RATIOS: INTERPRETATION AND

1
CHAPTER 23

• RATIOS INTERPRETATION AND
• USEFULNESS

2

• Focal point
• Financial statements are prepared not as an
  end in themselves but in order that users can
  make decisions. The financial statements
  therefore need to be interpreted. The calculation
  of ratio allows the relationships between
  different parts of the financial statements to be
  more clearly seen.

3
1ANALYSIS OF ACCOUNTING STATEMENTS AND USE OF
RATIOS

• The information gathered by calculating ratios
  will allow comparisons with
• ---The performance of the business in
  previous years
• ---The budget or planned performance in the
  current year
• ---The performance of similar business.

4
Different users of financial information have
different needs
5
The shortcoming of interpretation

• ---Estimating the future can only be done by
  interpreting the past.
• ---The information presented to the user is
  summaries, which may have the effect of
  distorting the nature of some of the information.
• ---Non-financial data, such as the number and
  skills of employees in the organization, should
  not be ignored.

6

• As well as ratios, the following factors about
  the organization's environment should be
  analyzed
• ---Markets in which the enterprise operates
• ---General economic conditions
• ---Size of business in relation to competitors

7
2 CALCULATION AND ANALYZING RATIOS

• Calculate only those ratios which are relevant to
  the needs of the user.
• State the definitions used.
• To analyze ratios, consider
• ---If a ratio has been computed over a
  number of time periods, does it show a worsening
  or an improving situation?
• ---Can the ratio be compared to an objective
  standard? That is ,can it be compared with an
  ideal ratio?
• ---Do all the ratios when taken together
  support the conclusions drawn from each
  individual ratio?

8
3 PROFITABILITY RATIOS

• ROCEoperating profits/operating assets
• Operating profit/sales
  sales/operating assets OR
• 
  operating assets/sales
• Various cost Production costs
  Non-current current assets
• elements/sales /sales
  asset/sales /sales
• 
  inventory receivables cash
  
  
• 
  /sales / sales
  /sales

9

• The gross profit percentage
• Gross profit percentageProfit/Sales100
• Percentage change in sales
• Percentage growth in sales(Sales this
  year-Sales last year)/Sales last year100
• Net profit as a percentage of sales
• Net profit/Sales100

10
Return on capital employed (ROCE)

• ---An enterprise needs to maximize the
  profits per of capital employed. Due to its
  importance the ROCE is sometimes referred to as
  the primary ratios.
• ---There are several ways of measuring ROCE,
  but the essential point is to relate the profit
  figure used to its capital base.

11
---Total capital employed in the business

• ROCE(1) Profit before interest and
  tax/(Share capital Reserves Long term
  liabilities)
• ---Equity shareholders capital employed
• ROCE(2)Profit after interest and preference
  dividend but before tax/(Ordinary share capial
  Reserves)100
• ---The interest referred to the interest
  payable on the long-term liabilities.

12
4 SHORT TERM LIQUIDITY RATIOS

• Current ratio (or working capital ratio)
• Current ratiocurrent assets/current
  liabilities
• Liquidity (or quick )ratio
• Quick ratiocurrent assets (less
  inventory)/current liabilities

13

• Conventional wisdom has it that an ideal current
  ratio is 21 and an ideal quick ratio is 11.It
  is very tempting to draw definite conclusions
  from limited information or to say that the
  current ratio should be 2,or that the quick ratio
  should be 1.However, this is not very meaningful
  without taking into account the type of ratio
  expected in a similar business. Many enterprise
  manage on much lower ratios than this.
• It should also be noted that a high current or
  liquid ratio is not necessary a good thing. It
  may indicate that working capital is not being
  used efficiently.

14
5 WORKING CAPITAL EFFICIENCY RATIOS

• Inventory turnover ratio
• Inventory turnover ratiocost pf
  sales/average inventory level
• Or
• Inventory turnover ratioaverage inventory
  during the accounting period/cost of sales365

15

• Note the average of opening and closing
  inventory is used here, but examination questions
  frequently do not provide the opening inventory
  figure and the closing inventory has to be taken
  instead of the average inventory.

16

• Receivables collection period (or average period
  of credit allowed to customers)
• Receivables collection periodclosing trade
  receivables/credit sales for year365
• Average period of credit allowed by suppliers
• Average period of creditclosing trade
  payables/credit purchases for year365

17
The working capital or cash operating cycle
Cash
Payables
Receivables
Raw materials inventory
Finished goods inventory
Working in progress
18

• It is possible to measure the length of the
  working capital cycle for a given firm
• 
  Days
• Average payables collection period (X)
• Average receivables collection period X
• Inventory turnover period X
• Length of working capital cycle X

19
6 OVERTRADING

• Overtrading means trying to operate without
  adequate working capital. It is often caused by
  an expansion in credit sales, and thus in trade
  receivables. This causes a shortage of cash.
• Overtrading may be indicated by
• ---Declining liquidity ratios
• ---High overdraft
• ---High receivables and payables.

20

• Overtrading may be cured or reduced by
• ---Borrowing or increasing in capital to
  increase
• current assets
• ---Sale of non-trading assets
• ---Tightening terms of credit granted to
  customers
• ---Negotiating longer credit terms from major
  
• suppliers.
•     

21
7 FINANCIAL RATIOS

• How a company is financed is crucial to an
  assessment of its stability and the risk of its
  collapse. A company with high loans compared with
  equity capital is at greater risk than one with
  few or no loans, because the interest on the
  loans has to be paid regardless of whether a
  company makes a profit or not.
• Equity to assets ratio
• Equity capital plus reserve/total assets
  minus current liabilities 100

22
Gearing ratio or leverage

• Gearing ratioloans preference share capital
  /(total assets- current liabilities)
• ---A high gearing ratio means a low equity to
  assets ratio, and vice versa. High gearing
  therefore means that the company is exposed to
  the risk of collapse if profit levels fall.

23
Interest cover

• Interest coverprofit before interest and
  tax/interest paid
• ---Interest on loan notes must be paid
  whether or not the company makes a profit. This
  ratio emphasized the cover (or security) for the
  interest by relating profit before interest and
  tax to interest paid.

24
8 INVESTOR RATIOS

• An investor in ordinary shares can look to
• ---The earrings of the company available to
  pay the ordinary dividend or to
• ---The actual ordinary dividend paid as a
  measure of the income earned by the company for
  him.
• The ratio he would compute in each case would be

25
Dividend per share Dividend per sharedividend
paid/number of shares Dividend cover Dividend
coverprofit-payment tpo preference shareholders
/dividend paid
26

• Note that the profit available for ordinary
  shareholders are after the deduction of the
  preference dividend .The cover represents the
  security for the ordinary dividend.
• Dividend yield
• Dividend yielddividend per share/current
  share price 100
• Earnings per share (EPS)
• Profits after tax and preference dividends
  ,but before ordinary dividends, divided by number
  of equity shares in issue.

27
Price earnings ratio (P/E ratio)

• ---This is regarded as a most important ratio.
• ---Current share price/EPS
• ---The higher the PE ratio the longer t will
  take to repay the investment in the share. Thus
  we could conclude that the lower the PE ratio,
  the better investment it is. However, this is not
  generally the case. High PE ratios are generally
  viewed as better than low ones, because the PE
  ratio is based on current EPS but the stock
  market is pricing the share on expectations of
  future EPS. If the market considers that a
  company has significant growth prospects, the
  market price of the share will rise.

28
9 APPRAISING THE POSITION AND PROSPECTS OF A
BUSINESS.

• The examiner lays great emphasis on the ability
  of students to make use of accounting data, not
  merely to prepare the data. Unfortunately it is a
  difficult area for which to prepare, as a wide
  variety of situation can be encountered.
• Remember
• ---If a ratio is computed, define what items
  have been included in the numerator and
  denominator, as for some ratios definitions vary.

29

• ---A question is usually in two parts, each
  carrying about the same marks. The first par is
  the calculation of the ratios and the second is
  the interpretation. Both must be provided.
• ---Show the ratio in the normal form, e.g.
  a ratio based on a profit figure is normally
  expressed a percentage.
• ---Do not be frightened of making what may
  be regarded as an obvious comment.
• ---Always show your working for all ratios.