Ratio Analysis

Profitability Ratios - provide an indication of an organisation’s profitability and changes in

profitability
1. Return on shareholders’ equity (Return on equity)

ROE = Annual Net profit after tax (Net Income) DIVIDED BY Ordinary shareholders’
equity

⮚ ROE shows how economically a company is being run.

⮚ This ratio is viewed from the investor’s point - not the Company.
⮚ The higher this ratio the better the investment in the company.
⮚ This ratio is expressed as a percentage of return the shareholders generate
from their investment in the company.
⮚ Return on Equity is a two-part ratio in its derivation because it brings
together the income statement and the balance sheet, where net income or
profit is compared to the shareholders’ equity.
⮚ In mathematical terms, Return on Equity is the company's net
income (located on the income statement) divided by the shareholders'
equity (located on the balance sheet). Multiply by 100 to express the ratio as
a percentage.
⮚ An average of 5 to 10 years of ROE ratios will give investors a better picture of
the growth of this company.
⮚ Most businesses have the option of financing through debt (loan) capital or
equity (shareholder) capital. Return on equity will increase - if the equity is
partially replaced by debt. The greater the loan number is, the lower the
shareholders' equity will be.
⮚ Handle leverage with care - Leverage is something that needs to be handled
with care. Rising debt drives up the interest payments on corporate loans.
Practically, a debt-financed company is likely to earn a smaller after-tax profit
than an equity-financed company, due to payment of interest expenses on
the loan.
⮚ Improve ROE by Increasing Profit Margins - Raise the price of the product,
negotiate with suppliers or change your packaging to reduce the cost of
goods sold, reduce your labour costs, reduce operating expense - any
combination of these approaches.
2. Return on total assets
ROA = Operating profit before tax (or) Net profit after tax (or) Earnings before
interest and taxes (EBIT) (or) Earnings before interest, taxes, depreciation, and
amortization (EBITDA) DIVIDED BY Total assets
⮚ This ratio measures the income generated from the total assets in a period.
⮚ It measures company’s efficiency in utilising its assets to generate profits
during a period.
⮚ In short, this ratio measures how profitable a company’s assets are
⮚ The higher the ratio the more efficient the company.
⮚ Positive ROA ratio usually indicates an upward profit trend as well
⮚ ROA is most useful for comparing companies in the same industry as different
industries use assets differently
⮚ This ratio helps both management and investors see how well the company
can convert its investments in assets into profit.
⮚ EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization (or)
EBITDA = Operating Profit + Depreciation + Amortization
⮚ EBIT = Net Income + Interest + Taxes (or) EBIT = EBITDA - Depreciation and
Amortization expense

3. Net Profit (or) Net profit margin

Net Profit = Operating profit before tax DIVIDED BY Sales Revenue
⮚ This ratio indicates how much each dollar of sale results in net profit.
⮚ The higher the ratio, the better the company’s performance

4. Gross Profit (or) Gross margin

Gross Profit = Gross Profit DIVIDED BY Sales Revenue
⮚ This ratio indicates how much each dollar of sale results in gross profit
⮚ The higher the ratio, the better the company’s performance since there
would be more available to cover indirect costs and other expenses.
⮚ This ratio is commonly used by auditors
⮚ For many firms, this ratio will have a relatively stable and predictable pattern
⮚ Fluctuations may indicate changes in the nature of the business (such as
competition, pricing policies, manufacturing efficiencies, sales mix changes),
or financial statement errors
⮚ If the gross margin to sales ratio is increasing, the auditor needs to be aware
of the possibility that sales may be overstated (e.g. fictitious sales without a
corresponding cost of goods sold (COGS) entry).
 5. Operating Expenses
Operating expenses = Each individual item of expense DIVIDED BY Sales revenue
⮚ This ratio indicates the company management’s ability to have a low operating
expense compared to its net sales
⮚ This reflects on the efficiency of management
⮚ The lower the ratio the more the profits
⮚ For example, a large increase in the ratio of repairs and maintenance to sales
may indicate that a capital item has been charged to the repairs and
maintenance account.

Activity ratios - Provides an indication of an entity’s efficiency in using available resources

1. Asset turnover Ratio:

Asset turnover = Net Sales DIVIDED BY Total Assets

⮚ It measures the efficiency with which a company uses its assets to produce
sales.
⮚ A higher ratio is favourable, as it indicates a more efficient use of assets.
⮚ Conversely, a lower ratio indicates the Company is not using its assets as
efficiently. This might be due to excess production capacity, poor collection
methods or poor inventory management.
⮚ The benchmark turnover ratio can vary greatly depending on the Industry.
Industries with low profit margins tend to generate a higher ratio and Capital-
intensive industries tend to report a lower ratio.

2. Inventory turnover ratio:

Inventory turnover = Cost of goods sold DIVIDED BY Average Inventory

Where, COGS = Opening Stock PLUS Purchases LESS Closing Stock

Average Inventory = Opening inventory PLUS Closing inventory divided by two

⮚ This ratio indicates how many times a year the entity's inventory is replaced.
⮚ The inventory turnover ratio can be compared over time and with the
industry average.
⮚ If the ratio is substantially below those of past years or the industry average,
it can indicate obsolete and slow-moving stock.
 ⮚ Generally, a high ratio is preferable as it indicates efficient inventory
management. However, it can also indicate problems such as unrecorded
inventory or inadequate stock levels which could lead to losses if there are
stock shortages.
⮚ The ratio varies significantly between industries, and for some industries, it
will vary seasonally.
⮚ Ratios may also vary within industries because of different methods of
accounting for inventory (e.g. first-in first-out (FIFO), weighted average).
⮚ It is common to use closing figures (i.e. year-end balances) for these
analytical procedures as this version of the ratios has the advantage of
increasing the likelihood of detecting a material misstatement related to
year-end adjustments. For example, if there was a financial statement fraud
where cost of goods sold had not been recorded by overstating year-end
inventory (i.e. not putting through the journal entry Dr. COGS, Cr. Inventory),
it would be easier for the auditor to detect if the inventory turnover ratio
used the closing balance.

3. Days in inventory ratio:

Days in inventory = Average inventory MULIPLIED BY 365 and DIVIDED BY Cost of

goods sold

⮚ The ratio indicates the timeframe that inventory is held for

⮚ The increase in the days shows that inventory is being held for too long - this
may indicate stock obsolescence and is also a possible indicator of poor
inventory management.

4. Debtors turnover ratio:

Debtors Turnover = Credit Sales DIVIDED BY Average Debtors

⮚ This ratio is an indication of an entity’s credit control policy.
⮚ The higher this ratio is, the better the performance.
⮚ A decrease in this ratio compared to prior years or industry average may
indicate deficiencies in the entity’s credit and collection policies, possible
uncollectability of some accounts, possible fictitious sales or incorrect cut-off,
or an increase in the credit period granted in order to increase sales.
⮚ Fluctuations in these ratios may indicate changes in liquidity or cash
management procedures.
 5. Days in debtors ratio (or) Average collection period in days ratio:

Days in debtors = Average debtors MULTIPLIED BY 365 and DIVIDED BY Credit Sales
⮚ This indicates the timeframe for debtors’ accounts to be paid or settled.
⮚ Generally, 30 days is good while 90 days would be too long.

6. Days in payables ratio (or) Average payment period in days ratio:

Days in Payables = Average accounts payable MULTIPLIED BY 365 and DIVIDED BY

Credit Purchases
⮚ This indicates how long a company takes to settle its accounts with creditors.
⮚ An average between 30 and 60 days is considered good. A very long period would be
a poor reflection of the entity’s credit worthiness while a very short period would
indicate that the entity is not taking full advantage of credit terms permitted by
creditors.

Liquidity Ratios - Liquidity ratios provide an indication of an organisation’s ability to meet

current obligations as they fall due. Unusual or unexpected trends may also indicate over- or
understatement of current assets (e.g. trade debtors, inventory) and current liabilities (e.g.
payables, accruals). The ratios need to be reviewed with regard to the organisation’s current
and projected cash flow.

1. Current Ratio:
Current Ratio = Current Assets DIVIDED BY Current Liabilities
⮚ This ratio measures a company’s ability to pay its short-term obligations with its
current assets.
⮚ Generally, a ratio of 2:1 is the benchmark.
⮚ A lower ratio means a higher liquidity risk. That is, the risk that the entity would
not be able to pay its creditors as they fall due.
⮚ An increase in the current ratio is not always a positive signal to the auditor
because it may indicate a build-up of trade debtors possibly due to less effective
collection procedures or a build-up in inventory because of difficulties in selling
products. Thus, the auditor would consider both inventory turnover and debtors
turnover in connection with changes in the current ratio.
 2. Quick Asset Ratio (or) Acid Test Ratio:

Quick asset ratio = Cash PLUS Marketable securities PLUS Trade debtors
DIVIDED BY Current Liabilities

(OR)

Quick asset ratio = Total current assets LESS Inventory DIVIDED BY Current
Liabilities

⮚ This ratio excludes inventories from current assets when meeting a

company’s short-term obligations.
⮚ The higher the ratio the better the liquidity position.
⮚ The benchmark is 1.5:1. The quick ratio should not drop below 1:1 as this
would indicate that the entity is not able to settle its current liabilities
immediately.
⮚ The comparative importance of the level or change in these ratios depends
on such factors as the predictability of future cash flows, the inventory
turnover ratio and the debtors turnover ratio.
⮚ For example, the less predictable the cash flows, the higher these ratios need
to be acceptable. On the other hand, if cash flows are very predictable, the
auditor is likely to be less concerned about a lower current ratio because the
organisation is likely to have sufficient cash flows coming in on a regular basis
to pay any bills.

Financing Ratios - Gearing ratios consider the long-term financial strength of an entity.
Debt–equity ratio and Debt–assets ratio indicates the gearing level. Number of times
interest earned ratio considers the ability of the entity to meet its interest commitments as
they fall due. Changes in these ratios may indicate business risk, and the auditor needs to
consider related audit risk.
Debt-equity ratio:
⮚ This ratio indicates the percentage of shareholders equity and debt employed to
fund the company’s assets.
⮚ The ratio indicates the proportion of borrowing from outside finance providers in
comparison to funding from shareholders.
⮚ Generally, a low ratio indicates a financially stable company
⮚ Higher ratio indicates that more creditor financing (bank loans) is used than investor
financing (shareholders) and are considered riskier to Creditors and investors thank
Companies with low debt to equity ratio.
⮚ For example, if the user wishes to know what proportion of total resources was
being provided by the owners as against those from third parties, the likely measure
would be total liabilities divided by shareholders’ equity. If, on the other hand, they
were considering the long-term financing position of the firm, then they would use
the ratio of long-term liabilities divided by shareholders’ equity. If the auditor is
looking for unusual trends, they may calculate both versions of the ratio.
Debt-assets ratio:
⮚ This is an important measurement because it shows how leveraged the company by
looking at how much of company’s resources are owned by the shareholders in the
form of equity and creditors in the form of debt. Both investors and creditors use
this figure to make decisions about the company.
⮚ This ratio indicates the percentage of debt compared to the total assets - it is an
indication of the percentage of assets that was funded by debt.
⮚ A general benchmark is below 60% although the benchmark for this ratio would vary
considerably across different industries.
⮚ Analysts, investors, and creditors use this measurement to evaluate the overall risk
of a company. Companies with a higher figure are considered riskier to invest in and
loan to because they are more leveraged. This means that a company with a higher
measurement will have to pay out a greater percentage of its profits in principle and
interest payments than a company of the same size with a lower ratio. Thus, lower is
always better.
⮚ If debt to assets equals 1, it means the company has the same amount of liabilities
as it has assets - This company is highly leveraged. A company with a DTA of greater
than 1 means the company has more liabilities than assets. This company is
extremely leveraged and highly risky to invest in or lend to. A company with a DTA
of less than 1 shows that it has more assets than liabilities and could pay off its
obligations by selling its assets if it needed to.

Number if times interest earned:

⮚ This indicates whether a company is able to pay its interest expense from its income.
⮚ A lower ratio might highlight a solvency issue.
⮚ As a benchmark, this ratio should not be lower than 2.5.