Information provided by accounting ratios

Welcome to the World of Ratio Analysis!

In this chapter, we are going to learn how to become "Financial Detectives." Up until now, you have learned how to prepare financial statements. But what do those numbers actually mean? Is a profit of $10,000 good? Well, it depends! If you invested $100,000 to make that profit, it's great. If you invested $1,000,000, it’s not so good.

Accounting ratios allow us to compare figures and make sense of a company's performance and financial health. They help us compare a company against its own past performance (trend analysis) or against its competitors (sector analysis). Don't worry if you aren't a "math person"—the formulas are logical, and once you see the patterns, they become much easier to remember!

1. Profitability Ratios: Are we making enough money?

Profitability ratios measure how effectively a business generates profit relative to its sales or the investment put into it. It’s like checking the fuel efficiency of a car.

Return on Capital Employed (ROCE)

This is often considered the "king" of ratios. It measures how much profit the business generates for every $1 invested in the business by owners and lenders.

Formula: \( \text{ROCE} = \frac{\text{Operating Profit}}{\text{Capital Employed}} \times 100 \)

Note: Capital Employed = Total Assets - Current Liabilities (or Equity + Non-current Liabilities).

Quick Review: A higher ROCE is generally better. It shows the management is using the company's resources efficiently to create wealth.

Gross Profit Margin

This looks at the relationship between sales and the direct cost of those sales.

Formula: \( \text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100 \)

Real-world Analogy: Imagine you buy a lemonade for $1 and sell it for $3. Your Gross Profit is $2. Your margin is \( \frac{2}{3} \), or 66.7%. If the price of lemons goes up, your margin falls.

Operating Profit Margin

This takes it a step further by including all the overheads (like rent and electricity) but before taking off interest and tax.

Formula: \( \text{Operating Profit Margin} = \frac{\text{Operating Profit}}{\text{Revenue}} \times 100 \)

Key Takeaway: If the Gross Margin is stable but the Operating Margin is falling, it means the business is struggling to control its overhead expenses.

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 or employees. These ratios look at "Short-term survival."

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: \( \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} \)

The "Ideal" Number: Historically, a ratio of 2:1 was seen as ideal, but in modern business, many successful companies operate safely with much lower ratios.

The Quick Ratio (Acid Test)

Some assets are harder to turn into cash than others. Inventory (stock) can take a long time to sell. The Quick Ratio ignores inventory to see if the company can pay its bills right now.

Formula: \( \text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}} \)

Common Mistake to Avoid: Don't forget to subtract Inventory! If this ratio is less than 1:1, the company might struggle to pay its immediate debts if it can't sell its stock quickly.

Key Takeaway: Liquidity ratios tell us about risk. Too little liquidity is dangerous; too much might mean the company is being "lazy" with its cash.

3. Efficiency (Activity) Ratios: How well are we working?

These ratios measure how effectively the business manages its "Working Capital" (Inventory, Receivables, and Payables).

Inventory Turnover Period

How many days, on average, does a product sit on the shelf before it is sold?

Formula: \( \text{Inventory Days} = \frac{\text{Average Inventory}}{\text{Cost of Sales}} \times 365 \)

(Use Closing Inventory if Average is not available).

Trade Receivables Collection Period

How long do our customers take to pay us? We want this to be as short as possible!

Formula: \( \text{Receivables Days} = \frac{\text{Trade Receivables}}{\text{Revenue}} \times 365 \)

Trade Payables Payment Period

How long do we take to pay our suppliers?

Formula: \( \text{Payables Days} = \frac{\text{Trade Payables}}{\text{Cost of Sales}} \times 365 \)

Asset Turnover

This shows how many dollars of sales we generate for every $1 of assets we own.

Formula: \( \text{Asset Turnover} = \frac{\text{Revenue}}{\text{Capital Employed}} \)

Did you know? ROCE is actually Operating Margin × Asset Turnover. If you want to improve your return, you either have to increase your profit per sale or sell more things using the same assets!

4. Capital Structure (Gearing): How are we funded?

Gearing looks at the long-term "Financial Risk" of a company. It compares how much of the business is funded by Debt (loans) versus Equity (the owners' money).

Gearing Ratio

Formula: \( \text{Gearing} = \frac{\text{Long Term Debt}}{\text{Equity} + \text{Long Term Debt}} \times 100 \)

Why does it matter?
- High Gearing: The company has a lot of debt. This is risky because interest must be paid even if profits are low.
- Low Gearing: The company is funded mainly by its owners. This is safer but might mean the company isn't taking enough advantage of loans to grow.

Interest Cover

This tells us how many times the company could pay its interest bill using its operating profit.

Formula: \( \text{Interest Cover} = \frac{\text{Operating Profit}}{\text{Interest Expense}} \)

If the answer is 1, it means all the profit is being swallowed by interest payments. This is a very scary place for a business to be!

5. The Limitations of Ratio Analysis

Before you finish this chapter, remember that ratios aren't magic. They have limitations:

1. Historical Data: Ratios use past figures. They don't guarantee what will happen in the future.
2. Price Changes: Inflation can distort figures over time.
3. Different Policies: One company might use different depreciation methods than another, making comparison difficult.
4. Creative Accounting: Companies might "window dress" their accounts (e.g., delaying a purchase) to make their ratios look better at the year-end.

Summary Checklist

- Profitability: Focus on ROCE and Margins (Are we making money?).
- Liquidity: Focus on Current and Quick ratios (Can we survive the short term?).
- Efficiency: Focus on "Days" (How fast are we moving cash and stock?).
- Gearing: Focus on Debt (Is our funding structure too risky?).
- Comparison: Ratios mean nothing in isolation—always compare them to something else!

Keep practicing the formulas! You don't need to memorize them all at once—use them in practice questions and they will eventually stick. You've got this!