Ratio Analysis

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Ratio Analysis

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FINANCIAL RATIO
 Financial ratio analysis involves calculating and
analysing ratios that use data from one, two or more
financial statements.
 Ratio analysis also expresses relationships between
different financial statements.
 The term "accounting / financial ratios" is used to
describe significant relationship between figures shown
on a balance sheet, in income statement, in a budgetary
control system or in any other part of accounting
organization.
 It shows the relationship between accounting data.

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Ratio Analysis
 Purpose:
 To identify aspects of a business’s
performance to aid decision making
 Quantitative process – may need to be
supplemented by qualitative factors to get a
complete picture of organization
 5 main areas worth analyzing: liquidity,
profitability, activity, solvency and efficiency.

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Ratio Analysis
1. Liquidity – the ability of the firm to pay its way, how easily
you can turn assets into cash
 working capital
 the current ratio
 quick ratio
2. Investment/shareholders – information to enable decisions
to be made on the extent of the risk and the earning
potential of a business investment
3. Gearing – information on the relationship between the
exposure of the business to loans as opposed to share
capital
4. Profitability – how effective the firm is at generating profits
given sales and or its capital assets
5. Financial – the rate at which the company sells its stock
and the efficiency with which it uses its assets

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LIQUIDITY

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LIQUIDITY
Measure:
The short term solvency of financial position of a firm. These ratios are calculated to
comment upon the short term paying capacity of a concern or the firm's ability to meet its
current obligations.

Focus on working capital and usually serve as supplements to the statements of income
and cash flow

A firm’s ability to satisfy its short term obligations as they come due. Can the firm pay its
bills/ current liabilities?

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Measure:
An indication of the liquidity of the business by comparing the amount of current assets
to current liabilities. The degree to which current asset can be used to pay current
debt obligation.

Formula / Explanation:
A business's current assets generally consist of cash, marketable securities, accounts
receivable, and inventories. Current liabilities include accounts payable, current
maturities of long-term debt, accrued income taxes, and other accrued expenses
that are due within one year.

Results / Interpretation:
In general, businesses prefer to have at least one dollar of current assets for every
dollar of current liabilities. However, the normal current ratio fluctuates from
industry to industry. A current ratio significantly higher than the industry average
could indicate the existence of redundant assets. Conversely, a current ratio
significantly lower than the industry average could indicate a lack of liquidity.
Higher CR =1. The business has sufficient CA to maintain normal business
operations.

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Measure:
A measurement of the liquidity position of the business.

Formula / Explanation:
The quick ratio compares the cash + cash equivalents + short term investment +net current
receivable to the current liabilities. The primary difference between the current ratio and the
quick ratio is the quick ratio does not include inventory and prepaid expenses in the
calculation.

Results / Interpretation:
Consequently, a business's quick ratio will be lower than its current ratio. It is a stringent test
of liquidity. The larger the ratio = the more liquid the business.
1:1 seen as ideal - The omission of stock/inventories gives an indication of the cash the firm
has in relation to its liabilities (what it owes).

A ratio of 3:1 therefore would suggest the firm has 3 times as much cash as it owes – very
healthy!

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INVESTMENT/SHAREHOLDERS
/ MARKET TEST RATIOS

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INVESTMENT/SHAREHOLDERS/
MARKET TEST RATIOS
 Based on the share market's perception of
the company.

For example: Price/Earnings ratio

 The higher the ratio, the higher the perceived

quality of the earnings by the share market.

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INVESTMENT/SHAREHOLDERS/
MARKET TEST RATIOS

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Measure:
EPS appears in income statements. Net Income earned for each share of
the company’s outstanding common stock. EPS shows what
shareholders earned by way of profit for a period.

Formula / Explanation:
Net income available to common stockholders by number of common stock
outstanding. Preferred Stock are subtracted from Net Income. Preferred
S/holders have the first claim to dividends.

Results / Interpretation:
Most companies strive to increase EPS by 10-15% annually. Other things
can affect Earning Per Share: share buybacks the company may
conduct (resulting in less shares), or the company releasing more
shares, which increases the number of total shares further diluting the
Net Earnings.

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Measure:
DPS shows how much the shareholders were actually paid by way of dividends.
It used by individuals who are evaluating various stocks to invest in and prefer
companies who pay dividends.

Formula / Explanation:
The denominator of the dividends per share formula generally uses the annual
weighted average of outstanding shares. The weighted average is also used
with the earnings per share formula. However, there are key differences
between these two formulas. The numerator for earnings per share is net
income, or earnings. The numerator for the dividends per share formula is
dividends. Earnings is effectively a continuous process throughout the year
whereas dividends are paid at a given moment.

Results / Interpretation:
This formula alone does not necessarily provide an overall outlook on a company
as some companies retain their earnings for growth instead of paying
dividends. A company with a low dividend payout ratio, i.e. a company who
pays a smaller percentage of their net income to stockholders, will reinvest
their net income which may lead to an increase in the value of the company
due to expansion.

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Measure:
How much of net income that dividends are chewing up which is
relevant in evaluating the sustainability of the dividend.

Formula / Explanation:
A company's dividends paid to shareholders expressed as a
percentage of total earnings.

Results / Interpretation:
A higher ratio indicates that a company pays more in dividends and
thus reinvests less of its earnings into the company. Whether or
not this is desirable depends on the rate of growth; investors tend
to prefer a higher payout ratio in a slow-growing company and a
lower one in a fast-growing company.

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Measure:
to make an estimate of appreciation in the value of a share of a company and is
widely used by investors to decide whether or not to buy shares in a particular
company.
Formula / Explanation:
the ratio between market price per equity share and earning per share.

Example Calculation: The market price of a share is RM30 and earning per
share is RM5.
Price earnings ratio = 30 / 5 = 6
The market value of every one dollar of earning is six times or RM6. The ratio is
useful in financial forecasting. It also helps in knowing whether the share of a
company are under or over valued.
For example, if the earning per share of AB is RM20, its market price RM140 and
earning ratio of similar companies is 8, it means that the market value of a
share of AB Limited should be RM160 (i.e., 8 × 20). The share of AB Limited
is, therefore, undervalued in the market by RM20.
In case the price earnings ratio of similar companies is only 6, the value of the
share of AB Limited should have been RM120 (i.e., 6 × 20), thus the share is
overvalued by RM20.

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GEARING

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GEARING-LEVERAGE

 The most common use of the term 'gearing' is to

describe the level of a company's net debt (net of
cash or cash equivalents) compared with its equity
capital, and usually it is expressed as a percentage.
 The gearing ratio shows how encumbered a
company is with debt.
 Depending on the industry, a gearing ratio of 15%
would be considered prudent while anything over
100% would be considered risky or 'highly geared'.
 'Gearing' is also used in a related sense to refer to
borrowings by an investment trust that boosts the
return on capital and income via additional
investment.

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FINANCIAL LEVERAGE

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PROFITABILITY

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PROFITABILITY
 Profitability measures look at how much profit the
firm generates from sales or from its capital assets,
the degree to which the business is profitable.
 Three common profitability ratios
 Return on Investment
 Return on Total Assets
 Return on Sales
 Different measures of profit – gross and net
 Gross profit – effectively total revenue (turnover) –
variable costs (cost of sales)
 Net Profit – effectively total revenue (turnover) – variable
costs and fixed costs (overheads)

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PROFITABILITY

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Profitability

 The higher the better.

 Shows how effective the firm is in using its
capital to generate profit.

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RETURN RATIOS

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Financial

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 Asset Turnover
 Asset Turnover = Sales turnover / Total Assets
 Using assets to generate profit

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Inventory Turnover
 Stock turnover = Cost of goods sold / stock expressed as
times per year
 The rate at which a company’s stock is turned over
 A high stock turnover might mean increased efficiency?
 But: dependent on the type of business – supermarkets
might have high stock turnover ratios whereas a shop selling
high value musical instruments might have low stock
turnover ratio
 Low stock turnover could mean poor customer satisfaction if
people are not buying the goods (Marks and Spencer?)

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 Debtor Days
 Debtor Days = Debtors / sales turnover x 365
 Shorter the better
 Gives a measure of how long it takes the business to recover
debts
 Can be skewed by the degree of credit facility a firm offers

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ACTIVITY RATIOS

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OPERATING CYCLE

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 Measure: The number of days of inventory
by calculating
 Formula / Explanation: The amount of
inventory on hand (RM) to average day’s
Cost of Good Sold.
 Results / Interpretation:
The number of days tell us the time it takes to
convert the investment in inventory into sold
goods

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 Measure: The number of days between sale --
when an account receivables is created—to the time
it is collected in cash
 Formula / Explanation: The receivables divided
on Average say’s sales on credit or the number of
days receivables
 Results / Interpretation:
The longer the operating cycle, the more current
assets need because it takes longer to convert
inventories and receivables into cash. Longer the
operating cycle, the more net working capital
required

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 Measure: How long it takes a company to
pay its short term obligations
 Formula / Explanation: Apply same logic
to accounts payable as we did to account
receivables and inventories
 Results / Interpretation: Determine the
amount of an average day’s purchase on
credit. How long it takes , on average to go
from creating a payable to paying for it in
cash?

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 Measure: how long it takes to convert an
investment in cash back into cash (by way of
inventory and account receivable)
 Formula / Explanation: The number of
days purchases tell us how long it takes to
pay on purchase made to create the
inventory. How long on net, we tie up cash?
 Results / Interpretation: The longer the
operating cycle, the greater company needs
for liquidity
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 Alkazam Ltd
Statement of Financial Position as at 31 March
2018 2019
RM000 RM000 RM000 RM000
Current Assets
Bank 33.5 41.0
Accounts receivable 240.8 210.2
Inventory 300.0 370.8
574.3 622.0
Non-current assets
Fixtures & fittings (net) 64.6 63.2
Land & buildings (net) 381.2 376.2
445.8 439.4
Total assets 1,020.1 1,061.4

Current Liabilities
Accounts payable 261.6 288.8
Income tax 60.2 76.0
321.8 364.8
Non-current liabilities
Loan 200.0 60.0

Shareholders Funds
Paid-up ordinary capital 300.0 334.1
Retained profit 198.3 302.5
498.3 636.6
Total liabilities & equity 1,020.1 1,061.4
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 Alkazam Ltd
Statement of Financial Performance for year ended 31 March
2018 2019
RM000 RM000 RM000 RM000
Sales 2,240.8 2,681.2
Less Cost of goods sold 1,745.4 2,072.0
Gross profit 495.4 609.2
Wages & salaries 185.8 275.6
Rates 12.2 12.4
Heat & light 8.4 13.6
Insurance 4.6 7.0
Interest expense 24.0 6.2
Postage & telephone 9.0 16.4
Depreciation -
Buildings 5.0 5.0
Fixtures & fittings 27.0 276.0 32.8 369.0

Net profit before tax 219.4 240.2

Less Income tax 60.2 76.0
Net profit after tax 159.2 164.2

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ADDITIONAL INFORMATION:
 Credit purchases for the year 2019 were RM2,142,800.
 General prospects for the major industries in which Alkazam is
involved look good with a forecast glut of oil set to reduce the
cost of production and world demand for plastic remaining
strong.

The following are average indicators that relate to the plastic

retailing and manufacturing industries for the year 2019.
 Gross profit margin 25%
 Net profit margin 7%
 Inventory turnover 6 times
 Debt/equity ratio 0.6 : 1
 Return on Assets 12%
 Return on Equity 20%

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RELEVANT RATIOS
Important note: The calculations of the ratios in this illustration did not use “averages” for total assets, equity and
inventory. The 2018 and 2019 year end figures were used and this is a slight variation to the formulas provided.

Profitability Benchmarks 2018 2019

ratios:

Gross Profit Industry 22% 22.7%

Margin 25%

Net Profit Industry 7.1% 6.1%

Margin 7%
Return on 12% 15.6% 15.5%
Assets

Return on Industry 32% 26%

Equity 20%

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 Asset Benchmarks 2018 2019
Management
ratios:

Inventory Industry 5.8 times 5.58 times

Turnover 6%

Asset Turnover Not given 2.2 2.53

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 Liquidity Benchmarks 2018 2019
ratios:
Current Ratio Ideal standard 1.78:1 1.70:1
2:1
Acceptable
standard
1:1
Quick Ratio Ideal standard 0.85:1 0.69:1
2:1
Acceptable
standard
1:1
Days Payable Standard Credit 49.19 days
30 days purchases not
available

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Financial Benchmarks 2018 2019
Structure
ratios:

Debt/Equity Industry 1.05: 1 0.67:1

0.6:1
Standard
benchmark
1:1

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REPORT
 For the investor considering the purchase of shares in the
company, the return they will earn is the key financial factor but
an overall evaluation of the company’s performance and position
is also important to get a better picture of how well the company
is actually doing.
 ROE in 2019 is 26%. Whether or not this is attractive depends on
the perceived riskiness of this investment and other alternatives
available but this return is certainly more attractive than current
bank interest rates.
 ROE has decreased by 4% but the company’s ROE at 26% is
still better than the industry average of 20%
 Riskiness of business is being reduced by the significant
repayment of loan in 2019.

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 Profitability
 The NP% and ROA ratios show a small downward trend in
% over the 2 year period. ROE% ratio show a more
significant decrease but is still better than the industry
average.
 Gross Profit Margin is slightly unfavourable at about 2.3%
below the industry benchmark of 25%.
 The horizontal analysis information show that Sales have
increased by 20%. However operating costs have
increased by 34%.
 Asset Management
 IT has gone down slightly from 5.8 to 5.58 times.
 IT is still close to the industry benchmark of 6 times.
 AT has increased showing more sales being generated
from asset usage

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 Liquidity
 Current ratios of 1.78:1 (2018) and 1.70: 1 are at
above acceptable levels but below ideal level.
 Quick ratios appear more of a concern being
below acceptable levels in both years and even
more so in 2019 (0.69:1).
 Raises some concerns over the liquidity of the
business and inventory management (although IT
ratio only shows a slight decline in 2019).
 Days Payable is a concern as there may be poor
debt payment management.

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 Financial Structure
 Although slightly higher than D/E industry benchmark
(0.67:1), business has become less risky due to the
significant repayment of loan in 2019.
 TIE is extremely good for the business at 39.74 times (well
above 5 the standard benchmark).
 Cash flow situation
 Strong cash flow from operating activities (increased from
160,600 to 185,000).
 Spending under investing activities suggest more growth.
 Repayment of debt under financing activities imply
restructuring of business to have more equity funding
rather than debt funding.

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RECOMMENDATION
Given:
1) the strong forecast for the industry (ie general prospects
looking good and world demand for plastic products remaining
strong),
2) the sales growth in this business,
3) acceptable ratios as they are quite close to the industry
averages,
4) good cash flows from operating activities and
5) favourable ROE, although it has decreased, it is still better than
the industry average ROE.

=> it is recommended that the investor purchase shares in the

Alkazam Ltd company

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