# Rationalising the Ratios

This is from the “Accounting Makes Cents” podcast episode #18 released on Monday, 25 July 2022.

In today’s episode, we are going to talk about financial ratios. Those numbers that we get from the financial statements and what do we really do about them. This is an important step, especially for those who are taking on CIMA case study exams. In general, pre-seen materials come with the financial statement of the pre-seen company and that should give you a fair bit of idea about the financial health of the company.

Aside from that, of course, for the students who are doing objective tests, ratios are a big part of the syllabus. F2 and P2 sometimes contain various ratios to be remembered and calculated to get a big picture view of the results of a company. So this episode also helps with that.

In general, there are 4 types of financial ratios that we normally encounter during our CIMA journey. These are your profitability ratios, efficiency ratios, liquidity and gearing ratios, and investor or stock market ratios.

I’ll try and give a bit more detail about each.

### Profitability ratios

Profitability ratios are a financial metrics used by the company to assess its ability to generate revenue, monitor operating costs, how it accumulates balance sheet assets, and improve shareholders’ equity over time, using a set data from a specific point in time. These profitability ratios are normally done on annual numbers. So your year-end numbers can be used to calculate these ratios.

Some key profitability ratios are your gross profit margin, net profit margin, operating profit margin, return on capital employed (ROCE). You’ll find that it looks at the performance of the company and how profitable it is based on the results it has achieved.

### Efficiency ratios

The next set of ratios is the efficiency ratio. The efficiency ratio is normally used to analyse how well a company uses its assets and liabilities to help it generate the revenue and income it wants to achieve. Sometimes this is also referred to as working capital ratios because they deal with the working capital of the company. The working capitals include your receivables, payables, inventory, etc.

Efficiency ratio can be calculated by looking at the turnover of receivables, the repayment of liabilities, the quantity and usage of equity, and the general use of inventory and assets. Some key efficiency ratios that can be calculated are receivables turnover ratio, payables turnover ratio, inventory turnover ratio, asset turnover ratios. You’ll find that they relate a lot to the turnover of the working capital and assets. It basically measures the time it takes for the company to generate cash or income from a receivable or from when you’ve sold inventory or goods.

These types of ratios are good to be calculated but normally give an even better picture when you can compare it with numbers from another company. You can also do it as a year-on-year kind of comparison to see whether you are doing better or not. The faster the turnover is, the better the results are, because that means you are turning your assets and making cash faster.

### Liquidity and gearing ratios

Our third set of ratios is the liquidity and gearing ratios. This, as the name would suggest, deals with assets and liabilities and loans of the company. It looks at how leveraged the company is and whether the assets that it has can keep up with the obligations it has taken on with regards to these loans.

Some key ratios that are under liquidity and gearing are your current ratio, which looks at current assets over current liabilities; quick ratio, a variation of the current ratio excluding the inventory amount; gearing ratio, which looks at how much debt you have versus equity.

Something to look at when we analyse liquidity of a company is to see how fast it can cycle cash. Cycle meaning when we use cash to buy inventory, pay our payables, collect our receivables and then it becomes cash. The faster we can cycle the cash, the better the liquidity is of the company.

Gearing ratios can also give signals as to problems and issues in the company. If the gearing ratio is high, this could signify that the company is too leveraged, owes a lot of money that it might not be able to repay back. Of course, this is not always 100% the case, but the higher the debt, the higher the repayments, and so we need to earn more to be able to service the loan, and so on.

### Investor or stock market ratios

Our last set of ratio in this episode looks at the investor ratios, or sometimes called the stock market ratios. These ratios are important because they show what the market thinks of the company. This is especially relevant when the company that we are referring to is a public or listed company.

Some of the key ratios in this category are your price/earning ratio, dividend cover, dividend yield, and other calculations. These look at the investment that a shareholder can make in the company and then, it also looks at the growth potential of that investment in that company.

### Finally

As mentioned previously, what is important to remember is that while it’s good and well to understand how to calculate ratios and what they mean, it is always better that when you make these calculations that they are made with a comparison in mind. The story that the numbers tell become more compelling, relevant and meaningful when compared against another company’s or another period.

## Show notes simplified

As accountants, the world expects us to deal with the number problems of the world. When we see numbers on a financial statement, it’s not just a math problem for us, but a story waiting to be told. In this episode, MJ the tutor talks about some of the financial ratios we perform and calculate (and what they mean) to get the story out of those financial statements.

Credits:
“Ding Ding Small Bell” (https://freesound.org/s/173932/) by JohnsonBrandEditing (https://www.youtube.com/channel/UC1RImxnsbfngagfXd_GWCDQ) licensed under CC0 Licence.