RATIO ANALYSIS

Ratio Analysis Attempts to judge a firm’s financial performance Based on the assumption that firms will be aiming to make a profit

Judging performance In order to be successful, a company must: Make a profit Ensure that it has enough liquidity ot meet immediate payments Plan its long-term financing to make sure that it can pay creditors Control its financial transactions efficiently Remain attractive to existing and prospective shareholders

Performance (or profitability) Ratios To judge how well the firm is making profit

Liquidity ratios To study how well a firm is managing its cash and liquid assets

Gearing ratios To see how well the long-term financing is being managed

Financial efficiency ratios To assess the effectiveness of management of particular aspects of the firm

Shareholders’ ratios To measure the attractiveness of the firm to its shareholders

Which best summarise financial performance?

Which best summarise performance? Performance & liquidity ratios

Using ratios On their own, useful but limited Better to compare to other results so the company can be judged in relative terms

Bases for comparison Comparisons to a standard Inter-firm comparisons Intra-firm comparisons Ratios should be compared over time in order to register trends in efficiency & allow for unusual occurrences in one particular year

Profitability & liquidity RATIO ANALYSIS Profitability & liquidity

Profitability/performance ratios ROCE Net profit x 100 Capital employed Compare to interest rate in bank? Operating/gross profit margin Operating/gross profit x 100 Sales (turnover)

Liquidity ratios Cash-flow problems cause the closure of 20% of businesses that fail in the UK Liquidity ratios compare short-term (current) assets with short-term (current) liabilities If creditors do not receive payment, they can force the liquidation of the firm

Current ratio Current ratio = current assets:current liabilities ‘Ideal’ current ratio is between 1.5:1 and 2:1 Maximum as well as minimum is recommended Opportunity cost of holding too many current assets is lost opportunity to purchase non-current assets

Acid test (quick) ratio Inventories – are they quickly converted into cash or not? Acid test ignores inventories, considering only cash, bank balances & receivables Acid test ratio = (current assets – inventories): current liabilities Ideal is between 0.75:1 and 1:1

Gearing total equity + non-current liabilities Examines capital structure of a firm and its likely impact on firm’s ability to stay solvent Gearing (%) = non-current liabilities x 100 total equity + non-current liabilities

Gearing If ratio is greater than 50%, high capital gearing If less than 25%, then low capital gearing 25%-50% is within normal range

High capital gearing - benefits Relatively few shareholders means greater control for existing shareholders Company can benefit from a very cheap source of finance when interest rates are low In times of high profit, interest payments are usually much lower than shareholders’ dividend requirements

Low capital gearing - benefits Less risk of creditors forcing company into liquidation Avoids problem of having to pay high levels of interest on borrowed capital when interest rates are high Avoids pressure facing highly geared companies that must repay their borrowing at some stage

Ideal gearing ratio It depends!

Liquidity ratios Current ratio