Financial ratios and investment

Profitability and return Ratio

Also called performance ratios, helps shareholders asses the performance of management.

  1. Gross Margin

The measure of the margin earned by a company on revenue before overhead costs is deducted.

Calculation:

     2.   Operating Margin

The amount of profit left after all expenses have been deducted from revenue except interest and tax.

     3.    Net Margin

A measure of profitability of a firm.

Calculation: Net Income divided by revenue multiplied by 100.

     4.    Asset turnover

Measures the efficiency of a company using its assets to generate sales.

Calculation: Revenue divided by assets  “expressed as …. times “

     5.   Return on Capital Employed (ROCE)

The ROCE analysis how growth in profits relates to the capital invested to make the profits. The higher the ratio the better but this will have to be compared to previous years, other companies and industry averages.

Calculation: Profit before interest and taxation  divided by total assets less current liabilities multiplied by 100.

Note instead of total assets less current liabilities, Capital Employed  = Shareholders Funds + long term debt.

Long-term solvency and stability Ratio

     1.   Gearing Ratio

Analysis how much a company is reliant on debt. Typically a company with a gearing ratio of more than 50% is highly dependant on debt, whilst a company with a gearing ratio of less than 50%, does not highly depend on debt to finance activities.

Calculation: Long-term liabilities divided by capital employed multiplied by 100

Note Capital Employed = Shareholders Funds + long term debt.

2.   Interest cover

Analysis whether interest costs are high compared to the level of its profits. A interest cover of 2 times or less is classified as low. Typically it should exceed 3 times before a company has acceptable interest cost.

Calculation: Profit before interest and tax divided by interest charges     

Short-term solvency and liquidity Ratio

       1.    Current ratio

Analysis the ability of a company to meet current liabilities with current assets. The higher the ratio the better but typically a ratio of greater than 1 is expected. The ability of a firm to turn assets into cash influences the ratio.

Calculation:

        2.      Quick ratio or acid test ratio

Analysis how a company without its inventory can meet current liabilities with current assets excluding inventory. The ratio gives a clearer view of a company’s liquidity position because it takes into account that some company’s assets are easily turned into cash. For example, supermarkets who can easily turn inventory into cash.

Calculation: Current assets less inventories divided by current liabilities

Efficiency Ratio

       1.  Receivables days

Measures the average time it takes for the company to receive funds from customers. Typically receivables should pay within 30 days and more than this can arguable mean that a business manages its funds very poorly. But this depends upon the nature of the business and as mentioned earlier on comparisons.

Calculation: Receivables divided by sales multiplied by 365 days

        2.  Inventory turnover

The ratio measures the average day’s inventory items are held for. This indicates how well a business trading. If inventory days are building up then a business is experiencing slowdowns in trade or that investment in inventories is much more than necessary.

Calculation: Inventory divided by cost of sales  multiplied by 365 days.

         3.  Payable days

Assesses a company’s ability to pay for items purchased on credit. High payable days indicate that the business is not managing its long-term finance.

Calculation: Trade payables divided by cost of sales multiplied by 100.

Shareholder investment

         1.  Earnings per share

This ratio measures the return on each individual ordinary share in the year.

Calculation: Dividend per share divided by dividend cove

2.   P/E ratio

Measures the returns on ordinary shares of a company. A high EPS indicates that shareholders are confident in the company’s future, whilst a low P/E ratio means a lower level of confidence.

Calculation: Share Price divided by earnings per share.

           3.   Dividend Cover

Calculation: Earnings per share divided by dividend per share

Limitations of financial statements

When using financial ratios to interpret and analyse financial statements, there are issues with the level of accuracy involved and companies need to consider the following limitations of financial interpretation.

Financial statements are based on historic information (old past data). Therefore comparison to future decisions, then relevance is limited.

  • Financial statements can be influenced through creative accounting and window dressing.
  • Seasonal businesses will experience different results throughout the year.
  • In cases were a business acquires or disposes of it's business comparisons of other years is difficult.
  • Ignores non-financial information.