RATIO ANALYSIS

Financial ratio shows the relationships between two or more financial data in a financial statement; it may be
expressed as a percentage or fraction of another figure or group of figures in the same financial statement.

It is generally a way of concisely showing the relationship between two variables.

To be useful, a calculated ratio needs be compared with other ratios. The following are the popular types of
comparisons:

➢ Trend Analysis: This involves comparing the computed ratios for the current period with past periods
ratios for the same enterprise. This will enable the analyst determine whether there has been an
improvement or a decline in the financial condition and performance over time (i.e trend of
performance over time).

➢ Cross Sectional Analysis: (i.e based on the performance of a similar business. This involves comparing
the computed ratios of an entity with ratios of another entity in the same line of business (preferably of
the same size). This will provide an insight into the relative condition and performance of the business.

➢ Comparison with industry averages: This involves comparing the computed ratios of an entity with the
average ratios obtained in the industry or sector. It also provides information on its relative
performance and financial condition.

➢ Pro-forma analysis:(i.e based on planned or expected performance): this involves comparing the
computed ratios of an entity with the ratios calculated based on budgeted information or activities

USES OF FINANCIAL RATIO

The information needs of accounting information users are not usually the same. This will depend largely on
the type of users and the purpose for which the information is needed. However, the various needs for which
accounting information analyses are needed are

1. Market valuation: Financial ratios such as EPS, P/E and earnings yield will assist in determining the
market value of a company. Market value = EPS x P/E.

2. Risk analysis: Financial ratios (through the gearing) will assist to measure the financial risk of an entity.

3. Profitability performance: Financial ratios will be used to measure the profitability performance of an
entity through the use of profit margin, return on capital employed, etc.

4. Liquidity: It helps to determine the ability of the firm to meet its current obligations as at when due.

5. Comparative Analysis: Financial ratios will facilitate inter-firm and intra-firm comparison.

6. Assets Utilization: Financial ratios will assist to assess how efficient an entity is in the use of its assets
to generate revenue.

7. Trend Analysis: Financial ratios will assist to identify pattern of a firm’s performance behavior and
financial position. That is, to know whether an entity’s performance is improving or declining.

8. Actual return on investments: Financial ratios (through the dividend yield) will assist to measure the
actual return on shareholders investments.
 LIMITATION OF FINANCIAL RATIO

1. Accounting policies: Financial ratios may not adequately and effectively measure the financial
performance between two or more entities if the entities operate under different accounting policies.

2. Manipulation of financial statements: Management may manipulate the financial statements so as to

achieve a desired objective and financial ratios based on such information will be misleading.

3. Business size: Financial ratios may not adequately and effectively measure the financial performance
between two or more entities if the entities are not of the same business.

4. Inflation: The non consideration of the impact of price changes (i.e inflation) in the preparation of
financial statements affects the accuracy and reliability of the results or financial decisions based on
financial ratio size.

5. Generally accepted formular: There is no standard and generally acceptable single formula for the
expression of some key ratios such as return on capital employed, profit margin, etc.

6. Isolation: Financial ratios are not really meaningful when used on isolation. For ratios to have
meaningful impact, it will be compared with another ratio or an established threshold.

7. Skill requirement: The use of financial ratios to analyse the financial performance of an entity over
time or performance between entities requires technical and accounting skills.

8. Inadequacy of Information: Information in the annual report and accounts may be inadequate to
enable detailed analysis.

CLASSIFICATION OF FINANCIAL RATIOS

1. Profitability Ratios: This provides an insight to the degree of success in achieving this primary
objective. They are ratios that express profit earned in relation to other key figures in the financial
statements. The following are the common examples of profitability ratios:

2. Gross profit margin: This ratio measures the gross profit of the business to the revenue generated in
the same period.

Gross profit margin = Gross profit X 100%

Revenue

3. Operating profit margin: This is also known as profit margin. This ratio measures the gross profit of the
business to the revenue generated in the same period.

Profit margin = Operating profit X 100% NB: Operating profit = Profit before interest and Tax (PBIT)
Revenue

3. Return on Assets (ROA):. This ratio measures the company’s profitability from assets utilization. i.e It
measures the efficiency of the business in effectively using its assets to generate net income.

ROA = Profit after tax X 100%

 Total assets / Average total assets

4.. Return on Capital Employed (ROCE): This is a fundamental measure of business performance. It measures
the company efficiency of using capital invested to generate profit.

ROCE = Profit before interest and Tax X 100%

Capital Employed

Capital Employed (NB: Total assets – currents liabilities or Share capital + Reserves +Long term Liab. loans)

Return on Equity (ROE): This is also known as return on shareholder equity (ROSE). It measures the company
efficiency of using capital invested by the equity holders to generate profit.

Return on Equity = Profit after Tax X 100%

Shareholder's equity (Share capital + Reserves)

EFFICIENCY RATIOS
These are ratios that measure the efficiency of an entity in utilization of their resources within the business.

1. Inventory Turnover: This ratio measures how often the business turns its inventory into sales. It measures
how rapid with which business is able to turn its inventory into sales.

Inventory turnover = Cost of sales X 100% NB: It is expressed in Number of times

Average inventory

2. Inventory holding period: This ratio measures the average period or length of time in which inventory is
held before it is used or sold.

Inventory holding period = Average inventory X 365days

Cost of sales

3. Trade receivables collection period: This ratio measures estimated times it takes on average to collect the
payment customers after the sales has been made. . The shorter the period, the better for the business.

Receivables collection period = Average Trade receivables X 365days

Credit Sales

4. Trade payables payment period: This ratio measures estimated times it takes on average to settle the
suppliers after the buying goods on credit. The longer the period, the better for the business.
Payables payment period = Average Trade payables X 365days

Credit Purchases

5. Assets turnover ratio: The asset turnover ratio measures how effectively did the entity utilize its assets to
generate sales for the period.

Formular = Sales Revenue X 365days = Answer in number of times

Capital employed

LIQUIDITY RATIOS
These are ratios that measures the ability of an entity to meet its short- term obligations.

1. Current ratio: This ratio measures the ability of the business to meet its short -term obligations using its
current asset.

Current ratio = Current assets = 2:1

Current liabilities

2. Quick or acid test ratio: This ratio measures the ability of the business to meet its short- term obligations
quickly.

Quick ratio = Current assets – Inventory = 1:1

Current liabilities

LONG TERM SOLVENCY OR DEBT RATIOS

These are ratios that assess whether the total debts of the entity are within control and are not excessive.

1. Gearing ratio: This ratio measures the total long -term debt of a company as a percentage of either

a. The equity capital

b. Total capital of the company

Debt to equity ratio = Long term Debt

Share capital + Reserves

Gearing Ratio = Long term Debt

Share capital + Reserves + Long term Debts

2. Total Debts Ratio: This measures the proportion of business assets that is financed with debts taking into
consideration of unsecured creditors in the events of liquidation.

Total Debt x 100%

Total Assets

3.Interest Cover ratio: This ratio measures how many times the entity operating profit can settle the interest
expense.

Interest Cover = Profit before interest and tax (Operating profit)

Interest charges / Finance cost

NB: Interest cover is expressed in number of terms

INVESTORS RATIOS
These are ratios that are of interest to the investors of the business (Equity Shareholders and Debt holders)

1. Earnings Per Share (EPS): EPS measures the profit available to the ordinary shareholder for each equity
share of the entity.

EPS = Profit after tax attributable to ordinary shareholders less Preference dividend X 100%

Weighted average number of shares in issue during the period

NB: EPS is expressed in Naira and Kobo or Kobo only

2. Dividend Per share: This measures the total current period dividend attributable to a unit of ordinary shares
in issue

DPS = Ordinary share dividend x 100%

Total number of shares

NB: DPS is expressed in Naira and Kobo or Kobo only

3. Dividend Yield: This measures the measures the dividend paid by an entity in relations to current market
price of the entity’s shares.
Dividend Yield = Dividend per share x 100%

Current market price per share

NB: DY is expressed in percentage.

4. Earning Yield: This measures the measures the earnings available to the ordinary shareholders in relations
to current market price of the entity’s shares.

Earning Yield = Earnings per share x 100%

Current market price per share

NB: EY is expressed in percentage (Very similar to dividend yield)

5. Price earnings ratio (P/E ratio): This ratio measures how expensive or cheap a share is in relation to its
annual earnings.

PE ratio = Market price per share

Earnings per share

NB: PE Ratio is expressed in number of times

6. Dividend Cover: This measures the number of times that an entity’s dividends are covered by profits.

Dividend Cover = Earnings per share / Dividend per share

NB: Dividend cover is expressed in number of times