Business finance : theory and practice

Ratio analysis
Thus the price in 2007 reflected the future, rather than the 2007 profits, which were
used in the calculation of that year’s ratio. The increased profit led to an increase in the
dividend cover despite the raised dividend in 2008.
Generally we have a picture of a business that has significantly improved in most
aspects of its performance and position over the year. It was more profitable, which
led to strong cash flows (see the cash flow statement) and, therefore, to much better
liquidity and lower capital gearing.
Apart from the problems of ratio analysis, which we shall consider shortly, it must
be recognised that this analysis is very limited in its scope. We have considered only
two years’ figures. It would probably be much more instructive to have looked at
ratios stretching over a number of years. We have only used another period for the
same business as our basis of comparison. It would be at least as useful to compare
Jackson plc’s performance with that of other businesses in the industry; perhaps the
industry averages for the various ratios. Possibly best of all would be to compare
actual performance with the planned one. We know that the trade receivables settlement
period was shorter for Jackson plc in 2008 than it had been in 2007, but this is not
to say that this represented a satisfactory performance compared with the industry
average, or compared with the business’s budgeted trade receivables collection
period.
Other ratios
There is an almost limitless number of ratios that can be calculated from one set of
financial statements. Those that we have considered represent only a sample, though
they are what seem to be the more popular ratios used in practice. Certain ratios may
be particularly appropriate in certain types of business. Obviously an inventories
turnover period ratio is appropriate to a business that deals in goods in some way. To
a business offering a service, it would be inappropriate.
Ratios need not be derived exclusively from financial statements. The sales revenue
per employee ratio is widely used. Cost per tonne/mile (that is, the cost of transporting
a tonne of cargo for one mile) is widely used in the transport industry. Sales
revenue per square metre of selling area is widely used in the retail trade.
Caution in interpretation of ratios
It must be obvious from what we have seen so far that ratio analysis is not a very exact
science. The choice of the ratios that are calculated, the precise definition of these ratios
and the conclusions that are drawn are very much matters of judgement and conjecture.
Ratios tend to raise questions rather than answer them. Ratios can highlight areas
where this year’s performance was different from last year’s, or where one business’s
performance was different from that of other businesses in the industry. They will not
tell you whether this year’s performance was better than planned, whether it was better
than that of other years, or whether Business A is better than the rest.
It follows that it is not appropriate to be dogmatic in interpreting ratios. For example,
the trade receivables settlement period for Jackson plc was shorter for 2008 than it
was for 2007. This cannot automatically be interpreted as an improvement, however.
It might be that a lot of pressure has been put on credit customers to pay promptly and
that this has led to some loss of customer goodwill, which will, in due course, have an
adverse effect on the business’s profitability.
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