This should be a revision section for you, ratio analysis having been covered in your earlier studies. The ratios we shall consider can be grouped into four main types:
Liquidity
Profitability
Debt and gearing
Investor.
We will now consider the main ratios under each heading.
Liquidity
A company may be profitable but not necessarily liquid and able to pay its obligations when required – failure to do so may lead to the company being wound-up. The ratios and figures under this heading indicate the extent to which a company can meet its current liabilities as they become due. The common liquidity ratios are:
The current ratio, which is calculated as:
s liabilitie Current
assets Current
The acid test ratio, which is calculated as:
s liabilitie Current
stock less assets Current
These two ratios show the liquid resources available to pay the short-term liabilities, low ratios indicating potential cash flow problems. The quick (acid test) ratio is often calculated because of the length of time it may take to convert stock into cash, this ratio giving the truer picture of the liquid assets of the organisation. The yardsticks which an organisation’s ratios are traditionally compared to are 2:1 for the current ratio and 1:1 for the acid ratio. However, the yardsticks should be viewed in relation to the organisation in question, and in relation to other ratios – a company with high stock turnover can have a healthy liquidity position with an acid ratio of less than 1.
When considering current and acid ratios remember that high results may indicate overstocking, poor collection of debtors or that the company has excessive cash; in such
cases action should be taken to determine why there is a high ratio and steps taken (if appropriate) to correct the situation.
The debtors’ payment period, which is calculated as:
sales 365 Credit
debtors
Trade
This shows the length of time taken by a company’s debtors to pay their bills. In general companies give 30 days’ credit on invoices and this can be used as a yardstick. The resultant ratio, however, must be viewed in the light of any seasonal variations which may be present in the figures used to calculate the ratio. Industry norms and the type of customers the firm has also need to be considered in
determining a yardstick to use (e.g. a high level of overseas customers may mean that terms longer than 30 days may be given).
The stock turnover ratio, which is calculated as:
sales 365
It shows the number of days that stocks are held; as with the debtors’ payment period care must be taken to note any seasonal fluctuations contained in the figures used, for which reason it is better to look at the trend in this figure. An increase may indicate a slow down in sales or that the firm is overstocking.
Stock turnoverdebtor payment period give a good indication of the cash conversion period.
The ratio can also be calculated to show the number of times average stock is turned over in a year:
In addition, calculations by Beaver, Lev and others in the USA have shown that the most significant single index of solvency is provided by establishing a trend line over a period, from the ratio:
The primary (or most frequently used) ratio is return on capital employed (ROCE). This is usually calculated as:
This provides a measure as to how the investment of capital in the company is being rewarded. The result can be compared to the cost of capital and the returns available elsewhere reflected in interest rates and other companies’ ROCE figures. You can see a breakdown of this ratio in Figure 2.1.
Profit/Assets employed
Assets/Sales Profit/Sales
Current assets/Sales
Fixed assets/Sales
Admin.
costs/Sales
Production Costs/Sales
Selling &
distribution costs/Sales
Stock Land & buildings Labour
Debtors Plant & equipment Material
Cash Fixtures & fittings Expenses
Vehicles
Figure 2.1: Breakdown of ROCE
However, as with many other ratios, there is no one agreed method of calculating it.
Problems in its calculation include the following:
(a) Should profit be pre-tax or post-tax? Shareholders will prefer post-tax because this is the money available to pay dividends with; management will prefer pre-tax unless they are responsible for minimising the company’s tax liability.
(b) Should non-recurring items, e.g. profit on the sale of an asset or arising from an insurance claim, be included?
(c) Should non-trading profits, such as rents and investment income, be included?
(d) Should total assets or net assets (net assets = total assets minus current liabilities) be used as the capital employed figure? Often a company has a permanent bank
overdraft (which is included in the current liabilities) and therefore should be considered to be part of capital employed.
(e) Should intangible assets such as goodwill be included in the capital employed figure?
(f) How should assets be valued:
At cost?
At written-down book values?
At replacement values?
At current market values?
(Remember – the understatement of a company’s assets can produce an artificially high ROCE.)
(g) Which balance sheet date and profit figures are relevant? Should the capital employed be that at the start or end of the year, or some average figure?
The method chosen to calculate ROCE depends on the individual company. There is some evidence that companies often choose the set of values which gives them the highest ROCE but, whichever method is chosen, you must be consistent between years and companies to allow comparability. Industry norms are also important, e.g. service industries tend to have higher profit margins than manufacturing industries.
Other common profitability ratios are:
Gross trading profit : Sales
Net trading profit : Sales
(It is useful to compare trends in these two measures against each other to provide an indication as to how well expenses are being controlled.)
Net profit : Equity capital
Net profit : Working capital
Sales : Capital employed (expressed as a number of times)
Fixed asset turnover rate, measured by Sales : Fixed assets (expressed as a number of times) with a possible breakdown to asset class.
Current asset turnover rate, which is subdivided into the following:
(i) Sales : Total current assets (ii) Sales : Debtors
(iii) Sales : Stocks held
In this calculation the figure of sales may be replaced by the cost of sales (if known) since stocks at cost value remove the potentially distorting effects of selling price changes in response to market conditions.
Note: The Du Pont Index is a variation on the primary ratio:
employed Capital
Sales SalesProfit
made up of the secondary ratios – the profit margin and asset turnover. Profit may be calculated before interest and taxation or just as pre-tax profit. The first shows the level of profit achieved on sales and the second shows how well assets are being used to generate sales. Often there is a trade-off between profit margin and turnover – high profit levels may lead to low sales and vice versa. Used in a series of ratios over a period of time this
provides more information than the basic ROCE ratio.
An obvious check on profitability is to look at the level of profit or loss shown in the accounts and the change from previous years.
Debt and Gearing
The gearing ratio is expressed as Debt capital : Equity capital. Again there is no one accepted method of calculating this ratio – some analysts prefer to use long-term debt only, whilst others prefer to use all debt (excluding provisions) in a company’s structure.
(The latter is often called the debt ratio.) Similarly, there is no agreement as to whether balance sheet or market values should be used.
There is no absolute “correct” level of gearing, although an often quoted benchmark for the debt ratio is 50%; the resultant figure again should be considered in line with previous years and industry norms.
The significance of the gearing ratio is the extent to which profit fluctuations are borne by the equity holders. The higher the level of gearing the greater the impact on shareholder wealth of changes in profit levels (see later in course). Moreover, a high level of debt makes future borrowing more difficult.
Example
Gearing ratio is frequently calculated using the formula:
Gearing ratio
The following is an extract from the balance sheet of Denton Ltd as at 31 December 200X:
£000 Creditors: Amounts falling due after more than one year
8% debentures 10,000
Capital and Reserves:
Ordinary share capital (£1 ord shares) 30,000
10% Preference shares 15,000
Remember, however, that this is only one method of calculating the gearing ratio, and you should always make this clear in using it.
Other ratios in this group include:
Equity interests : Net assets
Debentures : Net assets
These two ratios provide an indication of the cover of fixed assets to the particular type of capital investment. Moreover, by establishing a ratio of Fixed assets : Equity capital you can see to what extent the shareholders “own” the fixed assets.
Debenture interest cover measures the “safety” of the interest payment – the higher the cover the more dependable the payment is. It is calculated by dividing the Net profit before tax and debenture interest by the Debenture interest payable. For example, if the profit before tax and interest was £15,000 and the debenture interest was £3,000 then it would be 15/3 = 5 times covered.
The cash flow ratio, measured as:
)
This shows the ability of an organisation to meet its commitments, with changes in the ratio showing changes in the cash position of the firm.
Investor Ratios
A major ratio in this class is that of earning per share (EPS) calculated as:
Net profit after tax, debenture interest, extraordinary items, minority interests and preference dividends/No. of ordinary shares in issue and ranking for dividends. It is measured in pence.
Investors wish to see growth in the EPS in order to fund investment and increases in dividend payments. An inability to sustain a level of EPS could have a negative impact on the level of a company’s dividend.
When looking at the trend of the EPS over time changes in capital structure, such as the issuing of new shares or the conversion of convertible loan stock, need to be considered. Similarly, when comparing different companies differences in their number of issued shares should be considered. In the former case it would be useful to
calculate the fully diluted earnings per share which takes into account all capital
instruments ranking as equity shares now or in the future; for example, convertible loan stock or share options. This also gives investors an indication of the effects of the future exercise of share options, warrants and such like (including in the numerator the savings in financing such instruments and the additional profits to be earned from utilising the funds raised in the business).
Dividend cover shows how many times the declared dividend could be paid out of distributable profits. For example, if a company’s profit after tax and debenture interest was £40,000 and a dividend of £32,000 was declared, the dividend cover would be:
dividend
If preference share dividends are payable these, too, form a prior deduction when considering dividend cover on ordinary shares. The ratio shows the proportion of distributable profits being paid out and indicates the risk that if earnings fall this level of payout could not be maintained. A high cover may indicate that the firm is investing in future growth.
Dividend cover can also be calculated using the EPS:
Dividend cover =
The dividend yield of a company’s shares is important because it shows the return the investor receives on the market value of shares (declared dividend is based on the nominal (or par) value of shares). The shareholder can compare the yields between different investments to help determine the value for money of his shares in the company. Dividend yield is calculated as:
share 100
Dividends paid to shareholders in the UK are net dividends (after tax); to determine the gross dividend figure to use in the above calculation we have to adjust for taxation, using the following formula:
Thomas plc has just declared a net dividend of 10p per share. If the current share price of Thomas is 135p, what is the dividend yield?
Gross dividend
Dividend yield 100
Interest yield is the equivalent of dividend yield for the return on the market price of loan stock.
Be careful not to confuse interest yield with the coupon rate, which is the return on the face value of the debt.
The interest yield is generally higher than the dividend yield. This is because
shareholders expect to receive capital gains on their shares. When capital gains and dividend yield are added together they should produce a higher return than interest yield, reflecting the greater risk of holding shares (risk is considered in detail in a later study unit).
Earnings yield is the equivalent of dividend yield for the return on the market price of earnings per share.
The gross value of the EPS is used in order to allow comparability with dividend yield.
The price earnings (P/E) ratio compares the market price of a share to the earning per share and is expressed as:
tax)
Note that the net basis is used rather than the gross basis we encountered in earlier ratios. For example, if ABC plc has 200,000 ordinary shares of £1 which are currently quoted in the market at £1.70, and its net earnings for the year were £45,000, the P/E ratio would be:
0,000) (45,000/20
1.70 7.56.
An investor purchasing the shares at £1.70 would, in other words, be paying 7.56 times the annual earnings on those shares. The level of a company’s P/E ratio is seen as a reflection of the market’s views on the prospects of a company. A company with a higher P/E ratio than another may have better growth prospects or more secure earnings. This is because the P/E ratio should remain constant over time, and an increased EPS will result in an increased market price and thus an increased P/E ratio.
However, the only real value of the P/E ratio is that it shows the relationship between earnings and market price for a company, which may be difficult to interpret when market prices are fluctuating widely due to circumstances outside the control of the company, such as changes in interest and exchange rates.
Miscellaneous Items
The following ratios may also be of use to stakeholders when analysing reports:
Value added per employee
Sales per employee
Asset structure – this involves calculating the varying proportions in which the assets are structured, for example:
Fixed assets 35%
Investments 5%
Net current assets 60%
100%
Sources of asset structure, for example:
Ordinary capital and reserves 50%
Debt capital 45%
Net current liabilities 5%
100%
Alternatively the asset structure could show gross current assets, while gross current liabilities are shown in the source of asset structure. The two could then be compared to see to what extent outside interests “own” the company assets.
Proportions of shareholders’ interests, for example:
Preferential capital 10%
Ordinary capital 50%
Capital reserves 8%
General reserves 20%
Specific reserves 12%
100%