Ratio analysis

Introduction: Making Sense of the Numbers

Welcome! If you’ve ever looked at a set of financial statements and felt overwhelmed by the rows of numbers, you’re not alone. Think of a company’s financial statements like a medical report. On their own, the numbers tell you "what" is happening, but Ratio Analysis tells you "why" it matters and how healthy the "patient" (the company) really is.

In this chapter, we are going to learn how to turn raw data into meaningful insights. We will look at how efficiently a company uses its assets, how much profit it makes from its sales, and whether it has enough cash to keep the lights on. Don't worry if you find the math intimidating at first—once you understand the logic behind the formulas, the rest falls into place!

1. Profitability Ratios: Are We Making Money?

Profitability ratios are the "headline" figures. They tell us how well the company is performing in terms of generating profit relative to its size and investment. In F2, we focus heavily on how well management uses the resources at their disposal.

Return on Capital Employed (ROCE)

This is often considered the most important ratio. It measures how much profit the company generates for every \$1 of capital (equity and long-term debt) invested in the business.

The Formula:
\n\( \text{ROCE} = \frac{\text{Operating Profit (EBIT)}}{\text{Total Assets} - \text{Current Liabilities}} \times 100 \)
\nNote: The denominator "Total Assets - Current Liabilities" is the same as "Equity + Non-Current Liabilities".

Real-World Analogy: Imagine you put \$100 into a savings account and get \$5 interest. Your "return" is 5%. ROCE is the same thing, but for the whole company.

Quick Review: A higher ROCE is generally better. If a company's ROCE is lower than the interest rate it pays on its loans, it is actually losing value by borrowing money!

Profit Margins

There are two main margins to watch:

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• Gross Profit Margin: \( \frac{\text{Gross Profit}}{\text{Revenue}} \times 100 \). This shows how efficiently the company produces its goods before overheads.
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• Operating Profit Margin: \( \frac{\text{Operating Profit}}{\text{Revenue}} \times 100 \). This shows how well the company manages its operating expenses like rent, salaries, and electricity.
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Common Mistake to Avoid: Don't confuse "Markup" with "Margin." Margin is always calculated as a percentage of the Selling Price (Revenue), not the Cost.

Key Takeaway: Profitability isn't just about the dollar amount of profit; it's about that profit relative to sales and investment.

2. Liquidity Ratios: Can We Pay the Bills?

Liquidity is all about "Cash Flow." A company can be profitable on paper but still go bankrupt if it runs out of cash to pay its suppliers today.

The Current Ratio

The Formula: \( \frac{\text{Current Assets}}{\text{Current Liabilities}} \)
\nThis asks: "Do we have more things that will turn into cash within a year than bills we have to pay within a year?"

The Quick Ratio (Acid Test)

The Formula: \( \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} \)
\nWhy subtract inventory? Because inventory (like unsold cars or clothes) can be hard to sell quickly in an emergency. This is a "tougher" test of liquidity.

Did you know? In some industries, like supermarkets, a low Quick Ratio is normal because they sell inventory so fast (high turnover) that they don't need to keep huge piles of cash sitting around.

Key Takeaway: If the Quick Ratio is less than 1.0, the company might struggle to pay its immediate debts if it can't sell its stock quickly.

3. Efficiency (Working Capital) Ratios

These ratios measure how well the company manages its day-to-day operations. We often express these in "days."

Inventory Days

\( \frac{\text{Inventory}}{\text{Cost of Sales}} \times 365 \)
\nHow many days does it take to sell our stock? Lower is usually better (less money tied up in a warehouse).

Receivables Days

\( \frac{\text{Trade Receivables}}{\text{Revenue}} \times 365 \)
\nHow long do our customers take to pay us? If this number is growing, the company might have "bad" customers who aren't paying.

Payables Days

\( \frac{\text{Trade Payables}}{\text{Cost of Sales}} \times 365 \)
\nHow long do we take to pay our suppliers? Taking longer might help our cash flow, but it might upset our suppliers!

Memory Aid: The "Cash Gap"
\nThink of it as a timeline: You buy stock (Inventory Days), you sell it, and then you wait to get paid (Receivables Days). Meanwhile, you have to pay your supplier (Payables Days). The gap between paying your supplier and getting paid by your customer is the "Cash Conversion Cycle."

Key Takeaway: Efficiency ratios show if a company is "lean" or if it’s getting "clogged up" with unsold stock or unpaid debts.

4. Solvency and Gearing: Looking at the Long Term

While liquidity looks at the next few months, Solvency looks at the next few years. It focuses on the company’s capital structure.

Gearing Ratio

The Formula: \( \frac{\text{Long-term Debt}}{\text{Equity} + \text{Long-term Debt}} \times 100 \)
\nThis tells us what percentage of the company is funded by loans versus the owners' money.

Analogy: If you buy a \$200,000 house with a \$150,000 mortgage, your "personal gearing" is high (75%). You are more at risk if your income drops or interest rates rise.

Interest Cover

The Formula: \( \frac{\text{Operating Profit}}{\text{Interest Expense}} \)
This tells us how many times over the company could pay its interest using its profits. If this ratio is 1.0, the company is barely earning enough to pay the bank—leaving nothing for shareholders!

Key Takeaway: High gearing isn't always bad (debt can be cheaper than equity), but it increases financial risk.

5. Limitations of Ratio Analysis

Before you finish, remember that ratios are not perfect. In F2, you are expected to critique the numbers, not just calculate them.

• Historical Data: Ratios look at the past, but investors care about the future.
• Window Dressing: Companies might "tweak" their year-end figures (e.g., delaying a purchase) to make their ratios look better.
• Accounting Policies: One company might use Straight-Line Depreciation while another uses Reducing Balance. This makes direct comparisons difficult.
• Inflation: Old assets are recorded at historical cost, which can make ROCE look artificially high because the "Capital Employed" (the denominator) is undervalued.

Quick Review Box:
1. Always compare ratios to last year (Trend analysis).
2. Always compare ratios to competitors (Sector analysis).
3. Always look for the reason behind the change (e.g., did Receivables Days go up because sales increased or because the credit control department is failing?).

Summary: The Big Picture

Ratio analysis is a powerful tool for CIMA students. By mastering these formulas, you can strip away the complexity of consolidated financial statements and see the underlying health of a business. Remember: A ratio on its own is just a number; it only becomes "information" when you compare it to something else!

Keep practicing these formulas, and soon you'll be reading financial statements like a pro. You've got this!