? Capital Structure
Financial analysis is the evaluation of a firm’s past, present and anticipated future
Its objectives are to identify then firm’s financial strengths and weaknesses and to
assist in financial planning.
Financial ratios are the principal tools of financial analysis, because they can be used
by a variety of people to help them diagnose the financial well-being of a firm.
People such as accountants, analysts, bankers, managers, investors and owners use
ratios to evaluate a firm’s financial performance and financial condition and to
compare these with other like firms or with itself over time. Profitability ratios, for
example, measure financial performance whereas liquidity ratios measure financial
Users of Financial Ratios
The various people who might be expected to employ financial analysis can be
grouped as follows:
? Analysts and advisers
(accountants, investment analysts, credit rating agencies)
? Business Contacts
(creditors, customers, employees, suppliers, trades unions)
(Banks, debenture holders, financial institutions, shareholders)
(competitors, government agencies, public bodies, stakeholders)
Alternatively interested parties can be separated into internal and external users.
? Directors ? Accountants/analysts
? Managers ? Bankers
? Employees ? Competitors
? Owners/shareholders ? Customers
Each of these groups, however arranged, will be interested in different aspects of the
firm’s finances eg. Loan providers will be particularly interested in:
a) the firm’s ability to meet loan repayments plus interest (i.e. the firm’s
liquidity and cash-flow position)
b) the level of existing borrowings (i.e. the firms gearing position)
c) the availability of assets for security
Employees and trade unions, in contrast will be primarily interested in issues of job
security and wage negotiations.
A Framework for Analysis
A framework for financial analysis can be developed by seeking answers to the
following key questions:
1. Is this business making money, i.e. is it profitable?
2. Can this business pay its bills on time, ie. Is it liquid?
3. Is this business using its assets properly, ie. Is it operating efficiently?
4. Is this business overly dependent on borrowed money, ie. Is it too highly
Selected Ratios can be used to examine a firm’s finances in order to provide answers
to the questions mentioned above. Ratios to measure:
3. Operating Efficiency
4. Capital Structure (gearing)
Ratios can be shown in the form of 2:1, 1:1 or as percentages or as so many times.
Risk and Return
Profitability ratios measure return: liquidity, efficiency and gearing ratios measure
A study of the following ratios will help answer question 1.
Return on in Investment (ROI)
- the primary ratio
There are many ways of calculating this ratio; a common one is:
Net Profit (after interest and tax) x 100 = %
- Gross Profit Ratio:
Gross Profit x 100 = %
Net Profit Ratio:
Net Profit/sales x 100 = %
Return on Equity (shareholders’ Funds) ratio:
Net Profit (after tax and interest) / shareholders’ funds x 100 = %
A study of the following ratios will help answer question 2
Level of Working capital
Working capital = Current assets- current liabilities
Working Capital should be sufficient to cover:
a) Paying creditors
b) Allowing trade credit to customers
c) Carrying adequate stocks
Current assets: current liabilities
Acid Test Ratio
Current Assets- stock : current liabilities
A study of the following ratios will help answer question 3
Stock turnover ratio;
Cost of sales/average stock = times
(average stock = (opening stock + closing stock) /2
Cash turnover ratio:
Sales for the period / average cash balance = times
Debtors days (collection period) ratio:
(Debtors / credit sales) x 365 = days
Credit days (payment period) ratio:
(creditors / purchases) x 365 = days
** the difference between credit days and debit days ratios is also an important ratio
to be controlled
Capital Structure Ratios
A study of the following ratios will help answer question 4
Capital Structure Ratios measure the relationship between debt (external) finance and
equity (owners) finance, ie. The level of gearing or leverage.
There are a number of methods of calculating this ratio, a few common methods are:
(Fixed interest capital / fixed interest + equity) x 100 = %
Long term loans + pref. Shares / shareholders’ funds x 100 = %
shareholders’ funds + long tern loans
the gearing ratio gives an indication of a firm’s long term solvency; if the ratio is too
high this usually suggests over-dependence on external financing and the firm could
be at risk financially.
This ratio shows the proportion of the firm’s total assets which are financed by outsiders and is closely linked to the gearing ratio.
(Total debt finance / total assets) x 100 = %
This ratio is also related to gearing as it too gives an indication of longer term
solvency by assessing the firm’s ability to meet interest commitments.
Profit before tax and interest & tax = times
Total interest payable
Eg. Profit (before tax and interest) = ?50,000
Interest Payable = ?10,000
Interest cover = 5 times
Production Selling Admin
Costs* costs Costs Sales Sales Sales
* Labour costs
* Material costs
* Overhead costs
? Premises ? Stock
? Equipment ? Debtors
? Fixtures ? Cash
Here the profitability and efficiency ratios have been linked together.
Other Useful Ratio:
Sales Activity Ratios:
1. Sales per employee
2. sales per sq. metre of floor space
These ratios are particularly useful in retailing firms.
Limitations of Ratios
Many Ratios are available:
It is important to be aware that many ratios are available for use in evaluating a firm’s financial performance, and financial analysts may even use different methods of calculating the same ratio!!
Interpret with care:
Ratios need to be interpreted with care, and used selectively, and their results interpreted with care.
The use of differing accounting policies and procedures may distort comparisons: you need to compare like with like.
Whatever the method of calculating a ratio is chosen it should be applied with consistency.
The quality and amount of financial information available will affect the quality of the ratios calculated and hence the quality of the analysis.
Ratios are static, historic and retrospective: they may not be appropriate for making future projections.
Financial ratios are partial. They only reveal part of a firm’s overall performance,
other non-financial measures eg, marketing, production, quality and manpower are also required.
Financial ratio analysis on its own can give a misleading picture and must be used in conjunction with a more rigorous analysis of the business.
Financial Ratios – Other considerations
Reasons for Analysis:
It is important to consider why the analysis is being carried out and by whom as this will influence the choice of ratios.
Set target or standard ratios and compare actual performance with targets/standards
Use a cross-sectional analysis to compare the firm’s ratios with those of other firms in
the same market sector at the same time eg. Industrial or retail sector averages.
Compare like with like, size with size and same market sector.
Use time series analysis to determine and highlight trends in a firm’s ratios over time
Use graphs and charts to facilitate presentation and understanding