Use of ratios can help to assess the financial performance and position of a business. There are also several problems encountered when applying financial ratios. They examine various aspects of financial health and are widely used by stakeholders, lenders and managers. They can be very helpful in making management decisions, for example profit planning, working capital management as well as the business financial structure.
Smaller businesses can be, through ratios compared with larger organisations by use of a simple ratio. For example the operating profit ratio for a smaller business may be the same as for a larger business. These ratios may be comparable as opposed to comparing profits which would be less meaningful. To remove differences in scale, ratios can be used.
Although ratios may not be difficult to calculate, these may be difficult to interpret. They can help with identifying financial strengths and weaknesses of an organisation and provide a starting point for future analysis.
Ratios can be expressed in various forms, for example percentage or proportion. We only need to calculate few main ratios to give us basic information.
The ratios can be categorised into 5 main categories:
* Profitability - provide an indication of the degree of success of achieving business wealth. The profitability ratios are generally through profit made in relation to other key figures in the financial statements.
* Efficiency - can measure efficiency with particular business resources, for example employees or inventories.
* Liquidity ratios - business must have sufficient liquid resources available to meet its obligations. The liquidity ratios examine the relationship between liquid resources and amounts due for payment in the near future.
* Financing gearing - it measures the relationship between the contribution to financing a business made by the owners and the contribution made by lenders. It has an effect on the level of risk associated with the business.
* Investment - these may be used by shareholders who are not involved with managing the business to be able to assess the returns such as profits and dividends from their shares.
To use the ratios we need to know who is the person needing the information and why they need these information. Shareholders, for example, are likely interested in returns, thus profitability, investment and gearing ratios should be the main concern. Suppliers and lenders of short-term credits are generally interested in the ability of the business to repay the amounts owning to them.
We must remember, however, that only if we compare this information with some benchmark the information can be interpreted and evaluated. The benchmark could be a past performance, similar business or planned performance.
Past periods
By comparing past periods we can detect on whether there was an improvement or deterioration in performance. It is often useful to track particular ratios over time and detect trends. But inflation may distort the information and lead to overstatement of profits and understatement of assets value.
Similar business
A business survival may depend on the ability to achieve comparable levels of performance. Therefore it is useful to compare ratios of a competitor for the same period. We must be mindful, however of the year end comparisons and different trading conditions of the competitor. They may also have different accounting policies which will have an impact on the reported profits and assets value.
Planned performance
Ratios may be compared with targets that the management has developed. Planned performance will provide useful information on the business performance. We must remember, however, that the planned performance must be based on realistic assumptions. We may even prepare planned ratios for different business activities. To do it, the accountants will generally look at the past performance and the performance of the competitors.
How do we calculate the ratios?
The best way of explaining ratios may be an example.
Let's take a Statement of financial business position for an example company for the past 2 years.
Balance Sheet
ASSETS 2017 (£m) 2018 (£m)
Non-current Assets
( Property, plant, equipment at cost less depreciation)
Land and buildings 381 427
Fixtures and fittings 129 160
510 587
Current assets
Inventories 300 406
Trade receivables 240 273
Cash at bank 4 0
544 679
Total assets 1054 1266
Equity and liability
Equity
£0.50 ordinary shares ( Note 1) 300 300
Retained earnings 263 234
563 534
Non-current liabilities
Borrowings - 9% loan notes (secured) 200 300
Current liabilities
Trade payables 261 354
Taxation 30 2
Short term borrowings - 76
291 432
Total equity and liabilities 1,054 1,266
Income Statement
Revenue (Note 2) 2,240 2,681
Cost of Sales (Note 3) (1,745) (2.272)
Gross profit 495 409
Operating expenses (252) (362)
Operating profit 243 47
Interest payable (18) (32)
Profit before taxation 225 15
Taxation (60) (4)
Profit for the year 165 11
Notes:
The market value of the shares of the business at the end of the reporting period was £2.50 for 2017 and £1,50 for 2018
All sales and purchases are made on credit
The cost of sales figure can be analysed as follows
Opening Inventories 241 300
Purchases ( Note 2) 1,804 2,378
2,045 2,670
Closing Inventories (300) (406)
Cost of Sales 1,745 2,272
4. At 1 April 2016 the trade receivables stood at £223 million and the trade payables at £183 million
5. A dividend of £40 million have been paid to the shareholders in respect to each of the years
6. The business employed 13,995 staff at 31 March 2017 and 18,623 at 31 March 2018
7. The business expanded its capacity during 2018 by setting up a new warehouse and distribution centre
8. At 1st April 2016 the total of equity stood at £438 million and the total of equity and non-current liabilities stood at £638 million
The basics
Before we can start the evaluation, we need to know what information is obvious from the financial statements. Starting at the top it can be noted:
* Expansion of non-current assets from £510 million to £587 million. Note 7 mention new warehouse and distribution centre which may account for much of the values. If so, not much benefit would have arrived in sales or cost saving in 2018. Sales revenue expanded of 20% - from £2,240 million to £2,681 million - greater then the expansion of non-current assets.
* Major expansion in the area of working capital. Inventories increased by approx. 35%, trace receivables - 14% and trade payable by 36%. These are major increases, particularly in inventory and payables.
* Reduction in the cash balance - The cash balance fell from £4 million to £76 million overdraft and the bank may be putting pressure.
* Apparent debt capacity - comparing the non-current assets with the long-term borrowings implies that the business may be able to offer security on further borrowings. Potential lenders are generally looking at the value of assets that can be offered as security when assessing loan requests, although they are particularly interested in land and buildings. At 31 March 2018 non-current assets had a carrying amount of £587 million, but long-term borrowings had only £300 million ( but there was overdraft of £76 million).
* Low operating profit - Sales revenue expanded by 20% between 2017 and 2018, both costs of sales and operating expenses rose by greater percentage, leaving the gross profit and operating profit massively reduced. The level of staffing increased by 33% ( Note 6) that may have affected the operating expenses. Increased staffing must put strain on management, at least in a short term. The 2018 was not successful. Not at least, in profit terms.
We can now try to calculate ratios of profitability, efficiency, liquidity, gearing and investment.
Profitability ratios
To calculate profitability we can use the following:
* Return on ordinary shareholder's funds ratio;
* Return on capital employed ratio;
* Operating profit margin ratio;
* Gross profit margin ratio.
Return on ordinary shareholder-s funds - compares the amount of profit for the period available to owners with their average investment in the business during the same period.
ROFS = Profit for the year (less the preference dividend) / Ordinary share capital + Reserves X 100
In the case of the company it would be: 165 / (438+563)/2 X 100 = 33.0%
The average of the figures for ordinary shareholders funds has been used, because the average figure is normally more representative. The amount of shareholders funds was not constant throughout the year. We know from Note 8 that the amount on 1st of April was £438 million but it had risen to £563 million. The easiest approach to calculating the figure is average based on the opening and closing balance. If the beginning of the year figure was not available, we would only rely on the year end figure.
Now, the ratio for 2018 is:
ROSF = 11/ (563 + 534)/2 X 100 = 2.0%
In 2018 the ratio is poor a bank deposit would generally yield better returns. We may find our from further ratios on why it has gone so bad.
Return on capital employed - is a fundamental measure of business performance and it expresses the relationship between the operating profit and the average long term capital invested in the business.
ROCE = Operating profit / (Share capital + Reserves + Non-current liabilities) X 100
Here, we use the operating profit ( the profit before interest and taxation) as the ratio measure the returns to the suppliers of long term finance before any deductions are made. So for the year 2017 the ROCE is:
ROCE = 243 / ((638X763)/2) X 100 = 34.7%
The capital employed figure ( total equity + non-current liabilities) is explained in Note 8. ROCE is often considered as the primary measure of the profitability
Operating profit margin - relates to operating profit for the period to the sales revenue.
Operating profit margin = (Operating profit / Sales revenue) X 100
It represents the profit before interest and taxation.
So the operating profit margin for the example would be:
Operating profit margin = (243/2243) X 100 = 10.8%
This ratio compares the operating profit to the sales revenue. It may vary across different business. For example supermarket have low prices so they will have low operating profit margin so thy need to stimulate sales.
High expenses may result in poor ROCE.
Gross profit margin - relates to gross profit of the business to the sales revenue generated for the same period. It is the difference between the sales revenue and costs of sales. A cost of sales represent a major expense to the company and a change may have significant impact on the profits.
Gross profit margin = ( Gross profit / Revenue) X 100
For the example for 2017 it would be:
Gross profit = (945/2.240) X 100 = 22.1%
For 2018 it would be:
Gross profit = (409/2.681) X 100 = 15.3%
The gross profit was lower, which means that the costs of sales were higher. This could mean that the prices were lower and purchase price increased.
The profitability ratios for the company are:
2017 2018
ROSF 33% 2%
ROCE 34.7% 5.9%
Operating profit margin 10.8% 1.8%
Gross profit margin 22.1% 15.3%
We can see that there is a significant difference in the operating profit margin ( approx 9%) and gross profit margin 6.8% which indicates that the operating expenses were greater. The decline in both ROSF and ROCE caused business incurring higher inventories purchasing costs relative to revenue. Investigation is needed to discover the reason for increase in costs of sale and operating expenses relative to sales revenue. We may want to further calculate staff expense as increase in staffing may cause increase of operating costs.
Efficiency ratios
These ratios try to assess on how successfully the various business resources are being managed:
* average inventory turnover period ratio;
* average settlement period for trade receivables ratio;
* average settlement period for trade payables ratio;
* sales revenue to capital employed ratio;
* sales revenue per employee ratio.
Average inventories turnover ratio - for some businesses inventories account for substantial proportion of total assets. This ratio measures the average period in which inventories are being held.
Average inventory turnover ratio = (Average inventories held / Cost of sales) X 365
The average inventories for the period can be calculated through average of the opening and closing inventory figures.
For the example for 2017 the ratio would be:
Average inventories turnover period = ((241 + 300)/2) / 1745) X 365 = 56.6 days
This mean that on average the inventories are being turned over every 56.6 days. So a product would generally be sold about 8 weeks later. Holding inventories has costs. Business should consider the likely demand, possibility of supply shortages, likelihood of raising prices, amount of storage space available and product perishability. We can multiply by 12 or 52 we can express the ratio in months of weeks.
For the example company, the ratio for 2018 was 56.7 days.
Average settlement period for trade receivables ratio - selling on credit is norm for most businesses and the business would generally be concerned about funds tidied up in trade receivables as the speed on payment can have a significant impact on the cashflow. This ratio calculates, how long on average, credit customers take to pay the amount they owe.
Average settlement period for trade receivables ratio = (Average trade receivables / Credit sales revenue) X 365
Businesses normally want shorter ratio as the funds are being tidied up and may be used for more profitable purposes. This ratio produces average figure and this average may be badly distorted by few large customers who are very fast or slow payers.
For the example company the ratio for 2017 would be:
Average settlement period for trade receivables ratio = ((223X240)/2) / 2.240 X 365 = 37.7 days
For 2018 the ratio was 34.9 days
Generally this reduction is welcome and it means that less cash is tided up in trade receivables. It might of been accomplished by chasing customers or giving large discounts for quick payments.
Average settlement period for trade payables ratio - it measures how long, on average the business takes to pay those who have supplied goods and services to it on credit.
Average settlement period for trade payables ratio = (Average trade payables / Credit purchases) X 365
This ratio only provides an average figure which can largely be distorted by payment period for one or two large suppliers. Some businesses aim to increase their ratio, but if taken too far it can result in the loss of goodwill of suppliers.
For the 2017 for the example company the ratio was:
Average settlement period for trade payables ratio = (((183 X 261)/2) / 1,804) X 365 = 44.9 days.
For the 2018 the ratio was 47.2 days. This means that there was an increase which can be beneficial for the business as the business is using free finance provided by suppliers. Small business may suffer cashflow problems because large business customers refuse to pay within reasonable time period. UK government introduced Prompt Payment Code which is a standard for payment practices of large businesses. This issue was causing over 50,000 businesses to close. Companies are required to publish information about their payment practices twice a year, including the proportion of invoices that were paid late. Poor payers risk reputation backlash.
Sales revenue to capital employed - examines how effectively the assets of the business are being used to generate sales revenue.
Sales revenue to capital employed = ( Sales Revenue / (Share capital + Reserves + Non-current liabilities)
Generally, the higher the sales revenue ratio is preferred as it suggests that assets are being used more productively in generating revenue. Very high ratio may indicate that the business is overtrading which means that it has insufficient assets to the revenue achieved. The age of assets, the valuation for assets or whether the assets are leased or owned can complicate interpretation.
For the example company for 2017 we achieve:
Sales revenue to capital employed = (2,240 / ((638+763)/2) - 3.20 times.
For the 2018 the ratio was 3.36 times and there seems to be an improvement.
Sales revenue per employee - relates sales revenue generated during the reporting period to employees. It provides the measure of the productivity of the workforce.
Sales revenue per employee = Sales revenue / Number of employees
Businesses prefer higher value for this ratio.
for the year 2017 for the example company the ratio would be:
Sales revenue per employee = £2,240m / 13,995 = £160,056
For 2018 the ratio would be $143,962.
This represents a decline which requires further investigation. The number of employees increased notably and investigation is needed to why it has not generated the additional sales revenue required to maintain the same ratio.
The efficacy ratios can be therefore summarised as follows:
2017 2018
Average inventory turnover period ratio 56.6 days 56.7 days
Average settlement period for trade receivables ratio 37.7 days 34.9 days
Average settlement period for trade payables ratio 44.9 days 47.2 days
Sales revenue to capital employed ratio 3.2 times 3.36 times
Sales revenue per employee ratio £160,057 £143,962
Maintaining the inventory turnover ratio may be reasonable and it will depend on the planning. A shorter trade receivables settlement and longer trade payables are both desirable.
The increased sales revenue to capital employed ratio seems beneficial. The decline in sales revenue per employee ratio is unwelcome and most likely due to dramatic increase in number of employees. For the inventory turnover ratios these need to be compared with targeted or planned ratios.
Liquidity ratios
Liquidity ratios are concerned with the ability of the business to meet it's short term financial obligations. The following ratios are generally used:
* current ratio,
* acid test ratio
Current ratio - compares the 'liquid' asset ( cash and those assets that soon will be turned into cash) with the current liabilities.
Current ratio = Current assets / Current liabilities
Some people believe that there is an ideal current ratio that is 2:1 or 2 times, but different types of business will require different current ratios. A manufacturing company have generally relatively high current ratio as it will hold inventory and finished goods, raw materials and work in progress. But a supermarket may have relatively low current ratio as it will only held fast moving inventories and sell on cash rather then on credit. However, the higher current ratio the more liquid the business will be. Liquidity is vital for the survival of the business.
For the example company for 2017 the current ratio will be:
Current ratio = 544 / 291 = 1.9 times ( or 1.9 : 1)
For 2018 it would be 1.6 times and this decline might not be a matter of concern.
Acid test ratio - is very similar to the current ratio but it represent more strident test of liquidity, because for many businesses inventories cannot be converted into cash quickly, thus it is better to exclude this asset from the ratio.
The Acid Test Ratio is calculated as follows:
Acid Test Ratio = Current assets (excluding inventories) / Current liabilities
For the example company for 2017 the ratio is as follows:
Acid Test Ratio = 679/432 = 1.6 times ( or 1.6:1)
we can see that the liquid assets do not quite cover the current liabilities and the business may be expecting some liquidity problems.
The minimum level for this ratio is generally stated as 1 times, but many highly successful companies have ratios below 1.0 without suffering liquidity problems.
for 2018 the ratio would be 0.6 times and this may well be a cause for concern and steps need to be taken to understand on why this has occurred.
The liquidity ratios can be summarised as below:
2017 2018
Current ratio 1.9 times 1.6 times
Acid test ratio 0.8 times 0.6 times
There has been clearly decline in liquidity and the decline in Acid test ratio is certainly worrying. The business may struggle to meet their obligations. This may be planned due to increase of non-current assets and the number of employees. When the benefits of expansion come to play the benefits may be derived. However, short term lenders and suppliers may be anxious by this decline in liquidity and lead them to press for payments.
Financial gearing ratios
Financial gearing occurs when a business is financed by borrowing rather then by the stakeholders equity. The extend to which the business is geared is important for assessing risks. Borrowing means paying interest and make capital repayments. When the borrowing is heavy it can be a significant financial burden and increase the risk of the business of being insolvent.
However, businesses still want to take on gearing, especially if the owners have insufficient funds and the only way to finance is to borrow. Gearing also can be used to increase returns to owners if the returns from borrowing exceed the interest.
An effect of gearing is that returns to shareholders become more sensitive to change in operating profits.The effect of gearing can, however, work in both directions. For highly geared business decline in operating profits will bring greater decline in returns to shareholders. The reason why the gearing seems to be beneficial for shareholders is that interest rates for borrowings are low in comparison to the returns that the typical business can earn. Plus, interest expenses are tax deductible which makes the borrowing quote cheap. It can be, however, debatable on whether low interest can be beneficial for the shareholders. There are hidden costs involves as it increases the risks.Some people even think that the benefits of gearing are illusory.
Two ratios are generally used to assess gearing:
* gearing ratio,
* interest cover ratio
Gearing ratio - measures the contribution of long term lenders to the long-term capital structure of the business.
Gearing ratio = (Long-term non-current liabilities / Share capital + Reserves + Long-term current liabilities) X 100
For the example company for 2017 the ratio would be as follow:
Gearing ratio = (200 / 563 + 200) X 100 = 26.2%
This level of gearing would generally be considered as very high.
For 2018 the ratio would be 36.0%.
Interest cover ratio - measures the amount of operating profit available to cover interest payable. It calculates as follows:
Interest cover ratio = Operating profit / Interest payable
The interest cover ratio for the example company would be:
Interest cover ratio = 243/18 = 13.5 times
It shows that the level of operating profit is much higher then the level of interests payable. The lower level of operating profit coverage, the greater risks to lenders that interests may not be paid. There is also risk to shareholders that the lenders will take action against the company.
The example company gearing ratios are as follows:
2017 2018
Gearing ratio 26.2% 36.0%
Interest cover ratio 13.5 times 1,5 times
The gearing ratios has changed significantly, this is due to increase to contribution of long-term lenders to financing the business. The gearing ratio in 2018 would not be considered high for a business that is trading successfully and low profitability is the problem. This was caused by increase in borrowings in 2018 and dramatic fall in profitability in that year. Only a small in future operating profits could cause inability to cover interests payable.
Investment ratios
There are various investment ratios:
* Dividend payout ratio
* Dividend yield ratio
* Earnings per share
* Price/earnings ratio
Dividend payout ratio - measures the proportion of earnings that is paid out to shareholders in the form of dividends:
Dividend payout ratio = (Dividends announced for the year / Earnings for the year available for dividends) X 100
In the case of ordinary shares, the earnings available for dividends would normally be the profit for the year ( profit after taxation) less any preference dividends relating to the year.
For the example company for 2017 the dividend payout ratio would be as below:
Dividend payout ratio = 40/165 X 100 = 24.2%
For 2018 it would be: 363.6%
This would be a very alarming ratio as paying dividends of £40 million seems very imprudent. This information can also be expressed in the dividend cover ratio.
Dividend cover ratio = Earnings for the year available for dividends / Dividends announced for the year
For 2017 for the example company the dividend cover ration would be:
Dividend cover ratio = 165/40 = 4.1 times. This means that the earnings available for dividend cover the actual dividend paid by just over 4 times. For 2018 the ratio is 0.3 times.
Dividend yield ratio - relates to the cash return from a share to its current market value. It helps the investors to assess return on their investment.
The ratio is:
Dividend yield ratio = (Dividend per share / Market value per share) X 100
For the example company for 2017 the ratio is:
Dividend yield ratio = 0.067/2.5 X 100 = 2.7%
The dividends proposed/number of shares = 40(300 X2) = £0.067 dividends per share ( the 300 is multiplied by 2 because there are £0.50 shares)
The ratio for 2018 is 4.5%
Earnings per share - relates to earnings generated by the business and available to shareholders to the number of shares in issue. For equity ordinary shareholders, the amount payable would be represented by the profit for the year ( profit after tax) less the preference dividend if applicable. It calculates as follows:
Earnings per share = Earnings available to ordinary shareholders / Number of ordinary share in issue.
In the case of the example company for 2017 the earnings per share are:
Earnings per share = £165/600m = 27.5p
This ratio is considered as the fundamental measure of the share performance. The trends over time help to assess the potential in the future. Increased profit does not always mean increase of profitability per share.
The ratio for 2018 was 1.8p.
Price/Earnings ratio - relates the market value of a share to the earnings per share. It calculates as follows:
P/E ratio = Market value per share / earnings per share
For the example company for 2017 the P/E calculates as: £2.50 / 27.5p = 9.1 times
The market value of the shares is 9.1 times higher then the current level of earnings. The higher the P/E ratio, the greater the confidence in the future earning power of the business.
for 2018 the ratio was 83.3 times.
This ratio provides a useful tool to market confidence and can be helpful in comparing different businesses. But different accounting policies in different businesses can lead to different earnings and profits which can distort comparisons between different businesses.
The investment ratios for the example company are as per below:
2017 2018
Dividends payout ratio 24.2% 363.6%
Dividends yield ratio 2.7% 4.5%
Earnings per share 27.5p 1.8p
P/E ratio 9.2 times 83.3 times
Although the Earnings per share has fallen, the share price has held reasonably well. The P/E ratio has improved in 2018.
Trend analysis
For well managed businesses changes in financial ratios are a result of deliberate policy. The ratios can also be used to predict the future. They can also predict the future failure of the business. The attempts for predicting failures have broadly been successful.
Limitations
The quality of the financial ratios will depend on the quality of the financial statements. Some important resources may not be acknowledged in the statements so ratios may do not include this information.
Financial ratios are also distorted by inflation because the reported value of assets may not represent its market value. This occurs because the assets are often reported at their original cost. Comparisons between businesses, therefore, are hindered. Inflation can also distort the profit.
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