Financial Ratios

• show how much money is available to pay the bills
• A firm without enough working capital has poor liquidity. It can't use its assets to pay for things when it needs them
• The liquidity of an asset is how easily it can be turned into cash and used to buy things. Cash is very liquid, non-current assets (e.g. factories) are not liquid, and stock (inventories) and money owed by debtors (receivables) are in between
• A business that doesn't have enough current assets to pay its liabilities when they are due is insolvent. It either has to quickly find the money to pay them, give up and cease trading, or go into liquidation
• Liquidity can be improved by decreasing stock levels, speeding up the collection of debts owed to the business, or slowing down payments to creditors (e.g. suppliers)
• A liquidity ratio shows how solvent a business is (how able it is to pay its debtors)

The two ratios are:

1) Current ratio

2) Acid Test Ratio (not in spec)

• Also called the working capital ratio
• Liquidity ratio (along with acid test)

Current Ratio =  current assets

                         -------------------

                           current liabilities

• A ratio of 1.5-2 would often suggest efficient management of working capital
• A ratio of <1 indicates cash problems
• A ratio of >2 indicates too much working capital (could invest this capital elsewhere e.g. putting    cash into R&D, too many debtors)

(Not actually on the spec but good to know)

• form of liquidity ratio

Acid Test = current assets - stock

                   -------------------------

                      current liabilities

• significantly less than 1 is often bad
• less relevant for businesses with high stock turnover
• Trend: significant deterioration in the ratio can result in a liquidity problem

• A profitability ratio shows the profit margin

The profitability ratios are:

1) Return on Capital Employed (ROCE)

2) Gross Profit Margin (GPM)

3) Operating Profit Margin (OPM)

4) Profit for the Year Margin (PYM)

• Considered to be the best way of analysing profitability and is expressed as a percentage

ROCE (%) =                operating profit                 

                    ------------------------------------- X  100

                    total equity + non-current liabilities

• have to compare it to the previous year or industry as a whole
• Businesses can use leasing to increase their ROCE

• Efficiency Ratios show how efficiently the firm is working (how well the business is using its resources and how well managers are controlling stock, creditors, and debtors)

There are 3 important efficiency ratios:

1) Inventory Turnover

2) Payable Days

3) Receivable Days

• Compares the cost of all sales a business makes over the year to the cost of the average stock held

Inventory Turnover =           cost of sales           

                                  ------------------------------   

                                   cost of average stock held

• Industries with typically low inventory turnover: construction, engineering, industrial distribution
• Industries with typically high inventory turnover: supermarket retail, fast-food, motor-vehicle production

• Holding stock may increase customer service & allow the business to meet demand
• Won't be as relevant in the service sector
• It may be misleading for seasonal businesses

Debtor (receivables) days:

trade debtors

             ----------------  X 365

revenue (sales)

Creditor (payables) days:

trade payables

            -----------------  X 365

cost of sales

• Creditor days should be less than debtor days, otherwise, there will be cash flow problems

Gearing =            non-current liabilities

                ---------------------------------------  X 100

                total equity + non-current liabilities

• A gearing ratio of 50% + is normally said to be high
• A gearing ratio of less than 20% is normally said to be low - not taking advantages of loans
• level of acceptable gearing depends on the business and the industry