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Ratio Theory ARM

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21 views6 pages

Ratio Theory ARM

Uploaded by

Moeeg Moeeg
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Liquidity ratios:

Liquidity means having cash or access to readily available cash to settle short-term
obligations.

In ratio analysis, liquidity is measured based on:

 Cash in hand or in the bank.


 Other current assets that will soon be converted into cash. Current liabilities to
be settled immediately.

Key liquidity ratios:

 Current ratio: Ratio of current assets to current liabilities.


 Quick ratio (acid-test ratio): Ratio of current assets excluding inventory and
prepayments to current liabilities.

• Excludes prepayments as they are not available to settle obligations.

• Excludes inventory as it might take a long time to be converted into cash.

Ideal ratios:

 Suggested ideal current ratio: 2.0 times (2:1).


 Suggested ideal quick ratio: 1.0 times (1:1).
 These ideals are not universally applicable; some industries have much lower
normal ratios.

Assessing liquidity ratios:

 Consider changes in the ratio over time.


 Compare with liquidity ratios of other companies in the same period.
 Compare with industry average ratios.

Reasons for a High Current Ratio:

 Excess Inventory: Large amounts of obsolete or slow-moving inventory.


 High Receivables: Extended credit terms leading to high accounts receivable.
 Cash Reserves: Signi icant cash or bank balances.
 Low Current Liabilities: Minimal short-term debt or current obligations.

Reasons for a Low Current Ratio:

 Low Inventory: Minimal inventory due to ef icient inventory management or


quick turnover.
 High Payables: High levels of accounts payable due to extended credit terms
from suppliers.
 Short-Term Debt: Signi icant short-term borrowings or current liabilities.
 Cash Flow Issues: Insuf icient cash reserves to cover immediate obligations.
Reasons for a High Acid Test Ratio:

 High Cash Reserves: Signi icant amounts of cash or equivalents.


 High Receivables: Large accounts receivable due to extended credit terms.
 Low Current Liabilities: Minimal short-term debt or current obligations.
 Prepaid Expenses: Minimal or no prepayments, indicating most assets are
liquid.

Reasons for a Low Acid Test Ratio:

 Low Cash Reserves: Insuf icient cash or equivalents.


 High Payables: High levels of accounts payable due to extended credit terms
from suppliers.
 Short-Term Debt: Signi icant short-term borrowings or current liabilities.
 High Inventory Levels: Inventory not considered in acid test ratio, leading to
lower ratio if reliant on inventory for liquidity.

Solvency Ratios

Solvency means having enough assets to pay off the liabilities of the business in the long
term Solvency ratios include gearing ratio and interest coverage ratio.

Gearing Ratio (Leverage)

 Measures the total long-term debt of a company as a percentage of either:


o The equity capital in the company, or
o The total capital of the company
 A company is high-geared or highly leveraged when its debt capital exceeds its
equity capital.
o High geared if:
 Gearing ratio (long-term debts / total capital employed) > 50%
 Gearing ratio (long-term debts/equity capital) > 100%

Implications of High Gearing

 The entity has a high level of debt, which may make it dif icult to borrow more
when new capital is needed.
 Indicates a risk that the entity may be unable to meet its payment obligations to
lenders when due.

Monitoring and Comparison

 The gearing ratio can be used to monitor changes in the amount of debt over
time.
 Allows for comparisons with the gearing levels of similar companies to judge if
the company has too much or too little debt in its capital structure.
Interest Coverage Ratio

 A debt and pro itability ratio used to determine how easily a company can pay
interest on its outstanding debt.
 Calculated by dividing the company's pro it before interest and taxes (PBIT) by
its interest expense during a given period, expressed in number of times.

Return on Capital Employed (ROCE)

This ratio measures pro it before interest and tax as a percentage of capital employed in
the business.

Calculation of ROCE

 Take pro it before interest and tax


 Capital Employed: Includes share capital and reserves, plus long-term debt capital
such as bank loans, bonds, and loan stock.
 Use the average capital employed during the year (average of the capital employed at
the beginning and end of the year).

Signi icance of ROCE

 A higher ROCE indicates more ef icient use of capital.


 ROCE should be higher than the company's capital cost; otherwise, it indicates
that the company is not employing its capital effectively and is not generating
shareholder value.

Factors Affecting ROCE

 Pro itability of Goods/Services Sold: Measured by the pro it to sales ratio.


 Volume of Sales Achieved: Measured by the asset turnover ratio.

Utility of ROCE

 Useful for comparing pro itability across competing entities based on the amount
of capital they use.
 More useful when comparing capital-intensive entities.
 For a single company, the ROCE trend over the years is a signi icant performance
indicator.
 Investors are more inclined to invest in companies with stable and rising ROCE
igures compared to those with volatile and inconsistent ROCE.
Return on Equity (ROE)

This ratio is also called return on shareholders' capital (ROSC) and return on investment
(ROI).

Purpose

 Measures the return on investment that the shareholders of the company have
mad

Calculation

 Uses the values of the shareholders' equity as shown in the statement of inancial
position (rather than market values of the shares).
 The average value of equity should be used if possible, which is the average of the
equity at the beginning and the end of the year.
 Pro it after tax and preference dividend is used as this is the amount attributable
to equity shareholders.

A good ROE is the indicator of effective management of equity inancing.

Return on Assets (ROA)

De inition

 A pro itability ratio that measures the return produced by the total assets of a
company.

Calculation

 Normally uses pro it before interest and tax and 'total assets,' which includes
both current and non-current assets.
 Other variations may use non-current assets only.

Purpose and Utility

 Helps management and investors assess how well the entity converts its
investment in assets into pro its.
 Figures of ROA depend highly on the industry and can vary substantially.

Best Practices for Comparison

 Compare against the company's previous ROA igures.


 Compare against the ROA of a company in a similar business line.

Dangers

Use of non-current asset in denominator is risky.

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