Interpretation of Accounts (Ratio Analysis) (Leaving Cert Accounting): Revision Notes

Interpretation of Accounts (Ratio Analysis)

What is ratio analysis?

Ratio analysis is a powerful tool used to make sense of the information provided in a company's final accounts. By calculating specific ratios, you can better understand how well a business is performing and assess its financial health from different perspectives.

Profitability ratios

Profitability ratios help measure how effectively a business generates profits from its operations and investments. These ratios are essential for evaluating how well management is using company resources to generate returns.

Return on capital employed (ROCE)

ROCE shows how efficiently a company uses all its capital to generate profits before interest and tax.

Formula: $\text{ROCE} = \frac{\text{Net profit before interest and tax}}{\text{Capital employed}} \times 100$

Return on shareholders' funds (ROSF)

ROSF measures the return generated specifically for ordinary shareholders after all other costs and dividends have been paid.

Formula: $\text{ROSF} = \frac{\text{Net profit - Preference dividend}}{\text{Ordinary share capital + Profit and loss balance}} \times 100$

This ratio is particularly important for current and potential shareholders as it shows the actual return on their investment.

Gross profit margin

Formula: $\text{Gross profit margin} = \frac{\text{Gross profit}}{\text{Sales}} \times 100$

This shows what percentage of sales revenue remains after deducting the cost of sales. A declining gross profit margin might indicate rising costs or increased competition affecting pricing.

Net profit margin

Formula: $\text{Net profit margin} = \frac{\text{Net profit}}{\text{Sales}} \times 100$

This reveals what percentage of sales revenue becomes final profit after all expenses. Comparing gross and net profit margins can help identify whether problems lie with cost of sales or operating expenses.

Liquidity ratios

Liquidity refers to a company's ability to pay short-term debts as they become due. Poor liquidity can lead to serious cash flow problems and potentially bankruptcy if not addressed.

Current ratio (working capital ratio)

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

Acid test ratio (quick ratio)

Formula: $\text{Acid test ratio} = \frac{\text{Current assets - Closing stock}}{\text{Current liabilities}}$

Gearing ratios

Gearing analyses how a company finances its operations - whether through fixed-interest sources (like debentures and preference shares) or equity capital (ordinary shares and retained profits).

Fixed-interest capital to total capital

Formula: $\text{Gearing ratio} = \frac{\text{Debentures + Preference shares}}{\text{Capital employed}} \times 100$

High gearing means more finance comes from fixed-interest sources. While this can amplify returns when profits are good, it also increases risk because interest payments are mandatory regardless of profit levels.

Low gearing means more finance comes from equity sources. This provides more flexibility as dividends don't have to be paid if profits are insufficient.

Interest cover

Formula: $\text{Interest cover} = \frac{\text{Profit before interest and tax}}{\text{Interest}}$

This shows how many times the company can cover its interest payments from current profits. Higher interest cover indicates lower financial risk and greater ability to service debt obligations.

Investment ratios

These ratios help current and potential shareholders evaluate the company's performance and returns. They are particularly valuable for making investment decisions and comparing different investment opportunities.

Earnings per share (EPS)

Formula: $\text{EPS} = \frac{\text{Net profit - Preference dividend}}{\text{Number of ordinary shares issued}}$

This shows how much profit has been earned for each ordinary share, helping shareholders assess the company's profitability on a per-share basis.

Dividend per share (DPS)

Formula: $\text{DPS} = \frac{\text{Total ordinary dividend}}{\text{Number of ordinary shares issued}}$

This reveals the actual dividend payment received by each ordinary share.

Dividend yield

Formula: $\text{Dividend yield} = \frac{\text{Dividend per share}}{\text{Market price per share}} \times 100$

This compares the dividend return to the current share price, allowing comparison with risk-free investment returns. Note that DPS represents the amount paid out to shareholders, not the total amount earned.

Dividend cover

Formula: $\text{Dividend cover} = \frac{\text{Net profit - Preference dividend}}{\text{Total ordinary dividend}}$

This shows how much profit is being retained by the company rather than distributed as dividends. Higher dividend cover indicates more funds available for reinvestment and growth.

Price earnings ratio (P/E ratio)

Formula: $\text{P/E ratio} = \frac{\text{Market price per share}}{\text{EPS}}$

This indicates how many years it would take for a share to recover its current market value based on current earnings. A low P/E ratio suggests the shareholder can recoup their investment relatively quickly, while a high P/E ratio may indicate market confidence in future growth.

Price dividend ratio

Formula: $\text{Price dividend ratio} = \frac{\text{Market price per share}}{\text{DPS}}$

This shows how many years it would take for a share to recover its current market value based on current dividend payments.

Activity ratios

Activity ratios measure how efficiently a business manages its assets and working capital. These ratios help identify areas where operational efficiency can be improved.

Debtors' average period of credit

Formula: $\text{Debtors' credit period} = \frac{\text{Total debtors}}{\text{Credit sales}} \times 12$

This shows how many months, on average, it takes customers to pay their debts. A shorter period is generally better for cash flow.

Creditors' average period of credit

Formula: $\text{Creditors' credit period} = \frac{\text{Total creditors}}{\text{Credit purchases}} \times 12$

Stock turnover

Formula: $\text{Stock turnover} = \frac{\text{Cost of sales}}{\text{Average stock}}$

This measures how efficiently stock is managed. Higher turnover generally indicates better stock management and fewer resources tied up in inventory.

Average stock

Formula: $\text{Average stock} = \frac{\text{Opening stock + Closing stock}}{2}$

This provides the average stock level for calculating stock turnover.

Analysing ratios for different stakeholders

Different stakeholders focus on different aspects when analysing company accounts. Understanding these perspectives is crucial for comprehensive financial analysis.

Current and potential shareholders

Debenture holders and bank managers

When deciding whether to lend money, they focus on different criteria that assess the company's ability to repay debts and service interest obligations.

Limitations of ratio analysis

While ratio analysis is valuable, it has several important limitations that must be considered when interpreting results.

When answering exam questions, always calculate ratios from given figures and work backwards if needed. State clearly whether trends are positive or negative, and explain what they actually mean rather than simply stating "increase" or "decrease". Include appropriate labels with calculations and provide meaningful commentary on the trends observed.