The ratio analysis toolkit for the Case Study

Ratios turn a page of figures into a diagnosis. They let you compare one year with another, one company with another and a company with its industry, without being misled by size. This topic sets out every ratio you are likely to need, with its formula, what it tells you and how to read it, followed by a full worked example.

What ratios are and how they are grouped

A ratio is the relationship between two connected figures in the financial statements. Ratios remove the problem of comparing absolute figures. You can use them to compare performance over two or more periods, to compare a company with another in the same industry and to compare it with the industry average.

Ratios can be described by how they are built. A coverage ratio shows ability to meet obligations, such as interest cover. A return ratio compares the benefit earned with the resources committed, such as return on investment. A turnover ratio shows how many times a resource is used to generate benefit, such as inventory turnover. A component percentage relates one part to the whole, such as gross profit to sales.

Profitability ratios

ROCE can be split into two parts: ROCE = (PBIT ÷ sales) × (sales ÷ net assets). In words, return depends on the profit margin and on how hard the assets work. A company can raise ROCE by earning more on each naira of sales, by selling more from the same assets, or both.

The November 2015 Pathfinder solution calls profit before interest and tax divided by revenue the net margin. We call that the operating profit margin and keep net profit margin for profit after tax divided by revenue. Its current ratio also divides by 102.67 where current liabilities are 105.67, though the answer rounds to 0.5 to 1 either way. The Pathfinder solution is slightly different from ours.

Liquidity ratios

Net working capital is current assets less current liabilities. In general the higher these ratios, the better the ability to pay short-term debts. But balance matters. Too much cash tied up in working capital is idle money that earns nothing. Too little risks creditors taking action.

Under the Companies and Allied Matters Act 2020, the court may wind up a company that is unable to pay its debts (section 571(d)). A company is deemed unable to pay if a creditor owed more than the stated amount makes a written demand and the company neglects to pay for three weeks (section 572(a)).

The amount was ₦200,000 when the Act was passed and is now set by Corporate Affairs Commission regulations. Liquidity and profitability must be balanced to stay in business.

The operating cycle

The operating cycle is the time it takes to turn money invested in inventory back into cash. For a manufacturer it has four phases: buy materials and make goods, sell from inventory, extend credit to customers and collect from them. A trader skips the first phase. A service business has only the last two.

Use closing balances if they represent the year. Use the average of opening and closing balances if you want a more representative figure, and say which you used. Take 365 days unless told otherwise. The longer the net operating cycle, the more working capital the business needs, because cash is locked up for longer.

Efficiency or activity ratios

A higher turnover means the assets are working harder. The days measures and the turnover measures use the same data. If inventory is held for 45 days, turnover is 365 ÷ 45, which is about 8.1 times a year.

Long-term solvency and gearing ratios

Investment ratios

Worked example

Check ROCE with the split: operating margin 6% × net asset turnover 2.0 = 12%.

Commentary. Profitability is weak: a 6% operating margin and a 12% ROCE. Efficiency is also a concern, because customers take almost 88 days to pay, which ties up cash even though suppliers are paid at the same pace as stock is sold. Liquidity is acceptable on the current ratio but thin on the quick ratio, and cash is only 8% of current liabilities.

Gearing is moderate at 40%, and interest cover of three times leaves limited room if profit falls. Shareholders receive a small yield, and the dividend is covered 2.3 times. The priority is to shorten the collection period and improve the margin.

Choosing the right ratios

The requirement tells you which ratios matter. Match the question to the group instead of calculating everything.

Worked example: two years side by side

Profitability. Gross margin fell four points and operating margin fell four points, so the loss of margin came from direct costs and was not recovered by savings elsewhere. Efficiency. Customers now take 22 days longer to pay and stock stays 21 days longer, so more cash is locked into working capital. Liquidity. The current ratio fell from 1.8 to 1.2, which fits that picture.

Gearing. Gearing rose from 25% to 38%, which suggests that borrowing has paid for the extra working capital, and interest cover has halved to 2.9 times. Conclusion. The business is growing its balance sheet faster than its profit and is becoming more exposed to a profit shock. The board should tighten credit control, cut slow stock and review pricing before it borrows more.

Interpreting ratios in a report

• Define the ratio you use and say whether you used closing or average balances.
• Calculate it for every year given, and set the industry figure beside it if one is supplied.
• Discuss groups in order and do not mix them.
• Explain the cause from the facts in the case, then the effect and the action.
• Put the calculations in an appendix and the key figures and comments in the body.

A useful sentence pattern is: the [ratio] moved from [x] to [y], against an industry figure of [z]. This is because [cause from the case], which means [effect on the business], so management should [action]. Use it for each important ratio and the report will always contain a comparison, a cause, a consequence and a recommendation.

Limits of ratio analysis

Ratios are a starting point, and their limits should be stated in a report. Most of the checks below take only a line or two.

• Year-end balances. A statement of financial position shows one day. Seasonal businesses can look very different at other times, so say so, or use averages where the case gives opening balances.
• Different accounting policies. Depreciation, inventory valuation and revaluation affect profit and assets. Be careful when comparing companies that use different policies.
• One-off items. A gain on disposal or an exceptional cost distorts margins and returns. Adjust for it, or at least comment on it.
• Different definitions. Industry figures may be calculated differently from yours. State your formula and use theirs when they give it.
• Backward-looking. Ratios describe the past. Link them to the forecast and the strategy before you draw conclusions about the future.

Common mistakes

• Calculating ratios the requirement does not need. Choose the ones that answer the question.
• Quoting a ratio without a comparison or a comment.
• Using total sales for receivables days when credit sales are given.
• Confusing gearing measures, such as debt to equity and capital gearing, and not stating which one is used.
• Mislabelling ratios, such as calling an operating margin a net margin.
• Treating a high current ratio as always good, when it may signal idle cash or slow stock.

Quick revision

• Five groups: profitability, liquidity, efficiency, gearing, investment.
• ROCE = PBIT ÷ (equity + non-current liabilities) = margin × net asset turnover.
• Quick ratio removes inventory. Net operating cycle = inventory days + receivable days − payable days.
• Gearing: capital gearing, debt to equity, interest cover.
• Investment: EPS, P/E, dividend cover, dividend yield.
• Always compare, explain and recommend.

Practice questions

These are original questions in the style of the Institute of Chartered Accountants of Nigeria exam. Try each one before you open the answer.

Model answer

The next topic covers financial statements analysis in the Case Study: method, report and worked cases.

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