# Ratio analysis

The ability to analyse financial statements using ratios and percentages to assess the performance of organisations is a skill that will be tested in many of ACCA’s exams. It will also be regularly used by successful candidates in their future careers.

The FMA/MA syllabus introduces candidates to performance measurement and requires candidates to be able to 'Discuss and calculate measures of financial performance and non-financial measures'. This article will focus on measures of financial performance and will detail the skills and knowledge expected from candidates in the FMA/MA exam.

FMA/MA candidates are expected to be able to calculate key accounting ratios, to know what they measure, and to explain what particular values mean. Ratios can be categorised into four headings: profitability, liquidity, activity (efficiency) and gearing.

#### Profitability

Profitability ratios, as their name suggests, measure the organisation’s ability to deliver profits. Profit is necessary to give investors the return they require, and to provide funds for reinvestment in the business. Five ratios are commonly used.

Return on capital employed (ROCE) = (Profit before interest and tax (PBIT) ÷ Capital employed) x 100%

Return on equity (ROE) = (Profit after interest and tax ÷ total equity) x 100%

Operating profit margin = (PBIT ÷ Revenue) x 100%

Asset turnover = Revenue ÷ Capital employed

Gross margin= (Gross profit ÷ Revenue) x100%

Return on capital employed (ROCE)/Return on equity (ROE)

Return on capital employed (sometimes known as return on investment or ROI) measures the return that is being earned on the capital invested in the business. Candidates are sometimes confused about which profit and capital figures to use. What is important is to compare like with like. Profit before interest and tax (PBIT), can also be given as Operating profit. This represents the profit available to pay interest to debt investors and dividends to shareholders. It is therefore compared with the long-term debt and equity capital invested in the business. Capital employed can be calculated as (non-current liabilities + total equity) or (total assets - current liabilities). By similar logic, if we wished to calculate return on ordinary shareholders funds, we would use profit after interest and tax divided by total equity.

A return on capital is necessary to reward investors for the risks they are taking by investing in the company. Generally, the higher the ROCE or ROE figure, the better it is for investors. It should be compared with returns on offer to investors from alternative investments of a similar risk.

Operating profit margin
Operating profit margin (sometimes known as net profit margin) looks at operating profit earned as a percentage of revenue. Again, in simple terms, the higher the better. Poor performance is often explained by prices being too low or costs (cost of sales or overheads) being too high.

Asset turnover
This measures the ability of the organisation to generate sales from its capital employed. Generally, the higher the better, but in later studies you will consider the problems caused by overtrading (operating a business at a level not sustainable by its capital employed). Commonly a high asset turnover is accompanied with a low return on sales and vice versa. Retailers generally have high asset turnovers accompanied by low margins.

The ROCE and Operating profit margin ratios are often considered in conjunction with the asset turnover ratio. They are considered at the same time because:

 ROCE = Operating profit margin x Asset turnover PBIT ÷ Capital employed = PBIT ÷ Revenue x Revenue ÷ Capital employed

This relationship can be useful in exam calculations. For example, if you are told that a business has an Operating profit margin of 5% and an asset turnover of 2, then its ROCE will be 10% (5% x 2). This is more than a mathematical trick. It means that any change in ROCE can be explained by either a change in Operating profit margin, or a change in asset turnover, or both.

Gross margin
Operating profit margin looks at profits after charging non-production overheads. Gross margin on the other hand focuses on the organisation’s trading activities. Once again, in simple terms, the higher the better, with poor performance often being explained by prices being too low or cost of sales being too high.

#### Liquidity

Liquidity measures the ability of the organisation to meet its short-term financial obligations.

Two ratios are commonly used:

Current ratio = current assets ÷ current liabilities

Quick ratio (acid test) = (current assets – inventory) ÷ current liabilities

Current ratio
The current ratio compares liabilities that fall due within the year with cash balances, and assets that should turn into cash within the year. It assesses the company’s ability to meet its short-term liabilities. Traditionally textbooks tell us that this ratio should exceed 1:1. For a company to be able to safely meet its liabilities it should probably exceed 2:1, however, acceptable current ratios vary between industry sectors, and many companies operate safely at below the 2:1 level.

With the current ratio it is not the case of the higher the better, as a very high current ratio is not necessarily good. It could indicate that a company is too liquid. Cash is often described as an ’idle asset‘ because it earns no return and carrying too much cash is considered wasteful. A high ratio could also indicate that the company is not making sufficient use of cheap short-term finance.

Quick ratio
The quick ratio (acid test) recognises that inventory often takes a long time to convert into cash. It therefore excludes inventory values from liquid assets. In practice a company’s current ratio and quick ratio should be considered alongside the company’s operating cash flow. A healthy cashflow will often compensate for weak liquidity ratios.

#### Activity (efficiency) ratios

These ratios can be known as activity ratios, efficiency ratios, cash ratios or working capital ratios and can also be included under the liquidity heading.

Receivables collection period = receivables ÷ credit sales × 365 days

Inventory holding period =  inventory ÷ cost of sales × 365 days

Payables payment period =  payables ÷ credit purchases (or cost of sales) × 365 days

Activity ratios measure an organisation’s ability to convert statement of financial position items into cash or sales. They measure the efficiency of the business in managing its assets.

Receivables collection period
If a company has average accounts receivable of \$20,000 on annual credit sales of \$40,000 then on average 50% of its annual credit sales are uncollected. If credit sales are spread evenly over the year, then this represents 50% of a year’s sales, equivalent to 183 days, to collect cash from customers. (\$20,000/\$40,000 ÷ 365 days = 183 days). For liquidity purposes the faster money is collected the better. Also, generally, the longer customers are given to pay, the higher the level of bad debts. However, too much pressure on customers to pay quickly may damage a company’s ability to generate sales.

Inventory holding period
This is calculated in a very similar way to the receivables collection period. It measures how long a company carries inventory before it is sold. Again, for liquidity purposes the shorter this period the better, as less cash is tied up in inventory. Also, long inventory holding periods can result in obsolete inventory. On the other hand, too little inventory can result in production stoppages and dissatisfied customers.

Payables payment period
This is also calculated in a similar way to the receivables collection period. Because the credit purchases figure is often not available to analysts external to the business, the cost of sales figure is often used as an approximation. The payables payment period measures the average amount of time taken to pay suppliers. Long payment periods are good for the customer’s liquidity but can damage relationships with suppliers.

#### Gearing

Gearing relates to an organisation’s relative levels of debt and equity and can help to measure its ability to meet its long-term debts. These ratios are sometimes known as risk ratios, positioning ratios or solvency ratios.

Three ratios are commonly used.

Debt to equity ratio =  non-current liabilities ÷ ordinary shareholders funds x 100%

Debt to debt + equity ratio = non-current liabilities ÷ (ordinary shareholders funds + non-current liabilities) x 100%

Interest cover =  operating profit ÷ finance costs

Capital gearing
Capital gearing, which is also known as leverage, looks at the proportions of owner’s capital and borrowed capital used to finance the business. Many different definitions exist; the two most commonly used are given above. When necessary in the exam, you will be told which definition to use.

A large proportion of borrowed capital is risky as interest and capital repayments are legal obligations and must be met if the company is to avoid insolvency. The payment of an annual equity dividend on the other hand is not a legal obligation.  Despite its risks, borrowed capital is attractive to companies as lenders accept a lower rate of return than equity investors due to their secured positions. Also interest payments, unlike equity dividends, are tax deductible.

Levels of capital gearing vary enormously between industries. Companies requiring high investment in tangible assets are commonly highly geared. Consequently, it is difficult to generalise about when capital gearing is too high. However, most accountants would agree that gearing is too high when the proportion of debt exceeds the proportion of equity.

Interest cover
This is sometimes known as income gearing. It looks at how many times a company’s operating profits exceed its interest payable. The higher the figure, the more likely a company is to be able to meet its interest payments. Anything in excess of three is usually considered to be safe.

Written by a member of the Management Accounting examining team