Page 5: Ratios
Ratios divide into three main areas:
- liquidity and working capital
Profitability ratios measure rate of return earned on capital employed, and analyse this into profit margins and use of assets. These ratios are frequently used as the basis for assessing management’s effectiveness in utilising the resources under their control.
- Return on capital employed (ROCE) measures return achieved by management from assets which they control, before payments to providers of financing for those assets, i.e. lenders and shareholders. Usually year end capital employed is used to compute this ratio.
- Profit margin is often seen as a measure of quality of profits. A high profit margin indicates a high profit on each unit sold. Asset turnover is often seen as a quantitative measure, indicating how intensively the management is using the assets. A trade-off exists between margin and asset turnover. Low margin businesses, e.g. food retailers, usually have high asset turnover. Conversely, capital-intensive manufacturing industries usually have relatively low asset turnover but higher margins, e.g. electrical equipment manufacturers.
Liquidity and working capital ratios
Liquidity ratios are used to assess a company’s ability to raise cash to meet payments when due. In practice, information contained in the cash flow statement is often more useful when analysing liquidity.
‘Liquidity’ implies the ability to convert assets readily into cash or to obtain cash. The short-term liquidity of an entity is measured by the degree to which it can meet its short-term obligations. Short-term is generally viewed as one year, or the organisation’s normal business cycle if longer. A lack of liquidity may mean that an organisation cannot pay its current debts and obligations.
- The current ratio is of limited use as some current assets, e.g. stocks, may not be readily convertible into cash, other than at a large discount. Hence, this ratio may not indicate whether or not the company can pay its debts as they fall due.
- The quick ratio omits stocks and is therefore a better indicator of liquidity. It is, however, subject to distortions, e.g. retailers have few debtors and utilise cash from sales quickly, but finance their stocks from trade creditors.
- Stock turnover and debtor days give an indication of whether a business is able to generate cash as fast as it uses it. They also provide useful comparisons between businesses, e.g. on effectiveness in collecting debts and controlling stock levels.
Gearing ratios examine the financing structure of a business. They indicate to shareholders the degree of risk attached to the company and the sensitivity of profits and dividends to changes in profitability and activity level.
If a business is highly geared, this usually indicates increased risk for shareholders as, if profits fall, debts will still need to be financed, leaving much smaller profits available to shareholders. Highly geared businesses are usually more exposed to insolvency if there is an economic downturn. However, returns to shareholders will grow proportionately more in highly geared businesses where profits are growing.
Low gearing provides scope to increase borrowings when potentially profitable projects are available. Companies with low gearing are likely to find it easier to borrow and should be able to borrow more cheaply than if gearing is already high.