Past performance is the best predictor of success – Jim Simons (Ratio Analysis).

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The key to a successful investment is a successful analysis of past performance.

Financial statements of a business give the most reliable insights into past performance.
Financial statements are past performance information and data for measuring solvency, profitability, efficiency, capital structure and yields/earnings of a business.

You should be most interested in knowing if the profitability would be sustained and if the investment would continue to give the most yields comparatively.

Then turn your focus to profitability ratios of return on capital employed and return on share capital. Also focus on shareholder ratios of earnings per share and price earning ratio.

Profitability ratios:

  1. Return on capital employed (ROCE) is given by the equation:

Profit before interest and tax/total assets – current liabilities

2. Return on share capital (ROSC) is;

Profit before tax/Share capital + Reserves

Shareholder ratios:

  1. Earnings per share (EPS) is;

Net profit or loss attributable to ordinary shareholders/weighted average number of ordinary shareholders during the period

2. Price earnings (P/E) ratio is;

Market price/Earnings per share

How useful are these indicators?

  1. Return On Capital Employed (ROCE) is a good standard measure of a business’s performance. It’s very useful when comparing businesses within the same industry.

A higher ROCE is interpreted to mean that a higher percentage of the value of a business could be returned as profit to stakeholders. An ROCE of twice at least the current interest rates indicate a business’s efficient use of capital.

2. Return On Share Capital (ROSC): The higher the ROSC, the more profitably the shareholders; investment in the business has been used.

ROSC is often used to compare performance between accounting periods rather than compare ROSC’s of companies in the same industry.

3. Earnings Per Share (EPS) is the most frequently used. The reason is, it’s believed to give the best view of performance. EPS shows how much of a business’s profit can be attributed to each ordinary share in the company.

A higher EPS indicates greater value (a higher profit relative to share price).

4. Profits Earning (P/E) ratio is a useful indicator of how the stock market judges the performance of a business. It’s used by potential investors to approximate the expected future earnings of a company and consequently, decide whether to invest or not.

A higher P/E ratio shows the willingness of investors to pay a higher share price out of the expectations of future growth.

No performance evaluation ratio should be used in isolation of others. They should be combined in order to improve the accuracy of inferences drawn.

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