Senior 5 Financial Ratio analysis

Profitability ratios

ROCE (return on capital employed) = net profit after tax/ capital employed (long term liabilities + equity)

It measures how good was the investment assuming only one year as the paying back money for the capital employed in the investment. Depending on the kind of investment each of them will has its own maturity horizon. Another limitation is that if you use this information to forecast in how many years your are paying off the investment then you will be assuming that the behaviour of the investment cash-flow is lineal and its not. It has a similar behaviour as the product life cycle.

gross profit margin = gross profit / sales revenue

net profit margin = net profit after tax / sales revenue

In these previous cases you have an idea on which percentage of your sales will be considered profits which at the end will be more investment for the company (retained profits) or more dividend paid to the shareholders which have invested in the company.

In the first one you could have a good idea of the role of the direct costs and in the second one of the total costs of producing.

Liquidity ratios

They will show how good is the company is in facing its close due dates liabilities. The ability to pay back its short-term debt.

current ratio = current assets / current liabilities

acid test ratio = (current assets – inventories) / current liabilities

The result should be near one. Even-though, this is a fast way of getting how liquid is the company, the figures for a balance sheet show only how is the situation in one moment at the end of one year this figures don´t tell us anything important about which was the dynamic of these figures during the year.

Other limitations

These ratios say something about the company that has already happened but most of the users of the information would like to know things about the future of the company. Some inter annual comparison will be affected by inflation, which could be more or less impossible to discount. There are some methods of valuing inventories or fixed assets which will lead to unfair comparisons between companies. For making decisions and concluding on diagnosis of the company the user will need to have more non quantitative sources of information apart from reading the notes to the financial statements.

This entry was posted in Senior 5 - Contents to study. Bookmark the permalink.