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Main Financial Ratios

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Main Financial Ratios

Author : Jim Riley Last updated: Sunday 23 September, 2012 Main ratios ( introduction) In our introduction to interpreting financial information we identified five main areas for investigation of accounting information. The use of ratio analysis in each of these areas is introduced below: Profitability Ratios These ratios tell us whether a business is making profits - and if so whether at an acceptable rate. The key ratios are: Ratio Gross Profit Margin Calculation [Gross Profit / Revenue] x 100 (expressed as a percentage Comments This ratio tells us something about the business's ability consistently to control its production costs or to manage the margins its makes on products its buys and sells. Whilst sales value and volumes may move up and down significantly, the gross profit margin is usually quite stable (in percentage terms). However, a small increase (or decrease) in profit margin, however caused can produce a substantial change in overall profits. Assuming a constant gross profit margin, the operating profit margin tells us something about a company's ability to control its other operating costs or overheads. ROCE is sometimes referred to as the "primary ratio"; it tells us what returns management has made on the resources made available to them before making any distribution of those returns.

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Operating Profit Margin

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Return on capital employed ( "ROCE ")

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Liquidity ratios indicate how capable a business is of meeting its short-term obligations as they fall due:

RATIO ANALYSIS

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Liquidity ratios indicate how capable a business is of meeting its short-term obligations as they fall due: Ratio Current Ratio Calculation Current Assets / Current Liabilities Comments A simple measure that estimates whether the business can pay debts due within one year from assets that it expects to turn into cash within that year. A ratio of less than one is often a cause for concern, particularly if it persists for any length of time. Not all assets can be turned into cash quickly or easily. Some - notably raw materials and other stocks - must first be turned into final product, then sold and the cash collected from debtors. The Quick Ratio therefore adjusts the Current Ratio to eliminate all assets that are not already in cash (or "near-cash") form. Once again, a ratio of less than one would start to send out danger signals.

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Quick Ratio ( or "Acid Test"

Cash and near cash (short-term investments + trade debtors)

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S tability Ratios These ratios concentrate on the long-term health of a business - particularly the effect of the capital/finance structure on the business: Ratio Gearing Calculation Borrowing (all longterm debts + normal overdraft) / Net Assets (or Shareholders' Funds) Comments Gearing (otherwise known as "leverage") measures the proportion of assets invested in a business that are financed by borrowing. In theory, the higher the level of borrowing (gearing) the higher are the risks to a business, since the payment of interest and repayment of debts are not "optional" in the same way as dividends. However, gearing can be a financially sound part of a business's capital structure particularly if the business has strong, predictable cash flows. This measures the ability of the business to "service" its debt. Are profits sufficient to be able to pay interest and other finance costs?

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Interest cover

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PriceE arnings Ratio ( "P/E Ratio") Dividend Yield

Market price of share / At any time, the P/E ratio is an indication of how highly the Earnings per Share market "rates" or "values" a business. A P/E ratio is best viewed in the context of a sector or market average to get a feel for relative value and stock market pricing. (Latest dividend per ordinary share / current market price of share) x 100 This is known as the "payout ratio". It provides a guide as to the ability of a business to maintain a dividend payment. It also measures the proportion of earnings that are being retained by the business rather than distributed as dividends.

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