Finance ratios deep analysis
Categorisation of ratios
You might recall that ratios can be classified into the subsequent four categories:
Profitability and return
Debt and gearing
Liquidity: control of cash and other working capital items
Shareholders' investment ratios (or 'stock market ratios')
Profitability and return
Return on capital employed (ROCE)
Profit before interest & tax (PBIT) Profit from operations
ROCE = % = %
Capital employed Total assets less current liabilities
Where capital employed = shareholders' funds + long-term debt finance
When analyzing ROCE, it is important to consider the following factors:
The level of risk associated with the business.
The extent to which the business relies on capital investment.
The ROCE of similar businesses in the industry.
Whether the ROCE is sufficient to cover the costs of additional borrowing,
taking into account current market borrowing rates.
There are potential challenges in achieving comparability when interpreting
ROCE, which include:
Differences in the policy regarding the revaluation of assets.
Variances in accounting policies, such as the treatment of goodwill and
research and development.
The classification of a bank overdraft as either a short-term or long-term
liability.
Return on equity (ROE) (return on net assets)
Profit after interest and tax
ROE = %
Book value of shareholders' funds
The perspective provided is narrower in terms of capital compared to ROCE,
yet the underlying principles remain consistent.
ROCE = Asset turnover × Profit margin.
Asset turnover
Sales Sales
Asset turnover = or
Capital employed Total assets less current liabilities
, The efficiency of asset utilization is assessed by this metric. However, it is
specifically applicable to capital-intensive businesses and focuses solely on
non-current assets
Profit margin
PBIT Gross profit
Profit margin = % Gross profit margin = %
Sales Sales
Debt and gearing
Debt ratio
Current and non-current liabilities % (>50% = high)
Debt ratio =
Current and non-current assets
Debt:equity
Interest bearing net debts
Debt:equity ratio = % (>100% = high)
Shareholders' funds
Value of debt
Or simply
Value of equity
Operating gearing (leverage)
Contribution (sales minus variable cost of sales)
Gearing =
PBIT
The correlation between the cost operating structure and profitability is
exemplified in this text. It also highlights the potential business risks that
may arise from fluctuations in volume
Interest cover
PBIT(incl int receivable) Profit from operations
Interest cover = or
Interest payable Finance costs
Is this a more effective approach to evaluating gearing? The company
needs to generate enough profit to fulfill its interest obligations.
Undoubtedly, this holds immense importance for bankers and lenders.
Categorisation of ratios
You might recall that ratios can be classified into the subsequent four categories:
Profitability and return
Debt and gearing
Liquidity: control of cash and other working capital items
Shareholders' investment ratios (or 'stock market ratios')
Profitability and return
Return on capital employed (ROCE)
Profit before interest & tax (PBIT) Profit from operations
ROCE = % = %
Capital employed Total assets less current liabilities
Where capital employed = shareholders' funds + long-term debt finance
When analyzing ROCE, it is important to consider the following factors:
The level of risk associated with the business.
The extent to which the business relies on capital investment.
The ROCE of similar businesses in the industry.
Whether the ROCE is sufficient to cover the costs of additional borrowing,
taking into account current market borrowing rates.
There are potential challenges in achieving comparability when interpreting
ROCE, which include:
Differences in the policy regarding the revaluation of assets.
Variances in accounting policies, such as the treatment of goodwill and
research and development.
The classification of a bank overdraft as either a short-term or long-term
liability.
Return on equity (ROE) (return on net assets)
Profit after interest and tax
ROE = %
Book value of shareholders' funds
The perspective provided is narrower in terms of capital compared to ROCE,
yet the underlying principles remain consistent.
ROCE = Asset turnover × Profit margin.
Asset turnover
Sales Sales
Asset turnover = or
Capital employed Total assets less current liabilities
, The efficiency of asset utilization is assessed by this metric. However, it is
specifically applicable to capital-intensive businesses and focuses solely on
non-current assets
Profit margin
PBIT Gross profit
Profit margin = % Gross profit margin = %
Sales Sales
Debt and gearing
Debt ratio
Current and non-current liabilities % (>50% = high)
Debt ratio =
Current and non-current assets
Debt:equity
Interest bearing net debts
Debt:equity ratio = % (>100% = high)
Shareholders' funds
Value of debt
Or simply
Value of equity
Operating gearing (leverage)
Contribution (sales minus variable cost of sales)
Gearing =
PBIT
The correlation between the cost operating structure and profitability is
exemplified in this text. It also highlights the potential business risks that
may arise from fluctuations in volume
Interest cover
PBIT(incl int receivable) Profit from operations
Interest cover = or
Interest payable Finance costs
Is this a more effective approach to evaluating gearing? The company
needs to generate enough profit to fulfill its interest obligations.
Undoubtedly, this holds immense importance for bankers and lenders.
