A Basic Guide

By Deskdemon.com


A ratio is the relationship between two quantities, expressed mathematically, in the form of a fraction or a percentage.

It is the relationship between certain items in the Financial Statements. Ratios are accepted as useful aids in assessing managerial efficiency, profitability and the debt capacity of a company.

Ratios: What it tells you

Ratio analysis essentially provides indicators of past performance in terms of profitability and operational activity. It also highlights financial strengths and weaknesses concerning solvency, liquidity and capital structure.

A Ratio in itself is of very little value. Its significance increases when:

It is compared with the same ratio for a series of consecutive years.

Changes in ratios from year to year can be helpful in indicating trends

It is compared with other ratios in the same financial statements

It is compared with Industry norms (eg. By comparing ratios with another company in the same line of business)

When several ratios all point in the same direction, the trend cannot be ignored.

Ratios: Who uses them & why

All internal and external business users will use ratios.

If used correctly, ratios provide valuable information about the operations and the state of affairs of a business.

Ratios: Glossary of terms

Liquidity Ratio

This ratio measures the ability of a company to pay its current liabilities out of its current assets. The following are the 3 most widely used measures of liquidity:

Current Ratio (Working Capital Ratio)

Indicates the extent of the ability of the company to pay its current liabilities out of the proceeds of its current assets. It takes into account the length of time it takes to complete the normal operating cycle of the business.

It is calculated as follows:

Current Assets = 63,492 = Current Liabilities = 51,947 1.2:1

Meaning: For ever ?1 of Current Liabilities the company has ?1.20 Current Assets

Depending on the type of business a Current Ratio of 2:1 is regarded as satisfactory. In the event of bankruptcy and should the book value of the current assets shrink by 50% on liquidation, the current creditors may still receive full payment of their debts, provided there are no prior claims or long term creditors.

Quick Ratio (The Acid Test)

This ratio measures the ability of the company to pay its current liabilities out of immediate realisable current assets when there is an urgency to pay creditors. As Stock are the least liquid of assets, we have to exclude stock from current assets.

It is calculated as follows:

Current Assets - Stock = 63,492 - 10,214 = Current Liabilities = 51,947 1:1

Meaning: Current Assets minus Stock is referred to as Quick Assets. The company has ?1 Quick

Assets for every ?1 Current Liabilities

A Company with a Quick Ratio of more than 1:1 will pass the Acid Test as there can be no doubt that such a company will be able to meet its current obligations at short notice. However, it is not the ultimate measure, and a company with a lower ratio can still be liquid.

Solvency Ratio

This is a measure of a company's financial strength. It is determined by the extent to which a company is able to pay all its liabilities out of its Net Profit after tax. Remember that depreciation is treated as an expense, without being a true expense! Depreciation may be added on to the Net profit after tax in the income statement when calculating this ratio. This ratio is always expressed as a percentage:

It is calculated as follows:
Net Profit after Tax + Depreciation x 100
Long Term Liabilities + Current Liabilities 1
= 28 + 9,158 x 100 = 918,600 = 8.48%
56,329 + 51,947 1 108,276

Meaning: Net Profit After Taxation plus Depreciation equals Cash Flow. This company is only capable of honouring 8.48% of its total debt from its Cash Flow.

A Solvency Ratio of 20% is a good standard.

Stability Ratio
Measures the financial safety of the company. The ratio that is most widely used to establish stability is the:

Gearing Ratio (Leverage Ratio)

The Gearing Ratio measures the percentage owners funds as opposed to the percentage outside funds.

Owners funds = The amount invested into the company by owners

Outside funds = Amount borrowed from outside sources

If more capital is invested by the owners than the amount borrowed, the risk decreases. This is known as low gearing. If outside interest exceeds the owners interest, the risk increases. This is known as high gearing.

Calculation is as follows:
Long Term Liabilities + Current Liabilities

Tangible Net Worth
= 56,329 + 51,947 = 108,276 = 98.8:1

1,095 1,095

Net Worth = Owners Equity (Total amount invested in the business by the owners)

Tangible Net Worth = Net worth - Goodwill - Trademarks/Patents

Meaning: For every ?1 invested by the member this company has borrowed ?98.80p.

This company operates mainly on outside funds. Up to 3:1 is acceptable but a 1:1 ratio is preferable.

Activity Ratio
Measure activity in terms of:

Creditors Payment Period (Days)
This measures the number of days a company takes to settle the amounts they owe to creditors.
It is calculated as follows:
Creditors x 365 = 39 956 x 365 = 37 days

Purchases 397 354 1

Meaning: It will take the company an average of 37 days to pay its creditors.

Companies normally have arrangements with their creditors to settle accounts within 30, 60 or 90 days. If this period suddenly increases, it needs to be investigated as it could indicate a cashflow problem.

This ratio is only applicable when the purchase figure is available.

Debtors Collection Period (Days)

This measures the length of time it takes the debtors to pay the company for credit purchases.

It is calculated as follows:

Debtors x 365 = 45,273 x 365 = 33 days

Sales 497,682 1

Meaning: It will take debtors an average of 33 days to pay their accounts. The shorter the period, the better. Ideally this period must be shorter than the credit payment period. It is desirable to first collect money from the debtors before you have to pay your creditors. Interest could therefore be earned on the money collected before paying the creditors on due date.

Inventory Turnover Ratio (Stock Turnover Ratio)

This measures the amount of times the stock was "turned around" during the accounting period.

It is calculated as follows:

Sales = 497,682 = 49 times per year

Stock 10,214

Meaning: The stock was turned over 49 times during the accounting period.

The Inventory Turnover Ratio is an average for all stock. Some stock will move faster than others, if different lines are carried. The quicker the stock turns over, the better. We have to compare the changes from year to year to be able to interpret this ratio correctly. A fall in the ratio is a sign of overstocking, redundant stock, a drop in sales or a combination of these.

Profitability Ratios

Measures the relationship between the generation of Profit and the actual Sales (Turnover)

Gross Profit %

Measures the difference between cost price and actual selling price of goods. Commonly referred to as "Mark-up".

It is calculated as follows:

Gross Profit x 100 = 107,917 x 100 = 21.69%

Sales 1 497,526 1

Meaning: The gross profit margin on sales is 21.69%. Every ?1 spent on purchase of stock, generated 22 pence profit.

In order to find out whether or not a gross profit percentage is acceptable it must be compared with previous years figures. A deterioration is a warning signal that the situation needs to be investigated.

Net Profit %

Measures profitability after all expenses including tax.

It is calculated as follows:

Net Profit After Tax x 100 = 28 x 100 = 0.005%

Sales 1 497,526 1

Meaning: The Net Profit After Tax percentage means that a net profit of only .005 pence was generated for each ?1 of Turnover.

If this ratio deteriorates, the expenses of the company should be analysed. This ratio puts the spotlight on overheads and administrative expenses.

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