

8. 4) Profitability Ratios (continued)
b) Return on Capital (R.O.C.) / R.O.C.E
= [Operating/Net profit Capital Employed] x100
This ratio shows the operating profit as a percentage of the capital employed. Capital employed is the same as the assets employed by a firm and is a good measure of size.
This is an important calculation, and is often referred to as the ‘primary efficiency ratio’. The higher it is, the better.

9. 5) Shareholders’ Ratios
Shareholders judge a company on its ability to reward them, in relation to their contribution to the company.
a) Dividend Cover
= Net profit after tax Dividends paid
This indicates the extent to which a company is retaining its profit to support future growth. A high figure suggests a company is looking to the future and shareholders will benefit in the long run. A balance is needed.
b) Dividend Yield
= [Dividend per share Market price of share] x100
This shows the annual percentage return on the money needed to purchase the share. This figure can be compared to the return on other investments (e.g. bank account/other shares). BUT the figure ignores the gains from an increase in share price.
c) Price/Earnings Ratio (P/E ratio)
= Market price of share Earnings per share
This ratio states the number of years that earnings from a share will take to repay the current price of the share. One may expect a low ratio to be favoured, but this is seen to show a lack of faith in the company by potential investors.