Ratio Analysis

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Ratio Analysis
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• 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
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• Ratio Analysis
• Key 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

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

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

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• 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

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• Profitability Ratios
• Gross Profit Turnover Cost of Sales
• Gross Profit Ratio (Margin)
  x 100
• 
  

• 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.

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• Profitability Ratios
• Net Profit Gross Profit Expenses
• Net Profit Ratio (Margin)
  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.

- (Profit) Mark-up Ratio
x 100

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• 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

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Profitability Ratios Rate of
Return on Capital Employed Ratio

x 100
Generally the higher the ratio, the more
effective the firm is in using its capital
assets.
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• Return on Capital Employed
• Example
• 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

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Liquidity Ratios
Liquidity ratios ability of a business to meet
its debts

• Working Capital
• Current Ratio
• Acid Test ratio

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• 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 firms cash flow and its ultimate
  long term survival.
• More firms fail through cash flow problems than
  any other reason.

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• 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.

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• Liquidity Ratios
• The Current Ratio the proportion of assets to
  liabilities.
• A current ratio of 21 means the firm has
  sufficient liquid resources to cover its
  liabilities twice over
• A current ratio of 0.751 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.

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• 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 firms 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.

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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

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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

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Efficiency Ratios

• Efficiency ratios a measure of the performance
  of the business

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

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• Efficiency Ratios
• Expense Ratio x 100
• Rate of Stock Turnover ?
  Times
• Average Stock
  
• 
  

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.
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• Efficiency Ratios
• Debtors Collection Period
  x 365
• The answer is a number of days (or x 52 weeks,
  or x 12 months)
• 
  

• Creditors Payment Period
  x 365
• The answer is a number of days (or x 52 weeks,
  or x 12 months)

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

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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

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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

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Improving Ratios

• To improve Net Profit
• Reduce Expenses
• Increase Gross Profit
• Pay suppliers quicker in order to obtain Cash
  Discounts

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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