Ratio Analysis

Ratio analysis is a technique for trying to help interpret financial accounts. From the financial accounts various ratios can be calculated. These ratios will then help us to examine the companies position in more detail and compare it to other companies in a similar industry or market segment. Here's a brief explanation of some of the key ratios:

Profitability ratios

These ratios help us to judge how good the firm's profit performance is. There are two key ratios to show profitability. They are:

Return on capital employed - this measures the level of profit of the firm compared to the amount of capital that has been invested in it. It is effectively the return the firm has made, and investors will want this to be higher than the rate of interest they could have got elsewhere. It is measured by:

Profit margin - this measures the level of profit compared to the turnover. It therefore shows the percentage profit on the sales. It can be measured as either a gross or net profit margin. The net profit margin would be:

Liquidity ratios

These are ratios that measure the liquidity of the firm. Firms have to ensure that they have the liquidity required to meet all their commitments. They need to be able to have sufficient assets to convert into cash, and can't afford to have all their assets tied up as capital.

Current ratio - this ratio compares the current assets and current liabilities. Clearly the firm needs to have more current assets than liabilities, and so at a minimum the figure should be more than 1. However, it should probably be quite a bit higher than this to ensure sufficient liquidity. It is measured by:

Acid test ratio - this ratio takes a closer look at the firm's liquidity. One of the current assets is stock, and this is clearly not always easy to turn into cash. In fact the firm may have high stock levels because they can't sell it all. So the acid test ratio takes the current assets and subtracts the stock. It is measured by:

If the value of this ratio is much less than one the firm may have a liquidity problem, as it may have insufficient assets to meet all its liabilities.