FINANCIAL RATIOS: WHAT DO THEY MEAN? (Part 2)

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The purpose of ratio analysis is to simplify the financial situation of a business by looking at the relationships between different categories of accounting data. The amounts used in ratio analysis will normally be read from a set of financial statements.

Two important limitations of ratio analysis which must be kept in mind are:

  • Two people can interpret the same ratio result very differently as there are no fixed guidelines on how the results of ratios must be interpreted.
  • The same result of a specific ratio can be excellent in one industry, but fatal in another industry. It is crucial to interpret a ratio within the context of the circumstances of the business and the industry it operates in, as well as general market conditions.

The first article in the series on financial ratios dealt with liquidity (short-term solvency) ratios and efficiency ratios. This article will discuss profitability ratios, return on investment (ROI) ratios and operating efficiency (OE) ratios.

Profitability ratios

Profitability ratios measure if a business is making a profit or a loss, and whether the ratios are acceptable or not. The rule of thumb is the higher the return, the better the business is at controlling its costs.

Financial ratio Formula What this ratio measures
Gross profit margin Gross profit / Net sales x 100 = x% The percentage of each rand of sales that is left over, after deducting cost of inventory sold, for paying expenses and making a profit
Net profit margin Net profit after tax / Net sales x 100 = x% The percentage of each rand of sales, after all expenses have been paid, that will be left as profit

 ROI ratios

ROI ratios are used to calculate the return on an investment made in a business or an asset. The general rule is that the higher the return, the more profitable the investment.

 

Financial ratio Formula What this ratio measures
Return on assets Net profit after tax / Average total assets* x 100 = x% The average percentage of profit after tax that was made on the business’s investment in total assets
Return on equity Net profit after tax / Average owner’s equity** x 100 = x% The average percentage of profit after tax that was made on the owner’s investment in the business

*Average total assets = (Opening long-term assets + Opening short-term assets + Closing long-term assets + Closing short-term assets) / 2

**Average total equity = (Opening equity + Closing equity) / 2

OE ratios

The result of operating efficiency ratios gives an idea of how efficiently a business is using its total investment in resources. Generally, the bigger the result of the ratio, the more efficient the business is at generating income from its assets and equity investments from its owner(s).

Financial ratio Formula What this ratio measures
Net working capital turnover Sales / Average net working capital^ How many rands of sales are generated for each rand of net working capital
Fixed asset turnover Sales / Average net fixed assets^^ How many rands of sales are generated for each rand of net fixed assets
Total asset turnover Sales / Average total assets^^^ How many rands of sales are generated for each rand invested in the assets of the business
Equity turnover Sales / Average total equity^^^^ How many rands of sales are generated for each rand invested by the owner(s) in the business

^Average net working capital = (Opening net working capital + Closing net working capital) / 2

^^Average net fixed assets = (Opening net fixed assets + Closing net fixed assets) / 2

^^^Average total assets = (Opening assets + Closing assets) / 2

^^^^Average total equity = (Opening equity + Closing equity) / 2

All the above ratios deal in some way or another with how efficient a business is at managing its expenses, income and assets. Remember to interpret all financial ratios against the backdrop of the business’s unique circumstances, taking into account the industry the business operates in and the market conditions for that industry.

For more information on this topic, please contact us for professional assistance and advice.

This article is a general information sheet and should not be used or relied on as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice.

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