Comprehensive Ratio Analysis Methods and notes to the calculation of ratios

1. Comprehensive Ratio Analysis
Financial Ratio Analysis
A useful framework for ratio analysis is that developed by the Dupont company. Dupont used this to control their subsidiary companies
Their framework followed the principle that the source of the % Return on Equity ( Shareholders Funds ) came from three elements:
PROFITABILITY EFFICIENCY LEVERAGE
(Net Profit as a % of Sales) (Sales Divided by Assets) ( The English Term for this is GEARING)
(Borowings as a % of Net Assets)
Called Asset Turnover If Shareholders cannot finance assets from their
own Funds they can Borrow at fixed interest rates
and acquire more assets. If the returns they obtain
on these assets are greater than the interest cost
any margin over the interest costs flow directly
to Shareholders.
The Dupont General Formula is: RETURN on EQUITY is equal to Profitability X Efficiency / ( 1 - Leverage % )
Or Return on Equity = (Net Profit / Sales) X (Sales / Net
Assets) / (Equity / Net Assets )
Profitability Ratios
The usual method for analysing Profitability is with a "Common Size Income Statement". In this statement each line of the Income Statement
(Profit and Loss Account) is expressed as a percentage of Sales. In this way any source of improvement or deterioration in Profitability can be
identified. Another form of analysis of the Common Size Income statement which can be used is called "Horizontal Analysis". In this type of
analysis the % growth of each line on the profit and loss account from one year to the next is calculated, again to identify the source of any problem.
The most frequently calculated PROFITABILITY RATIOS are:
RATIO CALCULATION METHOD NOTES
Gross Profit Ratio (Gross Profit Gross Profit / Sales Sales can be called Sales Turnover, Sales Income, Sales Revenue, Gross
Margin) Revenue
Gross Profit is Sales minus Cost of Sales. Cost of Sales can be called many
different things, but the best way to identify it is that it will be situated in the
rows between Sales and Gross Profit on the Profit and Loss Account.
Operating Profit Margin Operating Profit / Sales Alternative terms for Operating Profit are "Profit before Interest and Taxation"
or "Earnings before Interest & Taxation". It is usually the Sub-total row on the
Profit and Loss Account befor the Row entitled Interest.
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2. Comprehensive Ratio Analysis
Financial Ratio Analysis
Profitability Ratios (Continued)
The most frequently calculated PROFITABILITY RATIOS are:
RATIO CALCULATION METHOD NOTES
Profit Before Tax Margin Profit Before Interest & Tax / Sales Sales can be called Sales Turnover, Sales Income, Sales Revenue, Gross
Revenue
Profit before interest & tax can also be called "Earnings before Interest & Tax".
It is the row on the Profit and loss Account before the row entitled Taxation.
Net Profit Margin Net Profit / Sales Alternative terms for Net Profit are "Profit after Taxation", "Earnings after Tax"
or "Net Income" . It is usually the last row on the Profit and Loss Account
before the Row/s entitled Dividends.
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3. Comprehensive Ratio Analysis
Financial Ratio Analysis
Efficiency Ratios
Efficiency ratios deal with the efficiency with which Management has used the assets employed in the business.
Various Asset Turnover ratios can be calculated and any improvement or deterioration in performance can be identified
Commonly Calculated Efficiency Ratios are:
RATIO CALCULATION METHOD NOTES
Total Asset Turnover Sales / Net Assets Sales can be called Sales Turnover, Sales Income, Sales Revenue, Gross
Revenue
Expressed as a number of times eg 2.5 Net Assets = Fixed Assets + Net Current Assets (Net Current Assets = Current
times Assets - Current Liabilities)
Current Assets = Stocks ( Inventories ) + Debtors (Receivables) + Cash
Current Liabilities = Creditors (Payables) + Overdraft
Fixed Asset Turnover Sales / Fixed Assets
Expressed as a number of times eg 2.5
times
Stock (Inventory) Turnover Cost of Sales / Stocks Cost of Sales can be called many different things, but the best way to identify
it is that it will be situated in the rows between Sales and Gross Profit on the
Profit and Loss Account.
Expressed as a number of times eg 2.5
times
Can be expressed as a number of Days This is done by dividing the number of Times Stock is turned over into 365
Debtors (Receivables) Turnover Sales / Debtors
Expressed as a number of times eg 2.5
times
Can be expressed as a number of Days This is done by dividing the number of Times Stock is turned over into 365
Creditors (Payables) Turnover Total Annual Credit Purchases / This is not usually disclosed in Published Accounts
Creditors
Expressed as a number of times eg 2.5
times
Can be expressed as a number of Days
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4. Comprehensive Ratio Analysis
Financial Ratio Analysis
Combining Profitability and Efficiency Ratios
Profitability and Efficiency Ratios can be combined together to calculate
RATIO CALCULATION METHOD NOTES
Return on Net Assets Net Profit / Net Assets Net Assets = Fixed Assets + Net Current Assets (Net Current Assets = Current
Assets - Current Liabilities)
Current Assets = Stocks ( Inventories ) + Debtors (Receivables) + Cash
Current Liabilities = Creditors (Payables) + Overdraft
Return on Capital Employed Operating Profit / Net Assets Alternative terms for Operating Profit are "Profit before Interest and Taxation"
or "Earnings before Interest & Taxation". It is usually the Sub-total row on the
Profit and Loss Account befor the Row entitled Interest.
Net Assets = Capital Employed
Capital Employed is the total amount invested in a business by Owners who
have claims on Equity ( Share Capital + Retained Profits) and
Providers of Loans who have claims on the business for the amounts of their
loans and who receive interest.
Neither of these ratios is theoretically perfect. Return on net assets is calculated after deduction of interest and Operating Profits are subject to
Taxation after interest has been deducted. Operating profit flows to three destinations: THE GOVERNMENT ( Taxes on Profits); LENDERS
(Interest) and SHAREHOLDERS (Dividends plus Retained Profits). Net Profit only flows to SHAREHOLDERS though a part of the NET ASSETS are
Financed by LENDERS.
Therefore a further Ratio has been suggested as being the true measure for a combination of Profitability and Efficiency Ratios
RATIO CALCULATION METHOD NOTES
NOPAT : NET ASSETS (Operating Profit minus Taxes) / Net NOPAT is Net Operating Profit After Taxes
Assets
NOPAT only flows to two destinations: LENDERS and SHAREHOLDERS who have financed NET ASSETS through LOANS and EQUITY
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5. Comprehensive Ratio Analysis
Financial Ratio Analysis
Leverage or Gearing Ratios
If Shareholders cannot finance assets from their own Funds they can Borrow at fixed interest rates and acquire more assets. If the returns they
obtain on these assets are greater than the interest cost, any margin over the interest costs flow directly to Shareholders.
RATIO CALCULATION METHOD NOTES
Debt to Equity Ratio Long Term Debt / Equity Shareholders Equity Shareholders Funds is comprised of Share Capital plus retained Profits
Funds %
Debt to Net Assets Ratio Long Term Debt / Net Assets Net Assets = Fixed Assets + Net Current Assets (Net Current Assets = Current
Assets - Current Liabilities)
Net Assets = Capital Employed
Capital Employed is the total amount invested in a business by Owners who
have claims on Equity ( Share Capital + Retained Profits) and
Providers of Loans who have claims on the business for the amounts of their
loans and who receive interest.
RATIO CALCULATION METHOD NOTES
Return on Equity Net Profit / Equity Equity Shareholders Funds is comprised of Share Capital plus retained Profits
Also Known as
Return on Shareholders Funds
REMEMBER
RETURN on EQUITY is equal to Profitability X Efficiency / ( 1 -
Leverage % )
Or Return on Equity = (Net Profit / Sales) X (Sales / Net
Assets) / (Equity / Net Assets )
Liquidity Ratios
These are of use to those who have lent money to the company or are supplying goods on credit to the company.
They are a measure of how easily current assets can be turned into cash to pay lenders or suppliers
RATIO CALCULATION METHOD NOTES
Current Ratio Current Assets / Current Liabilities Current Assets = Stocks ( Inventories ) + Debtors (Receivables) + Cash
Current Liabilities = Creditors (Payables) + Overdraft
Quick Ratio or Acid Test Ratio (Cash + Debtors) / Current Liabilities Debtors should be able to be converted into cash quickly to pay current
liabilities
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6. Comprehensive Ratio Analysis
Financial Ratio Analysis
Ratios and Other Statistical Data which can be used by POTENTIAL INVESTORS in a Company
Before an investment in a company is considered a thorough analysis of the data pertaining to the company should be undertaken. Financial
Analysts refer to this as Fundamental Analysis. It comprises of a calculation of the ratios outlined above as well as additional calculations
outlined below. The investors may be Providers of Loans, for which they will receive returns in the form of interest payments.
Or these investors may wish to purchase Ordinary Shares in the Company. In this case returns they receive will be in the form of
Capital Gains from increases in the share price plus Income from Dividends.
Additional Ratios for Lenders
RATIO / STATISTIC CALCULATION METHOD NOTES
Interest Cover Operating Profit / Interest The higher this ratio the more likely it is that a company will be able to meet its
interest payments in the event of a deterioration in its trading situation
Usually expressed as a Number of Times The level of interest cover also determines the Interest Costs a company will
(US Terminology Times Interest Earned) pay for loans. Lower levels of Interest Cover mean that the Company is more
risky to lend to, so if it is more risky the lenders will require higher returns.
Additional Ratios for Investors in Ordinary Shares
RATIO / STATISTIC CALCULATION METHOD NOTES
Current Share Price Market Quotation Prices are quoted in the "Serious Press" and on Bloomberg.co.uk or
http://www.finance.yahoo.co.uk
Earnings per Share Net Profit / Number of shares in issue Will be quoted on Bloomberg & Yahoo Finance. Also shown prominently in
Companies' Published Accounts
Price / Earnings Ratio Curent Share Price / Earnings Per Price Earnings (PE) Ratios are quoted in the serious press and on Bloomberg
Share & Yahoo Finance. PE Ratios tend to be similar for companies in a particular
Industrial sector. Companies with higher PE ratios tend to be in favour with
investment fund managers who control large investment funds for pensions,
Insurance companies and Investment trusts. A low price earnings ratio may
also indicate that the Company is undervalued, and an investment in its
shares may yield possible capital gains.
Dividend per share Annual Reported Dividend per Share Will be quoted on Bloomberg & Yahoo Finance. Also shown prominently in
Companies' Published Accounts
Dividend Cover Net Profit after tax / Dividends or Gives some indication of certainty of dividend, but note that companies can
Earnings per share / Dividend per still pay dividends when they are making losses
share
Dividend Yield % Dividend per Share / Current Share Will be quoted on Bloomberg & Yahoo Finance. Also shown prominently in
Price Companies' Published Accounts
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7. Comprehensive Ratio Analysis
Financial Ratio Analysis
Ratios and Other Statistical Data which can be used by POTENTIAL INVESTORS in a Company
Additional Ratios for Investors in Ordinary Shares
RATIO / STATISTIC CALCULATION METHOD NOTES
Market Capitalisation Current Share Price Multiplied by Market Capitalisations for companies are quoted in the "Serious Press" and
Number of shares in issue on Bloomberg.co.uk or http://www.finance.yahoo.co.uk
Total Shareholder Return The increase in value of an investment Data for this calculation can be obtained from Yahoo Finance, share price
in a company's ordinary shares over a history.
period of years (Usually 3 or 5 Years)
assuming that all dividends are
reinvested in the company at the share
price on the date when dividends are
received
Book to Market Ratio Market Capitalisation / Equity The book to market ratio is important, since studies have shown that
Shareholders Funds Companies with low book to market ratios provide greater long term returns
than those with higher Book to Market Ratios in the same industrial sector
Price Earnings Relative A measure of the relationship between the Price Earnings Ratio for a
Company and the P.E. Ratio for the Market as a whole. Published in
Bloomberg and Yahoo Finance.
Dividend Yield Relative A measure of the relationship between the Dividend Yield for a Company and
the Dividend Yield for the Market as a whole. Published in Bloomberg and
Yahoo Finance.
Retentions Percentage Retained Profit / Net Profit
Sustainable Growth Rate Retentions Percentage Multiplied by The theory is that companies retain profits to invest and in doing so should
Return on Equity (Return on obtain at least the same level of Return on Equity for the profits retained for a
Shareholders Funds) year as it gets on what it has invested previously.
BETA Published on Yahoo Finance & BETA is a statistical measure which indicates how individual share prices
Bloomberg.com move up and down as the market as a whole moves up and down. Company
shares with a BETA of 1 move up and down exactly as the Market Moves up
and down. Company shares with a BETA of less than 1 move up less than the
market when the market is going up and move down less than the market
when the market is going down. These are known as DEFENSIVE SHARES.
Company shares with a BETA of more than 1 rise more than the market when
the market is rising and move down more than the Market when the market is
falling. These are known as AGGRESSIVE or SEASONAL Shares
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8. Comprehensive Ratio Analysis
Financial Ratio Analysis
Share Valuation Methods
Investment fund managers are looking for two things when they decide to make investments. Firstly they are looking for income from dividends and
secondly they are looking for potential share price growth. They assess potential share price growth by calculating an INTRINSIC VALUE for a
share. One of the most frequently used methods is to calculate the required return for a share using the CAPITAL ASSET PRICING MODEL.
The Capital Asset Pricing Model (CAPM) is a financial theory which states that the required return for a share should be equal to a RISK FREE RATE
plus BETA multiplied by the MARKET RISK PREMIUM. The MARKET RISK PREMIUM is the difference between the MARKET RATE OF RETURN
and THE RISK FREE RATE. The RISK FREE RATE is generally assumed to be the rate of return on short term government bonds such as Treasury
Bills. At 1.1.2005 this rate is approximately 5% per annum. Over a period of years the MARKET RATE OF RETURN has been 10% per Annum, thus
THE MARKET RISK PREMIUM is 5% (10% - 5%).
For a share with a BETA of 1.5, the required rate of return would this be 5% + 1.5 (10% - 5%) = 12.5%.
The REQUIRED RATE OF RETURN is then plugged into a formula for calculating the INTRINSIC VALUE of a share, which is based on the
assumption that CURRENT DIVIDENDS will grow at a percentage GROWTH RATE determined by SUSTAINABLE GROWTH. This is known as THE
DIVIDEND DISCOUNT MODEL. The formula for this model is :
INTRINSIC SHARE VALUE = (CURRENT DIVIDEND) Multiplied by (1 + Growth Rate) / (REQUIRED RATE OF RETURN - GROWTH RATE)
Thus if a share had a dividend of 20p per share, a Growth Rate of 5% pa and a Required Rate of Return of 12.5% the Intrinsic Value would be:
20 X 1.05 / (12.5% - 5%) = 280p
The INTRINSIC VALUE is then compared with the Current Share Price. If the INTRINSIC VALUE is substantially greater than the Current Share price
BUY, if it is substantially less then SELL.
Financial Ratio Analysis
A word of warning
Financial ratio analysis is useful in highlighting potential problems with a company, but it cannot provide all the answers for an Investment Decision.
Before investing a full analysis of the Economy, Market and Company's competitive position should be also examined.
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