Financial and Management
Accounting Techniques for
Managers
Lecture 6
Financial Ratios
• Financial ratios provide simple means of assessing financial
health of a business.
• And it can be helpful when comparing the financial health of
different businesses.
• There is no standard method of calculating many ratios.
• Variations in both the choice of ratios and their calculation
will be found in practice.
• However, it is important to be consistent in the way in which
ratios are calculated for comparison purpose.
Financial Ratio Classification
Financial Ratio Classification
• Ratios can be grouped into five categories.
• Profitability – provides insights relating to the degree of success in
achieving wealth for owners.
• Efficiency – provides insights to measure efficiency with which
particular resources used within the buisness. (Activity Ratio)
• Liquidity – one of the important ratios for the survival of business
that there are sufficient liquid resources available to meet maturing
obligations. (Amount owing that must be paid in near future)
• Financial gearing – provides the relationship between the
contribution to financing made by the owners of the business and
made by others in form of loan. (Risk of the business)
• Investment – concern with assessing returns and performance of
shares from the perspcetive of shareholders who are not involved in
management.
Need for Comparison
• Calculating ratio will not tell very much about performance
of business.
• Need benchmarking information to compare, interpreted and
evaluated.
• Three main possibilities
• Past period for the same business
• Similar businesses for same or past periods
• Planned performance for the business
Calculating Ratios
• The best way to explain financial ratios is through an
example.
• Case 1
Profitability
• Following ratios may be used to evaluate profitability of
business.
• Return on ordinary shareholders’ funds
• Return on capital employed
• Operating profit margin
• Gross profit margin
Return on Ordinary Shareholders’ Funds
(ROSF)
• This ratio compares the amount of profit for the period
available to owners with owners’ average stake in the
business during the same period.
Return of Capital Employed (ROCE)
• This ratio expresses the relationship between the operating
profit generated during a period and average long-term
capital invested in business.
Operating Profit Margin
• This ratio relates the operating profit for the period to the
sales revenues.
Gross Profit Margin
• This ratio relates the gross profit of the business to the sales
revenue generated for the same period.
Efficiency
• Following ratios may be used to evaluate efficiency of
business.
• Average inventories turnover period
• Average settlement period for trade receivables
• Average settlement period for trade payables
• Sales revenues to capital employed
• Sales revenues per employee
Average Inventory Turnover Period
• Inventory represents a significant investment for business.
• For some business, inventories may account for a substantial
proportion of total assets held. (Manufacturing)
Average Settlement Period for Trade
Receivables
• Selling on credit is norm for most business.
• Thus, trade receivables are a necessary.
• The speed of payment can have a significant effect on
business’s cash flow.
• This ratio calculates how long credit customers take to pay
amounts that they owe to business.
Average Settlement Period for Trade
Payables
• This ratio calculates how long the business takes to pay
those who have supplied goods and services on credit.
Sales Revenue to Capital Employed
• This ratio examines how effectively the assets of the
business are being used to generate sales revenue.
Sales Revenue Per Employee
• This ratio provides a measure of the productivity of
workforce.
Liquidity
• Following ratios may be used to evaluate liquidity of
business.
• Current ratio
• Acid test ratio
Current Ratio
• This ratio compares the liquid assets (cash and those assets
held that will soon be turned into cash) of the business with
the current liabilities.
Acid Test Ratio
• It represents a more strongent test of liquidity.
• Inventories cannot be converted into cash quickly.
• This ratio is a variation of current ratio, that excludes
inventories.
Financial Gearing
• Following ratios may be used to evaluate gearing of
business.
• Gearing ratio
• Interest cover ratio
Gearing Ratio
• It measures the contribution of long-term lenders to the
long-term capital structure of a business.
Interest Cover Ratio
• It measures amount of operating profit available to cover
interest payable.
Investment Ratios
• Following ratios may be used to evaluate investment of
business.
• Dividend payout ratio
• Dividend yield ratio
• Earnings per share
• Price/earning ratio
Dividend Payout Ratio
• It measures the proportion of earnings that a business pays
out to shareholders in the form of dividends
Dividend Yield Ratio
• It relates the cash return from a share to its current market
value.
• This can help investors to assess the cash return on their
investment in the business.
Dividend proposed/number of shares = 40/(300 × 2) = £0.067 dividend per
share (the 300 is multiplied by 2 because they are £0.50 shares)
Earning Per Share
• It relates the earnings generated by the business, and
avaiable to shareholders, during a period, to the number of
shares in issue.
• For equity (ordinary) shareholders, the amount available is
the profit for the year (profit after taxation) less any
preference dividend, where applicable.
Price/earnings (P/E) ratio
• It relates the market value of share to earnings per share.
Thank You
