Investment ratio

The shareholder or prospective investor will be very interested in the return he is obtaining from his purchase of shares in a business. This is calculated by dividend yield. This relates the income from shares, the dividend, to the value of the investment in the business. Consequently, the result can be compared with interest rates from other types of investment. Another factor, which would also be considered, would be any increase in share price as this represents a capital gain to the shareholder.

Capital structure ratio

The long-term finance of a business will be provided by its shareholders and long-term lenders.

Gearing ratio is an assessment of the extent to which a firm is financed by long-term loans. It is a very important ratio for prospective lenders as many like to

see the owners/shareholders providing at least half the overall capital of a business. They may not be prepared to lend if further lending would push the gearing ratio too high.

An important factor affecting lending decisions is the ability of a business to satisfactory meet its interest payments. If the gearing ratio is very high, a business will have large interest costs to meet out of its profits. Interest cover ratio indicates the level of cover, which the business has achieved.

If the gearing ratio becomes too high or if interest rates rise and the interest cover reduces, the business must look at ways to improve the situation. Two of the methods used are:

• to raise more shareholders' funds by issuing shares and perhaps using some of this cash to repay loans;

• selling fixed assets and using the proceeds to repay loans.

A particular interest group will be most concerned with specific aspects of the accounts and will therefore use the ratios relevant to those aspects (not all of these ratios would be used by everyone examining a set of accounts).

Case study 4. A bank manager has been asked to lend money to a small company. Explain which of the following ratios he would use first in examining the company accounts.

1. Return on capital employed.

2. Sales per employee.

3. Gearing ratio.

4. Net profit margin.

Case study 5. We must now have a look at the actual calculation of the ratios and start to see the way in which they can be interpreted. To do this we shall analyse the accounts of Newby Stores Ltd., from the viewpoint of John Slate as managing director.

Trading and profit and loss accounts for the year ended 31 December

		2000		2001
Sales		600		800
Closing stock	50		60
Add Purchases	430		600
	480		660
Less Closing stock	60		80
Cost of goods sold		420		580
Gross profit		180		220
Less Running expenses		100		140
Net profit before interest and tax		80		80
Less Interest		8		16
Profit before tax		72		64
Less Tax		30		41
		42		23
Less Dividends(10p per share)		2(15p per share)		3
Retained profit for the year		$40		$20