Lecture Notes- Financial Ratio Classification

Financial Ratio Classification and Analysis

Introduction

Financial ratios provide a quick and simple means of examining the financial conditions of a business. A ratio simply expresses the relation of one figure appearing in the financial statement to some other figure appearing in the same financial statement. (Peter Atrill et al 2002)

Uses of ratios

Financial ratios can be used for the following

·         For comparing financial health of different business.

·         Use to evaluate various aspects of financial position and performance.

·         Use for planning and control purposes.

·         Compare performance in relation to others in the same industry.

It can also be used for

-          Profit planning

-          Pricing

-          Working Capital Management

-          Dividend policy

Users of financial Ratios

Shareholders are interested in the following

-          Profitability

-          gearing and

-          Investment ratios.

Long term lenders

-          Concern with long term viability of the company

-          Look at profitability or gearing ratios.

Short term lenders for example suppliers

-          They are concerned with liquidity ratios.

FINANCIAL RATIO CLASSIFICATION

Profitability ratio

The primary purpose of every business is to create wealth for its owners and profitability ratios provide an insight to the degree of success in achieving this purpose. (Peter Atrill et al 2002).

The following the types of profitability ratios

-          Return on ordinary shareholders’ fund (ROSF)

-          Return on capital employed (ROE)

-          Net Profit Margin

-          Gross profit margin

RETURN ON ORDINARY SHAREHOLDERS’ FUNDS (ROSF)

ROSF =       Net profit after taxation and preference dividend (if any) x 100

                  Ordinary share capital plus reserves

Example

2001

                              159.2      X  100% = 31. 9%

                             498.3

2002

                       164.2      X     100% = 25.8%

                   

                       636.6

 2 .RETURN ON CAPITAL EMPLOYED (ROCE) 

ROCE =   Net profit before interest and taxation           x  100%

               Share capital + reserves + long term loans.

Example

2001

                        243. 4    x 100% = 34.9%

(200+498.3)     698.3

2002

ROCE =                  246.4    x 100% = 35.4%

(60 + 636.6)           696.6

NET PROFIT MARGIN

NPM =        Net profit before interest and taxation

            

                   Sales

2001

Net profit margin =        243.4   x 100% = 10.9%

   

                                   2240.8

2002

Net profit margin =          246.4   x  100% = 9.2%

                  

                                     2681.2

GROSS PROFIT MARGIN

GRM =     Gross profit x 100 %

                       
                        Sales

2001

          Gross profit margin   =            495.4   x   100% = 22.1 %

                                                         
                                                       2240.8

2002

Gross profit margin =              609.2     x   100% = 22.7%

                                              
                                                 2681.2

Summary of profitability ratios for Alexis Plc

                                               2001       2002

ROSF                                     31.9%      25.8%

ROCE                                    34.9%      35.4%

NET PROFIT MARGIN            10.9%      9.2%

GROSS PROFIT MARGIN       22.1%      22.7%

ANALYSIS FOR ALEXIS Plc

GROSS PROFIT MARGIN

·         Shows a slight increase in 2002 over the previous year: This could be due to the following

-          Increase in selling price.

-          Decrease in cost of sale.

NET PROFIT MARGIN

-          Shows a decline and this means that operating expenses (wages, rates, insurance etc.) absorbs portion of sales income in 2002.

ROSF

-          Profit available to ordinary shareholder has increase lightly over the period. Share capital and reserves has increased considerably. (see statement). The effect on this has been to reduce the return shareholders’ fund.

ROCE

-          Return on capital employed has improved in 2002. The decrease in long term capital over the period in the increase in net profit before interest and tax has resulted in better return.

(Peter Atrill et al 2002)

EFFICIENCY RATIOS

This is used to examine the efficiency to which the various resources of the business are managed. This include the following

-          Average stock turnover period

-          Average settlement period for creditors

-          Sales to capital employed

-          Sales per employee

Average stock turnover period: This measure the average numbers of days for stock are being held.

Average stock held   (average of closing and opening stock)

Cost of sales

2001

Stock turnover period =       (241 +300)/2   x   365 days = 57 days

     

                                             1745.4

 This means, on average stocks held is being turnover every 57 days.

2002

=      (300 + 370.8)/2  x  365 days = 59 days

2072 

NB. – Stocks represent huge investment for a business

Stock Level Determinants

-          Future demands

-          Future price rises

-          Space availability

-          Perishable products

-          Future shortages

(Peter Atrill et al 2002)

Average settlement period for debtors

           =     Trade debtors    x 365 days

                    Credit sale

2001   

    =        240.8 x  365 days = 39 days

   

             2240.8

2002

=          210.2  x 365 = 29 days

     

          2681.2           

Average settlement period for Creditors

           =     Trade creditors    x 365 days

                   

           Credit purchases

2001  

    =        221.4 x  365 days = 45 days

    

           1804.4

2002

=          228.8   x  365 = 39 days

           

          2142.8    

       

Sales to capital Employed

  =                                   sales

           

       Long term capital employed (share holders fund + long term loan)

2001

=                     2,240.8             =        3.2 times

                    

                498.3 + 200

2002

=            2,681. 2                     =      3.8 times

             

        636.6 + 60

Sales per employee =     Sales

                      

                Number of employees

2001

=         2240,800  =           $ 160, 057

        

              14

2002 

 =       2681, 200   =          $ 148,956

    

         18

Summary

Stock turnover period                                     57days                  59 days

Average settlement period for debtors              39 days                29 days

Average settlement period for creditors            45 days                39 days

Sales to capital employed                                3.2 times            3.8 times

Sales per employee                                          $ 160, 057          $148,956

ALEXIS OF EFFICIENCY RATIO 

Average settlement period

-          This reduced for both debtors and creditors

This could be due to:

-          Tighter credit control for debtors

-            Paying creditors promptly to maintain Goodwill or take advantage of discount.

(Peter Atrill et al 2002)

Stock Turnover Period

-          Slows an increase over the period

Sales to capital employed

-          Sales have increased more than capital employed.

Sales per employee

-          This has declined – needs to be investigated.

LIQUIDITY RATIOS

These are current ratio, acid test, operating cash flows to maturity obligation. 

Current Ratio 

This compares the liquid asset (cash + debtors stocks) with current liabilities (creditors due within one year).The ideal current Ratio is 2 times

  Current Ratio =   Current Asset

                              
Current liabilities (creditors due within one year)

2001 

Current ratio =                 544.2                  = 1.9 times

                                   
                                    291.7

2002

Current Ratio =                  584.0                = 1.8 times

                                   
                                        326.8

Comment 

A manufacturing Business would have high current Ratio because it holds stock – raw materials; work in progress (WIP), and finish goods whilst a super market chain would have low current ratio because it holds fast moving stock of finished goods.  (Peter Atrill et al 2002)

Acid Test Ratio

This represents a more rigid test of liquidity. It could be argued that for many businesses the stock in hand cannot be converted into cash quickly. An Acid test ratio should not be below 1.0 (Peter Atrill et al 2002)

=            current asset (excluding stock)

       
     Current liabilities (creditors within one year) 

2001

Acid test Ratio  =        (544.2 – 300) =         0.8 times

                                 
                                        291.7

2002

Acid test Ratio =          (584.0 – 370.8) =     0.7 times

                                    
                                          326.8

Operating cash flows to maturity obligation

This compares the operating cash flow to current liabilities of a business. It also indicates the ability of a business meeting its maturity obligations. Its been argued that the higher the ration the better the liquidity of the business. (Peter Atrill et al 2002)

     =       Operating cash flow

                                
                                  Current liabilities

2001

=      231.0    =      0.8 times

        
           291.7 

Operating cash flow is not enough to meet current liabilities at the end of the period.

2002

=   251.4    = 0.8 times

  
   326.8

ANALYSIS OF LIQUIDITY RATIO

                                                    2001                         2002

Current Ratio                               1.9                             1.8

Acid Test Ratio                             0.8                             0.7

Operating Cash Flow                    0.8                             0.8

Current and Acid Test Ratio

-          Decrease in figure for both ratios

-          Suggest worsen liquidity position for the position of the business 

Operating Cash Flow to Maturity Ratio

-          There is no change over  the period

-          The ratio is low and reveals cash flow for the period do not cover maturity obligation.

Comments

Acid Test Ratio

-          Stock turnover for Alexis is more than 50 days.

-          ‘liquid’ current assets do not cover current liabilities so the business may be experiencing some liquidity problem.

(Peter Atrill et al 2002)

GEARING RATIO

This measures the contribution of long – term lenders to long term capital structure of a business. This occurs when a business is financed in part by contributions from outside partner.

Reasons for Gearing

-          The owners don’t have enough funds

-          For tax purposes

-          Use to increase return to owners

Gearing ratio =           Long term liabilities                                x    100

                          
                   Share capital + Reserves+ long – term liabilities

  

Alexis plc

2001

Gearing Ratio      =          200                    x  100  =   28.6%

                                 (498.3 + 200)

2002

Gearing Ratio         =             60                      x 100           = 8.6%

                                          (636.6 + 60)

Interest cover ratio

This measures the amount of profit available to cover the interest payable

Interest Cover   =            Profit before interest and taxation

                                    
                                    Interest Payable

2001

 Interest cover     =              219.4 + 24            = 24 times

                                    
                                              24

2002

Interest cover       =           240.2 + 6.2       =   39.7 times

                                           
                                              6.2

INVESTMENT RATIOS

These are

1. Dividend per share
2. Dividend payout ratio
3. Dividend yield ratio
4. Earnings per share (EPS)

Dividend per share ratio

This relates dividends announced during a period to a number of shares in issue during that period (Peter Atrill et al 2002)

Dividend per share =           Dividend announced during a period

                                            Number of Shares in issue

NB.

-          Indicates cash return that a shareholder receives

-          Dividends are only proportion of earnings generated

-          Earnings could be ploughed back into the company for growth purposes.

(Peter Atrill et al 2002)

Alexis

2001  

 Dividend per share    =  40.2   (ie £0.5 shares and £300 share capital)

                                   
                                 600 (300*2)

                                                      =   6.7 p

2002

Dividend per share    =   60.0

                                     
                           668.2 (334.1*2)

                                                         =  9.0p

Dividend payout ratio

This measures the proportion of earnings that is pay out to shareholders in the form of dividend. (Peter Atrill et al 2002)

 Dividend payout ratio =   dividend announced for the year     x 100

                                     
                                      Earnings for the year available for dividends

2001

Dividend payout ratio       =           40.2       x  100                  =    25.3%

                                                   
                                                       159.2

2002

Dividend payout ratio   =    60.0      x  100                                        =  36.5 %

                                          
                                           164.2  

EARNINGS PER SHARE (EPS)

This relates the earnings generated by the company during a particular period and available to shareholders to the number of shares in issue. Earnings per share is used to measure the investment potential of a company.  (Peter Atrill et al 2002)

=   Earnings available to ordinary shareholders

      
      Number of shares in issue

2001

EPS =            159.2            =   26.5p

                  
                  600 (2x300)  

2002

EPS     =     164.2            =    24.6p

                  
                  668.2

PRICE PER EARNINGS (PE RATIO)

This relates the market value of a share to earnings per share. This ration measures the market confidence in the future of the company. The higher the PE ratio the greater the confidence in the future earning power of the company.

PE Ratio       =   Market value per share

                          
Earnings per share

2001

PE Ratio   =                   £ 2.50               = 9.4 times

(EPS = 26.5 / 1000)    
                                       £0.265

2002

PE Ratio   =                   £ 3.50               = 14.2 times

(EPS = 24.0 / 1000)    
                                   £0.240

The investment ratio for Alexi plc over the two year period is as follow

                                                          2001                              2002

Dividend per share                           6.7p                               9.0p

Dividend payout ratio                       25.3%                             36.5%

Dividend yield ratio                           3.0%                               2.9%

Earnings per share                           26.5p                             24.6p

Operating cash flow per share          38.5p                             37.6p

Price/earnings ratio                          9.4 times                        14.2times

Comment on investment ratio

There was an increase in dividend per share in 2002 when compared to the previous year

Dividend payout ratio is low for the year 2002. Only about a third of earnings available were distributed.

The dividend yield has a very little change over the period and it was very low.

Earnings per share shows a slight fall in 2002 compared to the previous year.

References

Atrill, Peter et al, 2002, 2^nd edition - Accounting: An Introduction, Prentice Hall, England