Welcome to the World of Ratios!
Hi there! If you’ve ever looked at a set of financial statements and thought, "Okay, the profit is $1 million... but is that actually good?"—then you are already thinking like an accountant. Numbers on their own don't tell the whole story. To understand if a business is truly healthy, we need to compare those numbers. That is exactly what Ratio Analysis is all about.
\n\nIn this chapter, we’ll learn how to perform a "health check" on a company. Don't worry if math isn't your favorite subject; the formulas are logical, and once you understand the "why" behind them, the "how" becomes much easier!
\n\n1. Profitability Ratios: Are we making enough money?
\nProfitability ratios look at how good a company is at generating profit relative to its sales or the resources invested in it.
\n\nReturn on Capital Employed (ROCE)
\nThis is often considered the "king" of ratios. It tells us how much profit the company generates for every $1 of capital (money) put into the business by owners and lenders.
Formula: \(\text{ROCE} = \frac{\text{Operating Profit (PBIT)}}{\text{Total Equity} + \text{Non-current Liabilities}} \times 100\)
The Analogy: Imagine you put $100 into a savings account and get $5 interest. Your "ROCE" is 5%. If a business has an ROCE of 20%, it’s working much harder for its investors!
Profit Margins
These ratios show what percentage of sales revenue actually turns into profit.
Gross Profit Margin: \(\frac{\text{Gross Profit}}{\text{Revenue}} \times 100\)
Operating Profit (Net) Margin: \(\frac{\text{Operating Profit}}{\text{Revenue}} \times 100\)
Common Mistake to Avoid: Make sure you use Revenue (Sales) as the bottom number (denominator), not the Cost of Sales!
Asset Turnover
This measures how efficiently a company uses its assets to generate sales.
Formula: \(\text{Asset Turnover} = \frac{\text{Revenue}}{\text{Capital Employed}}\) (expressed as 'times')
Quick Review: ROCE can actually be calculated by multiplying Operating Margin by Asset Turnover. This shows that a company can improve its return either by making more profit per sale OR by selling more using the same assets!
Key Takeaway: Profitability isn't just about the dollar amount; it's about the efficiency of turning investments and sales into actual profit.
2. Liquidity Ratios: Can we pay our bills?
Liquidity is all about cash flow. A company can be profitable but still go bankrupt if it runs out of cash to pay its suppliers today.
The Current Ratio
This compares what we own in the short term (Current Assets) to what we owe in the short term (Current Liabilities).
Formula: \(\frac{\text{Current Assets}}{\text{Current Liabilities}}\)
Did you know? A ratio of 2:1 was traditionally seen as "ideal," but many modern businesses (like supermarkets) operate successfully with much lower ratios because they manage their cash so quickly.
The Quick Ratio (Acid Test)
This is a "tougher" version of the current ratio. It removes Inventory (stock) from the calculation because inventory is the hardest current asset to turn into cash quickly.
Formula: \(\frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}\)
Key Takeaway: If the Quick Ratio is less than 1.0, the company might struggle to pay its immediate debts if its creditors all asked for their money at once.
3. Efficiency (Working Capital) Ratios
These ratios look at how well the company manages its day-to-day operations: stock, customers, and suppliers.
Inventory Days
How long does a product sit on the shelf before it’s sold?
Formula: \(\frac{\text{Inventory}}{\text{Cost of Sales}} \times 365\)
Receivables (Debtors) Days
How long does it take for our customers to actually pay us?
Formula: \(\frac{\text{Receivables}}{\text{Revenue (Credit Sales)}} \times 365\)
Memory Aid: If this number is increasing, it means your customers are taking longer to pay—which is bad for your bank balance!
Payables (Creditors) Days
How long do we take to pay our own suppliers?
Formula: \(\frac{\text{Payables}}{\text{Cost of Sales (or Purchases)}} \times 365\)
Key Takeaway: The goal is to collect cash from customers quickly, keep inventory moving fast, and pay suppliers within agreed terms (but not too early!).
4. Gearing and Solvency: The Long-Term View
Gearing looks at the risk associated with how the business is financed. Is it funded by the owners (Equity) or by borrowing (Debt)?
Gearing Ratio
High gearing means the company has a lot of debt relative to its total capital. This is risky because interest must be paid regardless of whether the company makes a profit.
Formula: \(\frac{\text{Long Term Debt}}{\text{Equity} + \text{Long Term Debt}} \times 100\)
Interest Cover
How many times over could the company pay its interest bill using its current profits?
Formula: \(\frac{\text{Operating Profit}}{\text{Finance Costs (Interest)}}\)
Don't worry if this seems tricky: Just remember that a low interest cover (e.g., less than 2) is a red flag. It means even a small drop in profit could leave the company unable to pay its interest.
5. Limitations of Ratio Analysis
Before you finish, remember that ratios aren't perfect! Always consider these points in your exam answers:
- Historical Data: Ratios tell us what happened in the past, not necessarily what will happen in the future.
- Comparison Issues: Different companies use different accounting policies (like different depreciation methods), which can make comparisons difficult.
- Inflation: Prices change over time, which can distort year-on-year comparisons.
- Window Dressing: Some companies might take steps just before the year-end to make their ratios look better than they usually are.
Final Key Takeaway: A ratio is just a starting point. It tells you what is happening, but as an accountant, your job is to investigate why it is happening!
Great job! You've just covered the core logic of Financial Ratios. Take a quick break and then try a few practice calculations to lock in the formulas!