1. ROCE of the previous year
2. ROCE being earned by other companies within the same industry if the information is available.
3. ROCE with the current market borrowing rates;

• What would be the cost of extra borrowing to the company if it needed more loans, and is it earning a ROCE that suggests that it could make profits to make such borrowing worthwhile?
• Is the company making a ROCE which suggests that it is getting value for money from its current borrowings?

b) Return on Equity. (ROE)

Measures again return on investment but targeting on ordinary shareholders. This ratio is specifically for shareholders and is aimed at measuring the return they should expect from their shares in the business.

C) Gross profit margin and Net profit percentage

These ratios are used to measure the financial performance of the business. The ratios show how aggressive the entity was in its sales promotion. For service sectors the gross profit margin will not be calculated as it is not involved in trading activities.

2. Liquidity ratios

The business should not only provide information on its profitability, but also to provide information that indicates whether or not the business will be able to pay its creditors, expenses, loans falling due at correct times. A company may be profitable but if it fails to generate enough cash to settle its liability is said to be insolvent.

Suppliers and providers of short term finance are interested in these ratios as are used in assessing the ability of the business to settle its current liabilities

a) Current Ratio

This compares assets which will become liquid within approximately twelve months with liabilities which will be due for payment in the same period and is intended to indicate whether there are sufficient short term assets to meet the short- term liabilities.

Recommended current ratio is 2: 1. Any ratio below indicates that the entity may face liquidity problem but also Ratio over 2: 1 as above indicates over trading, that is the entity is under utilising its current assets.

b) Acid test ratio

This shows that, provided creditors and debtors are paid at approximately the same time, a view might be made as to whether the business has sufficient liquid resources to meet its current liabilities.

A company in the service industry will not have inventories as such current ratio will not significantly be different from the current ratio. The calculation can be as:

This ratio should ideally be 1 for companies with a slow inventory turnover. For companies with a faster inventory turnover, a quick ratio can be less than 1 without suggesting that the company should be in cash flow trouble.

Both current and quick ratio offer an indication of the company’s liquidity position, but the absolute figures should not be interpreted too literally. It is often theorised that an acceptable figure should be 2:1 for current ratio and 1: 1 for quick ratio but these should only be used as a guide. Different businesses operate in very different ways. A supermarket group for example might have a current ratio of .5 and quick ratio of .17. Supermarkets have low receivables (as sales are usually made on credit), low cash, medium inventories (high inventories but quick turnover). While as in a manufacturing company these ratios may be regarded as showing solvency problems.

3. Asset management ratios

Management is required to maintain an optimum level of working Capital. Remember if an entity is having high inventory levels it will incur high storage costs, theft, insurance costs and stock losses. Like wise having low stock levels will disturb the production run of the company as it will regularly run out of inventories thereby loosing important business opportunities. The same can be said of receivables, having more receivable the company may run the risk of bad debts but also being too strict with debt repayment period may result in loss of customers.

The asset management ratios are also known as working capital ratios or the efficiency ratios. The aim is to measure how effectively the firm is managing its assets. These ratios are designed to answer this question: does the total amount of each type of asset as reported on the balance sheet seem reasonable, too high, or too low in view of current and projected sales levels? If the company has too many assets, its cost of capital will be too high hence its profit depressed. On the other hand, if asset are too low, profitable sales will be lost.

a) Inventory turnover ratio

The ratio is aimed at checking how vigorous the entity is trading. It measures approximately the number of times an entity is able to acquire the inventories and convert them into sales. A lengthening inventory turnover period from one accounting year to the next indicates:

1. A slow down in trading; or
2. A build in inventory levels, perhaps suggesting that the investment in inventories is becoming excessive.

The higher turnover ratio is good for the firm, but several aspects of inventory holding policy have to be balanced.

• Lead times
• Seasonal fluctuations in orders.
• Alternative use of warehouse space.
• Bulk discounts.
• Likelihood of inventory perishing or becoming obsolete.

b) Receivable day’s ratio

Another asset management ratio which is used estimates how long it takes for the credit customers to settle their balances. As outlined above it is very difficulty to establish the optimum level of receivables days, it will always depend with the nature of the business an enterprise is involved. For a Super store receivable days of 5 days will be considered as too long as it is supposed to operate on cash basis. While as in a Transport sector such receivable days will be considered as to mean to the customers and may result in loss of key employees. When setting the receivable days, an enterprise should also consider how long its major suppliers demand their payments. Failure to match receivable and payable days will result in failure to settle short term liabilities when they fall due.

Increase in receivable days may also indicate overtrading especially when the profit levels increases, together with receivable amounts but there is no improvement in collection of receivables.

The enterprise should always strive to be within the industrial averages because if they are too loose with their customers they run a risk of increasing the bad debtors levels.

The collection period for 2003 has improved as compared to 2002.i.e 91 days for 2003 as opposed to 122 days of 2003.
Some of the reasons for improvement may be:

a. Aggressive debt collection by the company.
b. Strict rules on credit transactions.
c. Offering cash discounts for early settlement.

c) Payable days ratio

Measures how long it takes for an entity to settle its creditors. The payable days should always be more than the receivable days. Remember the cash received from the customers will be used in settling the suppliers so it is imperative that the company should always ensure than they secure more payable days than the days they allow their customers.

Increase in payable days may indicate that the business is facing cash flow problems and will deter new and old suppliers from extending credit supplies to the business. On the other hand the business with short payable days indicates that it is not trusted by its suppliers. Usually if the payment record of the business has been bad suppliers will always insist cash purchases from the business.

In service industries the ratio is of little relevance than in trading organisations. The service industries purchase consumables which are not the core of their business unlike in trading activities where the performance is based on the level of purchases made.

Cash Cycle

The reason why a business needs liquid assets is so that it can meet its debts when they fall due. Payments are continually made for operating expenses and other costs, and so there is a cash cycle from trading activities of cash coming from sales and cash going out for the expenses. Cash cycle looks at the cash movements from the purchase of inventories up to when the customers settle their balances. So it is the flow of cash out of the business and back into it again as a result of normal trading operations. Cash goes out to pay suppliers, wages and salaries and other expenses, although payments can be delayed by taking some credit. A business might hold inventories for a while and then sell it. Cash will come back into the business from sales, although customers might delay payments by themselves taking some credit.

Management of liquid resources is closely connected to the management of working capital, and in particular the management of inventories, receivables and payables

The main points about the cash cycle are as follows:

1. The timing of cash flow in and out of a business does not coincide with the time when the sales and cost of sales occur. Cash flows can be postponed by taking credit. Cash flow can be delayed by having receivables.
2. The time between making a purchase and making a sale also affects cash flows. If the inventories are held for a long time, the delay between the cash payments of inventories and cash receipts from selling them will also be a long one.
3. Holding inventories and having receivables can therefore be seen as two reasons why cash receipts are delayed. If the business invests in working capital then its cash position will decrease.
4. Similarly, taking credit from suppliers can be a reason why cash payments are delayed. The business’s liquidity position will worsen when it has to pay the creditors, unless it can get more cash in from sales and receivables in the mean time.

A short working capital cycle indicates the business is well managing its working capital.

Suppose that a business buys goods for resale. It buys goods every day costing K10,000. Inventories are sold after 8 days, so that at any time, the business holds Inventories for seven days’ sales. All goods are sold on credit at a mark up of 20% on cost, and receivables are collected in 20 days. Suppliers are paid after five days.

The cash cycle and the net investment in working capital are as follows: (Remember it is inventory days plus receivable days less payable days)

As stated above a business should not over invest in working capital. The key point to note here is that a longer cash cycle ties up a bigger investment in working capital. It is therefore useful to monitor the length of cash cycle, and changes in it, to judge whether a business has an excessive working capital level or perhaps whether working capital is inadequate which may lead to liquidity problems.

4. Debt management ratios (Solvency ratios)

These ratios are also called the gearing ratios. These are mostly used by providers of finance to assess the finance risk of the business. A business with large proportional of debt capital to equity capital is said to be high geared.

Long-term solvency has to do with the business’s ability to survive for many years. The aim of long-term solvency analysis is to point out early that a business is on the road to bankruptcy. Declining profitability and liquidity ratios are key signs of possible business failure. As indicated earlier on, the ratios on their own carries less business meaning unless interpreted together with other non-financial indicators, such as loss of key suppliers, threatened litigation against the business, failure to settle liabilities and failure to adapt to new technologies.

Increasing amounts of debt in a business’s capital structure mean that the business is becoming heavily geared. This condition negatively affects long-term solvency because it represents increasing legal obligations to pay interest periodically and principal at maturity. Failure to make these payments can result in bankruptcy.

Business still require debt capital, in spite of its riskiness, debt is a flexible means of financing a certain business operation. Interest on debt is allowed for tax purpose as opposed to equity dividends paid. Debt capital avoids dilution of ownership for original members of the business as opposed to issuing of new shares. Also because debt usually carries a fixed interest charge, the cost of financing can be limited and the gearing can be used to advantage. If a business can earn a return on assets greater than the cost of debt (interest), it makes overall profit. However, it runs the risk of not earning a return on assets equal to the cost of financing those assets, thus incurring a loss.

The business with relatively high gearing ratios have a high expected return when the economy is normal as it debt offers a cheaper source of capital. When the economy goes into recession these businesses will be exposed to loss as the interest rates increases not matching with the expected return on business assets.

a) Debt equity ratio

Measures the direct proportion of debt to equity capital. A ratio over 100% indicates a highly geared company and any prudent lender will not be will to extend loan finance to such businesses. The equity holders will also be threatened as much of the profit earned during the year will have a bigger portion used in interest payments leaving less returned profit for the shareholders.

In our example which is included above the debt equity ratio can be calculated as;

The gearing level has improved in 2003 though minimal.

b) Total gearing ratio

This is calculated as the proportion of borrowed capital to total capital employed for the business. The purpose is the same as the debt equity ratio that is to measure financial risk of the business.

The gearing ratio of 2003 is better than for 2002.

c) Interest cover

If a business is highly geared it will be paying more interest. The ratio measures the ability of the business to pay interest to its lenders. Low interest cover is associated with high gearing. The interest cover ratio shows whether a company is earning enough profits before interest and tax to pay its interest cost comfortably, or whether its interest cost are high in relation to the size of its profit, so that a fall in PBIT would then have a significant effect on profits available for ordinary shareholders.

Year 2002 had a better interest cover than in year 2003.

5. Market value ratios

The market price of a company’s shares is of interest to the analyst because it represents what investors as a whole think of the company at a point in times. Market price is the price at which people are willing to buy or sell the shares. It provides information about how investors view the potential return and risk connected with owning the company’s shares. Market Price by itself however is not very informative for this purpose. Companies differ in number of outstanding shares and amount of underlying earnings and dividends. Thus, market price must be related to earnings by considering the price earning ratio and the dividend yield.

Investment ratios are concerned with the return on investment for shareholders, and with the relationship between return and the value of an investment in company’s shares.

a) Earnings Per Ratio. (EPS)

Earnings are profits for the year available to ordinary shareholders, which can either be paid out as dividends to the shareholders or retained in the business.

EPS measures the profit earned per share. The higher EPS will attract more investors to acquire shares in the company as it indicates that the business is more profitable enough to pay the dividends in time. But remember not all profit earned is going to be distributed as dividends the company also retains some profits for the business.

c) Price / Earnings ratio

This ratio measures the investors’ confidence in a company. The P/E ratio is useful in comparing the relative values placed on the earnings of different companies and in comparing the relative values placed on the earnings of different companies and in comparing the values placed on a company’s shares in relation to the overall market.

c) Dividend yield

This expresses dividend per share as a percentage of the current share price. Dividend yield is the return a shareholder is currently expecting on the shares of a company. It is calculated as follows

Shareholders look for both dividend yield and capital growth. Obviously dividend yield is therefore an important performance measurement tool for shares. The company need to balance the dividend pay out and the retained profit. A company with high dividend yield may be considered as risky as it may imply that the company is returning a huge portion of profit back to the shareholders as dividends leaving less profit which is an important internal source of funds.

d) Dividend Cover

It shows the proportion of profit on ordinary activities for the year that is available for distribution to shareholders has been paid or what proportion will be retained in the business to finance future growth. A dividend cover of 2 times would indicate that the company had paid 50% of its distributable profit as dividends, and retained 50% in the business to help to finance future operations. Retained profits are an important sources of funds for most companies, and so the dividend cover can in some cases be high.

Changes in dividend cover may have a signalling effect to the shareholders and prospective investors. For example, if a company’s dividend cover were to fall sharply between on year and the next, it could be that its profit has fallen, but the directors wished to pay at least the same amount of dividends as in previous year, so as to keep shareholders’ expectations satisfied.

High dividend cover indicates the company is making profits enough to sustain the payment of future dividends. The cover represents the ‘security’ for the ordinary shareholders.

Market and Economic Value

1. Market Value Added
   • The difference between the total amount of capital put into the business by finance providers and the current market value of stock and debts
2. Economic Value Added
   • The difference between the expected return on capital employed using the weighted costs of capital and the actual return made by the firm.