Uses of ratios

When assessing the performance of a business, we will normally use the

financial data to make this assessment. Profits are the main yardstick use to
assess whether a firm has performed well or poorly. However, profits alone will
not tell us too much.

For example, if a firm earned a profit in one year of £15,000, could we tell if the
firm had performed well? Actually, we would probably need to know much more
about the firm and the industry it operated in, as well as the prevailing economic
and other external factors that affected the firm.

Before we even begin to look at how assessment is performed, we should first of

all consider how we are going to use the data. One year's worth of information is
not normally enough. We will need some other standard to measure our data
against. The following basis of comparison are often used when assessing
performance
Past performance
Comparison of present performance with previous year's performance will tell us
a lot about the direction the firm is moving in - is it improving worsening or
maintaining performance levels compared with earlier years? Ideally a number of
previous year's data can be used to establish a trend performance (the overall
direction after taking into account minor fluctuations, although two years of
figures may shed some light on which way the firm is moving).
Industry analysis
Comparing one firm's performance with another is a meaningless activity unless
the firms are similar. It would be no use comparing a giant multinational with a
small butcher for instance. Comparison of firm operating in the same industry
will give us much more meaningful information about how a firm is performing
compared with rival competitions. This will be even more meaningful the firms
are of similar size (measured in either turnover or capital employed). Industry
analysis also allows us to see how firms are coping with changes in external
factors that affect them in a similar way. For example, analysing how football
clubs have coped with the collapse of ITV digital, or how mobile phone
companies are coping with the slow take up of third generation phones.

Ideally, we could combine the analysis of past performance and industry analysis
to see how the industry as a whole has performed over a number of years. This
will provide valuable information to see which firms are struggling and which
firms are managing to perform well in the circumstances. For example, if profits
have been rising over a number of years then this may seem an indicator of
good performance. However if other firms have seen profits rise even more
quickly, them the good performance would have to be called into question.

Ratio analysis
Assessing the performance of a business requires us to be very clear in actually
defining what we are trying to assess. In most cases, profits are seen as the
main objective of any firm. However, there are many other areas of a firm that,
although not directly affecting profit, will have an indirect affect of the
profitability of the firm.

To assess the performance of the firm profits alone cannot tell us much
information. We need some standard to assess items, such as profits, sales and
so on. Ratio analysis is the combination of figures from the financial statements
of the firm (profit and loss accounts and balance sheets) into a format where
judgements can be made on the overall performance of the firm. For example,
comparing profits to sales or profits to capital will allow us to see how effective
the firm is in generating profits out of sales. Alternatively, comparing profits to
capital gives us some idea of profits in relation to the size of the firm. A ratio is
simply two or more figures compared with each other to produce an overall
result, which is more meaningful than the original figures alone.

Ratios require formulas to be memorised. There are a number of different ratios

that can be used to assess different areas of the firm. Ratios are therefore
grouped according to type, or area.

Profitability ratios
These ratios focus specifically on the profits of the firm (both gross and net
profits). The profits are compared with sales, capital to provide some standard
for comparison. These ratios in this group are as follows:

Return on capital employed

Gross profit margin (gross profit in relation to sales)
Net profit margin (net profit in relation to sales)
Mark-up

Liquidity
Liquidity is a measurement of whether the firm has enough cash available for
immediate use. These ratios focus on the ability of the firm to meet day-to-day
running requirements. They look at the liquid resources (resources easily
convertible to cash) and compare these with the short-term debts of the firm
that will require payment in the next few weeks or months. Many small or new
firms find liquidity to be one of their greatest problems. The ratios used to
assess liquidity are as follows:

Current ratio (net current asset ratio)

Acid test ratio (liquid capital ratio)

Liquidity ratios are sometimes known as solvency ratios

Ways to improve liquidity if current ratio is less than 2: 1
If the working capital ratio is below the benchmark level 2:1 this means that the firm is not
in the safe side and might face problems is meeting its liabilities as they fall due. The firm
might need to take quick and immediate actions to rectify the situation or face the threat of
going out of business. The business can improve the liquidity in the following ways:

a) Sell of surplus fixed assets: a firm can improve its liquidity by selling off surplus fixed assets
and raise additional cash to solve the cash flow problems. However selling of fixed assets
might result in inefficiency.
b) Convert bank over draft into long term loans: converting overdrafts into loan might be a
good option for a firm facing liquidity problems as the obligation of payment will be delayed.
Furthermore profitability will also improve as interest rate for loan is usually lower than that
of an overdraft.
c) Making debtors pay early: a firm can also try to persuade debtors pay early and settle the
creditors as they fall due.
d) Delaying payments to creditors: delaying payment might be short term measure to resolve
the ongoing working capital problems. However this might result in creditors refusing to
supply goods resulting in stock outs and loss of sales.
e) Reduce bad debts: a firm can try to reduce bad debts by checking on the customer
references before providing credit. This will help them cut down on the bad debts and
achieve profits and safer liquidity position.

Ways to improve liquidity if current ratio is more than 2: 1

If the working capital ratio is more than the ideal position of 2:1 it signifies that the firm has more
than necessary assets which are lying idle and optimum return from those assets is not being
earned. Having a more than 2:1 ratio means that the firm is not being able to utilise the potential
and should do more investments to improve profitability as well as liquidity. Some of the ways in
which a firm can do so are:

a. Invest in more profitable ventures: having a high current ratio means that the business has
surplus assets and can be used in other profitable ventures and boost profitability and
liquidity of the business as well.
b. Repay any loans: the business can also get the situation under control by repaying any loans
early and save itself from excessive interest payments.
c. Delay payments to creditors: the firm can also try to delay the payments to creditors and
invest in other areas which will bring in higher returns.
d. Purchase fixed assets: buying fixed assets which will reduce the operating expenses might
be an appropriate way to utilise the excess assets available and also boost profitability
through falling expenses.
 Ways to improve gross profit margin:
If the gross profit margin is low this means that the firm is not being able to charge the
amount of prices it should be charging or the cost of product is high. The following measures
can be used to improve gross profit margin:
a. Better ordering techniques: a firm can undertake an efficient ordering technique to
minimise the cost of carriage and reduce the cost of goods.
b. Bulk buying: buying in bulk always leads to huge trade discounts and favourable terms
which can crucial for a firm looking for ways to improve its gross profit margin.
c. Trade discounts: the business can offer trade discounts to encourage sales in bigger
quantities and thus help to increase the gross profit.
d. Newer, fashionable stocks: the firm can also provide goods which are fashionable and
the customers would be willing to pay more for the stocks. This is more applicable to
firms dealing in fashionable items such as women wear, shoes etc.
e. Better payment terms with the suppliers: the firm can also try to pay the creditors early
to qualify for cash discounts and persuade them for other facilities like delivery, after
sale service to minimise costs and maximise profits.

Efficiency
There are other ratios, which are more likely to be used by internal groups to the
firm (i.e. mangers and directors) for assessing performance. Although these
ratios do not look specifically at profits, these ratios will measure the overall
financial efficiency of the firm which could eventually affect profits. Common
areas to assess are how a firm manages its stockholding, or its debtor and
creditor control. Also, how efficient the firm is in controlling expenditure will also
be assessed with these ratios. The activity ratios will cover:

Stock turnover (stock turn)

Debtor collection period (debtor days)
Creditor collection period (creditor days)
Turnover in relation to fixed assets
Turnover in relation to net current assets
Overheads in relation to turnover

Profitability ratios
For most firms, achieving profits are the main goal of the organisation. In limited
companies this is even more likely to be the case. This is because the company
is owned by shareholders who, expect possibly in the case of private limited
companies, have purchased shares with the aim of maximising their returns. The
profitability ratios will analyse accounts from the perspective of the size of the
profits, and then compare these profits to other figures.
Return on capital employed

Have a go at working this out for Buzz and then follow the link below to see how
you got on.

Profit margins
Both the gross profit margin and the net profit margin are calculated in a very
similar way (the only difference is in the measure of profits used in the ratio -
gross and net profits). It makes sense to consider these ratios together, as they
will often be affected in the same way by changes affecting the firm.

The formulae for the profit margins are as follows:

Gross profit margin - what does this tell us?

This ratio compares gross profits to the sales revenue. It tells us how much of
the sales revenue earned actually consists of gross profits - and therefore, how
much consist of costs of goods sold.

Net profit margin - what does this tell us?

Similar to the gross profit margin, this ratio compares the net profit to the sales
revenue. This tells us how much (as a percentage) or the firm's sale revenue is
made up of net profits.
What do falling profit margins mean?
The reason for a falling profit margin means that the 'gap' between sales and the
measure of profit has narrowed. This could be due to one or more of the
following:

Selling prices have fallen

Costs have increased

Imagine if the firm reduced its selling price to boost sales volume. This may lead
to higher profits. However, the profits on each sale made will be lower due to the
lower selling price. This would lead to an overall reduction in the net and gross
profit margins - even though profit levels have risen.

It is possible that the falling profit margins would be part of the firm's policy.
However, it may also be the case that profit margins fall due to circumstances
beyond the firm's control.

Possible reasons are as follows

Higher cost of materials or higher labour costs in production

Lower selling prices - possible due to a promotional campaign or other special
offer
Increased competition forcing prices down
Switch from profit maximisation to sales maximisation (i.e. price cuts)

Supermarkets operate with very low profit margins. Supermarkets, however, are
very profitable. This is because, although they earn very little profits on each
'unit' sold, there output is sold at a very rapid rate - thus the overall profits
quickly build up.

An antique dealer would not expect sales to be achieved in such as rapid rate.
This means that the antique dealer would probably have to charge high selling
prices - which mean a higher profit margin - in order to compensate for the
slower rate of sales. This means that profits build up at a slower rate, but in
bigger steps.

Mark-up & margin

The terms mark-up and margin are frequently used by those in business and
accounting, often in an incorrect manner. Each of these terms refers to the
relationship between the selling price of output and the cost of that output.

Mark-up refers to the amount of profit added on to the cost of a unit of output
in order to set a selling price - normally added on a percentage of the cost

Margin refers to the amount of profit in the selling price of a unit of output -
normally the percentage of the selling price that is profit

Both terms are looking at profits but from different perspectives, so there is
bound to be some link between the two measures.

Both mark-up and margin are often expressed in percentage terms. For
example, the phrase 'mark-up output by 20%' would mean that to set the selling
price, the cost of the output is increased by 20%.
The relationship can be summarised as follows:

Mark-up - Margin

Therefore

Or

Margin - Mark-up

Therefore

Efficiency ratios
These are mainly measures of financial control. They are rarely seen in media
headlines (or any other business stories) because they do not dramatically affect
the performance (either in profitability or liquidity) of the firm. As a result, these
ratios are more likely to be of interest to internal stakeholders of the firm,
(managers, budget holders, etc).

These ratios affect how efficiently the firm operates in terms of its working
capital management. As stated earlier, these ratios do not directly affect profit,
but improvements in these could affect future profitability.

Stock turnover
This ratio measure how quickly the firm 'turns over' (i.e. sells) its stocks. It,
measures the rate of stock turnover in terms of the time the average holding of
stock is held by the firm.

The formula to calculate the stock turnover is as follows:

The average stock is simply the arithmetical mean of the opening and closing
stock levels:

This will give us an answer in terms of the 'number of times' stock is sold during
a year.
There are no 'ideal' figures for what a firm's stock turnover should be. Firms that
sell consumer goods (especially perishable goods - supermarkets for instance)
would be expected to have a high stock turnover (perhaps as high as 100 or
more). Firms selling industrial goods, or slow moving consumer goods (jewellers,
for instance) may have a lower stock turnover of less than 10.

There is a link here with the profit margins. As stated earlier, firms can operate
with low profit margins, if they have a rapid stock turnover. Firms with lower
stock turnover (a lower rate of sales) will need higher profit margins to
'compensate'.

Debtor’s collection period and creditor’s payment period

These ratios measure how long the firm takes to settle its accounts with both
customers and suppliers. They give a result in terms of the average number of
days taken by our debtors to pay us, and how long the firm takes on average to
pay its creditors.

There are no ideal figures for debtor days and creditor days (common alternative
names for these ratios). Most firms will offer free credit periods to other firms so
we would expect to see result of at least 30 days or more. A survey taken in the
last five years found that the average length for debtor days would in the UK
was over 70 days.

Main areas to look out for would be as follows:

Increase in the length of time taken to settle accounts

Debtors collection period rising far quicker than creditor payment period

The firm would be concerned if there was a large discrepancy between the time
taken to collect from debtors and the time taken to pay its creditors. These
should be roughly the same. A firm could reduce the debtor's day figures by
offering discounts (or larger discount if already offered) for immediate or prompt
settlement of accounts.

The formulae used to calculate these ratios are as follows:

In most cases, all the purchases and sales will be on credit terms but be careful
not to include cash sales or purchases in this ratio.

The result will be in the form of 'number of days' taken.

Other efficiency ratios
The following ratios are used mainly to examine if the firm is controlling its
expenses efficiently i.e. expenses are increasing disproportionately fast), or if
assets are being used effectively in generating sales.

The following ratios may be used for this purpose:

Asset turnover ratio - turnover in relation to fixed assets

This shows how 'effectively' the net assets (total assets less total liabilities) of
the firm are being used to generate turnover. It will depend on the industry, but
a rising figure may indicate that assets are being used more efficiently to
generate extra sales.
===Turnover in relation to net current assets

Profitability and liquidity

The fact that a firm is profitable does not guarantee that it will have enough
cash to remain trading (being 'solvent'). It may seem surprising that a firm that
is making a profit or has made profits in the past can run out of cash, but this
disbelief stems from a common misunderstanding of what the terms 'cash' and
'profit' actually mean. People often assume that at the end of each year there is
an amount of money in the firm's bank account equivalent to its profit and that
this can be withdrawn and spent by the owner(s) of the firm. However, it is
more likely that the profits will be tied up in many different areas of the firm. For
example, the profit may have been used to acquire new equipment or stock; if
the goods have been sold on credit the revenue may still be in the form of
debtors. It is possible, therefore, for a firm to be profitable but to also be short
of cash because:

Differences between cash and profit

Many sales are on credit. These sales will be counted immediately towards
the profit even though the cash from the sale may actually appear months
later. Accepting and order for sales may mean that a firm has to spend more
on production without generating the cash flow from the sale until much
later. This problem is known as overtrading - where a firm experiences cash
flow by accepting extra sales without the necessary cash flow to produce the
output.

The firm may have invested heavily in capital items such as equipment.
Although this will involve a cash outflow, the 'cost' of these assets in the
profit and loss account will be 'written off' as depreciation over the working
life of the asset. This means that capital expenditure will affect cash flow not
profit.
 The firm may have invested in stocks. These will appear as an asset on the
balance sheet but will not appear as a cost until they are used up. The cash
outflow will occur when they are bought.

If a firm has paid for something in advance but not used it up yet (e.g. it has
paid for the use of some equipment or property in advance) this will reduce
cash flow but will only be recorded as a cost when the service or good is used
up next period. Conversely, if the firm has used up something, such as
electricity, this will count as a cost even if the bill has not been paid for. This
is summarised in the accruals concept.

Why is cash flow important?

Firms usually exist in order to make a profit. This may not always be their main
objective. It is also, however, important for firms to monitor their cash flow
position. This is because a firm will need cash to pay for the daily running of the
business.

Cash will be needed to pay wages, to pay bills, to pay suppliers and for the
general upkeep of the firm. If a firm cannot pay one of its creditors, then the
firm may ultimately face a bankruptcy order forced on to the firm by those who
it cannot pay. If it cannot pay its own workers then industrial action is likely to
occur.

Sufficient levels of cash are needed to ensure that a firm is liquid; it is

important, therefore, that managers track the cash flow position of the business.
This is likely to involve drawing up cash flow forecasts which estimate the likely
amounts of cash inflows and cash outflows over the near future. Very short-term
cash flow forecasts may be particularly important for small or newly established
firms, which often have to target cash flow over a daily or weekly period rather
than on a month by month basis. This is because a new or small firm is thought
to be more likely to fail than a larger firm. As a result, the sources of cash flow
available to a larger firm (such as extended credit periods offered, or extensions
to overdrafts) may not be offered to small firms if their cash flow becomes
negative.

Which is more important - cash or profit?

In the long run there is probably little point undertaking an activity if the value
of the sale is less than the value of the inputs used up (i.e. if turnover is less
than costs). This means that over time a firm will need to make a profit if it is to
continue with an activity. Firms will generally measure not just the absolute size
of the profits but also their size relative to the capital employed, to decide if an
activity is worthwhile.

In the short run, however, the priority is to keep the business going; this means
the firm must be liquid and have sufficient cash flow. There is little point in
getting involved in a project that is potentially profitable if, in fact, the business
will not survive long enough to be able to sell the products it produces. Firms
must pay attention to their cash flow as well as their profit. If a bill has to be
paid, cash is likely to be regarded as more important than profit; however, when
reviewing the firm's activities over a period of time it will usually be expected to
achieve a suitable rate of return in terms of profit.

A firm must be careful when engaging in activities to monitor the effect on each
transaction on both profit and cash flow. Many firms may forget that the cash
flow will be, in some cases, more important than the profits.

Limitations of ratios
It is important to realise that with ratio analysis that the question will rarely
focus on the calculation of ratios alone, most of the time the calculation of the
ratio will only be the first step on some investigation into some aspect of
business performance. Therefore it is especially important that you can interpret
and analyse what the result of the ratios actually mean,

Areas that are important in ratio analysis are as follows:

1. Analysing the ratios of a particular area of a firm (e.g.: profitability,

efficiency, liquidity, etc.)
2. Limitations of ratios
3. A basis for comparing the performance of two firms or one firm over time
4. As a tool to help decide a firm's strategy (e.g. has it a safe liquidity
position for expansion, or analysis of gearing to help decide on the best
form of finance)

When answering any question on ratios you must consider the following factors:

1. What type of firm are we dealing with?

2. What is the size of the firm and should this have any effect on the ratios?
3. Will the time of year have any effect on the ratios? (see liquidity ratios
section for example)
4. Have we got enough information to make any serious conclusions?
5. What external factors are important?
6. Are the accounts supplied reliable? Ratios are only as accurate, true and
fair as the original figures from which they were calculated

Obviously, the first stage should be to calculate the ratios in the correct manner.
Once you have completed this then it is time to start to interpret the results that
you have calculated.

This interpretation can be in the form of your theoretical knowledge of what the
ratio tells us. For example, the current ratio will look at the firm's ability to pay
day-to-day expenditure.

Once you have interpreted the meaning of the results you can then look around
to consider wider issues, such as the context of the question. For example, it
does not matter what size the firm's profit margin is if the economy is entering a
recession and a firm sells goods that are significantly affected by changes in
consumer spending. Also, you may wish to look at other non-financial factors
within the firm. A highly motivated workforce may be more important for cash
flow than an efficient debtor’s collection period.

It is important that you realise that although accounting ratios can be a very
useful tool they also have many serious limitations which can render the results
meaningless, or worse, can cause you to jump to incorrect conclusions.

Common limitations of ratios

Common limitations of ratios are as follows:

Not having more than one years' data. Even two years may not be enough to
give a clear picture of the overall direction of the firm.
Comparisons with other firms are only meaningful if the firm's are very
similar (same industry and similar size). Even firms that appear similar may
have different objectives, making any comparison meaningless.
All firms will be affected by changes in the economy in different ways - this
must be taken into account when analysing firm's results.
Firm's can window dress their accounts to make it look as if they are
performing better than they actually are. The actual accounts and the notes
to the account should be analysed to find out more about the results.
Balance sheets are drawn up on one day. If this day is not a typical day then
the ratios may give a misleading picture.
Concentrating on financial data means that we may ignore important non-
financial factors, such as industrial unrest, the training level of the workface
and managerial problems.

The best way to avoid falling into these traps is to spend time trying to
understand what the ratios actually mean. This is not just a question of learning
what they should theoretically show, but rather what thinking lies behind the
actual calculation of the ratio. For example, we all know that the current ratio
shows us the solvency position of a firm. However, we must look into the ratio
itself for it to provide meaning. A firm may have many current assets, but if
these are stocks which are not very liquid then the firm may face problems. We
also need to know the limitations of using a single financial statement rather
than the 'whole picture'. Balance sheets are just snapshots which may have
been constructed at an atypical time giving us unusual results. It is very
important that ratios should be considered with the previous years' equivalent
figures if any meaningful solution is to be offered.

It is also important that the ratios were calculated in a similar way, i.e. you are
treating 'like with like'. If you are engaging in comparing between two firms then
it is common sense to point out that the two firms should be similar firms. In
this chapter we have seen very successful firm having radically different ratios.

If you are to perform an inter-firm comparison then it is also important that the
same formulas were used and that the data used was of equivalent meaning. It
is also important that the accounting policies are consistent across the firms
being analysed. For example, has machinery been depreciated in a more-or-less
similar way such as the straight-line method?
The results that you calculate may indicate a problem which cannot be
summarised through financial figures and may actually require you looking at
the other areas of the firm, such as marketing or human resources. Remember,
of course to take into account that the firms will be affected by the economic
cycle. Firms will be affected in different ways, but all will be affected.

The best answers in ratio analysis are those that can join up the theoretical
knowledge with real world factors. It is very important that you structure your
answers carefully. Try to start off with the theory first before opening up to
wider issues. A common format could be as follows:

1. Calculation of ratios.
2. What does the ratio tell us anyway?
3. What does theory tell us about our result?
4. Can the context of the question explain the results?
5. How valid are our results anyway?
6. What other factors should we consider?

Exam tips

There is no other way around it; you will have to learn all the formulas for
the ratios - all of them!!

You can help yourself by practicing the ratios as much as possible - you will
find it easier if the ratios have actually been used.

Read the question very carefully. Sometimes questions will want just a
calculation and nothing else. However, it is likely that you will have to
consider the scenario of the questions as well as any theoretical knowledge
you have picked up through the course

The type of firm, time of year and market it operates in will all partly explain
the results of the ratio calculations.

Make sure that you are looking at the appropriate category of ratio - each
category will cover a slightly different aspect of the firm's overall financial
position.