Financial Management II

CHAPTER TWO
FINANCIAL STATEMENT RATIO ANALYSIS

Ratios express the relationship between two variables. Ratios are used to explain and interpret
financial statements. Ratios by themselves have no meaning unless when compared with other
ratios of passed periods or with those of other companies. A thorough ratio analysis can enable
one to assess the business in terms of: profitability, solvency, efficiency, capital structure and
shareholders’ investments

1. PROFITABILITY RATIOS

To know how profitable a business is, the following profitability ratios should be calculated
and interpreted accordingly:
1. Gross Profit to Sales Ratio

This ratio is also known as the margin rate and shows how much gross profit on average
the firm is making on every unit of sale. The sales figure is an important element in most
profitability ratios and is also called turnover. The margin rate is calculated on sales as shown
in the following formula
Gross Profit 100
Margin Rate = x
Sales 1
2. Gross Profit to Cost Ratio
This ratio is also known as the mark-up rate and shows how much gross profit on average
the firm is making on every unit of cost. The cost figure is often considered as the cost of goods
sold. The mark-up rate is calculated on cost as shown in the following formula
Gross Profit 100
Mark-up Rate = x
Cost 1

Cost of Goods Sold = Opening Stock + Purchases + Carriage Inward – Returns Outwards –
Closing Stock

3. Net Profit to Sales Ratio

The amount of net profit on sales (turnover) is equally important. The enterprise should
have a high net profit to sales ratio so as to stimulate growth, expansion and a higher return on
owner’s equity. However, if the enterprise is incurring so many expenses, the net profit to sales
ratio will be relatively low though the gross profit to sales ratio may be high. The net profit to
sales ratio is given as follows:
Net Profit 100
Net Profit to Sales = x
Sales 1

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4. Return on Capital Employed

This ratio expresses the net profit as a percentage of capital employed. It is also called
return on investment (ROI) and is given as follows:
Net Profit 100
ROI = x
Capital Employed 1

Capital employed is the summation of the fixed assets and working capital. Working capital is
the difference between current assets and current liabilities. Hence, capital employed can be
expressed as:
Capital Employed = Fixed Assets + Current Assets – Current Liabilities
5. Return on Equity Capital

It is also called the Equity Capital Earnings ratio. This ratio shows the proportion of profit
that is attributed to the equity capital of the business. It shows the amount of net profit
belonging to the ordinary shareholders and is given as follows:

Net Profit (excluding interest and preference dividend) 100

Return on Equity = X
Equity Capital 1
The equity capital consists of ordinary share capital plus reserves plus retained profits and
the profits or losses for the current year.

2. LIQUIDITY OR SOLVENCY
To know whether the firm can pay its short term liabilities, the following liquidity ratios
should be calculated and interpreted accordingly:

1. Current Ratio or Working Capital Ratio

The liquidity position of the firm is favourable if the current assets are at least twice the
current liabilities. However, the working capital can become negative due to overtrading.
Hence, the current ratio will be less than 1 since current assets are less than current liabilities.
This is an unfavourable situation in the enterprise and is a sign of insolvency. .
As a matter of fact, the current ratio should not be too high or too low. A favourable current
ratio should be 2:1. In calculating current ratios, the following formula should be applicable:
Current Assets
Current Ratio =
Current Laibilities
2. Quick Ratio or Acid-test Ratio
When the stock turnover is low, including stock as an element of the current assets in the
calculation of liquidity ratios may not reveal the true solvency situation of the enterprise, which
may be misleading. Though stock is a current asset, it is not a liquid asset. Liquid assets are
those current assets that can easily be converted into cash. Stock seems to be the only current
asset that is not liquid. To know the true liquidity position of the enterprise, it is wise to use the
quick ratio which is expressed as:
Current Assets - Stock
Quick Ratio =
Current Laibilities

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3. EFFICIENCY OR MANAGEMENT OF WORKING CAPITAL

To know whether the firm is efficient with the way the working capital is managed, the
following liquidity ratios should be calculated and interpreted accordingly:

1. Debtors’ Collection Period

It is important to know the number of days taken by debtors to pay their debts. An enterprise
that collects its debts promptly is efficient with respect to debts collection. Inefficiency comes
in when longer periods are allowed for the collection of debts owed by debtors. Since there are
365 days in a civil year, the following formula should be applied in the calculation of the
debtors’ collection period:
Trade Debtors 365
Debtors’ Collection Period = x
Credit Sales 1

2. Creditors’ Payment Period

It is important to know the number of days taken by the enterprise to pay the amount owed
to the creditors. An enterprise that uses a longer period to pay its creditors is efficient with
respect to creditors’ payments. This is because delaying payments and keeping creditors’
money may yield interest to the enterprise. However, this may strain business relationship.
Inefficiency comes in when shorter periods are used for the payments of creditors. Since there
are 365 days in a civil year, the following formula should be used in the calculation of the
creditors’ payment period:
Trade Creditors 365
Creditors’ Payment Period = x
Credit Purchases 1
3. Stock Turnover Ratio
This ratio indicates the number of time a batch of goods is completely sold and replaced
within a year. An enterprise is efficient when the stock turnover is relatively high. The stock
turnover ratio is expressed as follows:
Cost of Goods Sold
Stock Turnover = , Where Average Stock =
Average Stock
Opening Stock + Closing Stock
2

4. CAPITAL STRUCTURE
The capital structure of every enterprise is made up of owned capital and borrowed capital.
The borrowed capital consists of all the long term liabilities like debentures and long term loans
as well as preference share capital. The owned capital consists of ordinary share capital,
reserves, profits and even losses. The owned capital can still be called shareholders’ fund or
owners’ equity while the borrowed capital can also be called debt capital. A company is highly
geared when the proportion of debt in its capital structure is high. Capital gearing is the
relationship that exists between debt capital and owner’s equity. A company is lowly geared
when the proportion of debt capital is low with respect to equity. The gearing situation of an
enterprise is revealed by the gearing ratio which is given as:

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Debt Capital 100

Gearing Ratio = x
Equity + Debt Capital 1
Sometimes, the formula for gearing ratio is simply expressed as:

Debt Capital
Gearing Ratio =
Equity
5. SHAREHOLDERS’ INVESTMENTS
To invest in a firm, the investor may want to know whether his investment will be profitable
or not. In order to evaluate the profitability of shareholders’ investments, the following ratios
should be calculated, analysed and interpreted accordingly:

1. Dividend Yield
This ratio shows the proportion of dividend that can be yielded by a given investment and
is given as follows:
Ordinary Dividend per share
Dividend Yield =
Market Price per share
2. Dividend Cover

A high dividend cover shows a low dividend yield due to reinvestment of profits. This ratio
shows the rate at which the net profit to ordinary shareholders covers the dividend per ordinary
share. It is given mathematically as follows:

Net Profit (excluding interest and preference dividend)

Dividend cover =
Ordinary Dividend per share
Dividend per share should not be confused with dividend cover. It is important to note that
another name for dividend per share is earning per share.

3. Earnings per Share

This ratio shows the amount of profit to be paid as dividend per ordinary share. The ratio
relates equity earnings to the number of ordinary shares issued and is calculated as follows:

Net Profit (excluding interest and preference dividend)

Earnings per Share =
Number of Ordinary Shares Issued
4. Price/Earning Ratio

Ones the earning per share ratio is known, one may be interested in calculating the
price/earning ratio which shows the relationship between the market price of an ordinary share
and the earning per ordinary share. This ratio is expressed as follows:

Market Price per share

Price/Earning Ratio =
Earning per share

Though ratios are very necessary for the interpretation of financial statements, it is not
advisable to rely solely on ratios when making decisions based on the financial statements.

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This is because ratios have a number of limitations or weaknesses and can, sometimes, be
misleading.

Example 1
The profit and loss accounts and balance sheets of two manufacturing companies are shown
below: The Nominal value is 10,000 FCFA for the two companies.

Profit and Loss Account for the year ended 31st December 2018

SAM Ltd SON Plc

FCFA FCFA FCFA FCFA
Sales 150,000 700,000
Cost of Goods Sold 60,000 210,000
Gross Profit 90,000 490,000
Selling Expenses 13,500 84,000
Administrative Expenses 15,000 28,500 35,000 119,000
Net Profit 61,500 371,000
Taxation 16,605 100,170
Net Profit after taxation 44,895 270,830
Dividend 20,000 110,000
Retained Profit for the period 24,895 160,830
Retained profit brought forward 26,500 230,000
51,395 390,830

Balance Sheet as at 31st December 2018

SAM Ltd SON Plc
FCFA FCFA FCFA FCFA
Fixed Assets:
Building - 500,000
Machinery 190,000 280,000
190,000 780,000
Current Assets:
Stock 12,000 26,250
Debtors 37,500 105,000
Bank 500 22,000
50,000 153,250
Current Liabilities:
Creditors 22,605 27,395 117,670 35,580
217,395 815,580
Financed by:
Share Capital 100,000 400,000
Debenture 66,000 24,750
Profit and Loss 51,395 390,830
217,395 815,580
Note: The market value of a share is 12,000 FCFA and 15,000 FCFA for SAM ltd and SON Plc
respectively. The amount of stock is constant throughout the year for both companies. Both companies
made most of their sales on credit.

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Required: Compare these two companies in terms of their profitability, solvency, efficiency,
investment and capital structure.

Example 2
You have been provided with the balance sheet of MBANGE Plc as at 31/12/2013:
000 CFAF 000 CFAF 000CFAF
Fixed Assets:
Land and Building 340,000
Machinery and equipment 122,020 462,020
Current Assets:
Stock 60,000
Debtors 70,000
Bank 34,580 164,580
Current Liabilities:
Creditors 121,600
Dividend 5,000 (126,600)
Working Capital 37,980
Capital Employed 500,000
Financed by:
Equity:
Ordinary Share Capital 300,000
Reserves 80,000
Profit retained 20,000 400,000
Long-term liability:
Debenture 100,000
Capital Employed 500,000
Additional Information:
- Net profit for the year 70,000,000 CFAF
- Sales and purchases amount to 350,000,000 CFAF and 180,000,000 CFAF
respectively though all sales were made on credit basis.
- Opening stock is equal to closing stock
- The year has 365 days
Required:
a) Calculate the following ratios for the company:
i) Net profit to sales
ii) Return on capital employed
iii) Stock turnover
iv) Debtors’ collection period
v) Current ratio
vi) Dearing ratio
b) State three reasons why it is not recommended to rely exclusively on ratios.m