Accounting ratio analysis

Cue 1 Four ratio families as four dials on one dashboard.

AMARA 00:00 One ratio, thirty seconds, a business you know nothing about.

NADIA 00:04 Interest cover. Operating profit divided by interest payable. It answers whether the business earns enough to keep servicing its debt, and it is the first figure a lender turns to.

Cue 2 Same profit figure over two very different capital bases.

AMARA 00:16 The current ratio is taught as two to one.

NADIA 00:19 From a textbook decades old, and repeated because it sounds authoritative. A supermarket runs far below it and is entirely sound, because it takes cash at the till and turns stock over in days.

Cue 3 Supermarket versus manufacturer liquidity, side by side.

AMARA 00:33 So the figure is meaningless without sector.

NADIA 00:36 Without sector, and without a comparison. There are three worth making: this business last year, this business against its own budget, and this business against its sector. A ratio held up against a remembered rule of thumb is noise.

Cue 4 Window dressing timeline: payments held across the year end date.

AMARA 00:51 How far can these figures be arranged?

NADIA 00:54 Considerably, and mostly within the law. Year end is the thirty first of March. Hold supplier payments until the first of April and cash rises and the current ratio improves. Nothing underlying has changed; only which side of a date the payment landed.

Cue 5 Trend line across five periods beside a single flattering snapshot.

AMARA 01:11 What exposes it?

NADIA 01:12 A trend across several periods, and asking what moved in the fortnight either side of the date. A genuinely strong position looks strong continuously. An arranged one looks strong once a year.

AMARA 01:25 Return on capital employed. Why is it treated as the most complete profitability measure?

NADIA 01:31 Because it holds management to what they were given. Operating profit over the capital in the business. Two firms each earning a million tell you nothing until you know one used five million to do it and the other fifty.

Cue 1 Return on capital employed decomposed into margin times asset turnover.

AMARA 01:47 Return on capital employed has fallen. Where do I start?

NADIA 01:51 Decompose it. Return on capital employed is operating margin multiplied by asset turnover, and that identity is the most useful diagnostic in the whole set.

AMARA 02:01 What does it tell me?

Cue 2 Four movement patterns and the owner of each.

NADIA 02:03 Whether each sale made less money, or whether the same capital produced fewer sales. Those are completely different problems with different owners, and the single ratio hides which one you have.

AMARA 02:15 Margin down, turnover flat.

NADIA 02:17 Prices, input costs or overheads. That is a commercial and procurement conversation, and cutting capacity would make it worse.

Cue 3 Leased versus owned premises producing different capital employed for identical operations.

AMARA 02:24 And turnover down with margin flat?

NADIA 02:27 Underused capacity or falling demand. Operations and sales. Cutting prices there would destroy the one thing still working.

AMARA 02:34 Benchmarks. You said only three are defensible.

Cue 4 Trend line versus single point, and the argument the single point starts.

NADIA 02:37 This business last year, this business against its budget, this business against its sector. A remembered rule of thumb is not a benchmark, it is an opening position in an argument.

AMARA 02:49 What is the trap with sector comparison?

NADIA 02:52 Comparing unlike things. A firm that leases its premises and one that owns them show completely different capital employed for identical operations. Neither is better run. The accounting policy is doing the work, not the management.

Cue 5 Debtor days translated into pounds of cash outstanding.

AMARA 03:06 Last one. I present ratios monthly and nothing ever happens.

NADIA 03:10 Then you are presenting levels rather than movements. Say what changed, by how much, why, and what you want.

AMARA 03:18 And that is enough?

NADIA 03:19 Translate it too. Debtor days up nine days means nothing to an operations director. Forty thousand pounds of our cash sitting in other people's bank accounts gets you a decision before lunch.