ratio analysis

Question 1

Purpose of ratio analysis3

Answer 1

To build up a picture of the performance of the company

Absolute figures are of little value. They only provide insights if they can be compared with other relevant amounts in ratios
Examples:
How much sales are generated from fixed assets?
What percentage of sales turns into profit?
Why: Helps compare and understand efficiency, profitability, and overall financial health.

Question 2

comparisons- with earlier years

Answer 2

Step 1: Compare with earlier years.
Goal: Identify trends over time.
Question: Does the trend represent improvement or a decline?

Question 3

comparisons with company’s plan

Answer 3

Compare it with the company’s plan.
Is it in line with the company’s expectations as budgeted?
Not generally available in detail to an outside investor.
But company might indicate forward-looking aspects in OFR (Operating and Financial Review).

Question 4

Compare with those of other companies in the same industry

Answer 4

External standard.
No two companies are exactly alike, in products or in markets.
Different accounting policies used, for example, depreciation, inventory (stock) valuation.

Question 5

Compare with industrial average.

Answer 5

All the disadvantages of average figures.
Our company might be placed in a particular part of the market and so it is of limited value to compare with average of the industry.
Accounting policies may be different.
But provides a starting point.

Question 6

Return on shareholders’ equity

Answer 6

Profit after tax x 100%
———————————
Share capital + reserves

Performance of company from the shareholders’ perspective.
Essential to use profit after tax and after interest charges.

Question 7

Return on capital employed

Answer 7

(Operating Profit (before interest and tax) x 100%) / (Total assets – current liabilities)

Performance of company as a whole.
Measure of management efficiency.
Relates to all sources of long term finance.

Question 8

Return on total Assets4

Answer 8

operating profit before interest and tax x 100%
——————————————————
total assets

Another variation on measuring how well the assets of the business are used to generate operating profit before deducting interest and tax.

Question 9

Operating profit on sales

Answer 9

operating profit before interest and tax x 100%
——————————————————
sales (revenue)

perating profit margin’ the higher the better.
Reflects:
degree of competitiveness in the market economic situation.
ability to distinguish products.
ability to control expenses.

Question 10

Gross profit percentage

Answer 10

Gross profit x 100%
————————————
Sales (revenue)

Concentrates on costs of making goods and services ready for sale.
Small changes in this ratio can be highly significant.
There tends to be a ‘normal’ value for each industry.

Question 11

Total assets usage

Answer 11

Sales (revenue)
————————
Total assets

Indicates how well a company has used its productive capacity.
Use in trends of what has happened over time.

Question 12

Non-current (fixed) assets usage

Answer 12

Sales (revenue)
————————
non current assets

Interpreted as how many £s of sales have been generated by each £ of assets i.e. 62 pence of sales for each £1 of non-current (fixed) asset investment.

Question 13

Acid test/Quick ratio

Answer 13

Current assets minus inventory (stock) : Current liabilities

Question 14

Stock holding period (inventories holding period)

Answer 14

Average inventories held x 365
———————————————— Cost of sales

How quickly goods move through the business:
Generally, the shorter the better, but too short may risk being ‘out of stock’.
Assumption that year-end figures represent normal level for year.

Question 15

Customers (debtors) collection period

Answer 15

Trade receivables (debtors) x 365
—————————————————
Credit sales (revenue)

Speed of collecting from credit customers.

Compare with the credit period given, or the normal credit period for the industry.

Question 16

Suppliers payment period

Answer 16

rade payables (creditors) x 365
—————————————————.
Credit purchases

Paying too fast – risk of cash shortage.
Paying too slowly – risk of losing supplier.
Companies must disclose this information in the directors’ report.

Question 17

purchases formula

Answer 17

Cost of sales + closing inventory (stock) – opening inventory (stock)

Question 18

Gearing

Answer 18

Long-term loans x 100%
———————————————-
Ordinary share capital + reserves

Most often quoted in the financial press. A high figure indicates reliance on sources of long-term loan finance.
‘Long-term loan’ includes short-term portion of loans, in current liabilities in balance sheet.
Also, bank overdraft, if a permanent feature.
Interest payments must always be met, so company has exposure to interest rate movements.

Question 19

Interest cover

Answer 19

Operating profit
interest charge

Question 20

Earnings per share (formula)

Answer 20

profit after tax for ordinary shareholders /
number of ordinary shares

Question 21

Price earnings ratio (formula)

Answer 21

share price /
earnings per share

Question 22

What does p/e ratio compare

Answer 22

The price-to-earnings (P/E) ratio relates a company’s share price to its earnings per share.
A high P/E ratio could mean that a company’s stock is overvalued, or that investors are expecting high growth rates in the future.
Companies that have no earnings or that are losing money do not have a P/E ratio because there is nothing to put in the denominator.

Question 23

Dividend per share ( formula )

Answer 23

Dividend payable to ordinary shareholders/
Number of issued shares

Question 24

Dividend per share (what does it do?)

Answer 24

Calculating the dividend per share allows an investor to determine how much income from the company he or she will receive on a per-share basis.

Question 25

Dividend yield

Answer 25

Dividend per share x 100%/
Share price