Main Financial Ratios

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Main Financial Ratios

Author: Jim Riley Last updated: Sunday 23 September, 2012

Main ratios ( introduction)

In our introduction to interpreting financial information we identified five main areas for investigation ofaccounting information. The use of ratio analysis in each of these areas is introduced below:

Profitability Ratios

These ratios tell us whether a business is making profits - and if so whether at an acceptable rate. The keyratios are:

Ratio Calculation Comments

Gross ProfitMargin

[Gross Profit /Revenue] x 100(expressed as apercentage

This ratio tells us something about the business's abilityconsistently to control its production costs or to manage themargins its makes on products its buys and sells. Whilstsales value and volumes may move up and downsignificantly, the gross profit margin is usually quite stable(in percentage terms). However, a small increase (ordecrease) in profit margin, however caused can produce asubstantial change in overall profits.

OperatingProfit Margin

[Operating Profit /Revenue] x 100(expressed as apercentage)

Assuming a constant gross profit margin, the operatingprofit margin tells us something about a company's ability tocontrol its other operating costs or overheads.

Return oncapitalemployed("ROCE")

Net profit beforetax, interest anddividends ("EBIT") /total assets (or totalassets less currentliabilities

ROCE is sometimes referred to as the "primary ratio"; it tellsus what returns management has made on the resourcesmade available to them before making any distribution ofthose returns.

Efficiency ratios

These ratios give us an insight into how efficiently the business is employing those resources invested infixed assets and working capital.


Sales /CapitalEmployed

Sales / Capitalemployed

A measure of total asset utilisation. Helps to answer thequestion - what sales are being generated by each pound'sworth of assets invested in the business. Note, whencombined with the return on sales (see above) it generatesthe primary ratio - ROCE.

Sales or Profit/ Fixed Assets

Sales or profit /Fixed Assets

This ratio is about fixed asset capacity. A reducing sales orprofit being generated from each pound invested in fixedassets may indicate overcapacity or poorer-performingequipment.

StockTurnover

Cost of Sales /Average Stock Value

Stock turnover helps answer questions such as "have we gottoo much money tied up in inventory"?. An increasing stockturnover figure or one which is much larger than the"average" for an industry, may indicate poor stockmanagement.

Credit Given /"Debtor Days"

(Trade debtors(average, if possible)/ (Sales)) x 365

The "debtor days" ratio indicates whether debtors are beingallowed excessive credit. A high figure (more than theindustry average) may suggest general problems with debtcollection or the financial position of major customers.

Credit taken /"CreditorDays"

((Trade creditors +accruals) / (cost ofsales + otherpurchases)) x 365

A similar calculation to that for debtors, giving an insight intowhether a business is taking full advantage of trade creditavailable to it.

Liquidity Ratios

Liquidity ratios indicate how capable a business is of meeting its short-term obligations as they fall due:

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Liquidity ratios indicate how capable a business is of meeting its short-term obligations as they fall due:


CurrentRatio

Current Assets /Current Liabilities

A simple measure that estimates whether the business canpay debts due within one year from assets that it expects toturn into cash within that year. A ratio of less than one isoften a cause for concern, particularly if it persists for anylength of time.

Quick Ratio(or "AcidTest"

Cash and near cash(short-terminvestments + tradedebtors)

Not all assets can be turned into cash quickly or easily. Some- notably raw materials and other stocks - must first beturned into final product, then sold and the cash collectedfrom debtors. The Quick Ratio therefore adjusts the CurrentRatio to eliminate all assets that are not already in cash (or"near-cash") form. Once again, a ratio of less than onewould start to send out danger signals.

Stability Ratios

These ratios concentrate on the long-term health of a business - particularly the effect of thecapital/finance structure on the business:


Gearing Borrowing (all long-term debts + normaloverdraft) / NetAssets (orShareholders' Funds)

Gearing (otherwise known as "leverage") measures theproportion of assets invested in a business that arefinanced by borrowing. In theory, the higher the level ofborrowing (gearing) the higher are the risks to a business,since the payment of interest and repayment of debts arenot "optional" in the same way as dividends. However,gearing can be a financially sound part of a business'scapital structure particularly if the business has strong,predictable cash flows.

Interestcover

Operating profitbefore interest /Interest

This measures the ability of the business to "service" itsdebt. Are profits sufficient to be able to pay interest andother finance costs?

Investor Ratios

There are several ratios commonly used by investors to assess the performance of a business as aninvestment:


Earningsper share("EPS")

Earnings (profits)attributable toordinary shareholders/ Weighted averageordinary shares inissue during the year

A requirement of the London Stock Exchange - animportant ratio. EPS measures the overall profit generatedfor each share in existence over a particular period.

Price-EarningsRatio ("P/ERatio")

Market price of share /Earnings per Share

At any time, the P/E ratio is an indication of how highly themarket "rates" or "values" a business. A P/E ratio is bestviewed in the context of a sector or market average to get afeel for relative value and stock market pricing.

DividendYield

(Latest dividend perordinary share /current market priceof share) x 100

This is known as the "payout ratio". It provides a guide as tothe ability of a business to maintain a dividend payment. Italso measures the proportion of earnings that are beingretained by the business rather than distributed asdividends.

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