Financial Ratios

Ratio analysis is a technique by which users can analyse past and present data to determine the financial position of an entity. They can be measured in different ways:

1. As a ratio, like 0.4:1

2. As a decimal, like 0.4

3. As a percentage, like 40%

4. As days or time, especially when considering inventory and turnover

Financial ratios compare and analyse financial information. The following are some purposes of these ratios:

• Acts as a managerial tool to judge the financial performance of a business.

• Assesses if performance has improved.

• Compares performance with competitors.

• Analyses financial position.

• Assesses financial performance.

• Compares actual figures with expected figures.

• Aids in decision making.

• Can diagnose trends in profitability, liquidity and gearing.

Ratios have some disadvantages as well:

• Takes years for trends to appear.

• Methods of calculation must be standardised to compare with industry.

• Cannot compare with other industries.

• Limited to past performance.

• Does not identify causes of any problems.

Assets and Liabilities

Assets are items that a business owns and controls, which can also be used to generate income:

• Current assets (CA) – valid for under 12 months

  • Cash

  • Debtors/ Accounts Receivable

  • Inventory

• Non-current assets (NCA) – valid for over 12 months

  • Factories/warehouses

  • Tools

  • Land

  • Vehicles

  • Equipment

Liabilities are anything a business owes:

• Current liabilities (CL) – need to be paid back within 12 months

  • Short-term loans

  • Bank overdrafts

  • Creditors/ Accounts Payable

• Non-current liabilities – can be paid back after 12 months

  • Mortgages

  • Term loans

  • Debentures

Liquidity

Liquidity is the ease with which a company’s assets can be converted into cash, to pay of its current liabilities. It can be measured through the current ratio, also known as the working capital ratio:

A current ratio of 1.5 means that a business has $1.50 of assets to repay each dollar of its current liabilities.

A higher current ratio is better, as it suggests the company has more assets compared to debt. A ratio of less than 100% (or 1) indicates it can be hard for the business to repay short-term debts. A ratio of greater than 200% (or 2) means the firm should have no problem meeting debts and has a greater capacity to cope with an unexpected bill. A very high ratio suggests that a firm has a lot of its assets tied up in cash etc.

There are different ways to improve the firm’s liquidity:

• Borrowing more funds – debt finance

• Arranging extra time to pay off creditors

• Owner contributes cash capital

• Increase the rate of payments from debtors

Profitability

Profitability involves how effectively the business is usings its assets and invested funds to generate profit. A business can have high profit but can still go bankrupt if they can’t pay short-term debts.

Gross Profit Ratio

The gross profit ratio is generally measured through a percentage and can be calculated using the following:

Gross profit is calculated by subtracting the Cost of Goods Sold (COGS) from total revenue. COGS refers to direct expenses of production.

The gross profit margin tends to fall for the following reasons:

• Lower Sales Revenue

  • Can be caused by economic slowdowns

  • Pressure from competitors

  • Prices may fall as a result

• Increased COGS

  • Higher purchase and inventory costs (can be caused by exchange rate depreciation)

    
    

There are different ways of solving this:

• Boost Revenue

  • Change product mix

  • Adapt and innovate

  • Focus on marketing

• Decrease COGS

  
  

  • Bulk buy

  • Economies of scale

  • Just-in-time inventory management

  • Negotiate with suppliers

(Net) Profit Ratio

Net profit is calculated with the equation:

Which refers to expenses such as rent or utilities.

The Net Profit Ratio is calculated as follows:

There are certain characteristics of this ratio to consider:

1. A bigger value is always better

   
   

2. Often stated as a percentage

   
   

3. Almost always lower than (or equal to – very unlikely) gross profit

   
   

4. Possible to be negative if the business is new or failing

   
   

5. It shows profit as a percentage of sales.

There are different causes of a decreasing net profit margin:

• Lower net profit caused by higher expenses

  • Specific expenses such as rent, wages, utilities or marketing could be rising

    
    

There are a few methods to solve this issue:

• Lower expenses

  • Through technological integration, improving efficiency, etc.

• The same methods for improving gross profit (see above)

Expense Ratio

The formula for the Expense Ratio is:

For this ratio, a small number is preferred.

There are many causes of a high Expense Ratio:

• Higher expenses

  • Usually caused by an inneficiency involving an organisation's people, managers/owners, or processes

• Lower sales

  • This can be caused by poor economic conditions or new competition

    
    

There are different ways of improving the Expense Ratio:

• Set budgets to control expenses

• Marketing can help improve sales. Although marketing will increase expenses, it may help improve sales to a greater extent.

• Innovation can be performed to increase sales.

• Technology can be used to develop economies of scale, decreasing expenses.

• Refine processes to reduce expenses

• Improve productivity and efficiency

Return on Equity Ratio

This ratio is calculated as:

There are certain characteristics to consider with this ratio:

• A bigger value is better.

• It refers to how well the business uses owner’s/investor’s money to make money

• Shows how many dollars of profit a firm generates per dollar of shareholder equity

• Usually high for high growth firms

• Average the ratio of the past few years can give a better idea of growth.

  
  

There are different causes of a low Return on Equity Ratio:

• Higher expenses

• Lower revenue

Techniques to increase net profit (as discussed earlier) are useful for improving the Return on Equity Ratio. It is important to recognise that decreasing equity is counterintuitive for overall growth and so it is not a way to improve the Return on Equity Ratio.