Accounting ratios.

[check] This checklist offers guidance on understanding and interpreting accounting ratios. An understanding of the significance of such ratios will enable a clearer appreciation of the financial performance of a company and will provide a more balanced view of the figures presented in any financial report.

Definition

An accounting ratio is the comparison of two figures in a set of accounts. Sometimes it may be expressed as a ratio (as in 1:2) and sometimes as a percentage. Some accounting ratios are well known and frequently used, but you are free to calculate and use ratios that are relevant to your particular needs.

Advantages of understanding accounting ratios

A main reason for the production of accounts is the need to provide a historically accurate record, but this is only one reason. Intelligent analysis can get behind the figures and provide greater understanding.

How to use accounting ratios

You will need a set of accounts and you will need to decide which ratios are relevant to your needs. It is often extremely useful to spot trends by calculating the same ratios for several successive periods. Read the notes to the accounts and remember the following points:

* Compare like with like. For example, a change in the balance sheet date or accounting period may distort the figures.

* Seasonal and other special factors may have to be taken into account. For example, a manufacturer of fireworks is likely to carry low stocks in a balance sheet dated 30th November.

* Special factors may be disclosed in the notes or elsewhere. Always read all the accompanying notes.

* Accounting policies are important and should be stated. A different accounting policy may well produce a different figure. In particular, you should look for a change in accounting policy during the year under review. This may distort comparisons and trends.

* Management may distort the figures by action round the balance sheet date. For example, creditors may be paid or not paid, which affects borrowing and the number of creditors days outstanding. Purchases may be suspended in order to reduce stocks.

Return on Capital Employed (ROCE)

Many people consider this to be the key ratio. It is the relationship between profit and the amount of capital invested in a business by its owners. Different definitions of profit may be used and the profit after tax. It is:

10,500/22,500 = 46.7% (previous year is 24.7%)

If profit before tax is used the calculation is:

13,000/22,500 = 57.8% (previous year is 30.5%)

If profit before tax and interest is used, it is:

14,000/22,500 = 62.2% (previous year is 36.8%)

This definition is often used because it enables meaningful comparisons to be made between companies financed in different ways.

By most standards the ratios show a healthy position and one that has improved over the year in question.

Profit to turnover

This is one of the simplest ratios and one of the most commonly used. It is profit expressed as a percentage of turnover in the year. Sometimes profit before tax is used, sometimes profit after tax. Some analysts prefer to deduct interest and other financing charges. The different percentages are:</p> <pre> Current Year Previous Year Profit before tax and interest 28.0%

14.9% Profit before tax 26.0% 12.3% Profit after tax 21.0% 10.0% </pre> <p>Stock turn

This is the number of times that total stock is used (turned over) in the course of a year. Normally, the higher the stock turn the more efficiently the business is being run, though there are dangers in keeping stock too low. Stock turn is normally applied to all stock, rather than just to finished stock. Seasonal factors can distort the ratio, especially if the balance sheet date is not a typical one.

The figure for purchases for resale is needed and the summarised profit and loss account does not give it. However, if during the year, purchases for resale have been 24,000,000 [pounds sterling], the stock turn was

24,000/12,000 = 2.0 or 6 months.

This would probably be considered to be a bad result.

Number of days credit granted:

6,000/50,000 x 365 = 43.8 days.

A potential weakness is that sales over a period of time are being compared with outstanding debts at a fixed date. It is most meaningful when invoicing is done evenly over the period.

Current assets to current liabilities 

This compares 18,000 with 15,500 and results in a ratio of 1.2:1 (previous year 1.6:1). It is an extremely important ratio as it shows how assets that may be realised in the short term compare with liabilities that must be paid in the short term. It is possible (and frequently happens) that a business is profitable, but that it runs out of cash.

Gearing

The purpose of this ratio is to compare the finance provided by banks or other lenders with the amount invested by the shareholders. It is a ratio much used by banks. Generally speaking, lenders do not like to see a ratio of 1: 1 (or some other such proportion) exceeded.

Some people prefer to include overdrafts with long term loans and some prefer to exclude them. If the bank overdraft is excluded, the calculation is:

20,000/22,500 = 0.9:1 (previous year is 1.2:1).

Gearing is said to be high when borrowing is high in relation to shareholders' funds. This can be dangerous but shareholders' returns will be high if the company does well.

Trading profit to sales

This is the gross margin and is:

24,000/50,000 = 48% (previous year 40.4%).

Overheads to sales

This is: 10,000/50,000 = 20% (previous year 25.5%).

Useful reading

Finance for non financial managers in a week, 3rd ed, Roger Mason Chartered Management Institute London: Hodder and Stoughton, 2003

Mastering financial management: demystify finance and transform your financial skills, Stephen Brookson London: Thorogood, 1998

Essentials of management ratios, Philip Ramsden Aldershot: Gower, 1998

How to understand and use company accounts, 4th ed, Roy Warren London: Century Business, 1998

Practical Examples

ACME LTD

Summarised Profit and Loss Account for the year to 30th September 2001

                                 Current year   Previous Year
                                 [pounds            [pounds
                                 sterling]000   sterling]000

Sales                                  50,000          47,000
Less Cost of Sales                     26,000          28,000
Trading Profit                         24,000          19,000
Less overheads                         10,000          12,000
Profit before Tax and Interest         14,000           7,000
Less Interest                           1,000           1,200
Profit Before Tax                      13,000           5,800
Less Tax                                2,500           1,100
Profit after Tax                       10,500           4,700
Dividend                                7,000           4,000
Retained Profit                         3,500             700

Summarised Balance Sheet at 30th September 2001

                                            30-9-01
                                 [pounds            [pounds
                                 sterling]000   sterling]000

Fixed Assets                                           40,000
Current Assets
Stock                                  12,000
Debtors                                 6,000
                                       18,000
Current Liabilities
Creditors                               5,000
Bank overdraft                          1,000
Taxation liability                      2,500
Dividend liability                      7,000
                                       15,500
Net Current Assets                                      2,500
Long Term Loan                                        (20,000)
                                                       22,500
Share capital                                          10,000
Reserves                                               12,500
                                                       22,500
                                            30-9-00
                                 [pounds            [pounds
                                 sterling]000   sterling]000

Fixed Assets                                           34,000
Current Assets
Stock                                  11,000
Debtors                                 8,000
                                       19,000
Current Liabilities
Creditors                               4,000
Bank overdraft                          3,000
Taxation liability                      1,100
Dividend liability                      4,000
                                       12,100
Net Current Assets                                      6,900
Long Term Loan                                        (21,900)
                                                       19,000
Share capital                                          10,000
Reserves                                                9,000
                                                       19,000