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Let's get technical: ratio analysis
Nick Craggs examines how ratio analysis works in relation to limited company accounts
The financial statements of limited company accounts are read by a wide variety of users. From business owners looking to see how much money the company is making to employees wondering how secure their employment is, to suppliers wondering if they should offer more credit to the company.
One of the tools available to assess the performance and position of a company is ratio analysis. It is vital for anyone wanting to gain meaningful analysis of the company that they know not just how to calculate the ratios but also what the ratios show.
One of the first things people will ask when looking at a company is “is this company profitable?” Two of the key ratios to look at when ascertaining profitability are the gross profit margin and operating profit margin. Gross profit is the revenue figure less the cost directly attributable to making that sale, usually materials, production and labour. The gross profit margin is the gross profit divided by the revenue figure, expressed as a percentage, so if a company has revenue of £120,000, and gross profit of £90,000, the gross profit margin is £75% (£120,000/£90,000).
This shows how much gross profit a company should expect to make per pound of revenue. The only thing that can affect the gross profit margin is if the sales price per unit changes, or the cost per unit changes. All things being equal, the gross profit margin should stay the same at all levels of production.
However, in reality, as sales volume goes up, the company is able to negotiate better trade discounts, so the material per unit costs less, therefore the gross margin improves.
The operating profit margin is similar to the gross profit margin, this shows how much operating profit you are getting as a percentage of the sales figure, so this is operating profit divided by revenue. Operating profit is the gross profit after the deduction of the overhead costs. So this is a good measure of how well a company is controlling its overhead costs, such as administration. However, one of the key points of ratio analysis is that no ratio should be taken in isolation. A company might have a high operating margin, but compared to its competitors it might actually be worse at controlling its overheads – but it just happens to have a really high gross profit margin which feeds directly down into operating profit.
The other thing users of financial statements will want to investigate is risk. Employees might want to know how secure their jobs are, or potential investors might want to know how safe any potential investment will be. Two key measures of risk are gearing and interest cover.
Gearing is a measure of how much of the business is financed by loan debt rather than share capital and retained earnings. Loan debt is inherently more risky than share capital as you can choose not to pay a dividend to your shareholders (they may not be happy, but they will not shut the company down), but you cannot tell the bank you are not repaying the loan.
There are a couple of definitions of gearing, but I prefer long-term debt over equity and long-term debt. If a company has long term debt of £300,000 and equity of £500,000, the gearing ratio of the company is 37.5%, (£300,000/ (£300,000 + £500,000). The higher the gearing ratio, the higher the risk, and also the less likely that a bank is likely to lend the company more money in the future.
However, just like gross profit and operating profit margin, you should not just focus on one ratio in isolation. Another ratio that provides more information to users about risk is interest cover.
Operating profit is the profit you have left after you have paid your overheads to pay your interest. The higher operating profit is compared to the interest charge, the easier the company can pay its interest and the safer the company is, as operating profit can fall further before paying interest becomes an issue. This is calculated as operating profit divided by interest, so if a company has operating profit of £270,000 and an interest charge of £30,000, interest cover is nine (£270,000/£30,000), which generally is quite a high interest cover. It could be the case that a company is highly geared, however, if it is very profitable it might be able to easily pay its interest, so even if profits fell it should be able to pay its interest. On the other hand a company may have low gearing, but if it has low operating profits in comparison to the interest charge it might find that profits don’t have to fall much before it starts to have difficulty to pay its interest payments.
Of course, there are many more ratios you should look at, and there are other non-financial factors you would take into account when analysing a company.
• Nick Craggs is a tutor at First Intuition
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