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||Financial analysis is both art and science, requiring professional
judgement and an understanding of a company’s business and strategy.
It forms only one part of a comprehensive analysis of a company and
should contribute towards, and benefit from, the assessment covering
the non-financial aspects of the business.
Ratios provide a relatively simple means of examining the financial
health of a business. However, ratio analysis – by itself –
is incomplete. A product of any analysis of financial statements should
be a list of questions for the financial management of the company.
Financial analysis involves an understanding of each of the three
basic and important financial statements: balance sheets, profit and
loss statements and cash flow statements. Each statement is an indicator
of three critical dimensions of performance: balance sheet strength
(liquidity, leverage), operating performance and cashflow strength.
Balance Sheet strength
Liquidity: The short run financial capacity to meet obligations
and move opportunistically.
Leverage: The balance of debt and equity for long run risk/return
Operating Performance: The ability to generate
returns from the efficient employment of assets and capital.
Cashflow Strength: The ability to service debt,
pay dividends and taxes and to make discretionary expenditures (such
as capital expenditure).
||There are different types of ratios and we need to be familiar with
them. Here are examples of some that are used regularly:
||The ratio-type terminology is not in itself important, as long as
we understand that there are different ways of showing a ratio and
that we can interpret what it is telling us.
||Ratios are a method of summarising and presenting financial information
in an easily understandable form. We can use them to assist in assessing
the performance of a business by identifying relationships between
different figures which we consider to be significant. The use of
ratios is valuable to us not necessarily because they provide answers
but because they help to focus our attention on the important areas
at question. Therefore there is less likelihood of us failing to identify
a significant trend or weakness.
In isolation a ratio is of limited value. They must always be considered
relative to each other and also relative to whatever other information
is available about the company, its strategy and the market place.
There are two comparisons that can be carried out.
This is where we need to compare the company against its own past
record. Ratios can be used to assess previous performance by looking
at trends over a number of periods (this involves looking at the
ratios horizontally). Such an exercise will give us a good idea
of what is changing, or indeed not changing. To ensure meaningful
analysis of ratios, a minimum of three years financial information
We can carry out a peer group analysis i.e. information we can
obtain about the industry. Certain ratios can be “standard”
across an industry. However, if you are comparing different business
within the same industry, take care to think about:
• the size of the company
• accounting procedures
• product mix
• geographical spread
There is one further comparison which we have not yet mentioned
and that is the vertical comparison i.e. if one ratio is increasing
what impact can this have on another ratio? It is important to understand
the impact that a change in one ratio has on another. If there are
contradictory movements in related ratios, this should lead you
to question and to investigate why, to understand how the risk in
the business is changing.
For example, a decrease in the gross profit margin could have a
knock on effect to:
• the net profit margin
• an increase in gearing caused by increased borrowings to
compensate for lower profitability.
If the reverse was the case, it could mean higher contribution
from sales to cover overheads leading to an improvement in the net
profit margin and perhaps a decrease in borrowing.
Ratio comparison is essential to gauge the financial effect of the
management decisions. Also look at the vertical connections to see
whether the changes that are occurring do fit with what we know
about the business.
Do not forget, comparing figures will in itself prove nothing but
should raise questions in our minds which we need to direct towards
the management of the business.
||When using ratios we should view them both horizontally –
trends from period to period – and vertically. Vertical comparisons
can be ‘split’ into distinct ‘groupings’ as
||The relationship between the ratios in these five ‘groups’
can be of invaluable help in analysing a business.
Section C - Cashflow
||Cash flow is the lifeblood of any business. Therefore we begin our
structured analysis with cash flow ratios. The ratios should of course
be read in conjunction with the full cash flow statement.
• A broad measure of the business’s ability to meet
all of its short-term financial obligations from core cash flow.
• Indicates the ability to service total interest commitments
from cash generated from operations.
• Compared to Interest Cover in Section S (stake) this ratio
gives a far better indicator, given that profit is not equivalent
Section L – Liquidity
||Liquidity has an immediate bearing on the financial profile of a
business and therefore its ability to survive. A business that cannot
turn its current assets into cash runs the risk of failing. It is
essential therefore that when we look at a business, that they are
appropriate i.e. long-term facilities are used for longer term/fixed
assets, and short-term facilities for working capital. This should
ensure an acceptable structure to the balance sheet and mean that
the business should have sufficient cash to ensure the servicing and
repayment of its short-term debts.
• The number of times the business’s short term assets
cover its short term liabilities i.e. a measure of the business’s
ability to meet its day to day commitments.
• Technically if the ratio falls below 1.1 then the business
is illiquid, although the trading practice within the industry may
make this acceptable (e.g. food retailers) and comparison needs
to be made with others in the same industry.
It is essential when analysing this ratio to look at a number of
factors such as the nature of the business, the quality of the assets
and the seasonality of its trading.
• Who are the debtors/how well spread/age/how easy to ‘realise’?
• How saleable is the stock?
• If there is cash – where is it and is it, say, not
tied up in overseas companies?
Although the current ratio is a banker’s traditional favourite,
it is unfortunately one of the worst for predicting failure.
Quick Assets = Current Assets less Stock and Work in Progress (W.I.P.)
• A more conservative ratio than the current ratio as it
removes stock and W.I.P., which reflects the assumption that these
items will often take longer to convert to cash than the other current
• If the acid test is appreciably lower than the current ratio
this indicates that stock constitutes a large portion of current
assets. Comparison of the ‘gap’/difference between current/acid
test must therefore be monitored and particularly if the gap is
widening, period on period, then stock investigations need to be
Section A – Asset Management
||This section is concerned with how effectively the assets of the
business are being used. Many of the ratios relate to the working
capital of the business i.e. – stock, (raw materials, W.I.P.
and finished goods) trade debtors and trade creditors. It complements
the liquidity measures and helps us to understand movements in some
of the component parts of liquidity.
• A broad measure of asset efficiency. A ratio of 1.2 means
that the business generates £1.20 of sales for each pound
invested in assets.
• The ratio is a measure of capital intensity, with a low
asset turnover signifying a capital-intensive business and a high
turnover the reverse.
• One of the so-called activity ratios that measures the
average time in days that it takes to collect payment from debtors
and hence indicates the ability of management in controlling/collecting
payments from trade debtors – compare with terms of trade
and industry norms if these are available.
An increase in the ratio is generally a poor sign and could signify:
• Selling to larger, financially stronger customers who demand/take
longer periods of credit.
• A build up of bad debts within debtors figure.
• Customer selling to less reputable/weaker customers who
take longer to pay, in an effort to hold/increase sales levels.
• A relaxing of credit control
• A general decline in the industry or economy putting pressure
on all ‘parties’ in the industry.
• Indicates the efficiency of stock control.
• Indicate the rate at which stocks & W.I.P. are turned
into cash and therefore profit.
• Long and increasing period may indicate obsolete/unsaleable
stocks being held.
• Check the ‘split’ between stock and W.I.P. where
increasing W.I.P. could indicate inefficiencies in production processes
All fluctuations need to be investigated:
• Increasing ratios could be a bad sign (see above) but new
products/change in product mix could be a satisfactory explanation.
• Falling ratios could be a good sign but if the business
is ‘forced’ to sell from stock to protect/preserve cash
flow then the opposite may be the case.
• Indicates the length of credit in days taken from suppliers
and extent therefore of reliance on creditors – compare with
terms of trade and industry norms.
• Can be used to gauge the contribution made by suppliers
(creditors) to working capital management – but care, excessive
utilisation over the terms of trade may render the business vulnerable
to loss of goodwill and pressure from creditors.
• Investigate particularly increases in this trend, which
may be as a result of pressure on the business’s cash flow.
N.B. If cost of sales includes a substantial portion of non-supplier
element – i.e. direct labour, machinery costs etc. the ratios
will be distorted although still revealing a trend period on period
(providing make up of cost of goods remains the same).
NWA includes only those current assets and current liabilities
that vary in direct proportion to sales turnover assuming the terms
of trade and stock-holding policy remain the same. It is a useful
measure of the amount of money that is tied up in funding the day-to-day
trading activities of the business.
• Provides a measure of the business’ efficiency in
employing working capital to generate sales.
• Provides therefore a rough and ready guide to the likely
amount of additional working capital funding required from a given
increase in sales. If the net working assets to sales ratio is 15%
this means that the company has to invest 15 pence in working capital
for every incremental £1 of sales. Companies with high cash
conversion cycles (see chapter three) will have to invest higher
Section S – Stake
• Indicates the capital sufficiency or insufficiency of the
• Indicates the extent to which a business relies on borrowed
funds compared to shareholders funds. Total External Finance refers
to interest-bearing liabilities.
• The more highly geared the business, the more vulnerable
it is to a downturn in cash flow and profits, as the interest burden
will become disproportionately heavier and thus restrict the scope
for further borrowings. More seriously, the business may not be
able to meet its debt repayments as they fall due.
Increases in the ratio could be caused by:
• Losses – reducing capital resources
• Sales increasing rapidly, with working capital funding requirement
(see Net Working Assets to Sales) increasing faster than profit,
requiring increased debt to finance ‘the gap’.
• A build of fixed assets (funded by borrowings) that are
not making an adequate contribution to profitability.
• Margins depressed as a result of competition perhaps with
a fall-off in profit and retained profits in the business.
• A low ratio may indicate the extent to which the business
could raise further funds.
• Gearing varies from industry to industry, company to company.
There is no “ideal” gearing ratio – the situation
has to be assessed on a case by case basis and looked at in the
context of the strength of the company’s cash flow and business
• Indicates the extent to which a business relies on all
liabilities compared to shareholders funds.
• Like gearing, a higher and increasing ratio indicates an
increasing financial risk.
• In comparing leverage to gearing:
- If gearing is increasing whilst leverage remains static (or reducing)
then external finance (borrowing) is taking the place of other creditors
– if the reverse movement is seen, then there is more reliance
on other creditors.
- Compare also with movements in Trade Creditors Period ratio.
• Indicates the extent to which a business is generating
profit to meet its interest commitments.
• As long as a business is generating high levels of profits
and interest rates are low, then it should be able to carry a large
debt burden, i.e. cope with high levels of gearing, provided it
is also generating sufficient operating cash flow to meet debt maturities
as they fall due.
• A ratio of 1.0 occurs when the underlying profit before
interest is sufficient only to cover the interest charge and allowing
no profit retention to grow the capital base of the company.
• A ratio of less than 1.0 indicates potentially serious problems
which cannot continue over long periods.
• Indicates the number of times the profit after tax covers
the company’s declared dividend or drawings.
• If the ratio is less than 1.0 the directors are paying more
to the shareholders than the company earned.
Section P – Profitability
• Reasonable sales growth is normally “a good thing”.
It indicates an increasing market share or an expanding market or
• A negative sales growth may indicate that the company has
cut out unprofitable lines and therefore improved the overall situation
for the company or it may indicate that the company’s market
is shrinking and/or its market share is decreasing
• Any material changes in this ratio must be questioned,
as this ratio provides the measure of profitability of the core
business of the business. A measure of success in the marketplace.
• Depreciation can on occasions be included within cost of
sales, which will have an effect on gross profit. We need to enquire
as to any changes in depreciation policy as this will have an impact
on gross profit.
• A fall in the ratio whilst generally a poor sign could occur
due to a change in the method of stock valuation. Look at the notes
to the accounts to identify whether this is taking place.
• Any change in product mix where different margins apply
will affect the overall margin. Does the management have separate
management information to assist the company in understanding its
• A rising ratio could be:
- Increased efficiency
- New cheaper raw material supplier utilised. Is quality affected?
- Discounts received on bigger raw material orders
- Cheaper labour costs when moving overseas
• This ratio provides a further measure of the efficiency
of the business.
• It will be controlled by the pricing policy of the business
along with its control of overheads.
• Different industries will achieve different returns e.g.
manufacturing expects higher margins than food retailer which relies
on high volume, low margins.
• If this ratio is out of line with gross margins, investigate
the cause. Have overheads increased or decreased and why? Can they
be controlled or are they sustainable?
• How significant are the overheads to overall profitability?
• Has there been a change in the depreciation policy?
• Have costs moved from being variable to fixed or vice versa?
• This ratio measures the return on all capital employed
(including long-term debt as well as equity) against all net income
(core and non-core business) before tax and interest.
• The business’s performance should be judged on ROCE,
as it will not continue for long, without support, unless this return
exceeds at least the cost of borrowing.
• A comprehensive measure of a company’s performance,
especially from an equity investor’s perspective.
• From the banker’s perspective he needs to ensure that
the equity investors are happy with the return from a company, given
the level of risks involved in the company.
• A further comprehensive ratio measurement which
measures the return on the total assets being used by the business
Some analysts place too much reliance on ratio analysis. Empirical
studies such as those conducted by Professor Beaver demonstrate
that such ratios are not reliable predictors of failure. Professor
Altman invented the Z-Score – a weighted composite of financial
ratios, but though a better predictor of failure than many individual
ratios, it still could not achieve the 99% reliability required
by the banker.
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