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Financial ratio analysis
Profitability Ratios
Is the business is making acceptable profits.
Gross Profit Margin: [Gross Profit / Revenue] x 100 (as a percentage)
This ratio tells us something about the business's ability
consistently to control its production costs or to manage the
margins its makes on products its buys and sells. While sales value
and volumes may move up and down significantly, the gross profit
margin is usually quite stable (in percentage terms). However, a
small increase (or decrease) in profit margin, however caused can
produce a substantial change in overall profits.
Operating Profit Margin: [Operating Profit / Revenue] x 100 (expressed as
a percentage) Assuming a constant gross profit margin, the operating
profit margin tells us something about a company's ability to
control its other operating costs or overheads.
Return on capital employed (ROCE): Net profit before tax, interest and
dividends (EBIT) / total assets (or total assets less current
liabilities ROCE is sometimes referred to as the "primary ratio"; it
tells us what returns management has made on the resources made
available to them before making any distribution of those returns.
Efficiency ratios
These ratios give us an insight into how efficiently the business is
employing those resources invested in fixed assets and working
capital.
Sales/Capital Employed: A measure of total asset utilisation. Helps to
answer the question - what sales are being generated by each pound's
worth of assets invested in the business.
Sales or Profit / Fixed Assets: This ratio is about fixed asset capacity.
A reducing sales or profit being generated from each pound invested
in fixed assets may indicate overcapacity or poorer-performing
equipment.
Stock Turnover: Cost of Sales / Average Stock Value Stock turnover helps
answer questions such as "have we got too much money tied up in
inventory"?. An increasing stock turnover figure or one which is
much larger than the "average" for an industry, may indicate poor
stock management.
Debtor Days: (Trade debtors (average, if possible) / (Sales)) x 365 The
"debtor days" ratio indicates whether debtors are being allowed
excessive credit. A high figure (more than the industry average) may
suggest general problems with debt collection or the financial
position of major customers.
Creditor Days: ((Trade creditors + accruals) / (cost of sales + other
purchases)) x 365 A similar calculation to that for debtors, giving
an insight into whether a business i taking full advantage of trade
credit available to it.
Liquidity Ratios
Liquidity ratios indicate how capable a business is of meeting its
short-term obligations as they fall due:
Current Ratio: Current Assets / Current Liabilities A simple measure that
estimates whether the business can pay debts due within one year
from assets that it expects to turn into cash within that year. A
ratio of less than one is often a cause for concern, particularly if
it persists for any length of time.
Quick Ratio: Cash and near cash (short-term investments + trade debtors)
Not all assets can be turned into cash quickly or easily. Some -
notably raw materials and other stocks - must first be turned into
final product, then sold and the cash collected from debtors. The
Quick Ratio therefore adjusts the Current Ratio to eliminate all
assets that are not already in cash (or "near-cash") form. Once
again, a ratio of less than one would start to send out danger
signals.
Stability Ratios
These ratios concentrate on the long-term health of a business -
particularly the effect of the capital/finance structure on the
business:
Gearing: Borrowings (all long-term debts + normal overdraft) / Net Assets
(or Shareholders' Funds) Gearing (otherwise known as "leverage")
measures the proportion of assets invested in a business that are
financed by borrowing. In theory, the higher the level of borrowing
(gearing) the higher are the risks to a business, since the payment
of interest and repayment of debts are not "optional" in the same
way as dividends. However, gearing can be a financially sound part
of a business's capital structure particularly if the business has
strong, predictable cash flows.
Interest cover: Operating profit before interest / Interest This measures
the ability of the business to "service" its debt. Are profits
sufficient to be able to pay interest and other finance costs?
Investor Ratios
There are several ratios commonly used by investors to assess the
performance of a business as an investment:
Earnings per share ("EPS"): Earnings (profits) attributable to ordinary
shareholders / Weighted average ordinary shares in issue during the
year A requirement of the London Stock Exchange - an important
ratio. EPS measures the overall profit generated for each share in
existence over a particular period.
Price-Earnings Ratio ("P/E Ratio"): Market price of share / Earnings per
Share At any time, the P/E ratio is an indication of how highly the
market "rates" or "values" a business. A P/E ratio is best viewed in
the context of a sector or market average to get a feel for relative
value and stock market pricing.
Dividend Yield: (Latest dividend per ordinary share / current market
price of share) x 100 This is known as the "payout ratio". It
provides a guide as to the ability of a business to maintain a
dividend payment. It also measures the proportion of earnings that
are being retained by the business rather than distributed as
dividends. |
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