Chapter 31 · Ratio Analysis

What Is Ratio Analysis?

The statement of comprehensive income tells us about revenue, expenses and profit over a period. The statement of financial position shows assets, liabilities and capital on a particular date. Although these figures are useful on their own, it is easier to assess financial performance by expressing one relevant figure in relation to another. This is called ratio analysis.

• Profitability ratios measure how effectively the business earns profit from its revenue or capital.
• Liquidity ratios measure how readily the business can meet its short-term debts, such as wages and bills owed to suppliers.

Ratios are especially valuable when comparing different years, businesses in the same industry, or actual results against expectations. However, one ratio alone rarely proves that a business is healthy: it helps identify questions that need further investigation.

Example: Orient Plus

Orient Plus manufactures high-quality children’s clothes. Following the arrival of a competitor, its business struggled. At the end of 2016 it announced that 12 of 32 design and production employees would be made redundant. The financial figures show deteriorating profitability and liquidity.

Its net current assets fell from US$239,300 in 2015 to only US$14,300 in 2016. Its revenue also fell and operating profit shrank sharply, while the year ended with a small loss. Redundancies may reduce future wages, but they can also affect production capacity and staff morale. The example illustrates why managers should investigate both profitability and liquidity.

Gross Profit Margin

This ratio shows the proportion of revenue remaining after paying the cost of sales, before deducting overheads and other operating expenses. It helps assess pricing and direct production costs.

A higher margin usually indicates greater gross profit for each unit of sales, perhaps because prices rose or direct costs were managed better. Margins differ by industry, so a supermarket selling large quantities may reasonably have a lower margin than a specialist producer. Higher revenue does not automatically mean a higher gross profit margin.

Operating Profit Margin

The operating profit margin measures what remains after cost of sales and the business’s operating expenses have been deducted. It is a useful indicator of how well a firm manages day-to-day costs.

Compare the gross margin with the operating margin. A large gap suggests that operating expenses absorb a substantial share of revenue. If the operating margin improves while the gross margin changes little, overhead control may have improved.

Example: Santos Metal Products

Santos Metal Products made scaffolding and metal components in Brazil. Demand rose during preparations for the 2016 Rio Olympics. The company’s 2010–2014 figures allow managers to investigate rising revenue alongside changing profit margins.

Santos improved both margins, although operating expenses also rose. Increased orders may have allowed fixed costs to be spread over more sales, but these accounts alone do not prove precisely why the improvement occurred.

Mark-up

Some businesses calculate profit relative to the cost of an individual item, rather than relative to the selling price. This is the mark-up. It is particularly useful when setting selling prices.

Do not confuse mark-up with gross profit margin. Mark-up divides profit by cost; gross profit margin divides gross profit by sales revenue. In the US$236,000 example, the 18% mark-up corresponds to a gross profit margin of about 15.3% (36,000 ÷ 236,000 × 100).

Concept and Importance of Liquidity

A business may own valuable property or machinery and still have problems paying suppliers this week. Buildings and specialist equipment can take a long time to sell, while cash can be used immediately. Trade receivables can become cash when customers pay their bills, whereas inventories are often less liquid because the business first needs to sell them.

• Cash: immediately available to pay bills.
• Trade receivables: amounts due from customers, usually expected to be collected within the agreed credit period.
• Inventories: goods held for use or sale; converting these to cash is less certain.
• Non-current assets: often difficult to sell quickly without disrupting operations.

Insufficient liquidity can prevent a business paying wages, rent or suppliers despite reporting a profit. The current ratio and acid test ratio use current assets and current liabilities to assess short-term financial strength.

Current Ratio

This compares all current assets with amounts payable within the next year. The higher the current ratio, the greater the apparent short-term asset cover, although holding too many idle assets may be inefficient.

A low ratio might mean insufficient working capital. A very high ratio might mean cash is lying idle or stock is building up. Evaluate it alongside the industry, inventory levels, customer payment terms and cash forecasts.

Acid Test Ratio

The acid test ratio is stricter than the current ratio because it excludes inventories, which may take time to sell or may lose value. It measures the cover offered by more readily available current assets.

An acid test ratio of less than 1 may suggest a liquidity risk, but the significance depends on the business. A retailer collecting cash immediately may operate effectively with a lower ratio than a manufacturer allowing customers to pay later.

Example: Comparing Assets and Liabilities

Patel’s, a car dealership with more than 60 outlets in India, and UZZY Plastics, which manufactures polythene products. These examples show how ratios make two very different sets of figures easier to interpret.

UZZY Plastics appears more liquid on both measures in both years. However, it is important to consider how car dealerships and plastics manufacturers manage inventories and payment schedules differently before drawing a final conclusion.

Return on Capital Employed (ROCE)

ROCE compares the operating profit generated with the amount of long-term finance used by the business. It shows how effectively the firm uses capital invested in its operations. Capital employed may be calculated as capital and reserves plus non-current liabilities if no direct figure is supplied.

ROCE is valuable when comparing investment alternatives or the same firm over several years. However, business investment carries more risk than holding savings in a bank, so a high ROCE is not a guarantee of a risk-free return.

Using Ratios to Make Comparisons

Ratios make the performance and financial position of different years easier to compare because they standardise results. A larger firm may have more total profit but not necessarily a higher percentage return. Ratio trends can highlight improvements, problems and areas requiring management action.

• Year-on-year comparison: Is a company controlling operating costs more effectively than last year? Has its liquidity improved?
• Inter-business comparison: Compare ratios for businesses operating in similar markets, with comparable accounting methods.
• Context: Look for changes in product mix, investment, market conditions and exceptional expenses before drawing conclusions.

Example: Al-Dhabit Shipping

Al-Dhabit Shipping, a family-owned business in Oman, transported oil. In 2014 a sharp fall in oil prices reduced demand for its services. The family invested US$2 million to help the business survive. Its 2013–2015 figures allow us to analyse the recovery.

The 2014 deterioration is clear in profitability and liquidity. By 2015 the operating profit margin and current ratio had recovered beyond their 2013 values, but ROCE at 9.75% remained below the 2013 level of 11.30%. Revenue was also still below its 2013 level. The overall assessment should therefore be a qualified recovery, not a claim of complete improvement.

Large vs Small Businesses

Large businesses often have specialist finance teams that analyse ratios for managers and shareholders. Smaller business owners may not prepare detailed annual accounts or may be unfamiliar with ratio analysis, although they can still use the same methods.

• Large businesses: more published financial information, specialist staff and greater need to report performance to shareholders or other stakeholders.
• Small businesses: owners may focus first on cash, cost control, profit margins and day-to-day survival, although ratio analysis can help them judge pricing and short-term liquidity.
• Both: can compare their own results across years and use ratios to identify trends, but must interpret results in the context of their business.

Ratios are tools for judgment, not answers by themselves. Managers should combine them with other information such as changes in demand, loan commitments, inventory turnover and forecasts.