Unit 5: Ratio Analysis

I. Orientation: Foundations of Financial Ratio Analysis

Ratio analysis is the systematic evaluation of relationships between figures reported in financial statements. It converts absolute accounting amounts into relative measures, allowing users to assess an enterprise’s liquidity, operating efficiency, profitability, long-term solvency, and market performance.

Defining characteristics:

• Relationship-based measure: A ratio expresses one relevant accounting figure in relation to another, such as current assets divided by current liabilities.
• Financial-statement foundation: Figures are generally drawn from the balance sheet, statement of profit and loss, cash-flow statement, and accompanying notes.
• Forms of expression:
  • Pure ratio: Current ratio may be stated as 2:1.
  • Percentage: Net profit margin may be stated as 12%.
  • Turnover or times: Inventory turnover may be stated as 8 times.
  • Period: Collection time may be stated as 45 days.
• Comparative interpretation: A ratio becomes meaningful when compared with prior periods, budgets, competitors, industry averages, or established norms.
• Consistency assumption: Comparisons assume reasonably consistent accounting policies, classifications, valuation methods, and reporting periods.
• Analytical categories: Ratios are commonly grouped into liquidity, activity, profitability, solvency, and market test ratios.
• Interdependence: No category should be interpreted alone; for example, strong liquidity created by slow-moving inventory may conceal weak operating efficiency.

II. Ratio Analysis — Meaning and Managerial Relevance

A. Nature of Ratio Analysis

Ratio analysis identifies significant financial relationships rather than merely restating absolute accounting figures.

• Meaning: A ratio is the mathematical relationship between two logically connected variables.

Financial Ratio = Related Accounting Figure A / Related Accounting Figure B

• A is the numerator being evaluated.
• B is the relevant base or denominator.

• Analytical process: Ratio analysis involves calculation, comparison, interpretation, and investigation of causes.
• Classification by source:
  • Balance-sheet ratios: Both figures come from the balance sheet, such as the current ratio.
  • Income-statement ratios: Both come from the statement of profit and loss, such as gross profit margin.
  • Composite ratios: Figures come from different statements, such as return on assets.
• Comparison methods:
  1. Time-series analysis compares the same enterprise across accounting periods.
  2. Cross-sectional analysis compares enterprises for the same period.
• Interpretive nature: A ratio is an indicator, not a final explanation; a declining margin requires investigation into prices, volume, cost, or product mix.

B. Use of Ratio Analysis

Ratio analysis serves different decision-making needs by summarising financial strengths, weaknesses, and trends.

• Management use: Managers monitor working capital, asset utilisation, costs, borrowing capacity, and return on investment.
• Investor use: Shareholders evaluate profitability, earnings per share, dividends, and market valuation.
• Lender use: Banks and trade creditors examine liquidity, debt burden, interest coverage, and repayment capacity.
• Trend identification: Ratios reveal whether performance is improving or deteriorating over several periods.
• Planning and control: Actual ratios can be compared with budgeted standards to identify deviations requiring corrective action.
• Credit decisions: A supplier may use the current ratio and receivables turnover before granting credit.
• Inter-firm comparison: Common-size relationships permit comparison between businesses of different absolute sizes.

C. Advantages of Ratio Analysis

Ratio analysis makes extensive accounting data more understandable and useful for decisions.

• Simplification: Large monetary figures are reduced to concise relationships, such as a 15% operating margin.
• Comparability: Relative figures permit comparisons across periods and enterprises more effectively than absolute profit alone.
• Early warning: Deteriorating liquidity, falling turnover, or rising leverage may signal financial difficulty before failure occurs.
• Performance evaluation: Profitability and activity ratios help assess managerial efficiency in using resources.
• Forecasting support: Historical trends assist in preparing budgets, projected statements, and financing plans.
• Coordination: Related ratios connect operational decisions with financial outcomes; inventory policy affects both turnover and liquidity.
• Stakeholder communication: Standard indicators provide a common language for managers, investors, lenders, and analysts.

D. Limitations of Ratio Analysis

Ratios must be interpreted cautiously because their reliability depends on the underlying data and comparison basis.

• Historical information: Most ratios use past accounting figures and may not represent current conditions or future performance.
• Accounting-policy differences: Depreciation, inventory valuation, provisions, and revenue recognition can distort inter-firm comparison.
• Inflation effect: Assets recorded at historical cost may be understated, overstating turnover and return ratios.
• Window dressing: Management may temporarily improve year-end balances, such as paying liabilities immediately before reporting.
• Lack of universal standards: An acceptable ratio varies by industry, business model, season, and risk profile.
• Qualitative omissions: Ratios do not directly measure employee skill, customer loyalty, product quality, governance, or competition.
• Aggregation problem: Diversified businesses may combine segments with substantially different economics.
• Mechanical interpretation: A high current ratio can indicate sound liquidity or inefficient accumulation of cash and inventory.

III. Liquidity Ratios — Short-Term Payment Capacity

A. Liquidity Ratios

Liquidity ratios measure an enterprise’s ability to meet obligations falling due within the operating cycle or one year.

• Current ratio: This compares total current assets with total current liabilities.

Current Ratio = Current Assets (CA) / Current Liabilities (CL)

• CA includes cash, receivables, inventory, and other short-term assets.
• CL includes trade payables and other short-term obligations.
• A higher ratio generally indicates a larger liquidity cushion, but the desirable level depends on asset quality and industry conditions.

• Quick ratio: This removes inventory and prepaid expenses because they are less immediately available for paying liabilities.

Quick Ratio = Quick Assets (QA) / Current Liabilities (CL)
QA = CA - Inventory - Prepaid Expenses

• Cash ratio: This uses only the most liquid resources.

Cash Ratio = (Cash + Cash Equivalents + Marketable Securities) / CL

• Working capital: Although not a ratio, it provides a related absolute measure.

Working Capital = CA - CL

• Interpretive link: Liquidity should be examined with receivables and inventory turnover because slow conversion can weaken an apparently strong current ratio.

IV. Activity Ratios — Efficiency of Resource Utilisation

A. Activity Ratios

Activity ratios measure how efficiently assets are converted into sales, cash, or cost flows during a period.

• Inventory turnover: This shows how frequently average inventory is sold or consumed.

Inventory Turnover = Cost of Goods Sold (COGS) / Average Inventory (AI)
AI = (Opening Inventory + Closing Inventory) / 2

• Higher turnover may indicate efficient stock management, while exceptionally high turnover may indicate shortages.

• Receivables turnover: This measures the speed of collecting credit sales.

Receivables Turnover = Net Credit Sales (NCS) / Average Trade Receivables (AR)
Average Collection Period = 365 / Receivables Turnover

• NCS excludes cash sales and sales returns.
• AR is normally the average of opening and closing trade receivables.

• Payables turnover: This indicates how quickly trade suppliers are paid.

Payables Turnover = Net Credit Purchases / Average Trade Payables
Payment Period = 365 / Payables Turnover

• Total asset turnover: This relates sales generated to the average asset base.

Total Asset Turnover = Net Sales / Average Total Assets

• Fixed asset turnover: This assesses the productive use of property, plant, and equipment.

Fixed Asset Turnover = Net Sales / Average Net Fixed Assets

V. Profitability Ratios — Earnings and Return Performance

A. Profitability Ratios

Profitability ratios measure the enterprise’s capacity to generate profit from sales, assets, and owners’ funds.

• Gross profit margin: This reflects pricing and production or purchasing efficiency.

Gross Profit Margin = (Gross Profit / Net Sales) x 100

• Operating profit margin: This measures profit from core operations before interest and tax.

Operating Profit Margin = (Operating Profit / Net Sales) x 100

• Net profit margin: This shows the final profit retained from each unit of sales.

Net Profit Margin = (Profit After Tax / Net Sales) x 100

• Return on assets: This evaluates profit earned from the average resources controlled by the enterprise.

ROA = (Profit After Tax / Average Total Assets) x 100

• Return on equity: This measures the return attributable to ordinary shareholders.

ROE = (Profit After Tax - Preference Dividend) / Average Ordinary Equity x 100

• Return on capital employed: This relates operating profit to long-term funds employed.

ROCE = EBIT / Average Capital Employed x 100

• EBIT means earnings before interest and tax.
• Capital employed commonly equals equity plus long-term debt, or total assets minus current liabilities.

VI. Solvency Ratios — Long-Term Financial Stability

A. Solvency Ratios

Solvency ratios assess long-term debt exposure, financial structure, and the capacity to service fixed financing commitments.

• Debt-equity ratio: This compares debt financing with owners’ funds.

Debt-Equity Ratio = Total Debt / Shareholders' Equity

• Higher leverage increases potential shareholder returns but also raises financial risk.

• Debt ratio: This measures the proportion of assets financed through liabilities.

Debt Ratio = Total Liabilities / Total Assets

• Proprietary ratio: This indicates the proportion of assets financed by shareholders.

Proprietary Ratio = Shareholders' Funds / Total Assets

• Interest coverage ratio: This measures the margin available to meet interest charges.

Interest Coverage Ratio = EBIT / Interest Expense

• Low coverage indicates vulnerability to declining operating profit or rising interest rates.

• Debt-service coverage ratio: This considers both interest and scheduled principal obligations.

DSCR = Cash Earnings Available for Debt Service / Total Debt Service

• DSCR is the debt-service coverage ratio.
• Total debt service includes interest and principal repayments due for the period.

VII. Market Test Ratios — Shareholder and Market Evaluation

A. Market Test Ratios

Market test ratios relate accounting performance to ordinary shares, dividends, and the market price investors are willing to pay.

• Earnings per share: This calculates profit attributable to each weighted-average ordinary share.

EPS = (Profit After Tax - Preference Dividend) / Weighted-Average Ordinary Shares

• Price-earnings ratio: This indicates how many currency units investors pay for one unit of earnings.

P/E Ratio = Market Price per Share / EPS

• A high P/E may reflect expected growth, lower perceived risk, or market overvaluation.

• Dividend per share: This identifies the ordinary dividend allocated per share.

DPS = Ordinary Dividends / Number of Ordinary Shares

• Dividend payout ratio: This shows the proportion of earnings distributed rather than retained.

Dividend Payout Ratio = (DPS / EPS) x 100

• Dividend yield: This measures cash dividend return relative to market price.

Dividend Yield = (DPS / Market Price per Share) x 100

• Market-to-book ratio: This compares investor valuation with accounting value.

Market-to-Book Ratio = Market Price per Share / Book Value per Share
Book Value per Share = Ordinary Shareholders' Equity / Ordinary Shares Outstanding

• Interpretation: Market ratios combine financial-statement information with market expectations and therefore fluctuate with growth prospects, interest rates, risk perceptions, and investor sentiment.