Analysing Financial statement figures in isolation often does not give much of an insight into performance e.g. knowing that a business used €50,000 in materials last year and €70,000 this year would not provide any great indication on the level of performance in materials management. If these figures were compared to sales for both years and showed:

 The Purpose of Ratios

 

Last Year

This Year

Materials

€50,000 50%

 €70,000 56%

Sales

€100,000

€125,000

Provided that there was no significant change in the mix of products which generated the sales or the prices, you could infer that the performance in materials management had declined.

This technique of linking related figures is called ‘Ratio Analysis’ and is often used to give an insight into the status and performance of a business.

Ratios are particularly useful when used to compare:

Current levels of performance against past levels within the same business (Trend Analysis)

The performance of a business against that of other firms in the industry (Comparative Analysis)

The interpretative skill lies in the ability to discover the underlying causes which shape the ratios and care must be taken in the conclusions drawn from ratio analysis mainly because:- Those involving Balance Sheet items are taken at a specific date and if the business has seasonal variations in the level of trading they will not be representative of other months in the year.

Value judgements on the results are relative to circumstances.   A highly geared company may appear unstable but this ratio may be the result of rational management decisions when profits are high and the cost of borrowing relatively low.

A company with very old machinery will be likely to have a low book value for fixed assets and low depreciation charges against profits and therefore show a very positive Asset Turnover ratio, whereas a company similar in every other respect, which has just replaced all its machinery will return a lower figure.

The ratios may be helpful if you are submitting the projections to support funding or grant applications as it is common practice to use Ratio Analysis to interpret financial projections.

Profitability Ratios

Net Profit/Total Assets

Referred to as the primary ratio in that it measures the return on the total investment in the business.

Strategies to improve the ratio will be directed at increasing profit and improving the efficiency of assets in generating sales.

Net Profit/Sales

This ratio shows the overall performance of management in creating profit from sales.  It shows how they have managed prices, costs of sales and overheads to generate a return for the company.

Gross Profit/Sales

Shows management’s ability to control the crucial factors of selling prices, cost of sales and in manufacturing where capacity costs such as labour are involved, sales volume.

Net purchases/ Sales  %

To indicate the economies in buying and inventory management while controlling selling prices  in retail operations.

Materials/ Sales  %

To indicate the performance in procuring and utilising materials.

Wages /Sales %

To indicate the performance in utilising the labour resource.

Overheads/Sales %

To indicate management’s performance in administering and funding the business.

These ratios may be expanded to relate specific overheads to sales, specific materials         or categories of workers if the resulting information is considered valuable.

Net Profit / Capital Employed

Which measures the performance of management in making a return on the owners and borrowed funds.

Net Profit / Interest times

Which is called the interest cover and shows the ease with which a company can service its debt.   This would be particularly important when interest rates are high and the company has a high level of formal debt – see gearing below.

Liquidity & Solvency Ratios

Liquidity ratios show the ability of the business to meet its day to day financial obligations by comparing the expected short term cash position and inflows from debtors and stocks against the outflows to pay creditors.  

Current Ratio

Current assets/Current Liabilities expressed as a number i.e. times e.g. 2.5 which would suggest that for every € we will have to pay out we have a cover of €2.5. and hence would be considered to be in a strong liquidity position.              

Quick Ratio

Subtracts the value of stocks from the above ratio on the grounds that stocks may be overvalued and hard to realise in troubled times.  The quick ratio is therefore lower and provides a keener test of liquidity.

Debt/Equity

Measure the dependence on outside i.e. borrowed funds.  It is the major indicator of who really owns the business.              .    When the Debt/Equity Ratio is 100% it means that every “owner’s pound is matched by one from borrowings.  As this point is neared the business will be “highly geared”, and may encounter difficulty in raising further funds through borrowing.    A highly geared business may be the result of smart aggressive management – where it has come about by choice - but – where it may indicate problems in failing to properly structure the funding of the business and or generate profits.   A highly geared company can easily be pushed into short term cash flow driven strategies in order to meet debt repayments.

Equity/Total assets %

Is a converse way of looking at the above and shows the extent of the shareholders ownership of the company’s assets

Stock Turnover Days-

Measured as follows - Stocks X 360 / Cost of Sales to indicate the level of investment tied up in stocks.

Debtor Days

Measured by - Debtors X 360 / Sales (including VAT) to indicate the performance in collecting cash from debtors.

Creditor Days

Measured by - Creditors X 360 / Purchases (Inclusive of VAT) to show  the average credit time taken by the business.   A result for this ratio which is higher than normal for the industry or than had been returned by the business in the past might be an early indication of cash flow difficulties.

Volume Ratios

 

Volume / Capital Ratios analyse the performance of the business in a number of areas - the utilisation of assets in terms of generating sales,        the relationship between owner’s funds and borrowings and the rate at which cash is collected from sales and paid for purchases.

Sales / Total assets

Which shows the efficiency of management in generating sales from all the assets at their disposal.  The determinants are effective use of productive assets such as machinery and tight control over stocks and debtors.   The skill lies in gaining these benefits without downtime from overtaxing fixed assets, stock outs from low inventories and adverse customer reaction from tight credit control.

This ratio can be further analysed by separating the fixed and current elements.

Sales/Fixed Assets

To indicate the performance in utilising the fixed assets to generate sales.

Sales/Current Assets

Indicates the ability of management to generate sales while controlling debtors and stocks.

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