FINANCIAL STATEMENT ANALYSIS

RATIOS ANALYSIS
A tool used by individuals to conduct a
quantitative analysis of information in a
company’s financial statements. Ratios are
calculated from current year numbers and are
then compared to previous years, other
companies, the industry, or even the economy
to judge the performance of the company.
(Source: Investopedia)
 ADVANTAGES OF RATIO ANALYSIS
• It simplifies financial statements
• It helps in comparing companies of different size
with each other
• It helps in trend analysis which involves
comparing a single company over a period
• It highlights important information in a simple to
use form quickly. A user can judge a company by
just looking at a few numbers instead of reading
the whole financial statements
 LIMITATIONS OF RATIO ANALYSIS
• One ratio result is not very helpful. Comparisons need
to be made.
• May be difficult to compare firms in different
industries.
• Trend analysis need to take into account changing
circumstances over time which could have affected
the ratio results.
• Ratios are only concerned with accounting items to
which a numerical value can be given. There are
qualitative factors to consider.
 TYPES OF RATIOS
• Liquidity Ratios
• Profitability Ratios
• Efficiency / Activity Ratios
• Gearing / Solvency Ratios
• Investors/ Shareholders Ratios
 LIQUIDITY RATIOS
RATIO CALCULATION MEANING USE
Current Ratio Current Assets / Curent This shows the ability of Shareholders or investors in
Liabilities expressed as the firm to pay short the firm can use this ratio to
Current Assets : Current term obligations as they determine that if all
Liabilities fall due. creditors were to request
Eg. 2:1 their funds, would the firm
be able to pay its debts and
not suffer because of
working capital problems.
The ideal ratio is 2:1.

Quick / Acid Test (Current Assets – Stock) / This ratio is similar to This measures the real short
Ratio Current Liabilities the current ratio term liquidity of the firm
expressed as Current however, stock is since stock is excluded.
Assets - Stock : Current excluded, as it is not as There is an optimum ratio of
Liabilities liquid as other current 1:1 that firms try to keep
Eg. 2:1 assets. It only becomes however, a ratio of 0.55 to 1
liquid when it is sold and over is acceptable.
and this takes time.
 PROFITABILITY RATIOS
RATIO CALCULATION MEANING USE
Gross Profit Margin (Gross Profit / Sales Shows the % of profit that is Indicates how effectively
Revenue) x 100 expressed left after subtracting COGS management uses labour
as a % from Sales. This is the and supplies. Shows how
amount available to pay much is left to spend on
expenses. other operations eg R &
D
Net Profit Margin (Net Profit / Sales Reflects the performance os To get a good sense of
Revenue) x 100 expressed a business as it indicates the non-direct costs such
as a % how expenses are as administration and
controlled. marketing. Assists in
controlling them.
Return on Capital (Net Profit / Capital Measures the extent to Used to determine the
Employed (ROCE) Employed) x 100 which capital is used to feasibility of the current
expressed as a %. make a profit investment in the firm.
Capital Employed = Fixed
Assets + (Current Assets –
Current Liabilities)
 EFFICIENCY / ACTIVITY RATIOS
RATIO CALCULATION MEANING USE
Stock Turnover Cost of Sales / Shows the number Can assist the firm
Ratio Average Stock of times stock is in determining how
where Average ordered or best to hold stock.
Stock = (Opening replenished by the Can also indicate
Stock + Closing business for the sales trends for
Stock) / 2 year planning purposes.
Debtor Days Ratio (Debtors / Credit Shows the average Normally combined
Sales) x 365 length of time it with the creditor
takes for the firm to days ratio to
collect its debts indicate the cash
flow situations.
Creditor Days Ratio (Creditors / Credit Shows average Normally combined
Purchases) x 365 length of time to with the debtor
pay short term days ratio to
debts indicate the cash
flow situations.
 GEARING / SOLVENCY RATIO
RATIO CALCULATION
Gearing / Leverage (Long Term Debt /
Ratio Capital Employed) x
100 expressed as a
% business is financed
MEANING USE
Measures the Shows the risk of
degree to which investing in this
capital of the type of business. If
a business is highly
by long term loans geared, there is a
lot of risk involved.
This should never
be above 50%.
 INVESTOR / SHAREHOLDER RATIO
RATIO CALCULATION MEANING USE
Earnings Per Share (Net Profit- Indicates how much Can be used by
(EPS) Preference Share ordinary shares investors to
Dividends) / No. of have contributed to calculate return on
Ordinary Shares making a profit investment.
Dividend Yield Latest Annual Shows dividends Indicates returns
Dividend Payment per share as a earned on shares.
Per Share/Current percentage of
Market Value Per market price
Share
 TIPS ON RATIO ANALYSIS
• Once you have calculated your ratios, do not restate
the figures seen if doing an evaluation but instead look
at the differences.
• Once a comparison is made, make inferences about
the reason why the ratios are as they are.
• Ensure that you remember basic financial statements
• These are NOT ALL ratios, they are only the ones on
the syllabus. A ratio is any form of comparison
between figures and therefore you can be asked to
calculate anything. Eg Wages to Sales Ratio.