Financial Analysis and Ratios
Analysis
Financial Analysis and Ratios
Syllabus tag: KASNEB CPA | Intermediate Level | CA22 Financial Management | Topic 9 Financial Analysis and Ratios
Lesson objectives
By the end of this topic, you will be able to:
- Compute profitability, liquidity, efficiency, gearing and investor ratios
- Decompose ROE using the DuPont identity
- Interpret a ratio rather than merely calculate it
- State the limitations of ratio analysis
One set of accounts throughout
Every ratio below comes from the same company, so they can be read together.
| Income statement | KES |
|---|---|
| Sales | 4,800,000 |
| Cost of sales | (3,120,000) |
| Gross profit | 1,680,000 |
| Operating expenses | (960,000) |
| EBIT | 720,000 |
| Interest | (120,000) |
| Profit before tax | 600,000 |
| Tax | (180,000) |
| Profit after tax | 420,000 |
| Balance sheet | KES |
|---|---|
| Current assets (inventory 600,000) | 1,500,000 |
| Current liabilities | 750,000 |
| Equity | 2,400,000 |
| Long-term debt | 1,600,000 |
600,000 shares in issue, trading at KES 8.40.
Profitability
| Ratio | Working | Result |
|---|---|---|
| Gross margin | 1,680 / 4,800 | 35.0% |
| Operating margin | 720 / 4,800 | 15.0% |
| Net margin | 420 / 4,800 | 8.75% |
| ROCE | 720 / 4,000 | 18.0% |
| ROE | 420 / 2,400 | 17.5% |
ROCE uses EBIT, ROE uses profit after tax. That is not arbitrary. ROCE measures the return on all capital, so it must be taken before the returns to any provider of that capital are paid out. ROE measures what is left for shareholders, so it comes after both interest and tax.
Liquidity
| Ratio | Working | Result |
|---|---|---|
| Current ratio | 1,500 / 750 | 2.0 times |
| Quick ratio | 900 / 750 | 1.2 times |
Efficiency
| Ratio | Working | Result |
|---|---|---|
| Asset turnover | 4,800 / 4,000 | 1.2 times |
| Inventory turnover | 3,120 / 600 | 5.2 times |
Asset turnover asks how hard the capital works. Inventory turnover uses cost of sales, not sales, because inventory is carried at cost.
Gearing
| Ratio | Working | Result |
|---|---|---|
| Gearing | 1,600 / 4,000 | 40.0% |
| Interest cover | 720 / 120 | 6.0 times |
Investor ratios
| Ratio | Working | Result |
|---|---|---|
| EPS | 420,000 / 600,000 | KES 0.70 |
| P/E ratio | 8.40 / 0.70 | 12.0 |
A P/E of 12 says the market pays twelve shillings for each shilling of current earnings. High P/E usually signals expected growth — or an overvalued share. The ratio alone cannot tell you which.
The DuPont identity
ROE can be split into three drivers:
ROE = Net margin × Asset turnover × Equity multiplier
= 8.75% × 1.2 × (4,000 / 2,400) = 8.75% × 1.2 × 1.667 = 17.5%
which reconciles to the ROE computed directly.
This is the most useful analytical tool in the topic, because it says why ROE is what it is. Two companies can both report 17.5% ROE while one earns it through fat margins and the other through high turnover and heavy borrowing. The second is far more fragile, and only the decomposition reveals it.
:::checkpoint Company X has a net margin of 15%, asset turnover of 0.8 and an equity multiplier of 1.2. Company Y has a margin of 4%, turnover of 2.5 and a multiplier of 1.75. Compute both ROEs, then say which business you would rather own in a recession and why. :::
Interpreting rather than calculating
A ratio on its own means nothing. It needs a comparison: the same company over time, a competitor, or an industry benchmark. A gross margin of 35% is excellent for a supermarket and poor for a software firm.
Watch the direction of travel too. A current ratio rising from 2.0 to 3.5 sounds like improving health, but may mean inventory is not selling and receivables are not being collected. More is not always better.
Limitations
- Historic. The accounts describe a year that has ended.
- Accounting policies differ. Two companies using different depreciation or inventory methods are not directly comparable.
- Year-end distortion. Balance sheet figures are one day's snapshot, and a company can arrange that day to look good.
- No qualitative content. Ratios say nothing about management quality, staff, brand or the state of the order book.
- Inflation. Comparing figures across years without adjustment overstates growth.
:::checkpoint A company's inventory turnover falls from 8 times to 5 times while its gross margin is unchanged. Give two different explanations, one favourable and one unfavourable, and say what further information would let you distinguish them. :::