Ratio Analysis

Business Performance

Types of Information from the Accounts:

•Profit and Loss Account – the revenue and costs of a business over a time period

•Balance Sheet – the assets and liabilities of a business at a specific point in time

Use these sources to give ratios – the relationship between different aspects of

the business

Ratio Analysis

Liquidity Ratios

Profitability Ratios

Efficiency Ratios

A measure of the

performance of

the business

Ability of a business to

meet its debts

A measure of how much profit activities generate

Ratio AnalysisKey Categories

•Profitability ratios - a measure of how much profit its activities generate

•Liquidity ratios – ability of a business to meet its debts

•Efficiency ratios – a measure of the performance of the business

Profitability Ratios

• Gross Profit Ratio• Net Profit Ratio• Mark-Up Ratio• Return on Capital Employed Ratio (ROCE)

Profitability ratios - a measure of how much profit its activities

generate

Profitability Ratios

•Profit Ratios (Margin) – relates (compares) profit to turnover (sales revenue).

–In general the higher the profit margin the better

–A profit margin of 10% means that the firm makes 10p profit for every £1 of goods sold.

–Narrow margins – tend to be on products/services which are high volume, mass market products which are highly competitive

–Wide margins – tend to be on products/services that are low volume, high value with relatively high degree of monopoly power

Profitability Ratios

•Gross Profit: Turnover – Cost of Sales

–Gross Profit Ratio (Margin) = x 100

Gross Profit

Turnover

•This represents the amount of Gross Profit for every £100 of sales.

•10% means that for every £100 of sales, £10 gross profit (trading profit) was made before any expenses were paid.

Profitability Ratios

•Net Profit: Gross Profit – Expenses

–Net Profit Ratio (Margin) = x 100

Turnover

Net Profit

Gross Profit

Cost of Sales- (Profit) Mark-up Ratio = x 100

•The % of Net Profit on Turnover shows how much PERSONAL income the owner has out of every £100 of sales.

•If the Net Profit % increases while the Gross Profit % remains the same – this indicates a reduction in expenses.

Profitability Ratios

•Return on Capital Employed Ratio (ROCE)

–A measure of the efficiency of the firm in using its capital to generate profit.

–A ROCE of 15% suggests that the firm uses every £1 of capital to generate profits of 15p

Profitability Ratios

Rate of Return on Capital Employed Ratio =

x 100

Net Profit after Tax

Fixed Assets + Net Current Assets – Long Term Liabilities

Generally – the higher the ratio, the more effective the firm is in using its capital assets.

Return on Capital EmployedExample:

•Assume two firms produce identical products and have identical capital structures:

–Firm A – Capital Assets = £1,000,000.

Profit = £250,000

–Firm B – Capital Assets = £1,000,000.

Profit = £100,000

•Easy to see in this instance that firm A is the more efficient as every £1 of capital generates 25p in profit whereas for Firm B, every £1 of capital only generates 10p profit

•ROCE allows us to have a measure of the efficiency for firms with different capital structures

Liquidity Ratios

• Working Capital• Current Ratio• Acid Test ratio

Liquidity ratios – ability of a business to meet its debts

Liquidity Ratios–Looks at the ability of a firm to meet its expenditure and how much cash is tied up in the business available to pay for that expenditure.

–Careful management of income and expenditure is important to a firm’s cash flow and its ultimate long term survival.

•More firms fail through cash flow problems than any other reason.

Liquidity Ratios

•Working Capital – having sufficient funds at the right time to be able to meet liabilities

–Working capital management is crucial to the success of a firm

Working capital = the difference between current assets and current liabilities.

Liquidity Ratios

•The Current Ratio – the proportion of assets to liabilities.

–A current ratio of 2:1 means the firm has sufficient liquid resources to cover its liabilities twice over

–A current ratio of 0.75:1 would suggest that the firm is unable to meet its liabilities and could be in a weak financial position.

•A ratio below 1 does not mean the firm will collapse but it will be in a vulnerable position.

Liquidity Ratios

•Acid Test Ratio =

(Current Assets - Stocks) : Current Liabilities

The Acid Test Ratio gives an indication whether a firm can meet its liabilities without having to dispose of its stocks. It gives a clear and quick indication of the state of the firm’s liquid assets (those easy to turn into cash).

Comparing the Current ratio and the Acid Test ratio therefore gives an indication of the relative size of the stock holdings of a firm.

To improve the Liquidity Position

• Sell stock faster – this will reduce stock holding and increase cash/bank

• Reduce credit time allowed to debtors – debtors will pay quicker thus increasing cash

• Offer discounts to debtors – to encourage them to pay more quickly thus increasing cash

• Buy more goods on credit instead of paying by cash – this will increase cash held

To improve the Liquidity Position

• Inject more capital into the business – this will increase cash held

• Find cheaper suppliers – this will result in less cash going out

• Reduce drawings – this will result in less cash going out

• Sell fixed assets – this will increase the cash coming into the business

Efficiency Ratios

• Expense Ratio• Rate of Stock Turnover• Average Stock• Debtors’ Collection Period• Creditors’ Payment Period• Fixed Asset Turnover

•Efficiency ratios – a measure of the performance of the business

Expenses

Turnover

Average Stock

Cost of Sales

Efficiency Ratios•Expense Ratio = x 100

•Rate of Stock Turnover = = ? Times

•Average Stock = = £

Opening Stock + Closing Stock

2

NB – The Rate of Stock Turnover may be expressed as an average stockholding in days, weeks or months simply by multiplying the number of times the average stock is sold by 365 for answer in days, 52 for answer in weeks and 12 for answer in months.

Efficiency Ratios•Debtors’ Collection Period = x 365

The answer is a number of days (or x 52 = weeks, or x 12 = months)

Average Debtors

Total Credit Sales

Average Creditors

Total Credit Purchases

NB – Where only one figure is given for debtors or creditors this will be taken as the average.

•Creditors’ Payment Period = x 365

The answer is a number of days (or x 52 = weeks, or x 12 = months)

Efficiency Ratios•Fixed Asset Turnover =

The answer should be expressed as a ratio eg 0.75 : 1

Net Turnover

Fixed Assets at Net Book Value

Ratio Analysis

•Limitations of Ratio Analysis:–Usefulness dependent on the accuracy of the figures

–Only a part of the jig-saw – needs other information to make full judgement

–What has happened in the past is not necessarily a pointer to what will happen in the future!

–Statistics always have a limitation in that it depends when they are used and how they are used.

–No two businesses are fully comparable as the differences between them will always influence the performance of the business

–Ratios do not always reflect the degree of ‘intuition’/’genius’ that may influence the performance of a business

Importance of Ratios

• To have real significance, ratios have to be compared to a yardstick to determine whether it is good or bad.

• This yardstick is provided by comparison to previous years or to competitors ratios

Improving Ratios

• To improve Gross Profit %– Reduce Cost of Sales – change to a

cheaper supplier– Cut down on wastage/theft– Increase selling price of goods

Improving Ratios

• To improve Net Profit %– Reduce Expenses– Increase Gross Profit– Pay suppliers quicker in order to

obtain Cash Discounts

Improving Ratios

• To improve Rate of Stock Turnover– Attract more customers by

advertising/sales promotions or offering discounts – this should move stock quicker

– Lower the amount of stock you hold