Introduction
Users of financial statements can get a better understanding of the significance of the information in the financial statements by comparing it with other relevant information. Financial statement analysis is a study about accounting ratios among various items included in the balance sheet. Ratio analysis involves comparing one figure against another to produce a ratio, and assessing whether the ratio indicates a weakness or strength in the company’s affairs. These ratios include profitability ratios, liquidity ratios and debt ratios.
To explain how the ratios are calculated, the following summarized statement of financial position and income statement of the Company A will be used for the year ended 31 December 2017 and 31 December 2016.
Income Statement as at 31 December | ||
2017 | 2016 | |
Revenue | $3,095,576 | $1,909,051 |
Gross profit | $359,501 | $244,229 |
Interest | $17,371$ | $19,127 |
Profit before tax | $342,130 | $225,102 |
Income tax | $74,200 | $31,272 |
Profit for the year | $67,930 | $193,830 |
Statement of financial position as at 31 December | ||
2017 | 2016 | |
Non-Current assets | $802,180 | $656,071 |
Current Assets | ||
Inventories | $64,422 | $86,550 |
Receivables | $1,002,701 | $853,441 |
Cash at bank | $1,327 | $68,363 |
Total Current Assets | $1,068,450 | $1,008,354 |
Total Assets | $1,870,630 | $1,664,425 |
Equity | $888,899 | $651,969 |
Non-Current Liabilities | $100,000 | $100,000 |
Current Liabilities | $881,731 | $912,456 |
Total Liabilities | $1,870,630 | $1,664,425 |
Profitability ratios
Profitability ratios include:
- Return on capital employed
- Asset turnover ratio
- Net profit margin
- Gross profit margin
Return on capital employed (ROCE)
Return on capital employed (ROCE) measures the overall efficiency of a company in employing the resources available to it. It states the profit as a percentage of the amount of capital employed. In other words, It is a measure of the returns that a business is achieving from the capital employed, usually expressed in percentage terms.
ROCE = Profit before interest and taxation/Capital employed*100%
Capital employed= Shareholders’ equity plus Non-current liabilities or (Total Assets − Current Liabilities)
Example
Using the figures provided in the statement of financial position of the Company A
2017 | 2016 |
ROCE=360,245/988,899=0,36*100%=36% | ROCE=247,011/751,969=0,32*100%=32% |
Interpretation
What does a company’s ROCE tell us? The return on capital employed (ROCE) ratio shows how much profit each dollar of employed capital generates. In our example 0,36 shows that the company makes a profit of 36 cents per 1$ capital employed. The higher ROCE is more favorable as it shows that more dollars of profit are generated by each dollar of capital employed.
There are three comparisons that can be made.
- The change in ROCE from one year to the next can be examined. In this example, there has been an increase in ROCE by 4% (36%-32%) from its 2016
- The ROCE being earned by other companies, if this information is available, can be compared with the ROCE of this company.
- A comparison of the ROCE with current market borrowing rates may be made. Companies’ returns should always be higher than the rate at which they are borrowing to fund the assets. In this example, let’s suppose that current market interest rates for medium-term borrowing from bank is 10%, then the company’s actual ROCE of 36,4% would not seem low
.
Asset Turnover Ratio
Asset turnover is a measure of how well the assets of a business are being used to generate sales. In other words, a company that has a small dollar amount of assets but a lot of profits will have a higher return than a company with twice as many assets and the same profits.
Asset turnover ratio=Revenue/Capital employed
Example
Two companies each have capital employed of $100,000 but Company A makes sales of $400,000 per annum whereas Company B makes sales of only $200,000 per annum.
Company A | Company B |
Asset turnover ratio=$400,000/$100,000=4 | Asset turnover ratio=$200,000/$100,000=2 |
Interpretation
Company A is making a higher revenue from the same amount of assets (twice as much asset turnover as Company B) and this will help the Company A to make a higher return on capital employed than B.
Net profit margin
Net profit margin measures the amount of net income earned with each dollar of sales generated by comparing the net income and net sales/revenue of a company. In other words, the profit margin ratio shows what percentage of sales are left over after all expenses are paid by the business.
Net profit margin=Net profit/Revenue
Gross profit margin
Gross profit margin ratio is a profitability ratio that compares the gross margin of a business to the net sales/revenue. In other words, this ratio measures how profitable a company sells its inventory as it is a percentage markup on the cost of inventory.
Gross profit margin=Gross profit/Revenue
Example
Let’s assume the Company A has the following summarized income statements for two consecutive years
2016 | 2017 | |
Revenue | $70,000 | $100,000 |
Cost of sales | $42,000 | $55,000 |
Gross profit | $28,000 | $45,000 |
Expenses | $21,000 | $35,000 |
Net profit | $7,000 | $10,000 |
Net and gross profit margins will be:
2016 | 2017 |
Net profit margin=$7,000/$70,000=0,1=10% | Net profit margin=$10,000/$100,000=0,1=10% |
Gross profit margin=$28,000/$70,000=0,4=40% | Gross profit margin=$45,000/$100,000=0,45=45% |
Interpretation
A high-profit margin means a high profit per $1 of sales, but this also means that sales prices are high and it could lead to the depression of sales turnover. While calculating gross profit and net profit margins it will be quite informative to look at the two together. In the example above we see that although the net profit margin is the same for both years at 10%, the gross profit margin isn’t. As we see the improved gross profit margin has not led to an improvement in the net profit margin. This is because the expenses as a percentage of sales have risen from 30% in 2016 to 35% in 2017.
Debt Ratio
The debt ratio is the ratio of a company’s total debts to its total assets.
Debt ratio=Total debts/Total assets*100%
Assets = Non-Current Assets + Current Assets
Debts= Non-Current Liabilities + Current Liabilities
Example
Using the figures provided in the statement of financial position of the Company A the debt ratio will be
2017 | 2016 |
Debt ratio=($881,731+$100,000)/$1,870,630=52% | Debt ratio=($912,456+$100,000)/$1,664425=61% |
Interpretation
There is no absolute guide to the maximum safe debt ratio, but in general 50% is regarded as a safe limit to debt. In our example the debt ratio is quite high but it has fallen from 61% to 52% between 2016 and 2017. So the company seems to be improving its debt position.
Liquidity ratios
Liquidity ratios include:
- Current ratio;
- Quick ratio
Current ratio
The current ratio measures a firm’s ability to pay off its short-term liabilities with its current assets. The current ratio is an important measure of liquidity because short-term liabilities are due within the next year.
Current ratio= Current assets/Current liabilities
Example
Using the figures provided in the statement of financial position of the Company A the current ratio will be:
2017 | 2016 |
Current ratio=$1,068,450/$881,731=1,21 | Current ratio=$1,008,354/$912,456=1.1 |
Interpretation
A current ratio in excess of 1 should be expected. Otherwise, the company might be unable to pay its debts on time.
Quick ratio
Companies are not able to convert all their current assets into cash very quickly. For these reasons, we calculate and additional liquidity ratio, known as the quick ratio.
Quick ratio= (Current Assets-Inventory)/Current liabilities
Using the figures provided in the statement of financial position of the Company A the current ratio will be:
2017 | 2016 |
Quick ratio=$1,002,701+$1,327/$881,731=1,13 | Quick ratio=$853,441+$68,363/$912,456=1.01 |
Interpretation
The quick ratio should ideally be at least 1 for companies with a slow inventory turnover. For companies with a fast inventory turnover, a quick ratio can be less than 1 without suggesting that the company should be in cash flow trouble.