Financial Ratios (2024)

Financial Ratios

General Information on Ratios

When you pick up the published accounts of a company for the first time, itcan be an intimidating experience as you are faced by page after page ofnumbers. Financial ratios provide you with the tools you need to interpret andunderstand such accounts. They are essential if you want to look in detail at acompany's performance.

As the financial reports of a business contain a wealth of financialinformation, it is important to consider why we are analyzing and interpretingthe financial reports. The users of financial reports are wide ranging andinclude a variety of stakeholders: investors, creditors, customers andemployees. What do such stakeholders want to know?

• Is the business profitable?
• Can the business pay its bills?
• How is the business financed?
• How does this year compare to last year?
• How does our performance compare with our competitors?
• How does the business compare to the industry norms?

There are 3 main categories of ratio:

• Profitability Ratios - these include the Return on Total Assets, Return on Capital Employed, Net Profit Margin and Net Asset Turnover and are used to assess how profitable the company is.
• Short-term liquidity ratios - these include the current ratio and the acid test ratio and measure how easily the company can meet its short-term financial commitments like paying its bills.
• Long-term liquidity ratios - these include the Gearing and Interest Cover ratios and measure the extent to which the capital employed in the business has been financed either by shareholders or by borrowing and long term finance.

To fully analyze a set of accounts, you will need a reasonable knowledge ofeach or these types of ratio, so try to work gradually through the explanationsand worksheets to build up your understanding.

Profitability Ratios - Explanation

The absolute level of profit may provide an indication of the size of thebusiness, but on it's own it says very little about company performance. Inorder to evaluate the level of profit, profit must be compared and related toother aspects of the business. Profit must be compared with the amount ofcapital invested in the business, and to sales revenue.

Profitability ratios will inevitably reflect the business environment of thetime. So, the business, political and economic climate must also be consideredwhen looking at the trend of profitability for one company over time.Comparisons with other businesses in the same industry segment will provide anindication of management's relative ability to perform in the same business andeconomic environment.

The key profitability ratios are:

Return on Total Assets (ROTA) - Explanation

Return on total assets is a measure of profit in relation to the total assetsinvested in the business, and ignores the way in which such assets have beenfinanced. The total assets of the business provide one way of measuring the sizeof the business. This ratio measures the ability of general management to utilizethe total assets of the business in order to generate profits.

You will note that ROTA uses profit before interest and taxes. This isbecause ROTA is typically used to measure general management performance, andinterest and taxes are controlled externally.

Return on Capital Employed (ROCE)

ROCE, sometimes called Return on Net Assets, is probably the most popularratio for measuring general management performance in relation to the capitalinvested in the business. ROCE defines capital invested in the business as totalassets less current liabilities, unlike ROTA,which measures profitability in relation to total assets.

Capital Employed may be defined in a variety of ways, the most common beingFixed Assets plus working capital, i.e. Current Assets less Current Liabilities.This definition reflects the investment required to enable a business tofunction.

In order for a business to maximize profitability, management should considerthe two elements of ROCE. First, the business needs to sell goods and servicesat a price that exceeds the cost, which is measured by the netprofit margin. Secondly, the business must utilize the capital employed inthe business to generate sufficient sales volume and revenue to maximize profitability, which is measured by thenetasset turnover. The relationship between the two elements of ROCE areexpressed as follows:

Net Profit Margin

The net profit margin, sometimes known as the trading profit margin measurestrading profit relative to sales revenue. Thus a trading profit margin of 10%means that every 1.00 of sales revenue generates .10 (10p) in profit beforeinterest and taxes. Some industries tend to have relatively low margins, whichare compensated for by high volumes. Conversely, high margin industries may below volume. Higher than average net profit margins for the industry may be anindicator or good management.

Net Asset Turnover

The net asset turnover ratio measures the ability of management to utilize the net assets of the business to generate sales revenue. A well-managedbusiness will be making the assets work hard for the business by minimizing idletime for machines and equipment. Too high a ratio may suggest over-trading, thatis too much sales revenue with too little investment. Too low a ratio maysuggest under-trading and the inefficient management of resources.

SHORT TERM LIQUIDITY - Explanation

Short-term liquidity is the ability of the company to meet its short-termfinancial commitments. Short-term liquidity ratios measure the relationshipbetween current liabilities and current assets. Short-term financial commitmentsare current liabilities, which are typically trade creditors, bank overdraftsPAYE, VAT and any other amounts that must be paid within the next twelve months.Current assets are stocks and work-in-progress, debtors and cash that wouldnormally be re-circulated to pay current liabilities.

The key short-term liquidity ratios are:

Current Ratio

The current ratio is a general indicator of the business's ability to meetit* short-term financial commitments. This ratio assumes that all currentassets, if required, can be converted to cash immediately in order to meet allcurrent liabilities immediately. Many texts recommend that the current ratioshould be at least 2:1, that is current assets should be at least twice thevalue of current liabilities. Presumably, this is to allow a safety margin, ascurrent assets do not usually achieve their full value if they have to beconverted to cash in a hurry.

Nowadays, it is very difficult to prescribe a desirable current ratio.Technological advances in stock and inventory management have reduced the valueof stocks on many balance sheets. Aggressive financial management strategies bylarge companies have resulted in higher levels of trade creditors, and atightening grip on trade debtors. It is therefore important to look at the trendfor an individual business, and to compare businesses within the same industrysegment.

Acid Test

The acid test or quick ratio is the currentratio modified to provide a more prudent measure of short-term liquidity.The acid test ratio deducts stock and work-in-progress from current assets. Thisapproach is more cautious as it recognizes that stock is not always readilyconverted into cash at full value.

LONG TERM LIQUIDITY- Explanation

Long term liquidity or gearing is concerned with the financial structure ofthe company. Long term liquidity ratios measure the extent to which the capitalemployed in the business has been financed either by shareholders through sharecapital and retained earnings, or through borrowing and long term finance.

The key long-term liquidity ratios are:

Gearing Ratio

The gearing ratio measures the percentage of capital employed that isfinanced by debt and long term finance. The higher the gearing, the higher thedependence on borrowings and long term financing. The lower the gearing ratio,the higher the dependence on equity financing. Traditionally, the higher thelevel of gearing, the higher the level of financial risk due to the increasedvolatility of profits.

Financial managers face a difficult dilemma. Most businesses require longterm debt in order to finance growth, as equity financing is rarely sufficient.On the other hand, the introduction of debt and gearing increases financialrisk. But the company dependant on equity financing alone is unable to sustaingrowth. How much debt can a company take on before the benefits of growth areovertaken by the disadvantages of financial risk?

Interest Cover

While the gearing ratio measures the relative level of debt and long termfinance, the interest cover ratio measures the cost of long term debt relativeto earnings. In this way the interest cover ratio attempts to measure whether ornot the company can afford the level of gearing it has committed to.

CONCLUSION: OVERALL ANALYSIS - Explanation

When analyzing the financial results of a company, or comparing severalcompanies it is tempting to become so involved in calculating a wide variety offinancial ratios that the original purpose is forgotten. Why are we looking atthe financial reports? What do we want to know?

Let us go back to the key questions:

• Is the business profitable?
• Can the business pay its bills?
• How is the business financed?
• How does this year compare to last year?
• How does our performance compare to our competitors?
• How does the business compare to the industry norms?

These key questions indicate that the financial health of a company isdependent on a combination of profitability, short-term liquidity and long termliquidity. Historically, greater emphasis was placed on profitability. Since thedifficulties of the recession in the late 1980s liquidity, both short term andlong term, has increased in importance.

Companies, which are profitable, but have poor short term or long termliquidity measures, do not survive the troughs of the trade cycle. As tradingbecomes difficult in a recession such companies experience financialdifficulties and fail, or may be taken over. In contrast, companies, which arenot profitable but are cash rich, do not survive in the long term either. Suchcompanies are taken over for their cash flow or by others who believe that theycan improve the profitability of the business. Thus, those companies that dosucceed and survive over the long term have a well-rounded financial profile,and perform well in all aspects of financial analysis.

It is important when reviewing each aspect of financial performance tohighlight any significant changes in performance, either compared to last yearor compared to a competitor. Highlighting significant changes enables you tofocus on key events or major factors that may have important implications forthe company.

Finally, look at financial performance within the context of the political,business and economic environment in which the business operates.

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