Week 6

Ratio analysis

Phuong Thao NGUYEN

NEU-SAA
FINANCIAL RATIO CLASSIFICATIONS

• Profitability - relationship between profit, revenue,

assets, equity and capital employed;

• Efficiency - how effectively and efficiently the assets

and liabilities are used;

• Liquidity - ability of business to stay solvent by

meeting its short-term financial obligations;

• Financial Gearing – relationship between debt and

equity financing, indication of risk;

• Investment – helping shareholders assess returns on

their investment.
 Purposes
• To make informed decisions about a company
• Generally based on comparative financial data
• From one year to the next
• With another company
• With the industry
 Analysis techniques
• Horizontal analysis
• Vertical analysis
• Ratio analysis
 Horizontal analysis
• Trend analysis: evaluating a series of financial
statement data over a period of time
• Determine: increase/ decrease (%)
 Vertical analysis
• Common- size analysis: evaluating financial statement
data ➔ percent of a base amount
• Base amount:
• Total assets
• Net sales
Example – BP’s Balance sheets at 31/05/17 (£000) 2017 2016

Non-current assets 1,800 1,400

Current assets
Inventory 1,200 200
Receivables 400 800
Cash 100 100
1,700 1,100
Total assets 3,500 2,500

Equity and liabilities

Ordinary share capital (@ £0.50) 1,200 500
Share premium 600 0
Reserves 200 100
2,000 600
Non-current liabilities
10% loan notes 1,000 600
Current liabilities
Trade payables 200 500
Other payables 300 800
500 1,300
Total equity and liabilities 3,500 2,500
BP’s Income Statements (£000) 2017 2016
Revenue 2,000 1,000
Cost of sales (1,300) (700)
Gross profit 700 300
Distribution costs (260) (90)
Administration expenses (100) (60)
Operating profit 340 150
Interest (100) (60)
Profit before taxation 240 90
Taxation (50) (20)
Profit after taxation 190 70
Ordinary dividends (90) (50)
Retained profit for the year 100 20
Profit and loss b/fwd 100 80
Profit and loss c/fwd 200 100
Share price (£) 1.30 1.26
Industry information:
Industry PE ratio 22 20
Industry average growth in EPS (%) 12 8
 Why use ratios?
• An aid to understanding what the accounts are saying.

• Inter year comparisons - to establish a trend from past years,

to provide a standard of comparison;
• Intra firm comparisons - to compare against a similar business
in the same industry;
• Benchmark - compare against industry averages.

An inexact science, so results must be interpreted cautiously.

One ratio may indicate something but other ratios and data
are needed to support and interpret it in order for a
meaningful evaluation.
Profitability
 Profitability

We will look at:

1. Return on Ordinary Shareholders’ Funds %
(ROSF)/Return on Equity
2. Return on Capital Employed % (ROCE)
3. Operating profit margin %
4. Gross profit margin %
 1. RETURN ON ORDINARY
SHAREHOLDERS’ FUNDS

ROSF = Profit after tax and preference dividends x 100%

Ordinary share capital + reserves

• Measuring how much profit a company generates for its ordinary

shareholders with the money they have invested in the company.

Example – BP:
2017 2016
ROSF = 190/2,000 70/600
9.5% 11.7%
 2. RETURN ON CAPITAL EMPLOYED

ROCE = Operating profit (PBIT) x 100%

Capital employed*
* Usually where Capital Employed = Debt & Equity,
(i.e. Share Capital + Reserves + Non-current liabilities)
• Measuring how efficiently a business is using the funds
available from all sources of long-term finance.
Example – BP:
2017 2016
ROCE = 340/3,000 150/1,200
11.33% 12.50%
 3. OPERATING PROFIT MARGIN

Operating profit % = Operating profit x 100%

Sales Revenue
• Measuring the profit from trading operations (net profit,
before interest and tax) in relation to the sales revenue for a
period.

Example – BP:
2017 2016
Op Profit % = 340/2,000 150/1,000
17% 15%
 4. GROSS PROFIT MARGIN

Gross profit % = Gross profit x 100%

Sales Revenue

• Measuring the gross profit (where GP = sales revenue –

cost of sales) in relation to the sales revenue for a period.

Example – BP:
2017 2016
Gross Profit % = 700/2,000 300/1,000
35% 30%
Efficiency
 Efficiency

We will look at:

5. Inventory turnover period (days)
6. Receivables collection period (days)
7. Payables payment period (days)
8. Sales Revenue to Capital Employed/Asset
Turnover (times)
 5. INVENTORY TURNOVER PERIOD

Inventory = Closing inventories held x 365

turnover period Cost of Sales

• The number of days inventory is held for. A longer inventory

turnover period indicates either a slowdown in trading, or
possible excessive investment in inventory.
Example – BP:
2017 2016
Inventory turnover= 1,200/1,300 x 365 200/700 x365
337 days 105 days
6. RECEIVABLES COLLECTION PERIOD

Receivables = Trade Receivables x 365

settlement period Credit Sales Revenue

• Average time taken for debtors to pay us. Useful to compare against a
benchmark. Average in UK is 30 days, but if international trade, it will
take longer. Ideally this should be shorter than trade payables days,
and the lower the period, the better.

Example – BP:
2017 2016
Receivables period= 400/2,000 x 365 800/1,000 x 365
73 days 292 days
 7. PAYABLES PAYMENT PERIOD
Payables = Trade Payables x
365
settlement period Credit Purchases*
*can use COS as an approx. to purchases
• Average time taken for business to pay suppliers. Useful to
compare against a benchmark. Ideally this should be
longer than trade receivables days, although delaying too
much can cause problems e.g. loss of goodwill.
Example – BP:
2017 2016
Payables period= 200/1,300 x 365 500/700 x 365
57 days 271 days
8. SALES REVENUE TO CAPITAL EMPLOYED
SR:CE ratio = Sales Revenue
Capital Employed*
*Where Cap. Employed = Share Capital + Reserves + Non-current
liabilities
• Also known as Asset Turnover. Measures efficiency of the use of
Net Assets in generating Sales; year on year comparison used.
• A fall in ratio could be due to reduction in Sales or increase in
Net Assets.
• Depends on company – engineering company will be low,
supermarket with few assets will be high.
Example – BP:
2017 2016
Asset turnover = 2,000/3,000 1,000/1,200
0.67 times 0.83 times
Liquidity
 Liquidity

We will look at:

9. Current Ratio – the standard liquidity test
10. Acid Test Ratio (also known as quick ratio)
9. CURRENT RATIO

Current ratio = Current Assets : 1

Current Liabilities

• Indicates how comfortable a company’s current

assets can meet its commitments to pay its
current liabilities. Should be comfortably in excess
of 1:1.
Example – BP:
2017 2016
Current ratio= 1,700/500 1,100/1,300
3.4:1 0.85:1
10. ACID TEST RATIO

Acid Test ratio = Current Assets - Inventories : 1

Current Liabilities

Useful for companies with slow inventory turnover (and so

long cash cycles). Should ideally be at least 1:1, can be
lower if fast inventory turnover but below this indicates a
business may not be able to meet its current liabilities.

Example – BP:
2017 2016
Acid test ratio= 500/500 900/1,300
1:1 0.69:1
Financial Gearing
Financial Gearing

We will look at:

11. Gearing ratio
12. Interest Cover ratio
 11. FINANCIAL GEARING

• Gearing = Long-term (non-current) liabilities x100

Share capital + Reserves + Long-term (non-current) liabilities

• Long-term capital structure, mix of debt & equity.

• Higher the gearing, the less secure will be the financing of the
company and therefore its future (usually)

Example – BP:
2017 2016
Gearing ratio= 1,000/3,000 600/1,200
33.3% 50%
 12. INTEREST COVER RATIO

• Interest Cover = Operating profit

Interest payable
• Measures amount of operating profit available to cover interest
payable.
• The higher the better, as low coverage means risk to lenders that
interest payments will not be met.

Example – BP:
2017 2016
Interest cover= 340/100 150/60
3.4 times 2.5 times
Shareholders’ Investment Ratios
Shareholders’ Investment Ratios

We will look at:

13. Earnings per share
14. P/E ratio
15. Dividend per share
16. Dividend Cover
17. Dividend yield
 13. EARNINGS PER SHARE
EPS = Profit distributable to ordinary shareholders (PAT)
Number of shares in issue
• Measuring a company’s performance from an ordinary
shareholder’s point of view.
• Usually expressed in pence
• Comparison on previous years is used.
Example – BP:
2017 2016
EPS = 190/2,400 70/1,000
7.92p 7p
The growth rate of EPS = (7.92 -7)/7 x 100% = 13%
 14. PRICE EARNINGS RATIO

P/E ratio = Share Price

EPS
• The amount the shareholders are prepared to pay
for the share as a multiple of current earnings.
• High = strong shareholder confidence.
• Can be compared against all other companies.

Example – BP:
2017 2016
PE ratio = 130/7.92 126/7
16.4 times 18 times
 15. DIVIDEND PER SHARE

DPS = Total ordinary dividend

Total no. of shares issued

• How much of the overall dividend payout the

shareholders are entitled to.

Example – BP:
2017 2016
DPS = 90/2,400 50/1,000
3.75p 5p
 16. DIVIDEND COVER

DIVIDEND COVER = Profits after tax or: Earnings per share

Dividends Dividend per share

• Measures how many times the earnings available

for dividend cover the actual dividend.
• Inverse =dividend payout ratio.
Example – BP:
2017 2016
Dividend cover = 7.92/3.75 7/5
2.1 times 1.4 times
17. DIVIDEND YIELD

Dividend yield = DPS x 100

Market price per share
• Measuring the wealth in terms of a return
received by the ordinary shareholders.
Example – BP:
2017 2016
Dividend yield = 3.75/130 5/126
2.9% 4%