PowerPoint to accompany

Chapter 6
Financial Ratio
Analysis
 Learning Objectives
Identify the key aspects of financial performance and
financial position that are evaluated by the use of
ratios
Explain the terms profitability, efficiency, liquidity and
gearing
Summarise the alternative bases of comparison for
ratio analysis
Present the ratio formulae for the basic ratios
Calculate ratios to analyse the profitability, efficiency,
liquidity and gearing of a given entitys financial
statements over several periods

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

 Learning Objectives (continued)
Interpret basic ratios for profitability, efficiency,
liquidity and gearing
Discuss the limitations of ratios as a tool of financial
analysis

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

 Financial Ratios
Ratios = quick and simple means of examining the
financial health of a business

A ratio simply expresses the relationship between one

figure appearing in the financial statements with
another e.g. net profit in relation to capital employed

Ratios:
Simple enough to calculate
Can build up a good picture with just a few ratios
Can be difficult to interpret
Can be expressed in various forms e.g. %, fractions,
proportions depending on the need and use for the
information

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Financial Ratios (continued)
The key aspects of financial
performance / position evaluated by the
use of ratios are:

Profitability
Efficiency
Liquidity
Gearing
Investment
Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia
 Financial Ratio Classification

Profitability - Measure of success in wealth creation

Efficiency - Effectiveness of utilisation of resources
Liquidity - The ability to meet short-term obligations
Gearing - Measure of degree of risk to do with the
amount of leverage used to finance the business
Investment - Measure of the returns and
performance of shares held by a business (not
covered)

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

The Need for Comparison
Bases (benchmarks) that may be used as a basis of
comparison for ratio analysis include:
Intertemporal - Based on past performance
Budget - Based on planned performance
Intra-industry - Based on comparison of
performance with other firms in the same industry

A calculated ratio on its own does not say much

about a business - it is only when it is compared with
some form of benchmark that the information can
be interpreted and evaluated

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

The Key Steps in Financial Ratio
Analysis
Step 1:
Identify which key indicators and relationships require
examination
Identify who needs the information and why they need it

Step 2:
Choose the most relevant set of ratios that will accomplish
the desired purposes
Calculate and record the results using the selected ratios

Step 3:
Interpret and evaluate the results

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

 Calculation of Ratios
We will now focus on the calculation of
ratios and what they are telling us.

Note that we will NOT be focusing on

the Investment Ratios in any great
detail.

You have a summary of each of them in

your lecture notes

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Profitability Ratios
Return on shareholders funds (ROSF):

Compares the amount of profit for the period available to

the owners with the owners stake in the business
Normally expressed as a percentage

Net profit after taxation and preference dividend (if any)

ROSF = x 100
Average ordinary share capital plus reserves

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Profitability Ratios (continued)
Return on total assets (ROA):

Compares the net profit generated by the business with the

assets owned by the business
Normally expressed as a percentage

Net profit before interest and taxation

ROA = x 100
Average total assets

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Profitability Ratios (continued)
Net profit margin:

Relates the net profit for the period to the sales during that
period
Normally expressed as a percentage

Net profit before interest and taxation

Net profit margin = x 100
Sales

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Profitability Ratios (continued)
Gross profit margin:

Relates the gross profit of the business to the sales

generated during the same period
Gross profit represents the difference between sales and
cost of sales
Normally expressed as a percentage

Gross profit
Gross profit margin = x 100
Sales

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Efficiency Ratios
Average inventory turnover period:

Measures the average period inventory was held

Normally expressed in terms of days
Average inventory is the simple average of opening and
closing inventory for the period

Average inventory held

Inventory turnover periods = x 365
Cost of sales

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Efficiency Ratios (continued)
Average settlement period for accounts
receivable (debtors):

Calculates how long, on average credit customers take to

pay amounts owed
Normally expressed in terms of days

Average trade debtors

Average settlement period = x 365
Credit sales

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Efficiency Ratios (continued)
Average settlement period for accounts payable
(creditors):

Calculates how long, on average the business takes to pay

its creditors
Normally expressed in terms of days

Average trade creditors

Average settlement period = x 365
Credit purchases

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Efficiency Ratios (continued)
Asset turnover period:

Examines how efficiently the assets of the business are being

employed in generating sales revenue
Can be expressed in times:
Average asset turnover = Sales
Average total assets employed

Or in days
Average total assets employed
Average asset turnover period = x 365
Sales

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

The Relationship Between
Profitability and Efficiency
The overall return on funds employed in the business will
be determined both by the profitability of sales, and by
efficiency in the use of assets

Net profit before

interest and taxation
Sales

Multiplied by

Sales
Average total assets

Equals

The main elements

Return on average Figure 6.2 comprising the ROA
total assets
ratio

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Liquidity Ratios
Current ratio:

Compares the businesss liquid assets with short-term

liabilities (current liabilities)
Expressed in terms of the number of times the current
assets will cover the current liabilities

Current assets
Current ratio =
Current liabilities

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Liquidity Ratios (continued)
Acid test (also known as the quick or liquid) ratio:

Represents a more stringent test of liquidity than the current

ratio
Expressed in terms of the number of times the liquid current
assets will cover the current liabilities

Current assets (excluding inventory and prepayments)

Acid test ratio =
Current liabilities

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Liquidity Ratios (continued)
Cash flows from operations ratio:

Compares the operating cash flows with the current

liabilities of the business
Expressed in terms of the number of times the operating
cash flows will cover the current liabilities

Operating cash flows

Cash flows from operations ratio =
Current liabilities

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

 Financial Gearing (Leverage)
Financial Gearing: The existence of fixed payment
bearing securities (e.g. loans) in the capital structure
of a company
The level of gearing, or the extent to which a
business is financed by outside parties is an
important factor in assessing risk
Gearing may be used both to adequately finance the
business, and to increase the returns to owners -
provided that the returns generated from the
borrowed funds exceed the interest cost of borrowing

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Financial Gearing (Leverage)
(continued)
Gearing ratio:

Measures the contribution of long-term lenders to the long-

term capital structure of the business
Expressed in terms of a percentage

Long-term liabilities
Gearing ratio = x 100
Share capital + Reserves + Long-term liabilities

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

Financial Gearing (Leverage)
(continued)
Interest cover ratio (times interest earned):

Measures the amount of profit available to cover interest

expense of the business
Expressed in terms of the number of times the profit
generated by the business will cover the interest expense of
its gearing

Interest cover ratio = Profit before interest and taxation

Interest expense

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

 Trend Analysis
Trends may be identified by plotting key
ratios on a graph, giving a visual
representation of changes happening over
time
Intra-company trends may be compared
against industry trends
Key financial ratios are often published in
companies annual reports as a way to help
users to identify important trends

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

 Ratios and Prediction Models
Ratios are often used to help predict the future
however the choice of ratios and interpretation of
results depend on the judgement of the analyst
Researchers have developed ratio-based models
which claim to predict future financial distress as well
as vulnerability to takeover
The future is likely to see further ratio-based
prediction models developed to predict other aspects
of financial performance

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

 Limitations of Ratio Analysis
The quality of the underlying financial statements
determines the usefulness of the ratios derived from them
Ratios should not be used in isolation - use a variety of
techniques of analysis to enhance the picture
Ratios only offer a restricted view of relative performance
and position - not the full picture
No two businesses are identical and the greater their
differences, the greater the limitations of ratio analysis as
a basis for comparison
Any ratios based upon balance sheet figures will not be
representative of the whole period because the balance
sheet is a snapshot of a moment in time

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia

 Lecture Activity 1

Example 6.1
(Source: Accounting - an Introduction 4th
edition, Atrill et al. pp. 286-288)
We will be using Example 6.1 from your
textbook to calculate some of the ratios
and interpret / analyse them

Atrill, McLaney, Harvey, Jenner: Accounting 4e 2008 Pearson Education Australia