FINANCIAL RATIOS - What are Financial Ratios and what are they used for

FINANCIAL RATIOS

What are Financial Ratios and what are they used for

Stes de Necker

NOTE

This article is for general information 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.

The currency referred herein is the South African Rand and SARS means the South African Revenue Service. VAT means Value Added Tax.

CALCULATING RATIOS

The purpose of calculating ratios is to get a bird’s eye view of the financial situation of a business by analysing the relationships between different amounts on the financial statements. The major advantages of using ratio analysis are that it simplifies the information in the financial statements and allows you to compare the ratio results over time in a specific business, or between different businesses.

Some limitations of ratio analysis are the following:

There are no specific standards for what ideal ratios should be, so different people may interpret the same ratio in different ways.

Single ratios do not necessarily paint an accurate picture. Just like the meaning of a word can differ depending on the context of a sentence, a ratio must be interpreted in the context of the background of the business and the industry in which it operates.

Set out in the tables below are a number of financial ratios with their formulas and a brief explanation of what each ratio measures. 

1. Liquidity ratios (short term solvency ratios)

The liquidity ratios measure a business’s ability to pay off its current/short term liabilities i.e. the liabilities which will become due in the next 12 months.

Ratio name	Ratio formula	What it measures
Current ratio	Current assets / Current liabilities	Can the business pay their debts due in the next 12 months from the assets they expect to turn into cash within those 12 months? Generally a ratio of 1 or higher than 1 is considered acceptable.
Quick ratio (Acid test)	(Current assets –STOCK) / Current Liabilities	Can the business pay their debts due in the next 12 months from the cash and short term investments they have? Stock is excluded from the ratio as it must still be converted to a liquid asset (debtor/cash).Generally a ratio of 1 or higher than 1 is considered acceptable.

2. Efficiency ratios

Efficiency ratios show how efficient a business is in using its investment in current assets to make a profit.

Ratio name	Ratio formula	What it measures
Debtor days (A)	Average trade debtors* / Sales x 365	Average number of credit days clients take to pay their accounts. If the number of days are high, especially higher than the industry average, it can indicate problems with debt collection.
Stock days (B)	Cost of sales / Average stock**	Average number of days it took from receiving stock to selling the stock. If the stock days are higher than the average stock days for the industry, it can indicate poor stock management, for example, having too much money tied up in stock.
Creditor days (C)	((Trade creditors + accruals) / (Cost of sales + other purchases)) x 365	Average number of days it takes from purchasing from a supplier until paying their account. If the creditor days are very short, it may indicate that the business is not taking full advantage of trade credit available to it.
Cash conversion cycle (CCC)	Debtor days +STOCK days – Creditor days OR (A) + (B) – (C)	How fast a business turns stock into sales (debtors), then turn those sales (debtors) into cash by collecting what the debtors owe them, and then pay its suppliers for goods and services bought from them. The shorter the CCC, the better. This will mean: Better liquidity, Smaller need to borrow money, Money available to make use of discount terms for cash payments to creditors, Better capacity to fund expansion of the business.

*Average trade debtors = (Debtors’ opening balance + Debtors’ closing balance)/2

**Average stock = (Stock opening balance + Stock closing balance)/2

PURPOSE OF RATIO ANALYSIS

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.

A. 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

B. 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

C. 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.

VAT: The difference between standard-rated, zero-rated and exempt supplies

There are three categories of supplies that can be made by a VAT vendor: standard-rated, zero-rated and exempt supplies. Output tax must be levied on all supplies except exempt supplies. The VAT Act gives specific guidelines for zero-rated and exempt supplies but these fall outside the scope of this article. Please contact your tax practitioner for more information.

The following simplified formula is used to calculate the amount of VAT that a registered VAT vendor have to pay to SARS or can claim as a refund from SARS:

Output VAT levied on standard-rated and zero-rated supplies* – Input VAT claimed on qualifying expenses = Net VAT due to/(refundable by) SARS.

* A supply is defined as the provision of a product or service by a VAT vendor in return for payment in cash or otherwise.

I. Standard-rated supplies

Standard-rated supplies are supplies of goods and services on which output VAT is levied at a rate of 14%. The input VAT incurred on purchases of goods and services to generate standard-rated supplies can be deducted from output VAT payable to SARS.

Example 1:

XYZ Manufacturers manufactured inventories at a cost of R7 000 (VAT included).

The inventories were sold for R10 000 (VAT included).

All inventory sales qualify as standard-rated supplies.

Net VAT due to/(refundable by) SARS will be calculated as follows:

Output VAT levied on standard-rated supplies (R10 000 x 14/114)	R1 228
Less: Input VAT on purchases to make standard-rated supplies (R7 000 x 14/114)	(R    860)
Net VAT due to/(refundable by) SARS	R   368

II. Zero-rated supplies

Zero-rated supplies are supplies of goods and services on which output VAT is levied at a rate of 0%. The input VAT incurred on the purchase of goods and services to generate zero-rated supplies can be claimed against output VAT payable to SARS.

Example 2:

XYZ Manufacturers manufactured inventories at a cost of R7 000 (VAT included).

The inventories were sold for R10 000 (VAT included).

All inventory sales qualify as zero-rated supplies.

Net VAT due to/(refundable by) SARS will be calculated as follows:

Output VAT levied on zero-rated supplies (R10 000 x 0/114)	R     nil
Less: Input VAT on purchases to make zero-rated supplies (R7 000 x 14/114)	(R   860)
Net VAT due to/(refundable by) SARS	(R   860)

III. Exempt supplies

Exempt supplies are not subject to VAT. No output VAT, either at 14% or at 0%, is levied on exempt supplies. Input VAT incurred on expenses to make exempt supplies cannot be claimed against output VAT due to SARS.

Example 3:

XYZ Manufacturers manufactured inventories at a cost of R7 000 (VAT included).

The inventories were sold for R10 000.

All inventory sales are exempt supplies for VAT purposes.

Net VAT due to/(refundable by) SARS will be calculated as follows:

Output VAT levied on exempt supplies	R nil
Less: Input VAT on expenses incurred to make exempt supplies	(R nil)
Net VAT due to/(refundable by) SARS	R nil

Combination of standard-rated, zero-rated and exempt supplies

Where a VAT vendor makes standard-rated supplies and/or zero-rated supplies and/or exempt supplies, input VAT must be apportioned in the same ratio as the three different types of supplies stand to each other.

Example 4:

ABC Distributors made the following supplies for VAT purposes (VAT included where applicable):

Standard-rated supplies	R  60 000	60%
Zero-rated supplies	R  10 000	10%
Exempt supplies	R  30 000	30%
Total supplies	R100 000	100%

2. Expenses incurred in the making of total supplies amounted to R85 000 (VAT included).

Net VAT due to/(refundable by) SARS will be calculated as follows:

Pro rata Output VAT levied on standard-rated and zero-rated supplies [(60 000 x 14/114) + (R10 000 x 0/114)] Output VAT on exempt supplies	R7 368 R      nil
Less: Apportioned input VAT on expenses to make standard-rated and zero-rated supplies [(R85 000 x 60% x 14/114) + (R85 000 x 10% x 14/114)] Less: Apportioned Input VAT on exempt supplies	(R7 307) R      nil
Net VAT due to/(refundable by) SARS	R       61

Accounting software can be set up so that VAT is automatically recorded correctly for standard transactions. However, a computer programme will not be able to classify unique transactions for VAT purposes. Therefore it is still important that accounting staff is trained to handle VAT correctly, especially where grey areas exist.

USE OF FINANCIAL RATIOS

Ratio analysis can be used when financial information needs to be simplified to make it possible to interpret and compare the information. Banks often do ratio analysis when they need to decide whether to lend money to a client or not. If a business wants to open an account with a supplier, the suppliers often use ratio analysis to determine the financial health of the business before deciding if they will sell to the business on credit.

There are also other advantages to making use of ratio analysis.

Some of these advantages are:

·         Ratios simplify the relationships between different amounts in a way that is easy to understand.

Ratio analysis allows the user to get a bird’s-eye view of the changes that have taken place in the financial condition of a business.

Ratio analysis makes it easier to compare different businesses with each other.

Comparisons can be made in the same business, between different years or divisions, to monitor the efficiency and performance of business units.

Ratio analysis can be used in planning by using past ratios to forecast future financial situations e.g. when drawing up a budget. 

·         

Financial risk ratios

Financial risk ratios, also known as solvency ratios, are used to determine the long term financial health of a business by determining whether the business carries too much or too little debt.

1. Debt ratio (also known as gearing):

Formula: Liabilities/Assets

A business can finance its assets with capital from the owner(s) or money borrowed from a bank or similar institution. The debt ratio determines the proportion of the assets of a business that are financed through debt, e.g. a debt ratio of more than 0.5 means more than half of the business’s assets are financed through debt. A debt ratio of less than 0.5 means most of the business’s assets are financed through capital (equity).

2. Equity ratio:

Formula: Equity/Assets

The equity ratio is a variant of the debt ratio above. The equity ratio shows the proportion of the assets of a business that are financed through equity.

3. Times interest earned (Interest cover):

Formula: Profits before interest paid and income tax / Interest paid

This ratio indicates whether a business will be able to make the interest payments on its debts from its profits. For example, a ratio of 2.5:1 means that the business earns two and a half times the amount that is needed to cover its interest expense.

4. Free cash flow ratio:

Formula: Cash flow from operating activities – Capital expenditure

The free cash flow ratio gives the amount of cash from operations that is left after a business paid for its capital expenditure. This is the amount of cash that is available to repay loans to banks and loans from the owner(s) to the business, and to make investments.

5. Cash flow coverage ratio:

Formula: Operating cash flows / Total debt

Banks often look at this ratio when they have to decide if they will make a loan to a business as this ratio tells if a business will be able to make capital and interest payments on loans when they become due.

A ratio of 1:1 means the business is in a good liquidity position or in good financial health. A ratio of less than 1 implies that the business does not earn enough profits to be able to pay capital and interest out of its earnings. If a business has a ratio of less than 1, there is a good chance of bankruptcy within the next few years if the business does not do something to improve its financial position.

The above ratios are used to give an indication of the financial health of a business. It is however important to remember that different industries have different norms and what is interpreted as a problematic ratio in one industry, can be perfectly acceptable in another industry.