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There are two principal ratios used here。
Gearing
This measures as a percentage the proportion of all borrowing； including
long…term loans and bank overdra。。s； to the total of shareholders’ funds
– share capital and all reserves。 The gearing ratio is sometimes also known
as the debt/equity ratio。 For High Note this is： （4；908 ＋ 10；000） / 18；800 =
14；908/18；800 = 0。79 ： 1。 In other words； for every ￡1 the shareholders have
invested in High Note they have borrowed a further 79p。 This ratio is
usually not expected to exceed 1 ： 1 for long periods。
Interest cover
This is a measure of the proportion of profit taken up by interest payments
and can be found by dividing the annual interest payment into the annual
profit before interest； tax and dividend payments。 The greater the number；
the less vulnerable the pany will be to any setback in profits； or rise in
interest rates on variable loans。 The smaller the number； the more risk that
level of borrowing represents to the pany。 A figure of between 2 and 5
times would be considered acceptable。
Tests of growth
These are arrived at by paring one year with another； usually for elements
of the profit and loss account such as sales and profit。 So； for example；
if next year High Note achieved sales of ￡100；000 and operating profits of
￡16；000 the growth ratios would be 67 per cent； that is； ￡40；000 of extra sales
as a proportion of the first year’s sales of ￡60；000； and 84 per cent； that is；
￡7；300 of extra operating profit as a percentage of the first year’s operating
profit of ￡8；700。
Some additional information can be gleaned from these two ratios。 In
this example we can see that profits are growing faster than sales； which
indicates a healthier trend than if the situation were reversed。
46 The Thirty…Day MBA
Market tests
This is the name given to stock market measures of performance。 Four key
ratios here are：
Earnings per Share = Net Profit
Shares Outstanding
The a。。er…tax profit made by a pany divided by the number of ordinary
shares it has issued。
Price Earnings Ratio = Market Price per Share
Earnings per Share
The market price of an ordinary share divided by the earnings per share。
The PE ratio expresses the market value placed on the expectation of future
earnings； ie the number of years required to earn the price paid for the
shares out of profits at the current rate。
Yield = Dividends per Share
Price per Share
The percentage return a shareholder gets on the ‘opportunity’ or current
value of their investment。
Dividend Cover = Net Ine
Dividend
The number of times the profit exceeds the dividend； the higher the ratio；
the more retained profit to finance future growth。
Other ratios
There are a very large number of other ratios that businesses use for measuring
aspects of their performance such as：
。 sales per ￡ invested in fixed assets – a measure of the use of those fixed
assets；
。 sales per employee – showing if your headcount is exceeding your sales
growth；
。 sales per manager； per support staff etc – showing the effectiveness of
overhead spending。
Accounting 47
bined ratios
No one would use a single ratio to decide whether one vehicle was a be。。er
or worse buy than another。 MPG； MPH； annual depreciation percentage
and residual value proportion are just a handful of the ratios that would
need to be reviewed。 So it is with a business。 A bination of ratios can be
used to form an opinion on the financial state of affairs at any one time。
The best known of these bination ratios is the Altman Z…Score
（creditguru/CalcAltZ。shtml）； which uses a bined set of five
financial ratios derived from eight variables from a pany’s financial
statements linked to some statistical techniques to predict a pany’s
probability of failure。 Entering the figures into the on…screen template at
this website produces a score and an explanatory narrative giving a view
on the business’s financial strengths and weaknesses。
Some problems in using ratios
Finding the information to calculate business ratios is o。。en not the major
problem。 Being sure of what the ratios are really telling you almost always
is。 The most mon problems lie in the four following areas。
Which way is right？
There is natural feeling with financial ratios to think that high figures are
good ones； and an upward trend represents the right direction。 This theory
is； to some extent； encouraged by the personal feeling of wealth that having
a lot of cash engenders。
Unfortunately； there is no general rule on which way is right for financial
ratios。 In some cases a high figure is good； in others a low figure is best。
Indeed； there are even circumstances in which ratios of the same value are
Table 1。12 Difficult parisons
1 2
Current assets ￡ ￡ ￡ ￡
Stock 10；000 22；990
Debtors 13；000 100
Cash 100 23；100 10 23；100
Less current liabilities
Overdra。。 5；000 90
Creditors 1；690 6；690 6；600 6；690
Working capital 16；410 16；410
Current ratio 3。4 ： 1 3。4 ： 1
48 The Thirty…Day MBA
not as good as each other。 Look at the two working capital statements in
Table 1。12。
The amount of working capital in each example is the same； ￡16；410； as are
the current assets and current liabilities； at ￡23；100 and ￡6；690 respectively。
It follows that any ratio using these factors would also be the same。 For
example； the current ratios in these two examples are both identical； 3。4 ： 1；
but in the first case there is a reasonable chance that some cash will e in
from debtors； certainly enough to meet the modest creditor position。 In the
second example there is no possibility of useful amounts of cash ing
in from trading； with debtors at only ￡100； while creditors at the relatively
substantial figure of ￡6；600 will pose a real threat to financial stability。
So in this case the current ratios are identical； but the situations being
pared are not。 In fact； as a general rule； a higher working capital ratio
is regarded as a move in the wrong direction。 The more money a business
has tied up in working capital； the more difficult it is to make a satisfactory
return on capital employed； simply because the larger the denominator the
lower the return on capital employed。
In some cases the right direction is more obvious。 A high return on
capital employed is usually be。。er than a low one； but even this situation
can be a danger signal； warning that higher risks are being taken。 And not
all high profit ratios are good： sometimes a higher profit margin can lead
to reduced sales volume and so lead to a lower ROCE （return on capital
employed）。
In general； business performance as measured by ratios is best thought
of as lying within a range； liquidity （current ratio）； for example； staying
between 1。2 ： 1 and 1。8 ： 1。 A change in either direction represents a cause for
concern。
Accounting for inflation
Financial ratios all use pounds as the basis for parison： historical
pounds at that。 That would not be so bad if all these pounds were from the
same date in the past； but that is not so。 paring one year with one from
three or four years ago may not be very meaningful unless we account for
the change in value of the pound。
One way of overing this problem is to adjust for inflation； perhaps
using an index； such as that for consumer prices。 Such indices usually take
100 as their base at some time in the past； for example 2000。 Then an index
value for each subsequent year is produced showing the relative movement
in the item being indexed。
Apples and pears
There are particular problems in trying to pare one business’s ratios
with another。 A small new business can achieve quite startling sales growth
Accounting 49
ratios in the early months and years。 Expanding from ￡10；000 sales in the
first six months to ￡50；000 in the second would not be unusual。 To expect a
mature business to achieve the same growth would be unrealistic。 For Tesco
to grow from sales of ￡10 billion to ￡50 billion would imply wiping out
every other supermarket chain。 So some care must be taken to make sure
that like is being pared with like； and allowances made for differing
circumstances in the businesses being pared （or if the same business；
the trading/economic environment of the years being pared）。
It is also important to check that one business’s idea of an account
category； say current assets； is the same as the one you want to pare
it with。 The concepts and principles used to prepare accounts leave some
scope for differences。
Seasonal factors
Many of the ratios that we have looked at make use of information in the
balance sheet。 Balance sheets are prepared at one moment in time； and reflect
the position at that moment； they may not represent the average situation。
For example； seasonal factors can cause a business’s sales to be particularly
high once or twice a year； as with fashion retailers； for example。 A balance
sheet prepared just before one of these seasonal upturns might show very
high stocks； bought in specially to meet this demand。 Conversely； a look at
the balance sheet just a。。er the upturn might show very high cash and low
stocks。 If either of those stock figures were to be treated as an average it
would give a false picture。
GETTING PANY ACCOUNTS
It will be very useful to look at other parable businesses to see their
ratios as a yardstick against which to pare your own businesses
performance。 For publicly quoted and larger businesses whose accounts are
audited this should not be too difficult。 However； for smaller private panies
the position is not quite so simple。 In the first place； small panies；
that is； those with annual turnover below ￡5。6 million； a balance sheet total
below ￡2。8 million and employing fewer than 50 staff； need only file an
abbreviated balance sheet。 Even medium…sized businesses with turnover
up to ￡22。8 million can omit turnover from the information filed on their
financial performance。 Only public panies listed on a stock market and
larger panies have to provide full financial statements。
Despite the limitation； it is still possible to glean some valuable
information on financial performance using these sources：
。 panies House （wwwpanieshouse。gov。uk） is the official repository
of all pany information in the UK。 Their WebCHeck service
50 The Thirty…Day MBA
offers a free…of…charge searchable pany Names and Address Index；
covering 2 million panies； searchable by either the pany’s name
or its unique pany registration number。 You can use WebCHeck
to purchase a pany’s latest accounts giving details of sales； profits；
margins； directors； shareholders and bank borrowings at a cost of ￡1
per pany。
。 Credit reports such as those provided by ukdata；
checksure。biz； business…inc。uk cost around ￡8； are available
online and provide basic business performance ratios。
。 FAME （Financial Analysis Made Easy） is a powerful database that
contains information on 3。4 million panies in the UK and Ireland。
Typically the following information is included： contact information
including phone； e…mail and web addresses plus main and other trading
addresses； activity details； 29 profit and loss account and 63 balance
sheet items； cash flow and ratios； credit score and rating； security and
price information （listed panies only）； names of bankers； auditors；
previous auditors and advisers； details of holdings and subsidiaries
（including foreign holdings and subsidiaries）； names of current and
previous directors with home addresses and shareholder indicator；
heads of department； and shareholders。 You can pare each pany
with detailed financials with its peer group based on its activity codes；
and the so。。ware lets you search for panies that ply with your
own criteria； bining as many conditions as you like。 FAME is
available in business libraries and on CD from the publishers； who also
offer a free trial （bvdep/en/panyInformationHome。html
》 pany data … national 》 FAME）。
。 Keynote （keynote。uk） operates in 18 countries； providing
business ratios and trends for 140 industry sectors and sufficient information
to assess accurately the financial health of each industry
sector。 Using this service you can find out how profitable a business
sector is and how successful the main panies operating in each
sector are。 Executive summaries are free； but expect to pay between
￡250 and ￡500 for most reports。
。 London Stock Exchange’s website （londonstockexchange）。
。 Proshare （proshareclubs。uk 》 Research Centre 》 Performance
Tables） is an Investment Club website； which； once you have registered；
which you can do for free； has a number of tools that crunch public
pany ratios for you。 Select the panies you want to look at； then
the ratios you are most interested in： EPS； P/E； ROI； Dividend Yield and
so forth。 Press the bu。。on and in a couple of seconds all is revealed。 You
can then rank the panies by performance in more or less any way
you want。
。 Yahoo （h。。p：//uk。finance。yahoo 》 Free annual reports） has direct
links to several thousand public panies’ ‘Report and Accounts’
Accounting 51
online