Further Ratio Interpretation

Further ratio analysis interpretation Ratio Interpretation Return on shareholders’ funds (%) Higher ROSF is generally better, as it indicates higher profitability, BUT these returns are also affected by the levels of financial gearing. Higher levels of financial gearing also make this ratio higher. Return on Capital Employed (%) Higher ROCE indicates better financial performance. This is explained further by profitability or efficiency ratios. Operating profit margin or Return on Sales (%) A higher margin indicates more profitability and is therefore good. Gross Margin (%) A higher margin indicates more profitability and is therefore good. Overhead: Sales % A lower overhead : sales ratio indicates good control of operating expenses (or overheads) and so is good for profitability. Sales revenue to capital employed A higher SRCE ratio indicates a more efficient use of capital employed. Sales revenue to non current assets A higher SRNCA ratio indicates a more efficient use of non-current assets. Sales revenue to working capital A higher SRWC ratio indicates a more efficient use of working capital, but this can be difficult to interpret as working capital may be very close to zero or negative. Current Ratio A CR of > 1.0 is considered necessary for traditional manufacturing companies. This is not true for service and retail companies that often have CR < 1.0 and this does not indicate liquidity problems. Quick Ratio A QR of > 1.0 is considered to imply a safe liquidity position for traditional manufacturing companies. This is not true for service and retail companies that often have QR < 1.0 and this does not indicate liquidity problems. Gearing Ratio (%) Financial gearing measures the level of financial risk a company has taken. A ratio of < 30% is often considered to indicate a safe level of gearing. Some suggest that a ratio of >50% indicates high (risky) levels of financial gearing. Debt-Equity Ratio The D-E ratio is similar to the gearing ratio and also measures the level of financial risk a company has taken. A gearing ratio of 30% corresponds to a D-E ratio of 43% and a gearing ratio of 50% corresponds to a D-E ratio of 100%. Interest Cover This measures how easily operating profits cover interest expense. If this is < 1.0 then the company’s profit is turned into a loss before tax. Safer levels are given by an interest cover of > 3 or 4. Interest cover is affected by both the company’s level of debt and its profitability. Dividend Cover This measures how easily profit after tax covers the dividend charge for the year. If this is < 1.0 then the company’s profit is turned into a retained loss. Safer levels are given by a dividend cover of > 2, but this is hard to interpret and will be affected by both the company’s dividend policy and its profitability. Dividend per Share One would expect most shareholders to be happier with higher levels of DPS, although this may depend on their personal tax position. Dividend Yield (%) One would expect most shareholders to be happier with higher levels of dividend yield, although this may depend on their personal tax position. Dividend is only one benefit of owning shares and total shareholder returns measures the full benefit. Earnings per Share EPS is a very popular measure of profitability for shareholders. Higher EPS is considered as good news for shareholders. Price-Earnings Ratio A higher PE ratio is considered to indicate increased stock market confidence and is so considered good. The interpretation of this ratio is complicated by having an earnings figure as the denominator and so a high PE ratio may also reflect low earnings, which could be bad. Total Shareholder Returns (%) This measures the total return to the shareholder from investing in a company. This is both the dividend and the increase (or decrease) in share price. Higher returns are good for shareholders. According to finance theory the returns of the market as a whole should on average exceed the risk free rate of return by 6-9% per annum. Inventories turnover period (in days) This measure the level of inventory at the accounting year end. For many manufacturing companies an inventory turnover period of 30-60 days is considered normal, but if they are operating a just-in-time system this would be expected to be lower. Retailers usually have lower inventory turnover periods than manufacturers, as they do not hold raw material or work in progress. Service companies would be expected to have very limited inventory. Settlement period for trade receivables (in days) This will depend on the credit terms offered by the company. 30 or 60 days are quite common for manufacturers, but retailers are usually paid in cash and so have very low settlement periods. Settlement period for trade payables This will depend on the credit terms offered by the (in days) company’s suppliers. 30 or 60 days are quite common. Profitability ratios Return on ordinary shareholders’ funds = Return on capital employed = Gross profit margin Operating Profit Margin Net profit margin Overheads to sales Average stock turnover period= Average settlement period for debtors= Average settlement period for creditors= Sales to capital employed= Sales per employee= Efficiency ratios Liquidity ratios Current ratio= Acid test ratio= Operating cash flows to maturing obligations= *we are not using cash rather using operating cash flow from cash flow statement. Gearing ratios Gearing ratio= Interest cover ratio= Debt ratio= Equity ratio= Investment ratios Earnings per Share= Diluted Earnings per share= Dividend per share Dividend payout ratio Retention ratio Capital Gain Dividend Yield Ratio Total Shareholder Return Operating cash flow per share Price/earnings ratio (P/E)