RATIO ANALYSIS

D E LV I N G D E E P E R I N T O F I N A N C I A L S TAT E M E N T A N A LY S I S

Ratio analysis: an examination of accounting data through the comparison of two figures.

• One piece of financial information might be misleading.

  Profit before tax (R million) 2013 - 2014

Adidas 

 44,051

 Nike 

 54,100

Which company

appears to have

performed

better? 

  Profit before tax

(R million) 2013 - 2014

Sales (R million)

2013 - 2014

Profit as a percentage

of sales

Adidas 

 44,051

 271,414

 

 Nike 

 54,100

 787,100

 

Now which company

appears to be more

successful?  

1. THE CURRENT RATIO

Indicates short term liquidity position by comparing current assets and current liabilities.

Liquidity: refers to how easily an asset can be turned into cash – the easier, the more liquid.• Poor liquidity can lead to liquidation.

Liquidity can be improved by…• decreasing stock levels• speeding up the collection of receivables (debtors) • slowing down payments to payables (creditors)

Formula: 

2013 2014Working out and answer:      

 

Current Ratio Formula: current assets : current liabilities

Answer expressed as “x : 1”.

• A current ratio of between 1.5 – 2 : 1 is considered the ‘ideal’ ratio.

  • A low current ratio (less than 1 : 1) suggests business not well

placed to pay its debts.  W.r.t the current ratio, is bigger necessarily better?• NO!!!• High current ratio (above 2 : 1) represents a significant opportunity cost. • Current assets do not make the business lots of money, non-

current assets (the money makers!) do.  

2. GEARING RATIO

Gearing: compares the amount of capital raised by selling shares with the amount raised through long-term loans.

• Focuses on long term financial stability of a business.  • High level of borrowing (gearing) = high risk to a business.

– payment of interest and repayment of debts are not "optional" as dividends are.

 • Cannot pay dividends from a loss• Must pay back long-term loans with interest even if a loss is made.

Formula for calculating gearing is… 

non-current liabilities x 100total equity + non-current liabilities 1  The answer is expressed as a percentage.

Formula: 

2013 2014Working out and answer:      

 

Work out the gearing ratio for Pick ‘n Pay for the years 2013 and 2014…

Gearing ratio > 50% = “highly geared”. • Risk of defaulting on loans during periods of low profit • Heavily affected by changing interest rates.  Gearing ratio < 25% = “low gearing”. • Consider borrowing more money to grow the company. • Only if proposed investment gains > interest on the

borrowed money. Gearing ratio between 25% ‐ 50% = “normal”.

When is a high gearing acceptable?• When long‐term debt is relatively cheap due to low

interest rates.– In this case, increase long term loans and reduce

shareholders – less profits given through dividends• A well-established business producing reliable cash

flows.

Arguments for reducing and raising gearing

3. RETURN ON CAPITAL EMPLOYED (“ROCE”)Shows what returns (profits) business has made on the resources available to it. ROCE is calculated using this formula…

operating profit x 100 total equity + non-current liabilities 1

The answer is expressed as a percentage.

Formula: 

2013 2014Working out and answer:      

 

Work out the ROCE for Pick ‘n Pay for the years 2013 and 2014…

With ROCE, the higher the better.   To improve its ROCE a business can try to do two things…• Improve the top line (i.e. increase operating profit)

without a corresponding increase in capital employed• Maintain operating profit but reduce the value of total equity and non-current liabilities.

4. DIVIDEND PER SHARE

Dividend / share: shows the value of the total dividend per issued share for the financial year.

The formula for dividend per share is… total dividends

number of issued ordinary shares

The answer is expressed in cents/share

Formula: 

2013 2014Working out and answer:      

 

Let’s assume that Pick ‘n Pay paid out the following dividends…2013: R460,0002014: R240,000In both years, there were 500,000 shares issued

Work out the dividend per share for Pick ‘n Pay for the years 2013 and 2014…

The dividend/share ratio lacks context. We don’t know, for example…• Price of the shares – i.e. good/bad return on

investment?• How much profit for the year was distributed as a

dividend.

5. DIVIDEND YIELD

Dividend yield: expresses dividend / share as a percentage of the current market price. Indicates rate of return on investment.  The formula for dividend yield is…  ordinary share dividend (in cents) x 100 current market price (in cents) 1 The answer is expressed as a percentage.

Formula: 

2013 2014Working out and answer:      

 

To illustrate the calculation, consider this information…The average share price for 1 ordinary share of the company on the Stock Exchange during those financial years was 1415c (2013) and 1067c (2014)

Work out the dividend yield for Pick ‘n Pay for the years 2013 and 2014…

What is a good dividend yield?• Compare with current interest rates that you could

have received from saving your money in a bank account.

• Should be significantly higher to account for higher risk of buying shares.