MN10668 lec 8
Ratio analysis
1. Compare between entities
2. Comparisons over time
The function of ratio analysis
- Enable users of published financial statements to evaluate the financial performance
and financial position of the reporting entity for the purpose of making share trading,
lending and/or voting decisions. This usually takes the form of:
o Comparisons with other entities
o Comparisons over time
The classifications of ratios
1. Measures of an entity’s financial performance
2. Measures of solvency and liquidity
3. Measures of the control of working capital
4. Measures of return on investment and risk
Measures of a company’s performance
- Return on capital employed (ROCE)
- Profit margin
- Asset turnover ratio
, Return on capital employed
Profit before tax and interest sometimes called operating profit
- Where net capital employed = shareholders interests + non-current liabilities
- = total assets – current liabilities
- Take the capital employed figure from the year-end balance sheet – no need to
average it
Profit margin
- This shows what percentage of sales Revenue is profit
- Different products/industries and different sized businesses have different profit
margins
- Inter-firm comparisons should therefore be limited to companies in the same
industry of a comparable size
- Variations in the profit margin over time may be due to changes in sales mix, selling
prices and/or unit costs
Asset turnover ratio
- This shows the amount of sales revenue generated per £ of capital employed. It is a
measure of the level of activity and productivity
- Changes In the asset turnover ratio, may be due to producing at under capacity,
labour inefficiency, overstocking, etc.
Measures of liquidity and solvency
- Working capital/current ratio
- Liquidity/quick ratio or acid test
The nature of liquidity and solvency
- Solvency – refers to whether or not a business is able to pay its debts as and when
they become due. Sometimes even profitable businesses become insolvent, usually
due to over trading. A company that is insolvent is required by law to cease trading
and become bankrupt/liquidate
Ratio analysis
1. Compare between entities
2. Comparisons over time
The function of ratio analysis
- Enable users of published financial statements to evaluate the financial performance
and financial position of the reporting entity for the purpose of making share trading,
lending and/or voting decisions. This usually takes the form of:
o Comparisons with other entities
o Comparisons over time
The classifications of ratios
1. Measures of an entity’s financial performance
2. Measures of solvency and liquidity
3. Measures of the control of working capital
4. Measures of return on investment and risk
Measures of a company’s performance
- Return on capital employed (ROCE)
- Profit margin
- Asset turnover ratio
, Return on capital employed
Profit before tax and interest sometimes called operating profit
- Where net capital employed = shareholders interests + non-current liabilities
- = total assets – current liabilities
- Take the capital employed figure from the year-end balance sheet – no need to
average it
Profit margin
- This shows what percentage of sales Revenue is profit
- Different products/industries and different sized businesses have different profit
margins
- Inter-firm comparisons should therefore be limited to companies in the same
industry of a comparable size
- Variations in the profit margin over time may be due to changes in sales mix, selling
prices and/or unit costs
Asset turnover ratio
- This shows the amount of sales revenue generated per £ of capital employed. It is a
measure of the level of activity and productivity
- Changes In the asset turnover ratio, may be due to producing at under capacity,
labour inefficiency, overstocking, etc.
Measures of liquidity and solvency
- Working capital/current ratio
- Liquidity/quick ratio or acid test
The nature of liquidity and solvency
- Solvency – refers to whether or not a business is able to pay its debts as and when
they become due. Sometimes even profitable businesses become insolvent, usually
due to over trading. A company that is insolvent is required by law to cease trading
and become bankrupt/liquidate
