Financial Ratios and Ratio Analysis
- Financial ratios are essential for assessing business performance.
- They provide a structured way to analyze profitability, liquidity, and efficiency by comparing key financial data.
- Stakeholders, including managers, investors, and creditors, use these ratios to make informed decisions based on facts rather than assumptions.
Definition
Ratio Analysis
Ratio Analysis is a financial analysis tool that evaluates a company's financial performance using various ratios. It helps in assessing profitability, liquidity, efficiency, and solvency.
Why Ratio Analysis Matters
- Raw financial numbers can be misleading without context.
- Ratio analysis helps businesses compare performance over time and against competitors.
- Consider this:
| Company A | Company B | |
|---|---|---|
| Profit | €15 Million | €3 Million |
| Sales | €180 million | €12 million |
- At first glance, Company A appears more successful because it earns five times more profit than Company B.
- However, using profitability ratios tells a different story:
- Company A: $(15 \text{ million} / 180 \text{ million}) \times 100 = 8.3\%$
- Company B: $(3 \text{ million}/ 12 \text{ million}) \times 100 = 25.0\%$
- Always calculate ratios before making conclusions.
- Looking at just profit figures can give a distorted view of success.
Types Of Financial Ratios
- There are four main categories of financial ratios:
- Profitability Ratios: Measure how well a business generates profit.
- Liquidity Ratios: Assess whether a company can pay short-term debts.
- Financial Efficiency Ratios (HL Only): Evaluate how effectively a business uses resources.
- Gearing Ratios (HL Only): Examine the balance between internal and external financing.
Overview of Different Profitability and Liquidity Ratios
| Type of Ratio | Profitability Ratios | Liquidity Ratios |
|---|---|---|
| Ratios Used | Gross Profit Margin, Profit Margin, Return on Capital Employed (ROCE) | Current Ratio, Acid-Test Ratio |
| Purpose | Measures profitability relative to revenue or capital | Assesses ability to meet short-term debts |
| Key Stakeholders | Shareholders, Creditors, Managers, Investors | Suppliers, Lenders, Managers |
Investors focus on profitability, while creditors care more about liquidity.
Getting The Right Data
- Ratios are only as good as the data used.
- The most useful sources include:
- Business Financial Records
- Profit and Loss Statements and Balance Sheets provide the raw data needed.
- Industry Benchmarks, ratios should be compared to industry norms to make sense.
- Economic Conditions, a drop in profitability could be due to external factors like inflation, not poor management.
- A ratio by itself means nothing.
- Always compare it over time or against competitors.
How Ratios Are Expressed
- Ratios appear in two main formats:
- As a percentage: ROCE (Return on Capital Employed) is written as a percentage of capital invested.
- As a ratio: The acid-test ratio may be 0.9:1, meaning the business has \$0.90 in liquid assets for every \$1 of short-term liabilities.
Be specific in exams. If a question asks about profitability, don’t just discuss profits, they’re not the same thing.
Profitability Ratios: Gross Profit Margin, Profit Margin, and ROCE
- Profitability ratios assess whether a business is making enough money relative to its sales, assets, or capital investment.
