Financial Ratios (HSC SSCE Business Studies): Revision Notes

Financial Ratios

Introduction to financial analysis

Financial statements summarise a business's activities over a period, but simply looking at them doesn't answer many important questions. To gain deeper understanding, businesses must analyse their financial information.

Analysis involves working financial information into significant and meaningful forms, highlighting relationships between different aspects of a business. Interpretation then uses this analysed data to make judgements and informed decisions.

Analysis helps answer critical questions such as:

• How effectively are assets being used?
• Why hasn't increased advertising generated expected sales?
• Why have sales decreased over recent years?
• Why do overdrafts continue to increase?

Types of financial analysis

There are three main types of analysis that businesses use:

Vertical analysis compares figures within one financial year. For example, expressing gross profit as a percentage of sales or comparing debt to equity within the same year.

Horizontal analysis compares figures from different financial years, such as comparing 2020 and 2021 results to identify changes over time.

Trend analysis compares figures over periods of three to five years, helping identify long-term patterns and directions in business performance.

These methods use calculations of figures, percentages and ratios. Ratios are one of the main tools for analysing financial information, helping answer questions about profits, solvency, efficiency, growth and liquidity.

Liquidity ratios

Liquidity is the extent to which a business can meet its financial commitments in the short term (usually less than 12 months). A business must have sufficient resources to pay debts and cover unexpected expenses.

The key question is: can the business pay its debts when due? This requires assessing whether there is enough cash or assets that can be quickly converted to cash to repay accounts payable, interest and loans.

Current ratio (working capital ratio)

The current ratio measures a business's ability to pay back current liabilities with current assets. It shows short-term financial stability.

$\text{Current ratio} = \frac{\text{Current assets}}{\text{Current liabilities}}$

Interpreting the current ratio:

A ratio of $2:1$ is generally accepted as indicating sound financial position. This means the business should have double the amount of current assets to cover current liabilities.

However, the 'acceptable' ratio depends on several factors:

• Type of business
• How competitors in the industry operate
• External environment factors

Different industries operate successfully with different ratios. Large food retailers like Woolworths operate with ratios around $0.6:1$. Service businesses (doctors, dentists) that rely on cash payments also operate successfully with ratios below $2:1$. Businesses selling finished goods and keeping large inventories need higher ratios.

Strategies to improve liquidity:

Businesses can improve liquidity through:

• Factoring (selling accounts receivable)
• Selling non-essential non-current assets and using funds to reduce current liabilities
• Injecting more equity to pay off liabilities
• Better working capital management

Gearing ratios (solvency)

The capital structure of a business is determined by the mix of debt and equity. The proportion of each is known as gearing or solvency.

Solvency is the extent to which a business can meet its financial commitments in the longer term (more than 12 months). Gearing measures the proportion of debt (external finance) and equity (internal finance) used to finance business activities.

Understanding gearing

Gearing ratios show whether creditors will be paid and whether investors can expect good returns. Potential investors and creditors closely examine gearing ratios when making decisions.

The degree of gearing depends on industry type and business management. Industries with higher risk but potential for large profits (such as mining) may have higher debt to equity ratios—they are highly geared. Manufacturing industries with strong markets often carry high debt because profit potential is greater.

Factors businesses must consider:

• Return on investment
• Cost of debt
• Size and stability of earning capacity
• Liquidity of assets (greater cash flow and more liquid assets make interest payments more manageable)
• Purposes of short-term debt

Debt to equity ratio

The debt to equity ratio shows the extent to which a business relies on debt or outside sources to finance operations.

$\text{Debt to equity ratio} = \frac{\text{Total liabilities}}{\text{Total equity}}$

This ratio is an important management control because the relationship between debt and equity must be carefully balanced.

Interpreting the ratio:

• Ratio greater than $1$: business has less equity than debt
• Ratio between $0$ and $1$: business has more equity than debt
• Higher ratio = less solvent firm = higher risk

The higher the debt to equity ratio, the higher the financial risk. Businesses must carefully consider interest rates, business confidence and economic indicators to determine if their debt-equity balance is appropriate.

Industry variations:

The financial sector has one of the highest debt to equity ratios because banks borrow large amounts to then loan to others. Ratios higher than $2:1$ are common in this industry. Capital-intensive industries (large manufacturing, airlines) also commonly use high debt levels.

Strategies to improve gearing:

To improve gearing, businesses need to reduce debt or increase equity:

Reducing debt:

• Sell non-essential assets to pay off debts
• Re-negotiate loans to spread payments over longer periods
• Lease assets instead of purchasing them

Increasing equity:

• Retain more profits
• Inject more equity funding by selling shares (if public company) or inviting new owners

Profitability ratios

Profitability is the earning performance of a business, indicating its capacity to use resources to maximise profits. Profitability depends on revenue earned and the ability to increase selling prices to cover costs and expenses.

Who's interested in profitability?

Different stakeholders examine profitability for various reasons:

• Owners and shareholders: Want to know if the business earns acceptable returns on their investment
• Creditors: Need to know if they'll be paid and whether to offer credit in future
• Lenders: Want assurance that principal and interest will be repaid and whether to lend in future
• Management: Uses profitability to decide if policy adjustments are needed

The amount of profit is determined by factors including sales volume, mark-up on purchases, and expense levels. Financial information must be examined to see where changes have occurred and what future changes are needed.

Gross profit ratio

Gross profit is the difference between sales revenue and direct cost of goods sold. It represents the amount available to meet expenses and result in net profit.

$\text{Gross profit ratio} = \frac{\text{Gross profit}}{\text{Sales}}$

This ratio gives the percentage of sales revenue that results in gross profit. It's one way businesses measure profitability.

The gross profit ratio shows changes from one accounting period to another, indicating effectiveness of planning policies concerning:

• Pricing
• Sales
• Discounts
• Stock valuation

A business's gross profit must be sufficient to pay expenses and still provide profit for owners. If the ratio is low, the business may need to source alternative suppliers and investigate competitors.

Net profit ratio

Net profit represents the profit or return to owners (revenue less all expenses). For sole traders and partnerships, it represents return on their contribution. Companies typically return part of net profit to shareholders as dividends and retain part for future expansion.

$\text{Net profit ratio} = \frac{\text{Net profit}}{\text{Sales}}$

The net profit ratio shows the amount of sales revenue resulting in net profit. Since all expenses (wages, electricity, advertising) are deducted from gross profit to determine net profit, this ratio gives a more accurate indication of profitability than gross profit ratio.

Costs and expenses after gross profit must be low enough to generate net profit. Sales must be sufficiently high to cover all costs and still result in profit.

Strategies to improve profitability:

Businesses need to focus on:

• Reducing costs
• Increasing revenue

Return on equity ratio

The return on equity ratio shows how effective funds contributed by owners have been in generating profit, and hence the return on their investment.

$\text{Return on equity ratio} = \frac{\text{Net profit}}{\text{Total equity}}$

The return for owners must be better than returns from alternative investments (such as bank deposits). If return on equity rises due to increased leverage (debt), the improved result should be seen as carrying increased risk.

Owners are interested in:

• Current year's return
• Comparing current return with previous years
• Comparing against industry averages
• Comparing with alternative investment options (e.g., interest from financial institutions)

Interpreting the ratio:

Higher ratio = better return for owners. If returns are favourable, owners might consider expansion or diversification. If unfavourable, owners should consider alternatives, including selling the business.

Efficiency ratios

Efficiency is the ability of a business to minimise costs and manage assets so maximum profit is achieved with the lowest possible level of assets. It relates to management effectiveness in directing and maintaining business goals and objectives.

The more efficient the business, the greater its profits and financial stability.

Expense ratio

The expense ratio compares total expenses with sales, indicating the amount of sales allocated to individual expenses.

$\text{Expense ratio} = \frac{\text{Total expenses}}{\text{Sales}}$

This ratio indicates day-to-day business efficiency. Businesses aim to keep expenses at reasonable levels.

Management uses this ratio to determine:

• Where highest expenses come from
• Why the ratio has increased or decreased

For example, if the selling expense ratio increases, it may indicate advertising costs haven't generated expected sales increases. A decline in financial expense ratio might result from lower interest rates or less debt being used.

Accounts receivable turnover ratio

The accounts receivable turnover ratio measures effectiveness of a business's credit policy and how efficiently it collects debts.

$\text{Accounts receivable turnover ratio} = \frac{\text{Sales}}{\text{Accounts receivable}}$

This ratio measures:

• How many times the accounts receivable balance is converted into cash
• How quickly debtors pay their accounts

By dividing the ratio into 365, businesses can determine average time to convert the balance into cash.

Strategies to improve efficiency:

If not efficient in collecting accounts receivable, businesses should:

• Charge interest on overdue payments
• Offer discounts for early payments
• Be more selective when granting credit

Comparative ratio analysis

Figures, percentages and ratios alone don't provide a complete picture. For analysis to be meaningful, comparisons and benchmarks are needed. Comparative ratio analysis involves comparing a business's ratios against other figures for context.

Comparisons can be made:

• Over different time periods: Against previous years to identify trends
• Against standards: Using industry benchmarks
• With similar businesses: Against competitors or comparable firms

Comparing over time periods

Ratios provide a 'snapshot' at a particular point, and should be used carefully with other information. Sales and stock levels may vary significantly throughout the year, so financial information also varies.

Analysis can also include budget figures, comparing predicted against actual figures, usually over short periods (e.g., monthly). This information is typically available for internal stakeholders rather than external parties.

Comparing against standards (benchmarking)

Benchmarking involves comparing results against standards developed for a particular industry. However, care must be taken to ensure like-for-like comparisons. Each business has differences, and finding truly comparable firms may be difficult. Benchmarks are useful but merely guides.

For example, if industry average debt to equity is 80% and a particular business has 40%, it needs to examine risks and analyse reasons for differences.

Comparing with similar businesses

Inter-business comparisons are useful. Businesses may access relevant statistics from sources including the Australian Bureau of Statistics. Information must be up-to-date and accurately reflect industry norms.

When making comparisons, businesses must ensure information is relevant and comparable, considering factors like:

• Business size
• Industry sector
• Geographic location
• Economic conditions

Summary of financial ratios

Ratio	Formula	Measures	Interpretation
Current ratio	$\frac{\text{Current assets}}{\text{Current liabilities}}$	Liquidity	Shows short-term financial stability. Generally $2:1$ indicates sound position.
Debt to equity ratio	$\frac{\text{Total liabilities}}{\text{Total equity}}$	Gearing (Solvency)	Shows reliance on debt vs equity financing. Higher ratio = higher risk.
Gross profit ratio	$\frac{\text{Gross profit}}{\text{Sales}}$	Profitability	Shows percentage of sales retained as gross profit. Higher is better.
Net profit ratio	$\frac{\text{Net profit}}{\text{Sales}}$	Profitability	Shows percentage of sales retained as net profit. Higher is better.
Return on equity ratio	$\frac{\text{Net profit}}{\text{Total equity}}$	Profitability	Shows effectiveness of owner funds in generating profit. Generally aim for at least 10%.
Expense ratio	$\frac{\text{Total expenses}}{\text{Sales}}$	Efficiency	Shows proportion of sales allocated to expenses. Lower is better.
Accounts receivable turnover	$\frac{\text{Sales}}{\text{Accounts receivable}}$	Efficiency	Shows effectiveness of credit policy and debt collection. Higher is better.