Ratio analysis

In one paragraph

Ratios put figures in proportion so you can compare a business with its own past and with others of a different size.

Profitability — gross and net margin, and return on capital employed (ROCE): operating profit ÷ capital employed. ROCE is the one investors care most about; it asks what the business earns on the money tied up in it.

Liquidity — can it pay its bills? Current ratio = current assets ÷ current liabilities. Acid test does the same excluding stock, because stock is the hardest current asset to turn into cash quickly.

Gearing — long-term debt as a proportion of capital employed. High gearing means more risk: interest must be paid whatever the year does.

Efficiency — inventory turnover, receivable days, payable days. These are where cash actually leaks in a small business, and they are the least examined.

Reading them properly

A ratio alone means nothing. It has meaning against three things: the same business over time, the industry, and the business's own circumstances. A current ratio of 1.2 is alarming for a manufacturer and normal for a supermarket that takes cash and pays suppliers later.

How to actually use it

• Start with receivable days: your invoices' average age. It is the fastest available cash improvement in most small firms and needs no investment.
• Track three or four ratios monthly, in trend. The direction is more informative than the level.

Where it breaks down

• Based on historic accounts, which may be months old and are prepared under choices — depreciation, stock valuation — that differ between firms.
• They show *what* has moved and never *why*. A ratio is the start of a question.

If you are being examined on it

Always interpret and compare. Calculating a current ratio and not saying whether it is good for this business earns the calculation mark only.

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