1、Dr. Evarist Stoja,Financial Management,Financial Ratio Analysis,How healthy is a company?,Dr. Evarist Stoja,Financial Management,Lecture Objectives,To explore the concepts and application of financial ratio analysisTo introduce and develop a set of financial ratios to be used in financial statement
2、analysisTo establish comparators for such analysisTo set out a framework for the analysis of financial statementsTo consider how to interpret financial statements,Dr. Evarist Stoja,Financial Management,The Purpose of Financial Ratios,Financial ratios can help the user to analyse and interpret financ
3、ial information, particularly that contained within the financial statementsSuch ratios are used by a multitude of users, both within and outside the firm, with the main objective of determining the financial position and performance of the firmPlanning They can be used to help the finance manager p
4、lan for the next financial period. For example, what is the level of fixed assets I should employ in relation to the firms total asset base when I expand the trading operations of the firm?Control They can be used to identify problem areas within the firm. For example, why has my net profit margin (
5、net profit to sales ratio) deteriorated in the last financial period?Evaluation To what extent can the firm cover its near-term commitments in the coming financial period (current assets to current liabilities ratio)? Is the firm looking more financially risky (debt/equity ratio)?,Dr. Evarist Stoja,
6、Financial Management,What is a Financial Ratio?,So what is a financial ratio?It usually expresses a figure taken from the financial statements divided by another financial statements figureExample:Net profit margin =Net profit divided by salesHowever, sometimes it involves a resource available to th
7、e firm:Example:Sales per employee =Sales divided by number of employees,Financial statement figure,Divided by:,Financial statement figure,OR,Financial statement figure,Divided by:,Resource available to firm,Dr. Evarist Stoja,Financial Management,An Example of Why Ratios are Useful,Both of the compan
8、ies below are generating a healthy profit from their trading operations. Which company is more profitable?,Company ACompany A generates a net profit of 15 million from sales of 100 million.Absolute profit is lower i.e. 15m.BUT relative profitability is higheri.e. (15 / 100) x 100% = 15%,Company BCom
9、pany B generates a net profit of 25 million from sales of 200 million.Absolute profit is higher i.e. 25m.BUT relative profitability is loweri.e. (25 / 200) x 100% = 12.5%,Therefore, financial ratios help us to adjust for differences in size between firms. This helps us compare the financial position
10、 and performance of firms of almost any size.,Dr. Evarist Stoja,Financial Management,Bases for Comparison with Financial Ratios,Which of the following would appear a useful basis for comparing the financial ratios of a firm?,Dr. Evarist Stoja,Financial Management,Possible Bases for Comparison,Firms
11、in the same industry Yes, this is a good basis for comparison as their operations will be similar, as will their market environment, degree of business risk, and so on.Firms with the same length of establishment Not necessarily a good basis as they may operate in a different market, have a different
12、 mode of operation and may be subject to different pressures.Firms in the same geographical location Yes, this may be a useful basis for comparison, particularly if your customers are concentrated in that same geographical location.Firms with the same rate of growth This can be a useful comparison i
13、f they are operating in the same or a similar industry. They will be facing the same financing and liquidity constraints as your firm.,Dr. Evarist Stoja,Financial Management,Stronger firms than ours May be useful, though there is no point benchmarking a firm against an industry leader if you have li
14、ttle immediate prospect of competing directly with them.Weaker firms than ours May be useful, at least it will highlight our relative strengths and identify the problems faced by weaker firms in our industry so that we might avoid them.Firms with similar trading operations Yes, a useful basis for co
15、mparison, particularly if that firm is operating in the same industry. Even if the firms markets are a little different a comparison may be useful if the firm has a similar mode of operation, asset structure and/or financial structure.Firms of the same size Yes, a useful comparison, but only if thei
16、r industry or mode of operation is similar. Remember that larger firms may not be competing for customers but are certainly competing for investors.,Possible Bases for Comparison,Dr. Evarist Stoja,Financial Management,There are probably as many different views on essential financial ratios as there
17、are financial statement analysts!However, given below are the main financial ratios you will encounter:,The Main Financial Ratios,Dr. Evarist Stoja,Financial Management,The Main Financial Ratios,Investment RatiosThese help investors to determine the financial performance of equities/shares in the fi
18、rm.The firm must bear these ratios in mind to ensure that they appear a good investment prospect, to enable them to raise lower cost funds when they are required.Investors tend to focus on the risk and return of purchasing a share in the firm.Gearing RatiosThese help to describe the relationship bet
19、ween the owners (shareholders) investment in the firm and the investment of outsiders such as banks or bondholders.They help in assessing the financial risk of the firm, that is the possibility that the firm will encounter financial distress in the coming financial periods.,Dr. Evarist Stoja,Financi
20、al Management,The Main Financial Ratios,Profitability RatiosAs with investment ratios, they help us to ascertain the financial performance of the firm, though they focus on the wealth generated by the business in total rather than the wealth generated and distributed to shareholders.They tend to tel
21、l us how successful those managing the firm are at generating wealth from the sales made and capital employed by the firm.Liquidity RatiosCash and near-cash (current assets which can be converted to cash relatively easily) are the lifeblood of the firm and therefore should be monitored very closelyT
22、hey tell how us well the firm can cover its short-term commitments (current liabilities) from its short-term cash and near-cash (current liabilities),Dr. Evarist Stoja,Financial Management,The Main Financial Ratios,Efficiency RatiosThese ratios measure the efficiency with which the firm uses the res
23、ources available to itThey also measure how fast the firm turns over its stock, debtors and creditors, for example,Dr. Evarist Stoja,Financial Management,Calculating the Ratios,Before we look at the Financial Ratio Framework, it is important to understand how to calculate each of the main financial
24、ratios within each category. This is not as easy a task as it might appear as the definitions of the ratios are quite specific regarding the components, the numerator and denominator:,Numerator,Denominator,However, other than these very specific and commonly quoted ratios, we must remember that we c
25、an also create our own financial ratios to measure what we want. The important thing to remember is that, whatever ratio we calculate, it must be: Carefully computed; Make logical sense; Capable of sensible interpretation.,Dr. Evarist Stoja,Financial Management,The Main Investment Ratios,Dr. Evarist
26、 Stoja,Financial Management,The Main Investment Ratios,1. Dividend per share (DPS)Dividends proposed (income statement)DPS =- Number of shares in issueThis ratio measures the dividend announced during the year per each share in issueIt gives a measure of the absolute returns to the investor in terms
27、 of the relevant currencyIt is useful in monitoring the returns of a particular firm through time though is less useful for comparing firms as the size of DPS obviously depends on the value of each shareAlso, it measures only part of the returns to investors as it does not take into account the capi
28、tal gain they may receive for holding the share,Dr. Evarist Stoja,Financial Management,The Main Investment Ratios,2. Dividend yield (DY) Dividend per share / (1-t)DY =- x 100Market value of each share This ratio helps to overcome the problems with the DPS measure by showing the cash dividend returns
29、 to equity investors as a proportion of the shares current market value i.e. it shows equity dividend returns as a yield This return can then be more easily compared with the returns available on other shares or other forms of investment (e.g. bonds) The numerator DPS must be grossed up for tax to a
30、llow comparison with other forms of investment which are also quoted in terms of gross yields,Dr. Evarist Stoja,Financial Management,The Main Investment Ratios,3. Dividend payout ratio (DPR) Dividends proposed (income statement)DPR =- x 100Net profit after tax preference dividends proposed This rati
31、o measures the proportion of its earnings which are actually distributed (paid out) to shareholders The higher is this ratio, the more the firm is focused on keeping shareholders happy by distributing the created wealth, though if this ratio is too high then the firm may suffer by not retaining fund
32、s for updating or expanding its productive capacity,Dr. Evarist Stoja,Financial Management,4. Price-earnings ratio (PE)Market value of each sharePE =- Earnings per share This ratio measures the multiple which investors are prepared to pay in the equity market for each unit (pound) of earnings It giv
33、es a useful indication of the price that investors are willing to pay for future earnings and thus gives us a useful measure of earnings expectations PE ratios can vary significantly across industries and across economic cycles, though prices are generally between 10 and 20 times earnings,The Main I
34、nvestment Ratios,Dr. Evarist Stoja,Financial Management,The Main Investment Ratios,5. Earnings per share (EPS)Net profit after tax preference dividends proposedEPS =-Number of ordinary shares in issue This ratio measures total earnings (whether ultimately distributed or not) available to shareholder
35、s per share The shareholder then has some measure of the earnings generating power of the firm, regardless of its current dividend policy However, as it gives an absolute currency figure it is not a useful measure for comparing across firms, rather it is useful for comparing an individual firms perf
36、ormance through time,Dr. Evarist Stoja,Financial Management,The Main Gearing Ratios,Dr. Evarist Stoja,Financial Management,The Main Gearing Ratios,1. Debt-equity ratio (DE) Long-term debtDE=- x 100Equity capital + reservesThis ratio measures the ratio of external financing to internal (equity) finan
37、cing and shows the reliance of the firm on outside fundsA higher gearing ratio can signify a firm which finds it difficult to raise new equity financeA rule of thumb for gearing is that a ratio greater than 1 represents a fairly financially risky firmi.e. a firm which has more debt than risk capital
38、 to support its operationsHowever, the rule of thumb will vary across industries and some industries have very highly geared but successful firms,Dr. Evarist Stoja,Financial Management,The Main Gearing Ratios,2. The borrowing ratioShort-term debt + long-term debtBorrowing ratio = -x100 Short-term de
39、bt + long-term debt + equity capital + reserves This ratio measures not only the ratio of long-term debt to equity capital and reserves but also includes short-term debt in both the numerator and denominator The reason it is useful is because firms will often continually renew short-term debt, there
40、by treating it as if it is a form of longer-term capital, particularly when shorter-term interest rate are more favourable than longer-term rates It is a more inclusive measure of debt gearing,Dr. Evarist Stoja,Financial Management,The Main Gearing Ratios,3. Gearing ratioLong-term liabilitiesGearing
41、 ratio =- x 100Share capital +reserves + long-term liabilities This ratio measures the proportion of the capital structure contributed by external claimholders i.e. debt investors and others with a long-term claim on the firm It is more encompassing than the debt-equity ratio as it includes other lo
42、ng-term claims The higher the gearing ratio, the higher the probability that equity holders will be left with very little residual income (i.e. income left after debt holders have been paid) and therefore this is a good measure of financial risk.,Dr. Evarist Stoja,Financial Management,The Main Geari
43、ng Ratios,4. Interest coverProfit before interest and taxationInterest cover =-Interest expense This ratio measures the financial safety of the firm i.e. to what extent can it cover the interest payments to its debt holders? It is sometimes referred to as income gearing A rule of thumb for income ge
44、aring is that firms should be concerned if this ratio falls below about 5 Certainly a firm which has a ratio approaching 1 should be very concerned as it is approaching a situation of financial distress,Dr. Evarist Stoja,Financial Management,The Main Profitability Ratios,Dr. Evarist Stoja,Financial
45、Management,The Main Profitability Ratios,1. Gross profit margin (GPM)Gross profitGross profit margin = - x 100 SalesThis ratio measures the profitability of purchasing or manufacturing goods and selling themGross profit here is simply sales less the cost of sales,2. Net profit margin (NPM)Net profit
46、 before interest and taxationNet profit margin = - x 100 SalesThis ratio measures the profitability of the firm, regardless of its form of financing or tax positionIt is a very useful measure for comparing profitability across firmsIf a healthy gross profit margin produces only a small net profit ma
47、rgin then the firm has incurred significant indirect or overhead costs in its trading operations,Dr. Evarist Stoja,Financial Management,The Main Profitability Ratios,3. Return on capital employed (ROCE) Net profit before interest and taxationROCE =- x 100Share capital + Reserves + Long-term loansThis ratio measures the profit produced by the firm from its capital base (its debt and equity)It is one of the most commonly quoted profitability measures,
