Ratio analysis of financial statements

The financial statements of limited company accounts are read by a wide variety of users.

These include business owners looking to see how much money the company is making, to employees wondering how secure their employment is, to suppliers wondering if they should offer more credit to the company.

One of the tools available to assess the performance and position of a company is ratio analysis.  It is vital for anyone wanting to gain meaningful analysis of the company that they know, not just how to calculate the ratios, but also what the ratios show.

One of the first things people will ask when looking at a company, is “is this company profitable?”  Two of the key ratios to look at when ascertaining profitability are the gross profit margin and operating profit margin.

Gross profit is the revenue figure less the cost directly attributable to making that sale, usually materials and production labour. The gross profit margin is the gross profit divided by the revenue figure, expressed as a percentage, so if a company has revenue of £120,000, and gross profit of £90,000, the gross profit margin is £75% (£120,000/£90,000).

The shows how much gross profit a company should expect to make per pound of revenue. The only thing which can affect the gross profit margin, is if the sales price per unit changes, or the cost per unit changes.  All things being equal, the gross profit margin should stay the same at all levels or production.

However, in reality as sales volume goes up, the company is able to negotiate better trade discounts, so the material per unit costs less, therefore the gross margin improves.

The operating profit margin is similar to the gross profit margin, this shows how much operating profit you are getting as a percentage of the sales figure, so this is operating profit divided by revenue.

Operating profit is the gross profit after the deduction of the overhead costs. So this is a good measure of how well a company is controlling its overhead costs, such as administration.

However, one of the key points of ratio analysis, is that no ratio should be taken in isolation. A company might have a high operating margin, but compared to its competitors it might actually be worse at controlling its overheads, but it just happens to have a really high gross profit margin which feeds directly down into operating profit.

We have looked at two ratios which show company performance, but users of financial statements will also want to investigate risk. Employees might want to know how secure their job is, or potential investors might want to know how safe any potential investment will be. Two key measures of risk are gearing and interest cover.

Interest cover is calculated as operating profit divided by interest, so if a company has operating profit of £270,000 and an interest charge of £30,000, interest cover is 9 (£270,000/£30,000), which generally is quite a high interest cover.

It could be the case that a company is highly geared, however, if it is very profitable it might be able to easily pay its interest, so even if profits fell it should be able to pay its interest. Whereas a company may have low gearing, but if it has low operating profits in comparison to the interest charge, it might find that profits don’t have to fall much before it starts to have difficulty paying its interest payments.

Of course, there are many more ratios you would look at, and other nonfinancial factors you would take into account when analysing a company.

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Gareth John is a qualified chartered accountant and tutor at First Intuition.