Did you know that financial statements do not always provide accurate information about the financial performance of a company? They only provide figures, which have very little meaning without further analysis and calculation. That is why we carry out financial ratio analysis and calculate ratios.
Financial ratio analysis is a form of fundamental equity analysis. It is a quantitative method of comparing the relationship between two or more elements of financial data sourced from a company's financial statements such as the income statement or balance sheet. It reveals insight regarding profitability, solvency (liquidity), and efficiency. It also provides some useful information for shareholders.
Why calculate financial ratios?
Although the balance sheet, income statements, and cash flow statements provide essential financial information to stakeholders, financial ratios can provide a more accurate measure for comparing the financial performance of different firms. Financial ratios also help:
To simplify the information in the accounts, for example, 37% is easier to understand than 110 out of 295.
To allow comparison of a company over a certain period of time, like months or weeks.
To allow comparison of different sized firms. For example, it is easier to compare and understand a small and large firm's profit margin than simply stating one firm has £10 million revenue, whereas another firm has £1 million revenue. These values do not necessarily signify which firm is performing better.
What does the financial ratio analysis include?
Looking at financial statements and notes made by accountants - it is essential to gather relevant data needed for further calculations.
Making calculations - calculating the necessary ratios.
Making judgments - analyzing the ratios and stating whether financial performance is satisfactory or needs improvement.
Drawing a conclusion - thinking about any necessary steps which need to be taken in order to improve a company's performance.
Financial ratio analysis helps us answer the following questions:
Why is one business more profitable than another?
What returns are earned on an investment in the business?
Is a business growing, is it stagnant or is it collapsing?
Is a company able to pay its financial obligations?
How effectively is a business using its assets?
How long does a company have to wait for its customers to pay for the goods they buy on credit?
How long does it take for a company to pay its suppliers?
How many assets actually belong to a company?
How much of a company's operations are funded using debt?
Who uses financial ratio analysis?
The financial ratio analysis can be used by all stakeholders of a company:
Shareholders,
Competitors
Government,
Lenders,
Suppliers,
Potential investors.
What areas does financial ratio analysis cover?
In the table below you will find the areas covered by the financial ratio analysis and the ratios referring to each of them.
| Profitability | Solvency | Efficiency | Shareholder |
| Return on capital employed | Current ratio | Debt collection period | Earnings per share |
| Net (operating) profit margin | Acid test ratio | Credit payment period | Dividend per share |
| Gross profit margin | Gearing ratio | Inventory turnover | Dividend yield |
| | Asset turnover ratio | |
Profitability
Profitability is an ability of a company to generate profits from its operations. It is measured with income and expenses.
Solvency
Solvency is the ability of a company to pay off its debts and other financial obligations. It is a crucial measure of financial health in the short term.
Efficiency
Efficiency is the ability to which a company manages to use its working capital and total capital effectively.
Shareholder Analysis
Shareholder ratios show how much return shareholders receive on their investment.
How to calculate financial ratios
In order to calculate the ratios, first, we need to source data from a company's financial statements.
In the income statement you will find:
Revenue/Turnover,
Cost of sales,
Gross profit,
Net profit.
In the balance sheet you will find:
Current assets
Non-current assets,
Inventory/Stock,
Trade receivables,
Trade payables,
Current liabilities,
Non-current liabilities,
Shareholders' funds.
Financial ratios formulas
Let's look at some of the specific formulas for calculating financial ratios.
Return on capital employed (ROCE)
This ratio shows how efficiently a firm turns capital into profit.
The formula for calculating ROCE is the following:
If operating profit is £550,000 and the capital employed by the firm is £500,000, then ROCE is 110%.
It means that every £100 invested gives a profit of £110.
The higher the value, the better a firm is turning its funds and capital into profit.
Net (operating) profit margin (NPM)
This ratio shows how much net profit or income is generated as a percentage of revenue.
The formula for calculating NPM is the following:
If net profit is £300,000 and the revenue is £330,000, then NPM is 91%.
It means that every £100 of turnover creates £91 net profit.
The higher the value, the more net profit a firm is generating from its sales.
Gross profit margin (GPM)
This ratio shows the amount of money left over from product sales after subtracting the cost of goods sold.
The formula for calculating GPM is the following:
If gross profit is £440,000 and revenue is £100,000, then GPM is 110%.
The higher the value, the more gross profit a firm is generating from its sales
Current ratio
This ratio shows a firm's ability to pay short-term obligations.
The formula for calculating the current ratio is the following:
If current assets are £130,000 and current liabilities are £100,000, then the current ratio is 1.3 : 1.
It means that a company has more than the necessary amount of liquid assets in order to pay off its short-term debts.
The higher the value, the higher ability of a company to pay its short-term obligations.
Acid test ratio (quick assets ratio)
This ratio shows whether a firm has sufficient short-term assets to cover its short-term liabilities.
The formula for calculating the acid test ratio is the following:
If current assets are £130,000, stock £30,000 and current liabilities £100,000, then the acid test ratio is 1 : 1.
It means that if stock is ignored, a company has the exact amount of short-term assets to pay off its short-term debts.
The higher the value, the higher ability of a company to pay its short-term obligations without selling stock.
Debt collection period
This ratio shows how long on average a firm takes to collect a debt from its customers.
The formula for calculating the debt collection period is the following:
If receivables are £80,000 and annual revenue is £400,000, then the debt collection period is 73 days.
It means that it takes over two months for an average customer to pay.
The lower the value, the quicker customers pay off their debts.
Creditor payment period
This ratio shows how long on average a firm takes to pay its bills and invoices to its trade creditors.
The formula for calculating creditor payment period is the following:
If payables are £30,000 and cost of sales is £200,000, then the creditor payment period is 54.8 days.
It means that a company takes an average of 54.8 days to pay its suppliers.
The lower the value, the quicker a firm pays its bills and invoices to its trade creditors.
Stock (inventory) turnover
This ratio shows how many times a firm sells and replaces its inventory.
The formula for calculating stock turnover is the following:
If cost of goods sold is £188,000 and stock is £20,000, then stock turnover will be 9.4.
It means that on average the company sells its inventory just over 9 times per year.
The higher the value, the more often items sell.
Gearing ratio
This ratio shows how much of a firm's operations are funded using debt compared to using shareholders funds.
The formula for calculating gearing ratio is the following:
If non-current liabilities are £110,000 and capital employed is £330,000, then the gearing ratio is 33.3%.
It means that out of every £100 worth of capital employed, £33.3 has come in the form of loans.
The higher the ratio, the more of a firm's operations are funded using debt and the more risk the company faces.
Asset turnover ratio
This ratio shows how effectively a firm turns assets into revenue.
The formula for calculating asset turnover ratio is the following:
If annual sales revenue is £400,000 and assets employed are £450,000, then asset turnover is 88.9%.
It means that every £100 of assets creates £88.9 of revenue.
The higher the value, the better a firm is turning its assets into revenue.
Earnings per share (EPS)
This ratio shows how much profit a firm makes for each share sold.
The formula for calculating EPS is the following:
If profit after tax is £300,000 and there are 50 shares, then EPS is £6,000.
It means that a company makes £6,000 on each share.
The higher the value, the more a firm makes for each share.
Dividend per share (DPS)
This ratio shows the dividend that each share will receive.
The formula for calculating DPS is the following:
If total dividends are £70,000 and there are 50 shares, then DPS is £1,400.
It means that each share will receive a £1,400 dividend.
The higher the value, the more a firm pays out to investors.
Dividend yield
This ratio shows the return as a percentage of the market value of the share.
The formula for calculating dividend yield is the following:
If the ordinary share dividend is £200 and the market price of the share is £1,200, then dividend yield is 16.7%
It means that a company returns (pays a dividend) 16.7% of the market value of the share.
The higher the value, the higher the return for shareholders.
Limitations of ratio analysis
Ratios are only as reliable as the data from which they are drawn (financial statements). If the accounts are not true and fair then neither are the ratios.
Many factors cannot be measured by statistics, for example, strategic vision, staff morale and ethical/environmental stance are not easily quantifiable.
The figures have limited meaning when they are not compared to, for example, industry average ratios and ratios of previous years.
Ratios are only the tip of the iceberg. For an inclusive analysis, managers need to refer to the accounts (and notes) to understand underlying reasons.
What are non-financial ratios?
These are ratios that do not include any financial measures. They can be paired with financial ratios to help understand the full picture of business performance.
They can include:
customer relationships
employee relationships
operations,
quality,
cycle time,
business's supply chain.
As a result, it is important for businesses to examine both financial and non-financial ratios to gain a comprehensive insight into the organisation.
Financial Ratios - Key takeaways
Financial ratio analysis is a form of fundamental equity analysis.
It is a quantitative method of comparing the relationship between two or more elements of financial data sourced from a company's financial statements such as the income statement or balance sheet.
It reveals insight regarding profitability, solvency (liquidity) and efficiency. It also provides some useful information for shareholders.
The financial ratios simplify the information and allow comparison both within one and between different companies.
The most important ratios are: return on capital employed, net profit margin, gross profit margin, current ratio, acid-test ratio, gearing ratio, debt collection period, credit payment period, inventory turnover, asset turnover ratio, earnings per share, dividend per share and dividend yield.
You should not rely on the Financial Ratio Analysis as there are many factors limiting it.
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