Ppt+4+Ratio Analysis

8/8/2019 Ppt+4+Ratio Analysis

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Learning Outcome State the functions of accounting ratios

Calculate a range of ratios Draw logical conclusion from the ratios

State the limitations associated with ratio

analysis


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Uses of accounting ratios

Enable comparison of the performance of

the company

- in different years

- with its budgets and forecasts

- with other companies in similar trades


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Uses of accounting ratios

Provide information of the company in respect of

the liquidity, profitability, use of assets and capital

structure Eliminate the effects of the scale and size of

different companies or different years of the same

company so comparison can be provided.

Appraise the performance of the company, make

predictions for future performance and assist in

future planning


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Accounting ratios and

interpretation Liquidity

- current ratio / working capital ratio

- acid test ratio / quick ratio / liquid ratio

- stock turnover rate

- stock turnover period - debtors collection period

- creditors payment period


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Liquidity Liquidity is a measure of the amount of

funds a company can quickly use to settle

its debts.


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Liquidity current ratio This ratio indicates the ability of a business to

meet its short-term liabilities from its current

assets. The norm is 2:1.

If the ratio is too high, the company may beholding too many idle short-term assets. (They

may be used in a more profitable way.) If the ratio is too low, the company may not have

sufficient funds to meet its short-term liabilities.


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Liquidity acid test ratio This ratio indicates the ability of the business to

meet its short-term liabilities from its quick assets.

The norm is 1:1.

If the ratio is too high, the company may be

holding excessive liquid assets.

If the ratio is too low, the company may have aliquidity problem / cash flow problem.


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Liquidity stock turnover rate It shows the number of times that a business

can sell its average stock in a period.

A high ratio means high sales, fast stock

turnover and a low stock level.

A low ratio means low sales, low stock

turnover and a high stock level. (goods may

become obsolete, high storage cost)


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Liquidity debtors collection

period This ratio measures the debt collection

period of a business.

A low ratio means debtors pay back their

debts in a short period of time. The

company may have sufficient liquid fund.

A high ratio indicates a poor credit control

and a high risk of bad debts.


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Liquidity creditors payment

period This shows the length of time taken to pay

the creditors.

A long payment period may indicate that

the company has a liquidity problem. The

relationship between the company and the

suppliers may be affected.


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Accounting ratio and

interpretation Profitability

- gross profit ratio / gross margin / profit to

sales ratio

- net profit ratio / net profit margin

- return on capital employed

- assets turnover


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Profitability gross profit ratio It shows the gross profit on sales.

A low ratio means the stock is being sold at

lower prices. It may be a policy to stimulate

sales.

A high ratio may not result in high gross

profit figure unless a large volume of salesis achieved.


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Profitability net profit ratio It shows the net profit as a percentage of

sales.

It gives some ideas of the companys

pricing policy and cost control.

A low ratio may be the result of lower

selling prices or higher operating costs.


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Profitability return on capital

employed This ratio shows the profitability of a

business and the management effectiveness

in terms of the use of capital.

A higher ratio means a higher profitability

and a better management efficiency.


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Capital employed (Sole trader) Closing capital

Average capital

Capital balance + long term loans


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Capital employed (Partnership) Closing balance on fluctuating capital accounts

Average of opening and closing balances on the

fluctuating capital accounts Total of fixed capital accounts plus total of current

accounts

Average of fixed capital accounts plus total of

current accounts Any of the above plus long term loans to the

partnership


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Capital employed

(Limited company) - total assets

- long term suppliers of capital (ordinary

shares + preference shares + reserves +long-term loans)

- shareholders capital (ordinary shares +

preference shares + reserves) - shareholders equity (ordinary shares +

reserves)


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Return

Net profit after tax and preference share

dividends (for ordinary shareholders)

Net profit after tax + any preference share

dividends + debenture and long-term loan

interest (for all long-term suppliers of

capital)


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Profitability assets turnover This indicates the efficiency of the business

in using its assets to generate revenues.

A higher ratio means the company is more

efficient to use its assets to generate

revenues. This results in higher profitability.


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interpretation Management efficiency

- stock turnover rate

- debtors ratio

- creditors ratio

- assets turnover


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Management efficiency Stock turnover rate measures the efficiency of

sales and stock levels of a company.

Debtors ratio indicates the credit control of thecompany. (lenient credit control?)

Creditors ratio indicates the ability of the company

to obtain long-term financing.

Assets turnover shows the efficiency of the

business in using its assets to generate revenues.


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interpretation Long-term solvency and stability

- debt ratio

- gearing ratio


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DebtR

atio Debt ratio

Total debts

= ---------------------- X 100%

Total assets


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Long-term solvency debt ratio Debt ratio shows the total amount of

liabilities to total assets.

If the debt ratio is too high (more than 50%),

it is difficult to obtain further financing and

it also has a heavy burden of interest

expense.


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Gearing ratio

Gearing ratio

Prior charge capital

= --------------------------------------- X 100%

Total capital

Prior charge capital = preference shares + long

term loans Total capital = ordinary share capital + reserves +

preference shares + long term loans


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Long-term solvency gearing

ratio It is concerned with the companys long-term

capital structure.

A high gearing ratio indicates a high portion offunds is obtained from borrowings. It may lead tolong-term insolvency. It is difficult to obtainfurther financing and has to bear a high interest

burden.

Ordinary shareholders may not get any dividendsin bad times as very little profit is left over forthem


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Gearing ratio (P.

648 P.

649)

High geared company

Investment is more

risky

Larger dividends will

be available in good

times

Low geared company

The risk of investment

is relatively lower

It is more certain to

have dividends.


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Changing the gearing To reduce gearing

By issuing new

ordinary shares

By redeeming

debentures

By retaining profits

To increase gearing

By issuing debentures

By buying back

ordinary shares in

issue

By issuing newpreference shares


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Accounting ratio and

interpretation Investment appraisal

- earnings per share

- price earning ratio

- dividend cover

- dividend yield


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Earnings per share Earnings per share (EPS)

Net profit after tax and preference dividends

= ------------------------------------------------------

No. of ordinary shares issued

(ranked for dividends)


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Investment appraisal earning

per share It shows the profit in dollars associated with

each ordinary share.

A higher earnings per share indicates the

investors may have higher confidence in the

company. It is more profitable to invest in

the shares.


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Price / earning ratio Price / earning ratio

Market price per share

= -----------------------------------------

Earnings per share


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Investment appraisal price

earning ratio This ratio indicates the number of years

required to earn the amount invested in the

shares.

A high ratio indicates investors have strong

confidence in the company.

An unreasonably high ratio may be theresult of speculation in the stock market.


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Dividend cover Dividend cover

Net profit after tax and preference dividends

= -------------------------------------------------------

Ordinary dividends paid and proposed


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Investment appraisal dividend

cover It shows the amount of profit that has been

distributed as dividends.

A low ratio means a large amount of profits hasbeen retained as reserves which can help to

finance the operations of the company.

A high ratio means a large amount of profits has

been distributed as dividends. The dividend

payment is vulnerable unless the company

becomes more profitable.


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Dividend yield Dividend yield

Dividend per share for the year

= -------------------------------------------- X 100%

Current market price of the share


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Investment appraisal dividend

yield This ratio measures the rate of return

obtained from dividends on an investment

in shares.

A high dividend yield may imply the

company is more successful and efficient. It

is more profitable to invest in these shares.


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Other ratios (P.649

) The company will be able to pay interest on the

loan when it falls due. (short-term liquidity)

- current ratio and acid test ratio It will be able to repay the loan on maturity. (long-

term solvency)

- operating profit / loan interest

- total external liabilities

- shareholders fund / total assets


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Examples of interested group

(P.641) Profitability

- shareholders

- management

- employees

- creditors

- competitors

- potential investors


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Examples of interested group Liquidity

- shareholders

- suppliers

- creditors

- competitors


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Examples of interested group Management efficiency

- shareholders

- potential purchasers

- competitors


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Examples of interested group Investment appraisal

- shareholders



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Examples of interested group Capital structure

- shareholders

- lenders

- creditors



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Limitations of ratio analysis Different definitions of capital employed

may cause confusion.

Changes in price level will affect the

comparability of the ratios between two

financial periods.

Changes in external environment will affectthe comparison.


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Limitations of ratio analysis Differences in management and background of

various businesses may affect the comparison.

Different accounting definitions, methods,techniques and policies used by various businesses

may affect the comparability.

It is difficult to set up a proper standard for good

performance.

Short term fluctuations may not be reflected.

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Ppt+4+Ratio Analysis

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