Module 3

Ratio Analysis

How to analyze accounts?

 A review of amounts already included in the financial statements, and
 Further manipulation of amounts in the financial statements, using ratio analysis

Comparing results:
Comparison may be with:
 The previous year’s results of the same company or group (vertical analysis)
 The results of an equivalent company or group in the same period (horizontal analysis)
 Industry average
Considering the audience:
 Analysis of accounts should also take into consideration why analysis is being performed,
and for whom
 An investor- profits and growth, cash flows
 A bank-whether company has funds to repay the debts
 Employees-long-term job stability
 Customers and suppliers-ongoing trading relationship and the health of the company
Ratio Analysis:
Ratio analysis involves taking two or more balances from the financial statements and
manipulating them to reveal the relationship between them. This provides an indication of
performance and position in addition to that evident in financial statements.
Ratios:
Performance  Gross Profit margin
 Operating profit margin
 Net profit margin
 Asset turnover
 ROCE
Liquidity  Current ratio
 Quick (acid test) ratio
Efficiency  Receivable days
 Inventory days
 Inventory turnover
 Payable days
Solvency  Gearing
 Interest cover
Investor  Earnings per share
 P/E ratio
 Dividend yield
 Dividend cover

1. Performance ratios:
Also known as profitability ratios. They are of interest to most of the users.
Profit margins:
a. Gross Profit margin = Gross Profit X 100%
Revenue
 b. Operating profit margin = PBIT X 100%
Revenue
c. Net profit margin =
Profit of the year X 100%
Revenue
d. Asset Turnover = Revenue
Net Assets
e. ROCE = PBIT X 100%
Capital employed (equity
+ debt)
Sum 1: Extracts from
the financial statements of Highbury, a commercial baker for the years ended 31 October
20X7 and 20X8 are as follows:
20X7 20X8
$ $
Revenue 3,400 3,620
Cost of sales (1,200) (1,420)
Gross Profit 2,200 2,200
PBIT 1,150 1,300
Share Capital 100 100
Retained earnings 2,300 3,150
Revaluation reserve - 500
2,400 3,750
There is no debt in Highbury’s accounts. Calculate performance ratios for Highbury and
comment on the performance in 20X8 as compared to 20X7.
2. Liquidity Ratios:
Concerned with an entity’s abilities to meet its short-term obligations. They are of
interest to management.
a. Current Ratio: Determines whether a company or a group can meet its short-term
liabilities based on the realization of its current assets.
Current ratio = Current assets
Current liabilities

b. Quick (acid test)ratio:

This does not take inventory in to account when considering current assets are
calculated.

Quick ratio = Current assets-Inventory

Current liabilities

Sum 2: Shopmart, a regional supermarket, reports the following amounts in its financial
statements for the years ended 31 August 20X7 and 20X8.
20X7 20X8
$ $
 Inventory 340 365
Receivables 10 4.5
Cash 3.6 2.3
Payables 650 712
Calculate the current and quick ratios for both years and comment on them.

3. Working Capital Ratios or Efficiency Ratios:

Concerned with how well working capital is managed. They are therefore of most interest
to management.
a. Receivables’ days show how long, on average, it takes credit customers to pay. It is
calculated as,
Receivable days = Receivables X 365 days
Revenue

b. Inventory days show long, on average, inventory is held by a company before it is

sold.
Inventory days = Inventory X 365 days
Cost of sales

c. Inventory Turnover shows how many times inventory has been replaced.
ITR = Cost of sales
Inventory

d. Payable days show how long, on average, it takes a company to pay its credit
suppliers.
Payable days = Payables X 365 days
Cost of sales

4. Solvency Ratios:
Solvency ratios are concerned with a company’s long-term financial stability. They are of
interest to investors and management.
a. Gearing- assesses how a company is financed through debt or equity.
Gearing Ratio = Debt X 100
Debt+Equity

OR
Gearing Ratio = Debt X 100
Equity

b. Interest cover is linked with gearing in that it assesses a company or group’s ability to
absorb more debt. It is calculated as
Interest Cover = Profit before interest and tax
Interest
5. Investor Ratios:
These ratios are relevant to existing and potential shareholders. The management of a
company are also interested in these ratios from the point of view of monitoring them due
to their prominence with investors.

a. Earnings per share (EPS) is an important profitability indicator which is published for all
listed entities.
EPS = Profit
No of shares

b. P/E Ratio is an indicator of the market’s confidence in a company or group.

P/E ratio = Market price of share
EPS

c. Dividend yield shows the dividend pers share in relation to the share price.
Dividend yield = Dividend per share X 100
Share price

d. Dividend Cover assesses a company or group’s ability to pay its dividend out of profits.
Dividend cover = Profit after tax
Dividends
1. The following information has been taken from Preston’s financial statements for the
year ended 31 December 20X7:
Preston has inventory turnover of six times
The year-end receivables collection period is 42 days
Cost of sales for the year was $1,690,000
Credit purchases for the year were $2,150,000
Preston’s cash cycle at 31 December 20X7 was 68 days
All calculations should be made to the nearest full day, and the trading year has 365
days. What is Preston’s trade payables collection period as at 31 December 20X7?

2. The following extracts of the financial statements of Wiggo have been obtained:
Revenue $980,000
Cost of sales ($530,000)
Operating expenses ($210,000)
Equity $600,000
Loan, repayable 20X8 $300,000
Deferred tax $44,000 Payables $46,000
What is the return on capital employed of Wiggo?
3. The following extracts of the financial statements of Wiggo have been obtained:
20X5
Inventories $130,000
Receivables $80,000
Cash $10,000
Loan repayable 20X8 $90,000
Deferred tax $14,000
Payables $70,000
Overdraft $34,000
What is the quick ratio of Wiggo?
4. Apollo Co took out a new loan on 1st January 20X6. This loan is carrying an effective
interest rate of 8%. The initial proceeds of the loan are $2.5m, which is after paying issue
costs of $250k. The coupon rate on the loan is 6%. Apollo must keep to an interest cover
ratio of 9 times under the arrangements made with the bank.
What operating profit must be maintained by Apollo in the year ended 31st December
20X6, in order to meet the minimum interest cover ratio specified by the bank?
5. Rogers Co has just completed their financial statements for the year ended 30 June 20X6.
They are reporting a net profit of $1,250,000 for the current year, and they have $1
million 50 cent shares in issue. The current market price of Rogers' shares is $3.50.
Rogers Co has total dividends during the year ended 30 June 20X6 of $1,500,000.
What is the Price Earning (P/E) ratio of Rogers Co for the year ended 30 June 20X6?
What is the Dividend Yield of Rogers Co for the year ended 30 June 20X6?
6. Key figures from Franck’s financial statements for the year ended 30 September 20X2
are shown below:
$000
Revenue 9400
Profit from operations 1500
Share capital 15000
 Retained earnings 3000
Loans 2000
Franck has operated in the computer software industry for many years, gaining a
reputation for steady growth. It is interested in acquiring a company, Duik, who has
recently been put up for sale. Duik’s result can be seen below:
$000
Revenue 1200
Loss from operations (600)
Share capital 24000
Retained losses (1200)
Loans(owned to parent) 4000
a. Calculate Frack’s return on capital employed (based on profit from operations)
without the acquisition of Duik to one decimal place?
b. What is the combined operating margin if Franck and Duik are combined?
A company is considering several funding options for a new project. The new project may be
funded by $20m of equity or debt. Below are the financial statements given by the project it has
been funded in either manner.
Statement of financial position extract
Equity finance ($m) Debt finance ($m)
Creditors
Debentures 0.0 20.0
Capital
Share capital (50p) 22.0 14.5
Share premium 10.0 4.5
Reserves 10.0 3.0
42.0 22.0

Profit/Loss extract
$m
Turnover 200.0
Gross Profit 40.0
Expenses(excluding interest) (30.0)
Operating profit 10.0
Corporation tax is charged at 30%
Calculate profitability ratios and compare the financial performance of the company under both
equity and debt funding
 D S
Share price 200 p 80 p
EPS 10 p 8p
Dividend per share 2p 8p
Number of shares 2 million 4 million

Calculate the following ratios:

a. Dividend payout
b. Dividend cover
c. Dividend yield
d. PE ratio
Which company is seen to have a better future by the market?

20X6 20X7 20X8

Turnover $7.2 m $8.0m $7.9m
EPS 58.1c 60.2c 60.1c
DPS 24.3c 26.3c 27.6c
Closing share price $7.25 $8.85 $7.34
Return on equity 11% 9% -
Compare and contrast the financial performance of the company with expected return on equity.