**Profitability and return Ratio **

Also called performance ratios, helps shareholders asses the performance of management.

**Gross Margin**

The measure of the margin earned by a company on revenue before overhead costs is deducted.

**Calculation: **Gross profit divided by turnover times by 100%

** **2. **Operating Margin**

The amount of profit left after all expenses have been deducted from revenue except interest and tax.

** **3**. Net Margin**

A measure of profitability of a firm.

**Calculation:** Net Income divided by revenue multiplied by 100.

** **4. ** Asset turnover**

Measures the efficiency of a company using its assets to generate sales.

**Calculation:** Revenue **divided by **assets “expressed as …. times “

** ** 5**. Return on Capital Employed (ROCE)**

The ROCE analysis how growth in profits relates to the capital invested to make the profits. The higher the ratio the better but this will have to be compared to previous years, other companies and industry averages.

**Calculation:** Profit before interest and taxation divided by total assets **less** current liabilities **multiplied** by 100.

** Note** instead of total assets

**less**current liabilities, Capital Employed = Shareholders Funds + long term debt.

**Long-term solvency and stability Ratio**

** **1.** Gearing Ratio**

Analysis how much a company is reliant on debt. Typically a company with a gearing ratio of more than 50% is highly dependant on debt, whilst a company with a gearing ratio of less than 50%, does not highly depend on debt to finance activities.

**Calculation: **Long-term liabilities **divided by** capital employed **multiplied** by 100

** Note** Capital Employed = Shareholders Funds + long term debt.

2. **Interest cover**

Analysis whether interest costs are high compared to the level of its profits. A interest cover of 2 times or less is classified as low. Typically it should exceed 3 times before a company has acceptable interest cost.

*Calculation: **Profit before interest and tax divided by interest charges *

**Short-term solvency and liquidity Ratio**

** **1. ** Current ratio**

Analysis the **ability** of a **company** to meet **current liabilities with current assets**. The higher the ratio the better but typically a ratio of greater than 1 is expected. The ability of a firm to **turn** **assets** into **cash** **influences** the **ratio**.

**Calculation: **Current Assets divided by Current Liabilities

** **2.** Quick ratio or acid test ratio**

Analysis how a company without its inventory can meet current liabilities with current assets excluding inventory. The ratio gives a **clearer view** of a **company’s** liquidity position because it takes into account that some **company’s assets** are easily **turned** into **cash**. **For example,** supermarkets who can easily turn inventory into cash.

**Calculation:** Current assets **less** inventories **divided by **current liabilities

**Efficiency Ratio**

** ** 1.** Receivables days**

Measures the average time it takes for the company to receive funds from customers. Typically receivables should pay within 30 days and more than this can arguable mean that a business manages its funds very poorly. But this depends upon the nature of the business and as mentioned earlier on comparisons.

**Calculation:** Receivables **divided by** sales **multiplied** by 365 days

** **2.** Inventory turnover**

The ratio measures the average day’s inventory items are held for. This indicates how well a business trading. If inventory days are building up then a business is experiencing slowdowns in trade or that investment in inventories is much more than necessary.

**Calculation:** Inventory **divided by** cost of sales **multiplied by **365 days.

** ** 3. **Payable days**

Assesses a company’s **ability** to **pay** for items **purchased** on **credit**. High payable days indicate that the business is not managing its long-term finance.

** Calculation:** Trade payables

**divided**by cost of sales

**multiplied**by 100.

*S*hareholder investment

** ** 1. ** Earnings per share**

This ratio measures the return on each individual ordinary share in the year.

**Calculation: **Dividend per share **divided by **dividend cove

2. **P/E ratio**

Measures the returns on ordinary shares of a company. A high EPS indicates that shareholders are confident in the company’s future, whilst a low P/E ratio means a lower level of confidence.

**Calculation: **Share Price **divided by **earnings per share.

** ** 3. ** ****Dividend Cover**

**Calculation:** Earnings per share divided by dividend per share

**Limitations of financial statements**

When using financial ratios to interpret and analyse financial statements, there are issues with the level of accuracy involved and companies need to consider the following limitations of financial interpretation.

Financial statements are based on historic information (old past data). Therefore comparison to future decisions, then relevance is limited.

- Financial statements can be influenced through creative accounting and window dressing.
- Seasonal businesses will experience different results throughout the year.
- In cases were a business acquires or disposes of it’s business comparisons of other years is difficult.
- Ignores non-financial information.