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Authors: Colin Barrow
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This is a measure of the proportion of profit taken up by interest payments and can be found by dividing the annual interest payment into the annual profit before interest, tax and dividend payments. The greater the number, the less vulnerable the company will be to any setback in profits, or rise in interest rates on variable loans. The smaller the number, the more risk that level of borrowing represents to the company. A figure of between 2 and 5 times would be considered acceptable.
Tests of growth
These are arrived at by comparing one year with another, usually for elements of the profit and loss account such as sales and profit. So, for example, if next year High Note achieved sales of $/£/â¬100,000 and operating profits of $/£/â¬16,000 the growth ratios would be 67 per cent, that is, $/£/â¬40,000 of extra sales as a proportion of the first yearâs sales of $/£/â¬60,000; and 84 per cent, that is, $/£/â¬7,300 of extra operating profit as a percentage of the first yearâs operating profit of $/£/â¬8,700.
Some additional information can be gleaned from these two ratios. In this example we can see that profits are growing faster than sales, which indicates a healthier trend than if the situation were reversed.
Market tests
This is the name given to stock market measures of performance. Four key ratios here are:
The after-tax profit made by a company divided by the number of ordinary shares it has issued.
The market price of an ordinary share divided by the earnings per share. The PE ratio expresses the market value placed on the expectation of future earnings, ie the number of years required to earn the price paid for the shares out of profits at the current rate.
The percentage return a shareholder gets on the âopportunityâ or current value of their investment.
The number of times the profit exceeds the dividend; the higher the ratio, the more retained profit to finance future growth.
Other ratios
There are a very large number of other ratios that businesses use for measuring aspects of their performance such as:
sales per £ invested in fixed assets â a measure of the use of those fixed assets;
sales per employee â showing if your headcount is exceeding your sales growth;
sales per manager, per support staff etc â showing the effectiveness of overhead spending.
Failure prediction
Unsurprisingly the financial crisis has inspired an interest in whether or not financial ratios can be used as indicators of business failure.
A study in 2012 by a research analyst from the FT Group, which was published in the International Research Journal of Finance and Economics , set out to identify appropriate analytical tools to predict factors that could lead to failure in good time for preventative measures to be taken. The study employed financial information for a group of 50 distressed and 50 non-distressed UK listed companies during the period 2000â2010.
The study looked at the three most popular failure prediction models and concluded that although the multiple discriminant analysis (MDA) model as used in Altmanâs Z-Score achieved a lower percentage of overall correct failure prediction (an average of 68.9 per cent all three years and 80 per cent for cumulative three years), it resulted in slightly higher overall percentage in the first year prior to failure.
The Altman Z-Score ( www.creditguru.com/CalcAltZ.shtml ) uses a combined set of five financial ratios derived from eight variables from a companyâs financial statements linked to some statistical techniques to predict a companyâs probability of failure. Entering the figures into the on-screen template at this website produces a score and an explanatory narrative giving a view on the businessâs financial strengths and weaknesses.
You can read up on the alternative ways to predict business failure in the article âPredicting Corporate Failure of
This is a measure of the proportion of profit taken up by interest payments and can be found by dividing the annual interest payment into the annual profit before interest, tax and dividend payments. The greater the number, the less vulnerable the company will be to any setback in profits, or rise in interest rates on variable loans. The smaller the number, the more risk that level of borrowing represents to the company. A figure of between 2 and 5 times would be considered acceptable.
Tests of growth
These are arrived at by comparing one year with another, usually for elements of the profit and loss account such as sales and profit. So, for example, if next year High Note achieved sales of $/£/â¬100,000 and operating profits of $/£/â¬16,000 the growth ratios would be 67 per cent, that is, $/£/â¬40,000 of extra sales as a proportion of the first yearâs sales of $/£/â¬60,000; and 84 per cent, that is, $/£/â¬7,300 of extra operating profit as a percentage of the first yearâs operating profit of $/£/â¬8,700.
Some additional information can be gleaned from these two ratios. In this example we can see that profits are growing faster than sales, which indicates a healthier trend than if the situation were reversed.
Market tests
This is the name given to stock market measures of performance. Four key ratios here are:
The after-tax profit made by a company divided by the number of ordinary shares it has issued.
The market price of an ordinary share divided by the earnings per share. The PE ratio expresses the market value placed on the expectation of future earnings, ie the number of years required to earn the price paid for the shares out of profits at the current rate.
The percentage return a shareholder gets on the âopportunityâ or current value of their investment.
The number of times the profit exceeds the dividend; the higher the ratio, the more retained profit to finance future growth.
Other ratios
There are a very large number of other ratios that businesses use for measuring aspects of their performance such as:
sales per £ invested in fixed assets â a measure of the use of those fixed assets;
sales per employee â showing if your headcount is exceeding your sales growth;
sales per manager, per support staff etc â showing the effectiveness of overhead spending.
Failure prediction
Unsurprisingly the financial crisis has inspired an interest in whether or not financial ratios can be used as indicators of business failure.
A study in 2012 by a research analyst from the FT Group, which was published in the International Research Journal of Finance and Economics , set out to identify appropriate analytical tools to predict factors that could lead to failure in good time for preventative measures to be taken. The study employed financial information for a group of 50 distressed and 50 non-distressed UK listed companies during the period 2000â2010.
The study looked at the three most popular failure prediction models and concluded that although the multiple discriminant analysis (MDA) model as used in Altmanâs Z-Score achieved a lower percentage of overall correct failure prediction (an average of 68.9 per cent all three years and 80 per cent for cumulative three years), it resulted in slightly higher overall percentage in the first year prior to failure.
The Altman Z-Score ( www.creditguru.com/CalcAltZ.shtml ) uses a combined set of five financial ratios derived from eight variables from a companyâs financial statements linked to some statistical techniques to predict a companyâs probability of failure. Entering the figures into the on-screen template at this website produces a score and an explanatory narrative giving a view on the businessâs financial strengths and weaknesses.
You can read up on the alternative ways to predict business failure in the article âPredicting Corporate Failure of
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