1. CHAPTER 3
RATIO ANALYSIS

2. Chapter outline Introduction Requirements for financial ratios
Norms of comparison
Types of ratios
Profitability ratios
Profit margins
Turnover ratios
Liquidity ratios
Solvency ratios
Cash flow ratios
Investment ratios
Financial gearing
DuPont Analysis
Conclusion

3. Learning outcomes By the end of this chapter, you should be able to:
discuss the requirements for financial ratios
identify the norms of comparison used to evaluate ratios
identify the different types of ratios
define, calculate and interpret profitability, liquidity, solvency, cash flow and investor ratios
explain financial gearing
apply the DuPont Analysis system to evaluate return ratios.

4. Introduction
Information provided in financial statements is used to calculate financial ratios
Ratios attempt to provide more information in format that is comparable over time, between companies and between industries/countries
Ratios are more understandable than the financial figures in financial statements
Meaningful relationships between items from the financial statements are investigated with ratios

5. Requirements for financial ratios
Primary objective:
Simplify the evaluation of the financial performance and position of a company
Meaningful
Logical comparison between items from financial statements
Relevant
True indication of financial situation
Comparable
Ratio calculated in a consistent manner

6. Norms of comparison Conventions Comparison over time
Norms developed over time
May differ between firms/industries
Comparison over time
Determine if financial situation improved or declined
Determine trends in the values of the ratios
Comparison between companies
Determine the competitive position of the company relative to its competitors

7. Types of ratios Profitability ratios Profit margins Turnover ratios
Liquidity ratios
Turnover times
Solvency ratios
Coverage ratios
Cash flow ratios
Cash coverage ratios
Investment ratios

8. Profitability ratios
Evaluates efficiency with which a company utilises its capital to generate turnover
Small investment in assets generates large income – company is highly profitable
Large investment in assets generates small income – assets are not utilised efficiently
Possible to calculate the profitability of different capital items
Ensure relevant comparison between capital item and corresponding income/profit

9. Return on assets (ROA)
Measures how efficiently total assets are utilised to generate turnover
Compares profit after tax with total assets
ROA =
In order to improve ROA:
Improve profit figure, reduce amount of assets, or combination

10. Return on equity (ROE) Indicates return generated on total equity
Total equity includes ordinary shareholders’ equity, preference share capital and minority interest
Profit after tax represents profit available to equity providers
ROE =

11. Return on shareholders’ equity (ROSE)
Return generated on shareholders’ equity
Shareholders’ equity includes ordinary shareholders’ equity and preference share capital
Profit after tax minus non-controlling interest represents profit available to shareholders’ equity providers
ROSE =

12. Return on ordinary shareholders’ equity (ROSHE)
Return generated on ordinary shareholders’ equity
Ordinary shareholders’ equity includes ordinary share capital and reserves
Profit after tax minus non-controlling interest and preference share dividends represents profit available to ordinary shareholders
ROSHE =

13. Profit margins
Indication of the percentage of turnover that shows as profit after certain deductions are made
Profit margins could influence profitability ratios
Higher profit margins should increase profitability levels

14. Gross profit margin (GP)
Portion of turnover that is realised as gross profit after cost of sales has been subtracted
GP =

15. Operating profit margin (OP)
Portion of turnover that is realised as operating profit after operating expenses have been subtracted
OP =

16. Earnings before interest and tax margin (EBIT)
Profit made before taking any finance cost and tax into consideration
EBIT =

17. Net profit margin (NP) Portion of turnover available after tax is paid
Important to the equity providers
Indication of portion of the turnover that belongs to non-controlling interest holders, which can be paid out as ordinary or preference dividends or can be reinvested as part of the company’s reserves
NP =

18. Turnover ratios
Indicates speed with which an investment in assets is converted into turnover
Higher the value of the ratio the more times per year the investment is utilised to generate turnover, and the higher the total profit should become
Influences the profitability of a company
Higher turnover ratios should increase profitability levels

19. Total asset turnover ratio
Indicates efficiency with which total assets are utilised to generate turnover
The higher the value of TA turnover ratio, the more times per year the investment in total assets is converted into turnover
If a company is able to improve TA turnover ratio while maintaining same profit margins, its return on assets should increase
TA turnover =

20. Property, plant and equipment turnover ratio
Evaluates the utilisation of a company’s investment in PPE
PPE at carrying value
PPE turnover =

21. Current asset turnover ratio
Indicates the number of times per year that the investment in the current assets is converted into turnover
CA turnover =

22. Trade receivables turnover ratio
Shows number of times per year that investment in trade receivables is converted into turnover
TR turnover =

23. Inventory turnover ratio
Focuses on investment in inventory
Cost of sales is determined by the amount of inventory that is sold so INV ratio does not focus on the value of the company’s turnover
Cost of sales figure is used instead
INV turnover =

24. Trade payables turnover ratio
Evaluates efficiency with which company utilises trade payables to finance its purchases
When the TP turnover ratio is calculated, purchases of inventory during the year are required
TP turnover =

25. Liquidity ratios
Liquidity refers to ability to honour short-term obligations
Adequate liquidity: sufficient current assets are available to cover current liabilities
If company’s liquidity is consistently at insufficient levels, it may eventually result in problems with solvency in the long term: could threaten the survival of the business

26. Current ratio Compares current assets and current liabilities
Conventional norms of comparison: value of 2:1 if company maintains acceptable levels of liquidity
Value less than one: indicates that there is less than R1 of current assets to cover R1 of current liabilities – this could indicate insufficient liquidity
Current ratio =

27. Quick ratio Focuses on current assets and liabilities
Unlike current ratio, not all current assets are included:
Takes time to sell inventory
Prepayments cannot be reclaimed
Value of quick ratio more conservative estimate of current assets available to cover current liabilities
Quick ratio =

28. Cash ratio
Focus is placed solely on cash and cash equivalents available
Cash ratio indicates if sufficient cash is available to cover current liabilities
Cash ratio =

29. Turnover time ratios
Turnover times of current assets provide indication of time it takes to convert investment into turnover
Longer turnover times: weaker liquidity
Turnover times of current liabilities provide an indication of average period of time before liability is redeemed
Shorter turnover times: liabilities are paid earlier; negative effect on liquidity
Turnover times influence cash conversion cycle
More efficient management of working capital components could result in improved liquidity

30. Trade receivables turnover time
Average time it takes to convert investment in TR into turnover
Represents average collection period of trade receivables (i.e. how long customers that purchase items on credit take on average to pay accounts)
Increase in value of ratio over time could be sign of decreased liquidity; could also be indication that credit terms are too lenient
TR turnover time =

31. Inventory turnover time
Calculates average time it takes to convert inventory into turnover
Provides average age of inventory (i.e. how long an item of inventory has been in the business before it is sold)
INV turnover time =

32. Trade payables turnover time
Indicates average period it takes before trade payables are repaid
If TP turnover time decreases: trade payables are repaid earlier; negative effect on liquidity
Increase in TP turnover time: improved liquidity
TP turnover time =

33. Cash conversion cycle
Indication of the time that elapses from when cash is spent on purchase of inventory until it is received back again
Inverse relationship between CCC and profitability; could improve profitability by reducing CCC
CCC =

34. Solvency ratios
Solvency refers to a company’s ability to cover all its obligations when it eventually closes down its operating activities
Comparison between total assets and total debt capital
If value of assets exceeds the value liabilities: solvency level would most probably be sufficient
If this is not the case: long-term survival of the company may be at risk

35. Debt : assets ratio Relationship between debt capital and total assets
Provides indication of the portion of the total capital requirement that is financed by means of debt capital
The higher the value of this ratio, the weaker the solvency position
Debt : assets ratio =

36. Debt : equity ratio
Compares amount of debt capital with equity capital
The higher the value of this ratio, the weaker the solvency position
Debt : equity ratio =

37. Financial leverage ratio
Amount of total assets is compared with amount of equity capital included in the company’s capital structure
The higher the value of this ratio, the weaker the solvency position
Financial leverage ratio =

38. Coverage ratios
Consider ability to meet certain obligations when evaluating solvency
If a company is unable to cover some obligations could result in solvency problems
To determine if sufficient profits are available to cover obligations calculate coverage ratios
Coverage ratios focus on obligations company are legally bound to consider – compares it with profit available to pay the obligation

39. Finance cost coverage
Finance cost payable on debt capital usually represents legally enforceable obligation
If finance cost is not paid debt capital providers can take legal action to collect it
Finance cost coverage ratio indicates if sufficient profits are available to pay finance cost
Finance cost coverage =

40. Fixed payments coverage
Fixed payments: obligations that company always needs to honour
Obligations not honoured may result in termination of company’s activities
Usually consist of finance cost and lease payments
Profit available calculated by adding finance cost and lease payments to profit before tax
Fixed payments coverage =

41. Preference dividends coverage
Indicates if sufficient profits are available to pay preference dividends
Relevant profit figure: profit after tax and minority interest
Preference dividends can only be paid after provision has been made for all other obligations
Preference dividend coverage =

42. Cash flow ratios
Important to consider if sufficient cash flows are generated to cover a company’s expenses and liabilities
Also necessary to investigate a company’s sources of cash flows, and how these cash flows are utilised

43. Cash flow to turnover ratio
Quantifies portion of company’s turnover that is converted into CFO
Higher value indicates that turnover is converted into cash flow more efficiently
Cash flow to turnover ratio =

44. Cash return on assets
Indicates how efficiently company’s assets are utilised to generate operating cash flows
Higher value indicates that assets are utilised more efficiently to generate CFO
Cash return on assets =

45. Cash return on shareholders’ equity
Determines the cash return that the shareholders of a company received
Higher value indicates that shareholders received a higher cash return on their investment
Cash return on shareholders’ equity =

46. Cash flow to operating profit
Important to determine what portion of profit is eventually converted into cash flows
Cash flow to operating profit ratio provides an indication of the percentage of the operating profit that is converted into operating cash flows
Cash flow to operating profit =

47. Cash coverage ratios
When evaluating a company’s ability to meet obligations also possible to focus on cash flows rather that profit figures
Cash coverage ratios should provide analysts with an indication of whether the company has sufficient cash available to cover obligations
Since most obligations need to be paid with cash, these ratios are of great importance

48. Finance cost cash coverage
Determines cash flow available to pay finance cost obligations
Finance cost cash coverage =

49. Dividend cash coverage
Determines cash flow available to pay dividends
If insufficient cash flows are available to cover dividends company needs to obtain external cash flows
Dividend cash coverage =

50. Reinvestment coverage
Determines if sufficient cash flows are generated to cover reinvestment in fixed assets
Reinvestment coverage =

51. Debt repayment coverage
Determines if sufficient cash flows are generated to repay long-term debt capital
Debt repayment coverage =

52. Investing and financing coverage
Determines if sufficient cash flows are generated to cover company’s investing and financing cash flows
If company is unable to generate sufficient operating cash flows to cover these activities, they will have to obtain additional cash flows from its capital providers to meet the cash demand
Investing and financing coverage =

53. Investment ratios
One of the most important groups of users of company’s financial statements are the shareholders – both existing and potential
Are interested in potential benefits that investment will provide
Also interested to find out if investment in the shares of the company is expected to increase or decrease in value over time

54. Earnings per share
Indication of the distributable profit that was earned per ordinary share during the year
Attributable to the ordinary shareholders of the company
EPS =

55. Dividend per share
Indicates the amount that investors receive per share in the form of ordinary dividends
Usually only a portion of the EPS is declared as an ordinary dividend
Portion not paid out reinvested as retained earnings
DPS =

56. Price : earnings ratio
Indication of how many Rands investors are prepared to pay for each R1 EPS that is earned by the company
If P : E ratio is greater than one, it is usually an indication that investors expect company to continue to grow in future
P : E ratio =

57. Dividend payout ratio
Represents portion of attributable earnings that is paid to investors
Remaining portion is reinvested as part of retained earnings
Dividend payout ratio =

58. Ordinary dividend coverage
Ordinary shareholders have last claim on profits
When ordinary dividend coverage is calculated, focus is placed on attributable earnings
Usually dividends only declared if sufficient profits are available
If ordinary dividend coverage ratio is less than one, reserves from previous years used or additional debt capital obtained
Ordinary dividend coverage =

59. Market-to-book value
Compares market capitalisation of shares with book value of shareholders’ equity
Market capitalisation calculated using current market price: incorporate investor expectations about future financial performance
Book value of ordinary shareholders’ equity: total capital ordinary shareholders contributed
Comparison between the values provide indication of price investors are prepared to pay relative to investment at book values
High value for ratio sign that investors are expecting high future earnings from the company

60. Market-to-book value
Market-to-book value =

61. Financial gearing Effect that use of debt capital has on ROSE
If company is able to utilise debt capital efficiently may result in increased ROSE
If utilisation of debt capital is not efficient use of debt capital will have a negative effect on ROSE
Two important factors taken into consideration when evaluating financial gearing:
ROA
Cost associated with debt capital (RD)

62. Financial gearing If company is able to generate ROA in excess of RD:
Return on capital higher than its cost; surplus profit will be transferred to shareholders increasing ROSE
Company experience positive financial gearing
Also possible that opposite situation occur:
If ROA is lower than RD: company is earning less on debt capital than its cost; deficit will be transferred to shareholders and the use of debt capital will result in decrease in ROSE.
Classified as negative financial gearing

63. DuPont analysis Used to obtain a breakdown of return ratios
Possible to identify individual components that contribute to overall value of the return ratio
Also possible to evaluate changes in the values of the ratios over time to determine where possible problem areas exist
Can also compare the ratios of similar firms to investigate where value is created

65. Conclusion
The main requirements for financial ratios are to provide meaningful comparisons between items in the financial statements; that only relevant amounts must be included in their calculations; and that they need to be comparable over time.
When evaluating financial ratios it is important to compare the values of the ratios to conventional norms, the value of the ratio calculated for the company over a period of time or to the values of the ratio obtained for similar companies.

66. Conclusion (cont.)
The main categories of ratios are profitability, liquidity, solvency, cash flow and investment ratios.
Profitability ratios evaluate the efficiency with which a company utilises its capital to generate turnover.
Liquidity ratios refer to a company’s ability to cover current liabilities by means of its current assets.
Solvency ratios investigate the relationship between a company’s debt capital and its total assets.

67. Conclusion (cont.)
Cash flow ratios determine if sufficient cash flows are generated to cover the company’s obligations.
Investment ratios are calculated to determine the benefits that the investors of the company earned.
DuPont Analysis provides a breakdown of the components that contribute to a company’s ROE in order to evaluate changes in the ratio.