Chapter 23 Ratio Analysis

1.
1.1 1.2 1.3

Objectives
Explain the objectives of ratio analysis. Discuss the used of financial ratios. Calculate and interpret the following categories of accounting ratios: i! li"uidity ratios ! ii! profitability ratios ! iii! #anage#ent efficiency ratios ! iv! capital structure ratios ! v! invest#ent ratios ! Discuss the li#itations of ratio analysis. &pply ratios in cross'sectional co#parison and trend analysis. Explain the significance of and reasons for changes in ratios over ti#e or differences in ratios a#ong different co#panies. Co##ent on a co#pany*s perfor#ance in ter#s of: i! profitability ii! asset #anage#ent iii! financial #anage#ent iv! li"uidity v! cost control
2 b j e c ti v e s

1.$ 1.% 1.( 1.)

1 ses of , a tio & n a ly s is

+ i " u id ity , a ti o s

- r o fi ta b i l i ty , a tio s

. anage# ent E ffic ie n c y , a ti o s

C a p i ta l / tr u c tu r e , a ti o s

0n v e s t# e n t , a tio s

0n te r p r e ta ti o n o f , a ti o s

+ i # i ta ti o n s

2.

Objectives of Ratio Analysis

323'1

2.1

2.2

4o evaluate a co#pany*s financial position and perfor#ance5 we co##only apply ratio analysis to co#pare financial ratios derived fro# its financial state#ents and financial state#ents of other co#panies. 4hrough evaluating a co#pany*s past financial position and perfor#ance with ratio analysis5 we #ay be in a better position to forecast its future. 2nce ratios are calculated5 co#parisons can be #ade with: i! trend analysis 6 how an organisation*s perfor#ance co#pares with that of previous years7 and ii! cross'sectional co#parison 6 how its perfor#ance co#pares with that of other organi8ations operating within the sa#e sector or with industry averages at the sa#e point in ti#e.

3.
3.1

Uses of Financial Ratios

,atio analysis is applied to evaluate a co#pany*s financial position and perfor#ance in the following areas: i! +i"uidity ratios7 ii! profitability ratios7 iii! #anage#ent efficiency ratios7 iv! capital structure ratios7 and v! invest#ent ratios. Liquidity ratios 2f crucial i#portance to any organi8ation is its ability to #eet day to day debts as they fall due. 0t is not unco##on for a business which on paper! is #a9ing a profit5 to experience sever li"uidity proble#s and there are two co##only used ratios which highlight such a situation. Current ratio ()

(A) 3.2

(a) 3.3

Current ratio :

Current &ssets Current +iabilities

3.$

4he current ratio #easures the relationship between an organisation*s current assets

323'2

3.%

and its current liabilities. ;or exa#ple5 if an organisation*s balance sheet shows current assets of <=>5>>> and current liabilities of <3>5>>>5 the current ratio is 3:1 <=>5>>>?<3>5>>>!. 4his #eans that for every <1 of current liabilities the organi8ation has <3 of current assets. 4here is no standard or reco##ended current ratio since it will vary depending upon the sector in which an organi8ation operates. ;or exa#ple5 fast food outlets such as .cDonalds >.%:1!5 or football club such as 4ottenha# @otspur >.1):1! will be able to operate with a relatively low current ratio. 4his is due to the nature of their business which entails low levels of stoc95 debtors and an abundance of cash rather than credit sales. 0n such organi8ations cash flow and hence li"uidity will not nor#ally be a proble# and a relatively low current ratio will suffice. Acid test (quick) ratio ()

(b) 3.(

Auic9 ratio :

Current assets 6 stoc9 Current +iabilities

3.)

4he acid test ignores stoc95 and concentrates upon those assets which can i##ediately be turned cash if li"uidity proble#s do occur. Continuing the above exa#ple5 if stoc9s co#prise <$%5>>> of the organisation*s current assets5 its acid test ratio will be: <=>5>>> 6 <$%5>>> : 1.%:1 <3>5>>>

3.B

3.=

0n the event of sever li"uidity difficulties an organi8ation can encourage debtors to pay #ore "uic9ly5 whilst short ter# invest#ents can very "uic9ly be sold and converted into cash. @owever5 stoc9 can ta9e longer to convert to cash5 especially if it is of a specialist nature5 and it is5 therefore5 excluded fro# current assets when calculating the acid test ratio. & current or acid test ratio which is significantly different to that of other organi8ations operating within the sa#e sector #ight indicate a nu#ber of proble#s and should be investigated further: i! ratios which are significantly lower than those of other organi8ations operating within the sa#e sector #ight i#ply that an organi8ation is too dependent upon short ter# borrowings for the funding of its day to day operations.

323'3

ii!

;or exa#ple5 an organi8ation which has excessively high levels of trade creditors5 short'ter# loans and a ban9 overdraft5 #ay be forced to cease trading if any of these sources of finance is suddenly withdrawn7 whilst significantly high current and acid test ratios indicate that cash flow is not a proble#5 they #ight suggest that an organi8ation is not using its resources as efficiently as it could be5 resulting in a lower than expected rate of return which will not please existing or potential shareholders.

3.1>

;or exa#ple5 a high ratio #ight be due to excessive stoc9 levels indicating the need for an i#proved syste# of stoc9 control. &lternatively5 the level of debtors #ight be too high5 suggesting the need for an i#proved credit control policy to ensure that credit custo#ers pay pro#ptly and that had debts are #ini#i8ed. Chilst consistently high cash and ban9 balances could be invested elsewhere to earn a higher return. +i"uidity ratios are of crucial i#portance. &n organi8ation that is too dependent upon short'ter# borrowings or which cannot #eet its debts as they fall due is unli9ely to be able to continue its business for too long. Profitability ratios 2n their own the a#ounts stated for gross and net profit do not convey a great deal of infor#ation to the user of a set of accounts. 4heir usefulness #ay be greatly enhanced by expressing each as a percentage of sales5 allowing co#parison with previous year*s and other organi8ations operating within the sa#e sector5 as well as providing an indication of how well an organi8ation controls its costs. 4here are two types of profitability ratios5 those showing profitability in relation to sales and those showing profitability in relation to capital e#ployed. Profitability in relation to sales Dross profit #argin ! i! Dross -rofit .argin : Dross profit /ales x 1>>E

(B) 3.11

3.12

(a) 3.13

3.1$

4he gross profit #argin expresses the gross profit as a percentage of total sales. ;or exa#ple5 if our organi8ation #a9es a gross profit of <1%>5>>> on sales of <2%>5>>>5 its

323'$

3.1%

3.1(

gross #argin will be (>E. 0n other words for every <1>> of sales the organi8ation is #a9ing a gross profit of <(>. & significant decrease in the gross #argin between accounting periods #ight be due to a nu#ber of factors including: i! an increase in the cost of raw #aterials5 which it has not been possible to pass onto custo#ers in the for# of higher prices7 ii! an increase in co#petition in the #ar9et5 resulting in lower prices and s#aller gross profit #argins7 iii! a change in the product #ix5 with the business selling a higher proportion of goods with a lower gross profit #argin. 3et profit #argin ! ii! 3et -rofit .argin : -rofit before interest and tax x 1>>E /ales

3.1)

3.1B

3.1=

3.2>

4he net profit #argin expresses an organisation*s net profit as a percentage of total sales. 4hus5 if we #a9e a net profit of <2%5>>> on sales of <2%>5>>>5 our net profit #argin is 1>E. & significant decrease in the net profit #argin which is not acco#panied by a si#ilar change in the gross profit #argin5 #ight indicate that an organi8ation needs to i#prove control of its expenses. ;or exa#ple5 it #ight be that wages have increased significantly necessitating a review of the level of overti#e pay#ents and the grade and nu#bers of staff e#ployed. 4he opti#al gross and net profit percentage ratios will vary fro# industry to industry. Chat is of particular i#portance is that an organi8ation reviews trends in its gross and net profit #argin over ti#e and investigates any significant changes. Profitability in relation to capital employed 4ypes of ratios i! ,eturn on 4otal &ssets ! : -rofit before interest and tax x 1>>E 4otal assets

(b) 3.21

4otal assets represent the total sources of finance5 i.e. owner*s e"uity5 long ter# liabilities and current liabilities.

323'%

ii! ,eturn on Capital E#ployed ! ,2CE! : iii! ,eturn on /hareholders* Capital ,2/C! : 3.22

-rofit before interest and tax x 1>>E Capital e#ployed -rofit before tax x 1>>E

/hare capital and reserves

3.23

3.2$

3.2%

3.2(

,2CE is the #ost popular pri#ary profitability ratio5 which states the profit as a percentage of the a#ount of capital e#ployed. -rofit is usually ta9en as -F04 and capital e#ployed is share capital and reserves plus long ter# liabilities and loan capital. 4he ,2CE indicates how efficiently an organi8ation uses those resources invested in it. 4he only difficulty involved in calculating the ,2CE is deciding which definition of Gcapital e#ployedH to use. /o#e organi8ations include only shareholders funds share capital and reserves! in their definition5 whilst others include shareholders funds and long'ter# debt. &s with other ratios so far discussed5 as long as it is applied consistently the definition of capital that is used is not i#portant5 it is the trend indicated that we are interested in. ;ro# an investor*s point of view a high ,2CE indicates an efficient use of resources and hence a better return on their invest#ent. ;or exa#ple5 if an organi8ation #a9es a profit before interest and tax of <1%5>>> and total capital e#ployed is <1>>5>>>5 the ,2CE is a healthy 1%E indicating that resources are being effectively used. 4his ,2CE is li9ely to be acceptable to investors. 4he sa#e profit fro# a capital invest#ent of <%>>5>>>5 will result in a ,2CE of 3E <1%5>>>?<%>>5>>>!5 which is less li9ely to be acceptable to investors. 0n assessing ,2CE5 two secondary profitability ratios can be exa#ined which contribute towards the return on capital e#ployed: i! -rofit .argin : -F04 /ales ii! &sset 4urnover : /ales Capital E#ployed ,2CE : -rofit .argin x &sset 4urnover & co#pany #ay #a9e a low profit #argin on its sales but if it has a high asset turnover and thus uses its assets well to generate sales5 the resulting ,2CE will still be x 1>>E

3.2)

323'(

high. 0n contrast5 a high profit #argin #ay #ean that sales prices are high5 resulting in sluggish sales and thus low asset turnover and thus low ,2CE. (C) 3.2B Management efficiency ratios /everal ratios are used to indicate how efficiently an organi8ation is utili8ing its assets. 0n general the better its use of assets the higher an organisation*s rate of return. 4he #ost co##on of which are considered below. Fixed assets turnover (

(a) 3.2=

!"#)

;ixed &ssets 4urnover :

/ales ;ixed assets

3.3>

3.31

3.32

2f 9ey i#portant is how effectively an organi8ation utili8es its fixed assets. 4here is little point in having fixed assets which are constantly underutili8ed. 4he sales to fixed assets ratio indicates how #uch each <1 invested in fixed assets generates in sales. ;or exa#ple5 if an organi8ation has annual sales of <2%>5>>> and the net boo9 value of its fixed assets is <1>>5>>>5 its fixed assets turnover ratio is 2.%:1. 0n other words for every <1 invested in fixed assets <2.%> of sales is generated. 0n general5 the higher the fixed assets turnover ratio5 the #ore efficiently fixed assets are being utili8ed. @owever5 care #ust be ta9en when interpreting this ratio since it #ay be distorted through: i! a significant invest#ent in fixed assets during an accounting period which will increase the value of fixed assets and will in the short ter# result in a lower sales'fixed assets ratio7 ii! alternatively if little invest#ent in fixed assets ta9es place and fixed assets are written down to a low or negligible boo9 value in an organi8ations balance sheet5 the sales'fixed assets ratio will be very high. Stock turnover ratio ($%#)

(b) 3.33

/toc9 4urnover ,atio :

&verage stoc9 held &nnual cost of sales

x 3(% days

323')

3.3$

3.3%

3.3(

&s well as tying up an organisation*s resources5 holding unnecessarily high levels of stoc9 is expensive in ter#s of storage and security costs. &lso5 the longer that an organi8ation holds its stoc9 the greater the ris9 that goods will perish or beco#e obsolete. 4he stoc9 turnover ratio expresses in days how long5 on average5 a business holds stoc9 for. 4he shorter its turnover period the better5 since less #oney is tied up in stoc9 and stoc9 will be converted into cash #ore "uic9ly5 enabling an organi8ation to reali8e profits sooner rather than later. ;or exa#ple5 if during an accounting period an organisation*s cost of sales is <%>>5>>>5 and the average a#ount of stoc9 held is <125%>>5 the average length of ti#e that stoc9 is held is <125%>> <%>>5>>> x 3(% days : =.12% days I 1>days

3.3)

3.3B

4he average length of ti#e that stoc9 is held will depend upon the type of organi8ation and the sector in which it operates. ;or exa#ple5 a restaurant would not expect to hold fresh produce for #ore than a few days. &s already #entioned it is i#portant that an organi8ation does not burden itself with levels of stoc9 which are too high. 0t is e"ually i#portant that the level of stoc9 is not too low since this will result in lost sales. & good syste# of stoc9 control will assist in ensuring that an organi8ation holds the opti#u# level of stoc9. Debtors collection period (&'()*+,-)

(c) 3.3=

Debtors Collection -eriod :

&verage debtors &nnual credit sales

x 3(% days

3.$>

3.$1

4he debtors collection period indicates the average nu#ber of days between a credit sale ta9ing place and an organi8ation receiving cash pay#ent fro# a custo#er. 4he shorter the collection period the better5 since li"uidity will i#prove and the ris9 of bad debts will be reduced. ;or exa#ple5 if annual credit sales is <)%>5>>>5 and the average level of trade debtors is <%>5>>>5 on average the credit period ta9en by debtors is:

323'B

<%>5>>> <)%>5>>> 3.$2

x 3(% days :

2$.33 days I 2%days

3.$3

& good credit control policy will ensure that the average collection period re#ains as low as possible. Credit control is essential since if debtors ta9e too long to pay an organi8ation will struggle to #eet its own credit pay#ents as they fall due. 0n general5 the credit period should not exceed 3> days and anything significantly in excess of 3> days should be investigated. Creditors turnover period (&.()*+,-)

(d) 3.$$

Creditors 4urnover -eriod :

&verage trade creditors &nnual credit purchases

x 3(% days

3.$% 3.$(

&nother useful ratio is the creditor turnover period which shows the average nu#ber of days that a business ta9es to pay its suppliers for goods purchased on credit. ;or exa#ple5 if annual credit purchases a#ount to <3%>5>>>5 and the average a#ount of creditors is <2%5>>>5 the average ti#e ta9en to pay creditors is <2%5>>> <3%>5>>> x 3(% days : 2(.>) days I 2)days

3.$) 3.$B

3.$=

3.%>

/ince we are concerned with trends5 if credit purchases is not available the organisation*s cost of sales #ay be used instead. &lthough so#e organi8ations see trade credit as a for# of interest free funding5 it does in fact have a cost. Delays in paying suppliers will result in an organi8ation foregoing discounts for pro#pt pay#ent. Chilst an organi8ation which persists in exceeding the agreed credit period runs the ris9 of adversely affecting its business*s credit rating5 and even having its credit facility withdrawn by suppliers. +i9e the debtors collection period5 in general the period ta9en to pay suppliers should not exceed 3> days. Capital structure ratios 0nvestors5 potential investors and other lenders will be particularly interested in an

(D) 3.%1

323'=

organisation*s long'ter# funding arrange#ents. 4he higher the ratio of debt to e"uity the #ore dependant an organi8ation is upon borrowed funds5 and the greater the ris9 that it will be unable to #eet interest pay#ents on these funds when they fall due. (a) 3.%2 Debt ,atio : 4otal liabilities 4otal assets 3.%3 Debt ratio is the ratio of a co#pany*s total debts to its total assets. Debts consist of all types of debts. &ssets consist of all fixed assets at their balance sheet value5 plus current assets. 0t #easures the co#pany*s ability to #eet all liabilities. Equity ratio (.0) x 1>>E Debt ratio (/&)

(b) 3.%$

E"uity ,atio :

4otal owner*s e"uity x 1>>E 4otal assets

3.%%

E"uity ratio reflects the relative i#portance of e"uity financing to the fir#. 4he higher the e"uity ratio5 the better the ability of the co#pany will have to #eet its external obligations. Debt ratio plus e"uity ratio e"uals to 1>>E. earin! ratio (1)

(c) 3.%%

Dearing ,atio :

+ong ter# debt long ter# loans and preference shares x 1>>E Capital e#ployed

3.%( 3.%)

3.%B

Dearing is the relationship between a co#pany*s entity capital and reserves and its fixed return capital. Dearing is also referred to as GleverageH in so#e countries. & co#pany is highly geared if it has a substantial proportion of its capital in the for# of preference shares or loan notes. & co#pany is said to have low gearing if only a s#all proportion of its capital is in the for# of preference shares or loan notes. & co#pany financed entirely by e"uity shares has no gearing. 0f a co#pany uses ban9 overdraft persistently as a se#i'per#anent source of finance5

323'1>

3.%=

it #ay be included as part of long ter# debt. 4he i#portance of gearing can be illustrated by an exa#ple as follows. Exa#ple 1 4wo co#panies5 & and F5 both have capital of <1>5>>>. & has it all in the for# of e"uity shares of <1 each5 F has %5>>> <1 e"uity shares and <%5>>> of 1>E loan notes. Foth co#panies earn profits of <%5>>> in year 1 and <25>>> in year 2. 4ax is assu#ed at 3%E and the dividend paid is 1>c per share. 4he position will be as follows: & < 1>5>>> ' 1>5>>> & Jear 1 < %5>>> ' 15)%> 352%> 15>>> 252%> 32.%c Jear 2 < 25>>> ' )>> 153>> 15>>> 3>> 13c Jear 1 < %5>>> %>> $5%>> 15%)% 25=2% %>> 25$2% %B.%c F < %5>>> %5>>> 1>5>>> F Jear 2 < 25>>> %>> 15%>> %2% =)% %>> $)% 1=.%c

/hares +oan notes

-rofit before tax and interest +oan interest 4axation 3%E! Earnings Dividend 1>E! ,etained profits Earnings per share

4he effects of gearing can be seen to be as follows: a! loan interest is an allowable deduction before taxation5 whereas dividends are paid out of profits after taxation7 co#pany F has consistently higher retained profits than co#pany &. b! earnings of a highly geared co#pany are #ore sensitive to profit changes7 this is shown by the following table: & F

323'11

Change in profit before interest and tax Change in earnings

'(>E '(>E

'(>E '(( 2?3E

4he reason for the fluctuation is obviously the ele#ent of loan interest which #ust be paid regardless of profit level. 4his #ore than proportionate change in earnings is i#portant in relation to the share price of the co#panies. .any investors value their shares by applying a #ultiple 9nown as -?E ratio! to the earnings per share. &pplying a #ultiple of say 1> to the E-/ disclosed above would indicate share valuations as follows: & Jear 1 < 3.2% Jear 2 < 1.3> Jear 1 < %.B% F Jear 2 < 1.=%

/hare price

3.(>

3.(1

3.(2

4hus the price of a highly geared co#pany will often be #ore volatile than a co#pany with only a s#all a#ount of gearing. 3ote all co#panies are suitable for a highly geared structure. & co#pany #ust have two funda#ental characteristics if it is to use gearing successfully. 4hese are as follows: i! ,elatively stable profits 6 +oan interest #ust be paid whether or not profits are earned. & co#pany with erratic profits #ay have insufficient funds in a bad year with which to pay loan interest. 4his could result in the li"uidation of the co#pany. ii! /uitable assets for security 6 .ost issues of loan capital are secured on so#e or all of the co#pany*s assets which #ust be suitable for the purpose. & co#pany with #ost of its capital invested in fast depreciating assets or inventories subject to rapid changes in de#and and price would not be suitable for high gearing. 4he classic exa#ples of co#panies which are suited to high gearing are those in property invest#ent and the hotel?leisure services industry. 4hese co#panies generally enjoy relatively stable profits and have assets which are highly suitable for charging. Co#panies not suited to high gearing would include those in the extractive industries and high'tech industries where constant changes occur. 4hese co#panies could experience erratic profits and would generally have inade"uate assets to pledge as security.

323'12

(d) 3.(3

"nterest cover (234)

0nterest Cover : -rofit before interest and tax 0nterest charges 3.($ 4his ratio indicates how #any ti#es interest pay#ents on long ter# debt are covered by profit before interest and tax. 4he higher the level of interest cover the less li9ely the chance that interest pay#ents will not be #et5 and hence the lower the level of financial ris9 associated with an organi8ation. 4he lower this ratio the greater the chance that a decline in profits will result in either: i! interest pay#ents not being #et7 or ii! profits available for distribution to shareholders being very low5 resulting in s#all or no dividend pay#ents being #ade to shareholders. 0f lenders are not happy with the capital structure ratios calculated5 an organi8ation will find it difficult to raise additional long ter# finds5 or will have to pay a pre#iu# for such funds in the for# of higher interest rates. In estment ratios 0f pri#e concern to any investor is the return that they will receive fro# their invest#ent in an organi8ation. &ny return #ust be sufficient to reward the investor for the ris9 attached to that invest#ent. Dividend cover (562)

3.(%

3.((

(E) 3.()

(a) 3.(B

Dividend cover :

-rofit after tax less preference dividend 4otal dividend

3.(=

3.)>

4he dividend cover ratio indicates the proportion of available profits which is distributed to shareholders and the a#ount which is distributed to shareholders and the a#ount which is retained by the organi8ation. Care #ust be ta9en to ensure that investors are satisfied with the dividend declared5 whilst enough profits #ust be retained to fund the future growth of the organi8ation. Price Earnin!s (P#E) ratio (75)

(b)

323'13

3.)1 -?E ratio : Current price per share E-/ 3.)2 -?E ratio is the ratio of a co#pany*s current share price to the latest E-/. & high -?E ratio indicates strong #ar9et confidence in the future profit growth of the co#pany. Conversely a low -?E ratio indicates low #ar9et confidence in the co#pany #a9ing a profit. Dividend yield (62)

(c) 3.)3

Dividend yield :

Dividend per share of previous year x 1>>E Current #ar9et price per share

3.)$

3.)%

3.)(

Dividend yield is the rate of return a shareholder is expecting on an invest#ent in shares of a co#pany. /ince shareholders expect dividend yield and capital growth5 dividend yield is an i#portant indicator of a share*s perfor#ance. 4he yield will be influenced by the dividend policy of an organi8ation7 a co#pany which has traditionally paid high dividends will be popular with so#e investors and this will be reflected in its share price. ;ro# investor*s standpoint5 the dividend yield indicates the return that an investor earns fro# holding shares in a particular co#pany5 and the higher the dividend yield the better. & low dividend yield #ight persuade investors to dispose of shares and invest the proceeds elsewhere. Earnin! yield (5)

(d) 3.))

Earning yield :

E-/ Current #ar9et price per share

x 1>>E

3.)B

Earning yields #easures a co#pany*s earnings relative to its #ar9et capitali8ation value. 0t is another way of showing the financial return to ordinary shareholders.

323'1$

(!) 3.)=

"ummary of ratios 4he following table is the su##ary of ratios which are discussed above:
#roup 1. +i"uidity $atio a! Current ratio b! &cid test !ormula Current assets?current liabilities Current liabilities 2. -rofitability a! Dross profit #argin b! 3et profit #argin c! ,eturn on total assets d! ,eturn on capital e#ployed e! ,eturn on shareholders* capital Dross profit?sales -F04?sales -F04?total assets -F04?capital e#ployed x 1>>E -rofit before tax?share capital and reserves x 1>>E 3. .anage#ent efficiency a! ;ixed assets turnover b! /toc9 turnover c! Debtors collection period d! Creditors turnover period /ales?fixed assets &verage stoc9 held?annual cost of sales x 3(% &verage debtors?annual credit sales x 3(% &verage trade creditors?annual credit purchases x 3(% $. Capital structure a! Debt ratio b! E"uity ratio c! Dearing ratio d! 0nterest cover %. 0nvest#ent ratios a! Dividend cover b! -?E ratio c! Dividend yield 4otal liabilities?total assets x 1>>E 4otal owner*s e"uity?total assets x 1>>E +ong ter# debt?capital e#ployed x 1>>E -F04?interest charges -rofit after tax less preference assets 6 stoc9!?current

dividend?total dividend Current price per share?E-/ Dividend per share of previous year?current #ar9et price per share x 1>>E d! Earnings yield E-/?Current #ar9et price per share x 1>>E

4.

Interpretation of Financial Ratios

323'1%

(A) $.1

%ori&ontal analysis ( ) 0n hori8ontal analysis5 the current year financial ratios of a co#pany are co#pared with si#ilar ratios of the previous year. &ny significant changes are then be noted and their causes analysed. 4he #ain wea9ness of hori8ontal analysis is that any co#parison of financial ratios are restricted to those within the co#pany. 4hus5 with hori8ontal analysis5 it is difficult to judge how good or bad a co#pany is perfor#ing in relation to other co#panies operating in the sa#e econo#ic environ#ent.

(B) $.2

Cross'sectional comparison ( ) 0n cross'sectional co#parison5 the financial ratios of a co#pany are co#pared with the industry average ratios or ratios of co#parable co#panies5 that is co#panies in the co#parable industrial sectors and preferably of si#ilar si8es. /uch cross'sectional co#parison of perfor#ances between co#panies #ay highlight areas of strengths and wea9nesses of the co#pany in relation to the other co#panies. ;or #any co#panies5 finding suitable industrial average figures or co#panies which has released financial state#ents detailed enough for cross'sectional co#parison purpose can be difficult. (rend analysis ( ) 0n evaluating the financial position of a co#pany5 it is #ore i#portant to exa#ine the various historical trends of its financial ratios instead of just the financial ratios in isolation. 4hese trends of accounting ratios5 stretching over a nu#ber of years5 should give #ore insights and confidence in predicting li9ely future perfor#ance of the co#pany. ;or exa#ple5 a co#pany that shows low li"uidity ratios in its latest financial year #ay be suspected of having li"uidity proble#s. @owever5 if the sa#e co#pany shows consistent trends of low but i#proving li"uidity ratios in the last five years5 it is #ore li9ely that the co#pany can overco#e its li"uidity proble#s in the future. 0n contrast5 if the co#pany shows a fast declining trend of li"uidity ratios5 it #ay be facing li"uidity proble#s soon even if the latest li"uidity ratios are still healthy. ) er'trading ( )

(C) $.3

$.$

(D)

323'1(

$.%

$.(

2ver'trading occurs when a co#pany expands its business activities rapidly but without sufficient long'ter# capital to finance its expanding business. 2ver'trading trends to happen to s#all or #ediu# si8e co#panies as they finance their expanding business with short'ter# credits but do not expand their capital bases at the sa#e ti#e. & profitable and fast expanding business #ay fail due to over'trading because it has insufficient cash to pay its short'ter# liabilities and is forced into insolvency. /igns of over'trading and their probable causes are as follows: i! cash and li"uid assets decline sharply as #oney is diverted to fund business growth7 ii! debtors increase at a #uch higher rate than sales as #oney is short and debtors are not paid on ti#e7 iii! creditors increase rapidly because of loss credit control to increase sales7 iv! stoc9s increase at a #uch higher rate than sales due to pressure fro# the sales depart#ent for faster delivery to gain #ore sales. Compre*ensi e e+ample Exa#ple 2 4he balance sheets as at 31 Dece#ber 2>>) and 31 Dece#ber 2>>B5 trading and profit and loss accounts for the years to 31 Dece#ber 2>>) and 2>>B and other infor#ation of +ong +td. are set out below: Long Ltd, "tatement of !inancial Position as at -. December
/001 <>>> !i+ed assets +and K Fuildings ;ixture K fittings 3$5%>> B5%>> $35>>> Current assets /toc9 Debtors Fan9 1)5$>> 151>> $%> 1B5=%> +ess: Current liabilities 135%)> (2> $52%% 1B5$$% 215>>> (532% 2)532% <>>> <>>> <>>> /002 <>>> <>>>

(E) $.)

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Creditors Dividend payable 4axation

125>%> 152%> 352>> 1(5%>> 25$%> $%5$%>

B5%>> 15>>> 25B%> 1253%> (5>=% 335$2>

"*are Capital 2rdinary shares of <1 each $eser es /hare pre#iu# Deneral reserve ,etained profit (5B>> B5)%> =5=>> 2%5$%> /hareholders* fund Long term liabilities 1>E Debentures 1>5>>> $%5$%> )5%>> 335$2> 3%5$%> (5B>> ' =512> 1%5=2> 2%5=2> 1>5>>> 2>5>>>

323'1B

Long Ltd, "tatement of compre*ensi e income for t*e year ended -. December
2>>B <>>> /ales +ess: Cost of goods sold 2pening stoc9 &dd: -urchases 135%)> =>53>> 1>35B)> +ess: Closing stoc9 1)5$>> B(5$)> Dross profit +ess: Expenses -rofit before taxation 4axation -rofit after taxation =523> 25>>> )523> 352>> $5>3> %5%>> =>5>>> =%5%>> 135%)> B15=3> )52)> 15>>> (52)> 25B%> 35$2> <>>> =%5)>> <>>> 2>>) <>>> B=52>>

&dditional infor#ation: 1! 2! 4here was no interi# dividend paid in both accounting years. .ar9et price of <1 ordinary share on result declared: 2>>) 6 <2.% 2>>B 6 <2.= Debtors as at 1 Lanuary 2>>): <%>>5>>> Creditors as at 1 Lanuary 2>>): <1>5>>>5>>> &ll sales and purchases are #ade on credit ter#s. &dditional 1>E debentures for <25%>>5>>> were issued on 1 Lanuary 2>>B. /olution: &n analysis of +ong +td. by #eans of financial ratios together with a brief co##ent on the i#plications of the analysis are as follows: &nalysis on -rofitability 2>>B 2>>)

3! $! %! $.B

a!

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1. Dross profit #argin 2. 3et profit #argin 3. ,eturn on total assets $. ,eturn on e#ployed capital

=523> = =.)>E =%5)>> )523> + 15>>> = B.(>E =%5)>> )523> +15>>> = 13.3>E (15=%> B523> = 1BE $%5$%>

)52)> = B.2>E B=52>> (52)> + )%> = ).=>E B=52>> (52)> + )%> = 1%.3>E $%5))> )5>2> = 21E 335$2>

Co##ents: 4he ac"uisition of fixed assets is "uite substantial during the year. @owever5 return on total assets and capital e#ployed have declined slightly. 0t can be explained by the increase in the gross profit #argin and net profit #argin. b! &nalysis on .anage#ent Efficiency 2>>B 1. ;ixed assets turnover 2. /toc9 turnover period 3. Debtors collection period
=%5)>> = 2.23E $35>>> 1%5$B% 3(% = (% days B(5$)> B(> 3(% = 3.2B days =%5)>> =>53>> = $1.% da

2>>)
B=52>> = 3.2(E 2)532% =5%3% 3(% = $2 days B15=3> %(> 3(% = 2.2= days B=52>> =52%> 3(% = 3).% days =>5>>>

$. Creditors collection period 1>52)% 3(% ys

Co##ents: &ssets turnover for 2>>B have declined as co#pared to 2>>). 4his is #ainly due to the increase in sales in 2>>B i.e. around )E! falls below the increase in fixed assets i.e. around %)E!. /toc9 holding period has increased fro# $2 days to (% days. 4his is #ainly due to the higher stoc9 level. Debtors and creditors #anage#ent is satisfactory5 as the debtors* collection period is #uch shorter than the creditors pay#ent period. c! &nalysis on +i"uidity 2>>B 2>>)

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1. Current ratio 2. Auic9 ratio

1B5=%> =1.1% 1(5%>> 15%%> = >.>= 1(5%>>

1B5$$% =1.$= 1253%> $5B)% = >.3= 1253%>

Co##ents: +i"uidity ratios indicate that the co#pany appears to have no li"uidity proble# to #eet its current liabilities. Debtors turnover indicates that the sales are nearly cash sales5 and practically5 there is no need to finance debtors. /toc9 holding level is "uite high5 and since stoc9 turnover is slower than creditor turnover5 extra financing is re"uired. 4he co#pany #ay consider to 9eep a lower stoc9 holding level so as to reduce its wor9ing capital re"uire#ent. 2therwise5 li"uidity proble# can arise in case the stoc9 on hand cannot be sold. d! &nalysis on Capital /tructure 2>>B 1. Debt ratio 2. E"uity ratio 3. Dearing ratio
2(5%>> = $3E (15=%> 3%5$%> = %)E (15=%>

2>>)
1=5B%> = $3E $%5))> 2%5=2> = %)E $%5))> )5%>> = 22E 335$2>

1>5>>> = 22E $%5$%>

)523> +15>>> = B.23 15>>>

$. 0nterest cover

(52)> + )%> = =.3( )%>

Co##ents: 4he co#pany is not considered to be heavily geared. 0ts capital structure has re#ained the sa#e for both years. 4he ability to service its debt is satisfactory. e! &nalysis on 0nvest#ent 2>>B 1. E-/ 2. Earnings yield
$5>3> = <>.$> 1>5>>> $5>3> = 13.=>E 1>5>>> 2.=
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2>>)
35$2> = <>.3$ 1>5>>> 35$2> = 13.(BE 1>5>>> 2.%

3. -rice earnings ratio

2.= = ).2> >.$>3

$5>3> = 3.22 152%>

2.% = ).3% >.3$

35$2> = 3.$2 15>>>

$. Dividend cover %. Dividend yield

>.12% = $.3>E 2.=

>.1 = $.>>E 2.%

Co##ents: Due to increase in profit in 2>>B5 earnings per share5 earnings yield and dividend yield have increased. 4he share has beco#e #ore attractive to investors in 2>>B.

$.=

Exa#ple 2 +arge +td is now considering the possible ac"uisition of two s#aller co#panies5 /outh +td and 3orth +td. Foth of the# are in the sa#e industry. Copies of their latest state#ent of co#prehensive inco#e and state#ent of financial position for the year ended 31 .arch 2>>B are set out below. "tatement of Compre*ensi e Income for t*e year ended -. Marc* /001
/outh +td <>>> 4urnover Cost of sales Dross profit Distribution costs &d#inistrative expenses 2perating profit 0nterest payable -rofit before taxation 4axation -rofit after taxation (% 2% => (> B %2 2> 32 <>>> (>> $%> 1%> 2= 31 (> B> 3 )) 2) %> 3orth +td <>>> <>>> %>> 3(> 1$>

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-roposed dividend ,etained profit for the year ,etained profit brought forward ,etained profit carried forward

B 2$ 1>2 12(

1% 3% 3> (%

"tatement of !inancial Position as at -. Marc* /001

/outh +td <>>> ;ixed assets Current assets /toc9 Debtors Cash at ban9 B% 2% 1%> 2(> Current liabilities 4rade creditors 4axation payable -roposed dividends )% 2> B 1>3 1%) 3>( Capital and reserves /hare capital ,etained profit B> 12( 2>( +ong ter# loan 1>E debentures Fan9 loan secured! 1>> ' 3>( ' (= 21$ B> (% 1$% (% 3> 2> 11% 1$ 21$ (2 ($ 3 12= <>>> 1$= 3orth +td <>>> <>>> 2>>

4he financial controller of +arge +td is particularly interested in the li"uidity and profitability positions of the two target co#panies. & ratio analysis is prepared which helps you to decide which co#pany is a better invest#ent. $.1> /olution:

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a!

-rofitability ratios /outh +td 1. Dross profit #argin 2. 3et profit #argin 3. ,eturn on e#ployed capital
1%> = 2%E (>> (> = 1>E (>>

3orth +td
1$> = 2BE %>> B> = 1(E %>> B> = 3).$>E 21$

(> = 1=.(>E 3>( (> = 1$.)>E $>= (> = 2=E 2>(

$. ,eturn on total assets

B> = 2$E 32= B> = %%.2>E 1$%

%. ,eturn on shareholder*s capital

Co##ents: 3orth +td is a #ore profitable co#pany co#pared to /outh +td. 3orth +td*s gross profit #argin is higher than /outh +td*s by 3E. 2verhead expenses of 3orth +td also appear to be under better control co#pared to /outh +td. 2n the other hand5 /outh +td holds #ore assets co#pared to 3orth +td5 particularly the cash on hand5 this /outh +td has less favourable ratios regarding the return on capital e#ployed5 return on total assets and returns on shareholders* capital. 0t see#s that the #anage#ent of /outh +td is less capable of e#ploying the assets to generate profit. b! +i"uidity ratios /outh +td 1. Current ratio 2. Auic9 ratio
2(> = 2.%3 1>3 1)% = 1.)> 1>3

3orth +td
12= = 1.12 11% () = >.%B 11%

Co##ents: /outh +td is undoubtedly a #ore li"uid co#pany. /outh has a faster debtor turnover
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rate i.e. /outh*s 1% days vs. 3orth*s $( days! and holds a higher level of cash as co#pared to 3orth. c! Conclusion: 3orth +td is currently #ore profitable and under a #ore efficient operation co#pared to /outh +td. @owever5 further injection of cash #ay be re"uired as its cash level is low. /outh +td has a better li"uidity position. 4here is also available cash for further business develop#ent. Diven #ore efficient #anage#ent5 /outh +td could beco#e #ore profitable. 0f further injection of cash is not desired5 /outh +td see#s to be a #ore preferable invest#ent.

5.
%.1

i!itations of Ratio Analysis

0t can be seen that the calculation of a few fairly si#ple ratios will greatly enhance our understanding of an organisation*s financial position by su##ari8ing 9ey infor#ation in a user friendly way. @owever5 although undoubtedly useful5 the use of ratios does have certain li#itations which #ust be ta9en into account when using the#. 4he li#itations include: i! ratio analysis is concerned with trends over a period of ti#e. 0t is5 therefore5 of little use without co#parative infor#ation fro# previous accounting periods or other organi8ations7 ii! changes in an organisation*s accounting policies #ay #ale co#parisons over a nu#ber of years difficult. Chilst variations in the accounting policies adopted by different organi8ations #ust be ta9en into consideration when #a9ing co#parisons with other organi8ations7 iii! ratios are based upon past perfor#ance and hence historical data. &lthough they can indicate future trends there is no guarantee that these forecasts will be correct7 iv! econo#ic conditions #ust be ta9en into account when interpreting trends. ;or exa#ple5 if interest rates are high5 the ,2CE will need to reflect this7 v! the ratios calculated are only as good as the infor#ation on which they are based. 4he preparation of any financial state#ents will necessitate esti#ates being #ade with regard to ite#s such as bad debts5 the revaluation and depreciation of fixed assets5 and the outco#e of any legal proceedings. /hould any of these esti#ates be significantly incorrect5 the ratios and the accounts upon which they are based will also be adversely affected. vi! individual ratios should not be considered in isolation. 4o be used properly a nu#ber of the ratios discussed in this chapter need to be calculated and the
323'2%

%.2

overall reviewed. 4o calculate only one or two ratios #ight be #isleading. ;or exa#ple5 a business #ight on paper have a ,2CE of 2>E and a net profit of 2%E5 however5 its credit control #ight be poor. Conse"uently5 although profitable on paper5 poor #anage#ent of wor9ing capital #ight lead to cash flow proble#s resulting in the organi8ation being forced to cease trading.

323'2(