1. RATIO ANALYSIS

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

3. 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

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

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

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

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

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

9. Which best summarise financial performance?

10. Which best summarise performance?
Performance & liquidity ratios

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

12. 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

13. Profitability & liquidity
RATIO ANALYSIS
Profitability & liquidity

14. 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)

15. 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

16. 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

17. 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

18. 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

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

20. 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

21. 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

22. Ideal gearing ratio
It depends!

23. Liquidity ratios
Current ratio