Unit 3.

6 - Ratio Analysis

Learning Goals:
The purpose of ratio analysis
Types of financial ratios
Profitability ratio, liquidity ratio, efficiency ratio, gearing ratio
Uses and limitations of ratio analysis

What is a ratio?
A ratio is simply one number expressed in terms of another
For example, if Wayne has 50 goals and Jeremy has 20 goals, their ratio is 5:2

Purpose of Ratio Analysis

To aid analysis of a firm's financial position, such as short term and long term liquidity positions
To assess a firm's financial performance, such as its ability to control expenses
To compare actual figures with projected or budgeted figures (variance analysis)
To aid decision making, such as whether investors should risk their money in the business

Ratios are compared in two ways

HISTORICAL COMPARISONS: Involve comparing the same ratio in two different time periods for the same business.
Trends can then be shown which help managers assess the financial performance of a business.

INTER-FIRM COMPARISONS: involve comparing the ratios of businesses in the same industry. For example, two
businesses may have the same amount of profit although their sales revenue might be quite different. Ratio
analysis can therefore show the relative financial performance of a business.

**** WHY would we be comparing ratios with firms in the same industry??***

Types of Financial Ratios

Profitability Ratios

This examines profit in relation to other figures, such as the ratio of profit to sales revenue. Profitability ratios
help assess the financial performance of a business. These ratios are relevant to profit seeking organizations.
Managers, employees and potential creditors and investors will be interested in these ratios.

Liquidity Ratios
These examine a firm's ability to pay its shots term liabilities, such as by comparing working capital to short term
debt. Creditors and financial lenders are interested to assess the likelihood of getting the money back that they
arev owed.

Efficiency Ratios

These show how well a firm's resources are being used. For example, a firm may want to calculate the number
of days it takes to collect money from its debtors or how long it takes to sells its inventory. For example,
groceries (milk, bread, etc) sell a heck of a lot quicker than diamonds.

Shareholder Ratios

These measure the returns to shareholders in a company. Shareholders will be interested in the dividends they
earn in relation to the purchase price of a share. For example, if 2 stock announce a dividends of $.50 per share,
one with a stock price of $10 has a much better ROI than a company with a stock price of $50 per share.

Gearing Ratio

This looks at the long term liquidity position of a firm. Creditors and investors will be interested in this. A high
degree of gearing could mean inadequate long-term liquidity since the firm is committed to repaying its loans
with interest to financial lenders. Highly geared firms are risky. They are more vulnerable if interest rates change.

Profitability Ratios
Gross Profit Margin
GPM = Gross Profit / Sales Revenue x 100

Net Profit Margin

NPM = Net Profit/Sales Revenue x 100
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