ratios

Ratios

What are Ratios For?

The purpose of ratios are three fold

1 - to evaluate management's ability to get a good rate of return
2 - to appraise the financial strength of a company
3 - to assist in indicating the companies future financial performance.

Ratios can be loosely grouped into four headings, there is a fifth group, Investment Ratios but these are primarily for quoted companies.

Liquidity Ratios

These ratios are designed to tell you if the company can pay its current liabilities as they fall due.

This category includes Shareholder's Funds, Current Ratio, and Liquidity Ratio.

Efficiency Ratios

Also known as Turnover or Activity ratios and indicates how well the company is managing its assets and assist you in estimating the amount of cash required to generate further sales.

This category includes Collection Period, Creditor Days and Stock Turn.

Profitability Ratios

Shows how well are costs and expenses are controlled and to gauge the profits as a return on the resources of the company.

This category includes Profit Margin.

Debt Ratios

Also known as Solvency or Gearing ratios they show how much debt the company has in relation to its equity and indicates the extent the company is reliant on debt. And the ability of the company to raise and its capacity to repay debt when due.

This category includes Total Debt, Gearing, Interest Cover and Long Term Debt.

How are the Ratios Calculated?

Profit Margin %	Profit / Turnover	One of the most widely used ratios of all, it takes all expenditure into account and serves as a guide to overall performance when compared to previous years. Companies profit margins vary from industry to industry, although the margin should be stable with growth. Any major change needs to be ascertained, most common reasons are higher selling and administrative costs or a non recurring item. The change in profits may have been due to a one-time change in depreciation policy.
Profit / Capital Employed %	Profit / Shareholders Funds	In UK Data's view the ultimate ratio. The most important measure of profitability. Indicates results achieved regardless of the method of financing. It contrasts the profit made with the funds utilised to make that profit. The overall combination of management, the product, competition etc. are shown in this one ratio.
Profit / Assets %	Profit /Total Assets	This is the key indicator of the profitability of a company as it demonstrates how effectively the company is using its assets to generate profits, whether they are financed by shareholders funds or loans. High profits reflecting the efficient use of the company's resources.
Current Debt	Current Liabilities / Shareholders Funds	This ratio expresses current liabilities as a proportion of shareholders funds. A high ratio, implies shareholders funds are contributing a lower level of capital than short term liabilities. Any problems with cash flow, falling prices or a decline in sales will increase difficulties to meet payments on time.
Total Debt	(Current Liabilities + Long Term Liabilities) / Shareholder's Funds	This ratio expresses liabilities as a proportion of shareholders funds or total assets. A high ratio, implies the company has borrowed heavily in relation to its own funds, i.e. 200%, then creditors have �2 "invested" for every �1 the shareholders have! A high figure indicates that the company may not be able to raise more debt if required it also a signal that payments to suppliers may be delayed.
Long Term Debt	Long Term Debt / (Long Term Debt + Shareholder's Funds)	This ratio is similar to the total debt ratio and should be compared to it as it help to isolate the source of change. If a company purchased machinery on a 90 day bank loan, the capitalisation ratio would remain the same but the total debt ratio would increase.
Current Ratio	Current Assets / Current Liabilities	The essential ratio for suppliers and trade creditors, and the most popular, as this ratio demonstrates the company's ability to meet its short term obligations from its current assets when they fall due. Thereby not having to raise long term finance or realise fixed assets. The larger the ratio the better the short term protection for creditors. So a ratio of 3:1 means at that particular date the company had �3 of current assets to �1 of liabilities. The ratio does not take into account funds which may be available from other sources. As this ratio is derived from the balance sheet, it measures one moment in time, and does not take the quality of the assets into account. Seasonal influences can have an important effect.
Liqidity Ratio	(Current Assets - Stock) / Current Liabilities	Measures cash and near cash available to cover current debt. Seasonal influences can change this ratio substantially, consider a Christmas tree distributor, he will have high stock in December, converted to cash in January. Therefore showing a poor ratio in December and a good one in January.
Stock / Turnover	Turnover / Stock	Measures how quickly a company rotates its stock. Obviously one would expect a high stock turn from a super-market and a low one for a heavy engineering company. A low ratio without special reason is regarded as a poor sign, reflecting a) lack of demand for goods b) poor stock control c) overstocking. d) stocking up for a projected increase in sales If low, sales may be being lost due to lack of stock and failure to carry a large selection. A high ratio a) could imply the company is price cutting b) understocked c) failure to offer an adequate selection d) a market niche e) simply selling for the sake of market share.
Collection Period	(Trade Debtors / Sales) * 365	Indicates the average credit period given to customers or the time taken to collect in debts. The higher the figure, the longer it is taking the company to convert debtors into cash. Normally when most sales are on credit, and the collection period is more than one half over normal selling terms then the reasons need to be analysed. A high ratio is an indication of a) effective credit control b) planned sales c) maybe a restrictive credit policy d) few sales on credit A low ratio a) granting of special terms b) seasonal variations c) sharp rise in sales d) ineffective credit management e) possible increase in bad debts Be careful of seasonal influences, if a company normally had 10% of its sales in December (its year end) and this increased to 20%, then the debt turn would increase, although there has been no lengthening of credit terms.
Creditor Days	(Trade Creditors * 365) / Sales	An important figure which indicates how quickly the company pays its suppliers. The shorter the period the quicker the company pays its debts or operates on a cash basis. A long period then the company risks having supplies cut off.
Gearing %	Borrowings: Short Term Loan 0.96 Long Term Borrowings 8.92 Overdraft 0.00 Cash at Bank -16.42 -6.54 Shareholders Funds 11.92 Gearing = Borrowings: Shareholders Funds so �6.54/11.92 = -54.866	No one can agree on the composition of this ratio, however as this ratio is normally required by the companies bankers UK Data use the above. It shows the ratio between permanent capital (capital and reserves) to loans. Debt requires interest and capital repayments and the higher the amount, the more assets are being funded by debt as opposed to shareholders funds. A highly geared company is vulnerable to a fall in profits, and to increases in interest rates. The smaller the ratio the stronger the company. If it reaches 100% then the company is unable to be offer protection against a downturn in sales, cost increases etc.
Interest Cover %	Interest / Net Profit 1.88 / 5.16 = 36.43	Gauges the ability of a company to meet its interest charges from profits. An important figure in times of high and fluctuating interest rates. Cash flow from operations will be a better indicator of how well a company can cover its interest charges as well as its other fixed charges such as capital repayments of debt or lease obligations.
Credit Gearing %	Credit Limit / Shareholder's Funds 1.50 / 11.92 = 12.58	Your exposure compared to the owners capital
Indicator Ratio %		Expresses the credit limit requested or given, as a percentage. A principal supplier may have up to 30% although a "norm" would be up to 5%.

How is the Credit Limit Calculated?

It is not possible to give a formula for calculation of credit limit. An analyst will take into account all of the above figures, the history and context of the company, prevailing market conditions and use his own experience and judgement too. In addition, due to variety in accounts presentation, it is impractical to apply a single formula across the board for all companies.