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There are two principal ratios used here。 
Gearing 
This measures as a percentage the proportion of all borrowing; including 
long…term loans and bank overdra。。s; to the total of shareholders’ funds 
– share capital and all reserves。 The gearing ratio is sometimes also known 
as the debt/equity ratio。 For High Note this is: (4;908 + 10;000) / 18;800 = 
14;908/18;800 = 0。79 : 1。 In other words; for every £1 the shareholders have 
invested in High Note they have borrowed a further 79p。 This ratio is 
usually not expected to exceed 1 : 1 for long periods。 
Interest cover 
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 pany 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 pany。 A figure of between 2 and 5 
times would be considered acceptable。 
Tests of growth 
These are arrived at by paring 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 £100;000 and operating profits of 
£16;000 the growth ratios would be 67 per cent; that is; £40;000 of extra sales 
as a proportion of the first year’s sales of £60;000; and 84 per cent; that is; 
£7;300 of extra operating profit as a percentage of the first year’s operating 
profit of £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。
46 The Thirty…Day MBA 
Market tests 
This is the name given to stock market measures of performance。 Four key 
ratios here are: 
Earnings per Share = Net Profit 
Shares Outstanding 
The a。。er…tax profit made by a pany divided by the number of ordinary 
shares it has issued。 
Price Earnings Ratio = Market Price per Share 
Earnings per Share 
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。 
Yield = Dividends per Share 
Price per Share 
The percentage return a shareholder gets on the ‘opportunity’ or current 
value of their investment。 
Dividend Cover = Net Ine 
Dividend 
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 – a measure of the use of those fixed 
assets; 
。 sales per employee – showing if your headcount is exceeding your sales 
growth; 
。 sales per manager; per support staff etc – showing the effectiveness of 
overhead spending。
Accounting 47 
bined ratios 
No one would use a single ratio to decide whether one vehicle was a be。。er 
or worse buy than another。 MPG; MPH; annual depreciation percentage 
and residual value proportion are just a handful of the ratios that would 
need to be reviewed。 So it is with a business。 A bination of ratios can be 
used to form an opinion on the financial state of affairs at any one time。 
The best known of these bination ratios is the Altman Z…Score 
(creditguru/CalcAltZ。shtml); which uses a bined set of five 
financial ratios derived from eight variables from a pany’s financial 
statements linked to some statistical techniques to predict a pany’s 
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 business’s financial strengths and weaknesses。 
Some problems in using ratios 
Finding the information to calculate business ratios is o。。en not the major 
problem。 Being sure of what the ratios are really telling you almost always 
is。 The most mon problems lie in the four following areas。 
Which way is right? 
There is natural feeling with financial ratios to think that high figures are 
good ones; and an upward trend represents the right direction。 This theory 
is; to some extent; encouraged by the personal feeling of wealth that having 
a lot of cash engenders。 
Unfortunately; there is no general rule on which way is right for financial 
ratios。 In some cases a high figure is good; in others a low figure is best。 
Indeed; there are even circumstances in which ratios of the same value are 
Table 1。12 Difficult parisons 
1 2 
Current assets £ £ £ £ 
Stock 10;000 22;990 
Debtors 13;000 100 
Cash 100 23;100 10 23;100 
Less current liabilities 
Overdra。。 5;000 90 
Creditors 1;690 6;690 6;600 6;690 
Working capital 16;410 16;410 
Current ratio 3。4 : 1 3。4 : 1
48 The Thirty…Day MBA 
not as good as each other。 Look at the two working capital statements in 
Table 1。12。 
The amount of working capital in each example is the same; £16;410; as are 
the current assets and current liabilities; at £23;100 and £6;690 respectively。 
It follows that any ratio using these factors would also be the same。 For 
example; the current ratios in these two examples are both identical; 3。4 : 1; 
but in the first case there is a reasonable chance that some cash will e in 
from debtors; certainly enough to meet the modest creditor position。 In the 
second example there is no possibility of useful amounts of cash ing 
in from trading; with debtors at only £100; while creditors at the relatively 
substantial figure of £6;600 will pose a real threat to financial stability。 
So in this case the current ratios are identical; but the situations being 
pared are not。 In fact; as a general rule; a higher working capital ratio 
is regarded as a move in the wrong direction。 The more money a business 
has tied up in working capital; the more difficult it is to make a satisfactory 
return on capital employed; simply because the larger the denominator the 
lower the return on capital employed。 
In some cases the right direction is more obvious。 A high return on 
capital employed is usually be。。er than a low one; but even this situation 
can be a danger signal; warning that higher risks are being taken。 And not 
all high profit ratios are good: sometimes a higher profit margin can lead 
to reduced sales volume and so lead to a lower ROCE (return on capital 
employed)。 
In general; business performance as measured by ratios is best thought 
of as lying within a range; liquidity (current ratio); for example; staying 
between 1。2 : 1 and 1。8 : 1。 A change in either direction represents a cause for 
concern。 
Accounting for inflation 
Financial ratios all use pounds as the basis for parison: historical 
pounds at that。 That would not be so bad if all these pounds were from the 
same date in the past; but that is not so。 paring one year with one from 
three or four years ago may not be very meaningful unless we account for 
the change in value of the pound。 
One way of overing this problem is to adjust for inflation; perhaps 
using an index; such as that for consumer prices。 Such indices usually take 
100 as their base at some time in the past; for example 2000。 Then an index 
value for each subsequent year is produced showing the relative movement 
in the item being indexed。 
Apples and pears 
There are particular problems in trying to pare one business’s ratios 
with another。 A small new business can achieve quite startling sales growth 
Accounting 49 
ratios in the early months and years。 Expanding from £10;000 sales in the 
first six months to £50;000 in the second would not be unusual。 To expect a 
mature business to achieve the same growth would be unrealistic。 For Tesco 
to grow from sales of £10 billion to £50 billion would imply wiping out 
every other supermarket chain。 So some care must be taken to make sure 
that like is being pared with

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