Interpretation of Ratios

Interpretation of
Ratios 2
Week 6
Revision on last week’s material
QUESTION 1: Which is the correct formula for the current ratio?
A. Current Ratio = Current Assets – Current Liabilities
B. Current Ratio = Current Liabilities / Current Assets
C. Current Ratio = Current Assets / Current Liabilities
Revision on last week’s material
QUESTION 1: Which is the correct formula for the current ratio?
A. Current Ratio = Current Assets – Current Liabilities
B. Current Ratio = Current Liabilities / Current Assets
C. Current Ratio = Current Assets / Current Liabilities
Revision on last week’s material
QUESTION 2: Which is the correct formula for the ROCE?
A. ROCE = (Gross Profit) / (Total Assets – Current Liabilities)
B. ROCE = (Operating Profit) / (Total Assets – Current Liabilities)
C. ROCE = (Operating Profit) / (Current Assets – Current Liabilities)
Revision on last week’s material
QUESTION 2: Which is the correct formula for the ROCE?
A. ROCE = (Gross Profit) / (Total Assets – Current Liabilities)
B. ROCE = (Operating Profit) / (Total Assets – Current Liabilities)
C. ROCE = (Operating Profit) / (Current Assets – Current Liabilities)
Revision on last week’s material
QUESTION 3: Which of the following cannot be included in the current ratio?
A. Accounts receivable due in 3 years
B. Cash
C. Accounts Payable due in 20 days
D. Dividends Payable due next month
Revision on last week’s material
QUESTION 3: Which of the following cannot be included in the current ratio?
A. Accounts receivable due in 3 years
B. Cash
C. Accounts Payable due in 20 days
D. Dividends Payable due next month
The first one as it is a non-current item, while the rest is current.
Revision on last week’s material
A business that makes shoes sold £500,000 worth of products last year, compared to sales of
£800,000 this year. Last year it made a gross profit of £450,000, whereas this year the gross
profit reached £600,000. Calculate the gross profit margin for last year and this year and state
in which year the business had better performance.
Revision on last week’s material
A business that makes shoes sold £500,000 worth of products last year, compared to sales of
£800,000 this year. Last year it made a gross profit of £450,000, whereas this year the gross
profit reached £600,000. Calculate the gross profit margin for last year and this year and state
in which year the business had better performance.
Gross Profit for last year: (450,000/500,000) *100 = 90%
Gross Profit for this year: (600,000/800,000) *100 = 75%
Learning Outcomes
 To use and analyze the main financial efficiency ratios
 To use and analyze the main investment ratios
 To suggest ways to improve ratios
Accounting Ratios – Types
Accounting Ratios
Profitability
Ratios
Investment
Financial Ratios
Efficiency
Ratios
Liquidity Ratios
3. Financial Efficiency Ratios
Efficiency ratios are used to try to assess how successfully the various
resources of the company are managed.
The following ratios consider some of the more important aspects of
resource management:
 Average stock turnover period
 Average receivable days – debtors days
 Average payable days – creditors days
(Atrill and McLaney, 2007)
3. Financial Efficiency Ratios – Average
stock turnover period
Inventories often represent an important investment for a company and for some
types of businesses, inventories may account for a substantial proportion of the
total assets held.
The average stock turnover period ratio measures the average period for which
inventories are being held.
(Atrill and McLaney, 2007)
3. Financial Efficiency Ratios – Average
stock turnover period
The above formula is showing every how many
days per year the stock held is being “turned over”
For both cases, the average inventory can be calculated as a simple average of the opening and closing stock levels of a year.
There are two alternative formulas which express the average stock turnover period, either in number of
days per year or number of times per year
The above formula is showing every how many times per
year the stock held is being “turned over”
3. Financial Efficiency Ratios – Average
stock turnover period
Example 1: If Cost of Goods Sold (COGS) is 280,000 and average inventory
35,000, how much is the stock turnover ratio?
280,000/35,000 = 8 times per year
Example 2: COGS = 1,200,000, Beginning Inventory = 330,000, Ending
Inventory = 390,000. Calculate the Inventory turnover ratio in days per year.
Average Inventory = (330,000+390,000)/2 = 360,000
Inv. Turnover ratio = (360,000/1,200,000) * 365 = 109.5 days per year approx.
3. Financial Efficiency Ratios – Average
Receivable Days (or Debtor Days)
This ratio calculates how long, on average,
credit customers take to pay the amounts
that they owe to the company.
A company will normally prefer a shorter
average settlement period to a longer one.
It is significant to note that this ratio
produces an average figure for the number
of days for which debts are outstanding.
This number may be badly misinterpreted if
for example there are few customers who
are very slow or very fast payers.
(Atrill and McLaney, 2007)
3. Financial Efficiency Ratios – Average
Payable Days (or Creditor Days)
This ratio calculates how long, on average, the
business takes to pay those who have supplied
goods and services to it on credit.
This ratio provides an average figure, like in the
case of debtors days, and can be manipulated by
the payment period for one or two large
suppliers.
Trade payables provide a free source of finance
for the company and as a result, some
companies may attempt to increase the number
of average payable days. However, if this policy
goes too far, this may result in a loss of goodwill
of suppliers.
(Atrill and McLaney, 2007)
3. Financial Efficiency Ratios
EXERCISE on DEBTORS and CREDITORS DAYS
DEBTORS days = (5,000,000/25,000,000) * 365 = 73 days
CREDITORS days = (1,800,000/14,000,000) * 365 = 47 days
approx.

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4. Investment Ratios
There are several ratios which the shareholders are using in order to assess the
returns on their investment. The main two are:
1. Earnings per share
2. Dividend payout ratio
(Atrill and McLaney, 2007)
4. Investment Ratios – Earnings per share
The Earnings Per Share (EPS) ratio relates the
earnings generated by the business, and available
to shareholders, during a specific period, to the
number of shares in issue.
(Atrill and McLaney, 2007)
In simple terms, it is the amount of profit that each
stock in the company “owns.” If all the company’s
profits were distributed to shareholders, this is
how much you would get for each stock you own.
A lot of investment analysts regard the EPS ratio
as an important measure of share performance.
The trend in EPS over time is used to help assess
the investment potential of a business’ shares.
Example: if total earnings are £165 million and
outstanding shares are 600 million, the EPS will
be = 165/600 = 27.5p
4. Investment Ratios –
Dividend payout ratio
The dividend payout ratio measures the
proportion of earnings that is paid out to
shareholders in the form of dividends.
(Atrill and McLaney, 2007)
In other words, this ratio shows the portion of
profits the company decides to keep to fund
operations and the portion of profits that is
given to its shareholders in the form of
dividends.
The earnings can be expressed as net income,
which is the income after taxation.
Example: if annual dividends are £40 million and
net income £160 million, the dividend payout ratio
will be = (40/160) * 100 = 25%
Core points for interpretation of
the ratios
• What does the ratio indicate about company’s performance?
• Compare 2018 figures with 2019 figures calculated above
• Explain what do these numbers means and how has the
figure changed in 2019 as compared to 2018
• Reasons behind the value of the ratio going up/down in 2019
as compared to 2018
• Ways to improve the value to the ratio in future (in case it got
worse)
How to Improve Gross Profit
Ratio & Net Profit Ratio
Gross Profit Ratio (Revision: what is the formula for this ratio?)
By looking at the formula, how can this ratio be improved?
• By reducing direct costs (such as cost of sales or COGS)
Net Profit Ratio (Revision: what is the formula for this ratio?)
By looking at the formula, how can this ratio be improved?
• By controlling specific expenses
How to Improve Current Ratio &
Acid-Test Ratio
Current Ratio (Revision: what is the formula for this ratio?)
By looking at the formula, how can this ratio be improved?
• By increasing current assets or
• By reducing current liabilities
Acid-Test Ratio (Revision: what is the formula for this ratio?)
By looking at the formula, how can this ratio be improved?
• By Increasing sales and inventory turnover or
• By paying off liabilities quickly
How to Improve Debtor &
Creditor days
Debtor Days (Revision: what is the formula for this ratio?)
By looking at the formula, how can this ratio be improved?
• By offering discounts for early repayments
Creditor Days (Revision: what is the formula for this ratio?)
By looking at the formula, how can this ratio be improved?
• By negotiating paying terms with the suppliers
Conclusion
Ratio analysis plays a very important role in improving the
financial performance from the company’s point of view.
Investors also use a lot of ratios in order to decide whether
to invest in the company or not.
Thank You
Any Questions ?