1. RATIO ANALYSIS
The users of financial reports require information on a variety of aspects of the nature of the business in order to make future investment decisions.
The areas of consideration for these decisions can be identified as :
Liquidity, Efficiency, Profitability, Leverage and Market and they can be assessed using ratios to compare two different numbers and bring them to a common base. In this way we can compare different accounting periods or different businesses.
Ratios are used dividing one dollar amount of one account by the dollar amount of another account. They can be expressed in two possible ways:
1 Directly as a ratio , for example 2.15:1.0
2 As a percentage , for example 215%

2. LIMITATIONS
Ratios need to be calculated for a number of years in order to identify a TREND.
Limited data can affect accuracy i.e. limited disclosure may make it difficult to calculate all ratios.
Comparisons require consistency between reports – business may adopt different accounting procedures.
Historical cost accounting has limitations –i.e. the appreciation of land and buildings.
Ratios can only be used to assist accountants, managers or owners because they do not identify the cause of the problem.
Ratios can not be taken in isolation unless a reliable industry average can be used.
Customer service, Health and Safety, Quality control, strategies for employee learning and growth, environment objectives and community involvement

3. COMMON AILMENTS OF BUSINESS
OVERSTOCKING- having too much stock tied up in inventory.
EXCESSIVE BOOK DEBTS- granting too much credit to customers.
UNDER CAPITALISATION –too rapid growth for investment.
OVER INVESTMENT IN NCA – over capitalisation of equipment.
INSUFFICIENT SALES- subordinating salesmanship to production.
INSUFFICIENT PROFITS – usually tied up with insufficient sales but could be due to excessive expenses.

4. Liquidity
This information enables analysis of the ability of the company to meet debts as they fall due, and creditors as well as potential lenders to the company would be most concerned about these ratios. Investors would want to assess how financially stable a business is by using these ratios as well as additional information obtained from the Cash Flow Statement.
The Working capital Ratio or Current Ratio is calculated by ( net accounts receivable are used - Accounts receivable less Allowance for Doubtful Debts as this is what we think we will receive)
Current assets
Current liabilities

5. Liquidity
The ideal level for this ratio is 2.0:1.0 or 200%. This might be considered ideal as this indicates that for every dollar that we owe as a current obligation we have $2 of current assets to meet this obligation.
This will vary according to the industry examples from 2009 annual reports: Woolworths 76%,Reject Shop 86, Harvey Norman 111%,Maquarie Radio 202%.
Generally if the ratio is increasing or above 100% then the short term asset base is increasing , inventory might be being sold more slowly, debtors may be taking longer to pay, there also might be idle cash that could be invested.
If the ratio is below 100% or decreasing this indicates that the short term asset base may be decreasing, in proportion to the liabilities, inventory might be sold more quickly, Debtors may be paying more promptly.

6. Liquidity
The second ratio to look at liquidity is the Quick Asset Ratio. This compares the current assets and liabilities that can be quickly converted into cash. This is also called the Acid Test Ratio.
Quick Asset Ratio=
Current Assets ( not including stock and prepayments)
Current liabilities ( not including overdrafts)

7. Liquidity Quick Asset Ratio Continued
A ratio of 1:1 or 100% is the minimum safe amount and 1.5:1 or 100% to 200% is recommended . Having said this some industries with strong cash flows operate safely with smaller amounts. Annual reports of Retail stores will have a quick asset ratio of much less than 100 as they have stock make up a large proportion of their assets. David Jones 13%, JB HiFi, 31%,News Corporation 121%, Wotif.com 76%

8. Stability- Gearing /Leverage
All financing options are provided by either internal or external finance by lenders.
Internal is money supplied to the business by the owner , or earned from trading or for selling assets for cash these are all forms of capital and in a company the capital comes from shares.
External finance comes from money supplied to the business by a loan provider who is paid interest, or a trade creditor who supplies products before being paid, all outside the business.

9. Debt to Equity Ratio Total Liabilities Equity ( end)
Businesses will not want to have a high proportion for their financing coming from external sources ( unless interest rates are vey low) as they will be exposed to repaying these amounts and interest and they are a major consideration when looking at the businesses obligations and how stable or exposed it is. The higher the external source of funds to internal the higher the gearing or leverage. This is measured by the Debt to Equity Ratio. A low ratio- low gearing means there is a low proportion of debt( external ) funding compared to internally generated equity.
Total Liabilities
Equity ( end)

10. Stability- Gearing /Leverage
A business will usually prefer to have a low gearing, because that means that it is providing funds through daily trading but from the owners who are less likely to require repaying of capital. The requirement to repay borrowed external funds at a set point in the future and interest, places pressure on the business, the pressure can also affect the cash flow of the business.
The ideal ratio is hard to state as below 40% would be seen to be conservative 1:1 or 100% is possibly too high. This is not always the case we find as sometimes a business will have a high turnover and be able to service the interest repayments or they may be operating in a time of low interest rates.

11. If the ratio is higher than this there is a high level of borrowed funds, liabilities have increased and interest rate pressure might cause problems down the track.
If the ratio is decreasing or below 100% then there is a low level of borrowed funds, equity might have increased and interest rates are less of a concern as the business is not as exposed to the repayment obligations.
2009 examples: Harvey Norman 29%, David Jones 64%, Telstra 215%, Navitas Education Colleges 222%
The level of gearing must be viewed in relation to the profit and the ability of the business to service the interest payments.

12. Stability- Gearing /Leverage
As the level of gearing must be viewed in relation to the profit and the ability of the business to service the interest payments, the next ratio is classified as a profitability ratio but gives us a look at how many times our profit will pay the interest expense. In this way some texts consider it a good tool in assessing gearing as it is a gauge of how much profit is generated for the cost of borrowing that money – Times Interest Earned.

13. Stability- Gearing /Leverage
Times interest earned
This ratio compares EBIT- Earnings before interest and tax, compared to the interest costs expensed and capitalized. What the hell does that mean? If a building takes more than a year to construct , the interest paid on the loan is capitalized- made part of the value of the asset.
Profit before income tax + interest expense
Interest costs expensed and capitalised

14. This ratio shows us how many times the profit of the business can cover the interest it is incurring to create that profit. The less highly geared a business the less interest so this ratio gives us a gauge on the ability of this particular business to cover the interest it is incurring.
A ratio of 4 : 1 means that the business is able to cover the cost of the interest four times over. The higher the better but if it is over ten times the companies leverage/ gearing could be too low and may be able to operate from a situation of higher borrowings, higher gearing/ leverage.
This ratio changes in relation to the companies profit and is often listed as a Profitability gauge.

15. Profitability
These ratios take into account revenue and expense items from the Income Statement/ Statement of comprehensive income.
Once we have our [profit figure for the period the job of the accountant has just begun, we use this figure to analyse the performance of the business.
Profitability refers to earning capacity during the period.
The figures we arrive at we can compare to industry averages, Budgeted profit, comparisons to previous periods.
The profit ratios are: Profit ratio, expense ratio and return on assets or return on owners investment.

16. Profitability The Profit Margin Ratio Profit after income tax
Total revenues
All positive results for this ratio are good as they indicate a profit and changes in this relationship will sometimes be due to other income or expenses.
Generally this will increase if we are selling higher sale priced inventory or if our expenses are have decreased.

17. If this ratio is decreasing then we are making less profit for the revenue we are selling it for , expenses are increasing , stock is selling for less or other fixed costs are being spread over fewer products.

18. Profitability Rate of return on assets
This ratio indicates how efficiently the business is using its asset to generate profit. Interest is added back to before tax profit to take the financing of assets out of the analysis.
Return on assets =
Profit before income tax + interest
Average total assets( Current yr + last yr/2)

19. A positive result for this asset means that a profit has been made so the bigger the better. If Interest expense does not specify what portion is interest expense then assume it all is a state that.
Generally if the ratio is increasing, the money invested is being used more efficiently, a greater return may be being returned from the same quantity of assets.
If the ratio is decreasing, the assets are being used less efficiently and the business might need to reconsider the amount of assets ensuring that they are not idle.

20. Management Efficiency Ratios
These ratios are used to measure how effective the business is at collecting income and paying costs. They will use these ratios to investigate debtor collection, creditor payment or inventory turnover.
Debtors Collection Period.
This ratio indicates how long it takes debtors to pay for credit sales. Debtors have terms or 7 days , 14 or a month and all should be paid in the time planned for or cash flow can be affected.

21. Management Efficiency Ratios
Debtors Collection Period –
Average Debtors ( balance at the start and the end /2) x365
Net Credit Sales
This gives the average number of days that it takes to collect debtor payment.
Ideally the ratio should be 30 days.
If this ratio is too high then the debtors are taking too long and debtor collection policy needs to be reviewed. If below 30 days then incentives are working to get early payment.

22. Management Efficiency Ratios
Debtors Turnover =
Average debtors
Net credit sales
By dividing this number into 365 we can work out the number of days in the debtors collection period.
365
Debtors Turnover = number of days

23. Management Efficiency Ratios
Stock Turnover
This ratio shows how long the business has had to store inventory before selling it. It is the number of times that the entire amount of inventory is sold. The business needs to find a balance between turning stock over too fast and having all of the expenses related to re stock and having stock turnover too slowly and having obsolete stock.
Turnover for the period =
Cost of sales
Cost of Average Inventory = times per period

24. Management Efficiency Ratios
The Turnover for the Period id divided into 365 to work out how many days the turnover is.
The optimum level of turnover depends on the type of firm, Increased turnover means greater cash flow and if the turnover ratio is increasing the stock is moving faster.
If the ratio is decreasing then we are holding onto stock longer and, we may review our promotions and offer enticements to buy. We may need to check the age of stock and consider changing the selling price to entice sales.

25. Market Ratios
These ratios indicate to investors how much the company is returning to investors through shares and growth.
Earnings Per Share.
This is required to be calculated if shares are publicly traded. This ratio shows how much profit is allocated to each share.
Profit after Income Tax- Preference Dividends
Weighted Average Number of Ordinary Shares*
*Weighted Average number of shares is equal to the number of ordinary shares at the beginning - the number of shares bought back multiplied by a weighting factor for what portion of the period the shares were held.

26. Market Ratios
The number of shares must be used not the share dollar value so we get a per share split of the profit.
This ratio shows the earnings per share and if they are increasing it is good and shows the company is expanding and growing.
An increase says the company is returning more to the shareholders per share and a decrease means less per share.

27. Market Ratios Price /Earnings Ratio
This indicates how much the individual user of the financial information is willing to pay for each dollar of profit that the company has made.
Market price per Ordinary Share
Earnings per Ordinary Share
This ratio comments on what the market thinks of the Company and how many times the dividend that will be returned, are people prepared to spend, to be invested in our company. What are the expectations of our business from the market assessments of our reports.
If people will only pay 2 x what they will receive as profit then it means the market does not value our shares as much as if the ratio tells us they are prepared to pay 8 times the profit they will receive.

28. Market Ratios
The last ratio that analyses the return to investors is the Dividend Yield.
This indicates what proportion of the share does the dividend return to the investors. This can be compared to other possible investments.
The annual dividend per share=
cash dividend paid for the year
the number of shares

29. Market Ratios
We then take this dividend per share and place it into this formula-
Annual Dividend per Ordinary share
Market Price per Ordinary share
This ratio is important to investors as they can see what their return per share is compared to the selling price of the share. They can then compare to any other investment options.

30. Market Ratios
If this ratio is increasing that is good- more money for each share. If it is decreasing that is bad and future investment less likely as the return is diminishing compared to the dollar invested. This compared to other investments will be the main thing investors solely interested in the dividend return from the shares, will base their decision on. Shareholders will also pay particular attention to the growth prospects of the business as well as the dividend return per share.

31. Limitations of Ratio Analysis
Every question on Ratio Analysis needs a disclaimer that there are limitations to what the information can provide.
Past performance does not predict future results.
Ratios lack detail
Limited perspective as they are at a set point in time.
It is difficult to make meaningful comparisons between businesses.
These other areas can form an important part of performance analysis :
Customer service, Health and Safety, Quality control, strategies for employee learning and growth, environment objectives and community involvement.