RATIO ANALYSIS

A. PROFITABILITY RATIOS or PROFITABILITY RATIOS They focus on the years Profit. The profit figure alone is not a useful performance indicator. It is necessary to look at the value of profit in relation to the value of turnover.

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Return on Capital Employed (ROCE): Also called Primary Ratio. ROCE = Profit before tax and interest / long term capital employed * 100 Where, Profit before tax and interest = Earnings before interest and tax (EBIT) And LT Capital Employed = Shareholders funds + LT loans - It compares the profit with the capital - The advantage of this ratio is that it relates profit to the size of the business - The higher the ratio, the better. Gross Profit Margin = Gross Profit / Turnover *100 or Mark-up = Sales Turnover Cost of Sales / Turnover * 100 - It shows the gross profit made on sales turnover. - Higher gross margins are usually preferable to lower ones. - It may be increased by raising turnover relative to cost of sales, or cost of sales could be reduced relative to turnover. Net Profit Margin = Profit before tax and interest / Turnover * 100 - It helps to measure how well a business controls its overheads. - Net profit = gross profit overheads. - If there is a small difference between the gross profit and net profit, this suggests that overheads are low. - Higher margins are usually better than lower ones. B. ACTIVITY RATIOS or ASSET USAGE RATIOS They are used to measure how effectively a business employs its resources. (1) Asset Turnover = Turnover / Net Assets - It measures the productivity of assets. - It looks at how much turnover is generated by the assets employed in the business. (2) Stock Turnover = Cost of Sales / Stocks - It measures a business uses or sells its stock. - One approach to stock turnover is to calculate how many times during the year a business sells its stock - Another approach to stock turnover is to calculate the number of days it takes to sell the stock. This is found by: Stock Turnover = Stocks / Cost of Sales * 365 - High stock turnovers are preferred (or lower figures in days) - A higher stock turnover means that the profit on the sale of stock is earned more quickly.

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(3) Debt Collection Period = Debtors / Turnover * 365 - It measures the efficiency of a businesss credit control system. - DCP is the average number of days it takes to collect debts from customers - Businesses prefer a short debt collection period because their cash flows will be improved. C. LIQUIDITY RATIOS A business must make sure that it has enough liquid assets to pay any immediate bills. Liquid assets include cash and assets that can be quickly converted into cash such as stocks, debtors and short-term investments. (1) Current Ratio = Current Assets / Current Liabilities - It focuses on current assets and current liabilities. - It is also known as Working Capital Ratios. - It is suggested that a business will have sufficient liquid resources if the current ratio is between 1.5:1 and 2:1. - If the ratio is below 1.5 it might be argued that a business does not have enough working capital. This might mean that a business is over-borrowing or over-trading. (2) Acid Test Ratio, or Quick Ratio = Current Assets Stocks / Current Liabilities - It is a more severe test of liquidity. - Since stocks may obsolete or deteriorate, therefore they are excluded from current assets. - If a business has an acid test ratio of less than 1:1 it means that its current assets less stocks do not cover its current liabilities. D. GEARING RATIOS They are used to analyse the Capital Structure of a business. They compare the amount of capital raised from ordinary shareholders with that raised in loans and, in some cases, from preference shareholders and debentures. They can asses whether or not a business is burdened by its loans. (1) Gearing Ratio = Fixed Cost Capital / Long Term Capital *100 Its one version relates the total long term loans and other fixed cost capital to long term capital employed. Fixed cost capital includes long term loans from banks, certain preference shares and debentures. Long term capital includes shareholders funds, any reserves and long term loans. If the gearing ratio is less than 50 per cent the company is said to be low geared. This means that the majority of the capital is provided by the owners. If the ratio is greater then 50 per cent the company is high geared. This means that a much higher proportion of total capital is borrowed. Another version of the gearing ratio looks at the relationship between borrowing and equity: Gearing Ratio = Borrowing / Equity *100 Borrowing is defined as long term loans.

(2) Interest Cover = Profit before Interest and Tax / Interest The gearing ratio is a balance sheet measure of financial risk. Interest cover is a profit and loss account measure. It assesses the burden of interest payments by comparing profit and interest payments. If interest cover is 1, this means that all of the firms profit would be used to pay interest E. SHAREHOLDERS RATIOS They provide information help investors to make decisions about buying and selling shares. They are used to analyse the performance of public limited companies. They can also be helpful to the owners of private limited companies. (1) Earning Per Share (EPS) =Profit after Tax / Number of Ordinary Shares It a measure of how much profit each ordinary share earns after tax. It does not show how much money is actually paid to ordinary shareholders. This is because companies actually retain some profit in reserve. The EPS is generally shown at the bottom of the profit and loss account. If the company had any preference shareholders, any dividends paid to these would have to be subtracted from profit. (2) Price/Earning Ratio = Share Price / EPS It is a main indicator used by investors in deciding whether to buy or sell particular shares The P/E ratio relates the current share price to the EPS. The P/E ratios provide a useful guide to market confidence and can be helpful in comparing companies. (3) Dividend Per Share = Dividend (Ordinary Shares) / Number of Shares It shows how much money ordinary shareholders receive per share. (4) Dividend Yield = Dividend Per Share / Share Price *100 The dividend yield is the dividend per ordinary share expressed as a percentage of the current share price. (5) Return on Equity (ROI) = Profit After Tax / Equity The ROE looks at the return on the money contributed by, and belonging to, ordinary shareholders. It defines equity as the ordinary shareholders capital plus reserves. (6) Dividend Cover = Profit After Tax / Dividends (Ordinary Shares) It measures how many times a companys dividend to ordinary shareholders could be paid from net profit.