7.2 Financial Ratio Analysis

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7.2 Financial Ratio Analysis

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Financial Ratio Analysis

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The process of assessing the financial performance of a business based on the relationships between key figures within the financial accounts.

Allows for more meaningful comparison of year to year performance and with competitors.

Types of ratio analysis include:

Profitability, Liquidity, Gearing, Efficiency.

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Financial Ratio

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Comparisons made between two or more figures in a set of accounts.

Allows for more meaningful comparison of year to year performance and with competitors.

Types of ratio analysis include:

Profitability, Liquidity, Gearing, Efficiency.

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Financial Statement

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Formal records that summarise a business’ financial performance, activities and worth over a specific period of time.

Financial statements produced annually or at interim points in a year include:

Balance sheet, Income statement

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Balance Sheet

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A formal financial document that summarises the net worth of a business at a given point in time.

It balances net assets with total equity.

When analysing financial accounts two important aspects are working capital and liquidity.

Interested parties will also look at payables and receivables in relation to purchases and sales respectively.

Used to calculate the gearing ratio.

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Income Statement

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A formal financial document that summarises a business’ trading activities and expenses to show whether the business has made a profit or a loss in a given period of time.

As well as the bottom line i.e. the profit or loss an income statement can also be used to analyse profit margins, profit quality and profit utilisation.

Along with a balance sheet an income statement can be used to measure and assess business performance

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Profitability

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A measure of the ability of a business to generate profits.

A key corporate and financial objective for most businesses.

Compares profit to another financial factor such as revenue or capital employed.

High sales revenues are often considered irrelevant if profit levels are low in comparison.

Measures of profitability include:

ROCE, Profit margins

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Return on Capital Employed (ROCE)

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A profitability ratio that measures how efficiently a business is using capital employed to generate profits

Calculated as: Operating profit / (Total equity + non-current liabilities) x 100

Capital employed = total equity + non-current liabilities i.e. all the money invested in the business from:

Share, Capital Reserves, and Retained Earnings long term loans

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Liquidity

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A measure of a business’ short term survival i.e. its ability to meet short term debts and day to day expenses.

One key measure of a firm’s liquidity is working capital i.e. current assets – current liabilities.

The current ratio is a liquidity ratio.

Calculated as: Current assets / Current liabilities.

Expressed as x:1

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Current Ratio

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A measure of a business’ liquidity and short term survival i.e. its ability to meet short term debts and day to day expenses

Calculated as: Current assets / Current liabilities

Expressed as x:1 i.e. For every x of Current assets the business has £1 current liabilities

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Gearing

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A measure of the proportion of a business’ capital that is funded through long term loans (debt v. equity).

Calculated by: Non-current liabilities / Total equity plus non-current liabilities x 100

Loans are compulsory interest bearing i.e. you have to pay interest on them even if profits are low or non-existent.

A highly geared firm is at greater risk if interest rates are likely to increase.

Expressed as a %.

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Efficiency Ratios

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Financial measures of how efficiently management are utilising finance and other resources within the business to generate a return.

Allows for both interfirm and intrafirm comparisons.

Measures of financial efficiency include:

Inventory turnover, Receivables days, Payables days.

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Receivable Days

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An efficiency ratio that looks at how long it takes on average for customers to pay the business for goods or services it has purchased on credit.

Calculated by: Receivables / Revenue x 365

A business may try to have a shorter receivables days to ease cash flow problems.

Expressed in number of days.

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Payable Days

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An efficiency ratio that measures how long it takes on average for the business to pay for supplies it has purchased on credit

Calculated as: Payables / Cost of goods sold x 365

A business may try to have a longer payables days ratio to ease cash flow problems or meet cash flow targets.

A short payables days may result in discounts from suppliers.

Expressed as a number of days.

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Inventory Turnover

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An efficiency ratio that measures how frequently a business turns over its inventory in a year and hence whether stock is being used efficiently to generate sales.

Calculated by: Cost of sales / Average inventory held

Average inventory held can be calculated by finding the average of inventory at the start and end of the year or alternatively if this information is not given divide cost of sales by inventory.

Will vary depending upon the nature of the firm.

Expressed as a number of times.

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Financial Data

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Quantifiable facts and figures relating to the finance function of a business

Examples of financial data include:

Cash flow, Financial ratios e.g. ROCE and gearing, Revenue, Break-even level of output.