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Ratio Analysis

GCSE Business Studies


Revision Presentations 2004
Introduction

Analysing financial performance is about judging the successes and


failures of a business by considering a number of financial
measures. Most of these measures are known as ratios.
A ratio is a measure of one piece of information in terms of
another
A non-financial ratio might be the numbers of boys to girls in a class,
or the number of GCSE passes in business studies as a percentage
of all the GCSE passes in the school.
Ratios are normally compared with the previous years’ figures or
with figures from competitors to see whether the business has
improved or not and whether it is better or worse than a rival.
The main areas that ratios look at are:
 Profitability
 Financial efficiency
 Liquidity

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Who Might Use Ratio Analysis

Anyone with an interest in the financial performance of the


business will find ratio analysis useful
Owners/shareholders (e.g. return on investment; profitability
ratios)
Employees (e.g. profitability ratios)
Managers (the full range)
Creditors and banks (e.g. liquidity ratios)
Competitors (profitability and liquidity ratios)
Government (e.g. the Inland Revenue – who calculate how
much tax is due by a business)

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Profit and Profitability

Profit is an absolute measure – it equals sales revenue less


costs
Profitability is a relative measure – it shows amount of profit
“relative” to what created profit
e.g. ROCE investment ratio measures relative profitability of a
business compared with amount of capital invested in
business.

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Profitability Ratios

What are they?


 Gross profit margin
 Operating profit margin
Why use them?
 Insights into how well the business is trading in its markets
 Is sales revenue being maximised?
 Are costs being kept under control?
 Analyse and spot favourable and unfavourable trends
 Compare performance with competitors

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Gross Profit Margin

Calculation
 Gross profit divided by sales (expressed as a percentage)
Why it might increase
 Increase in selling price of existing products
 Introduction of new products which achieve a higher gross profit
margin
 Reduction in cost of sales e.g. a fall in raw material prices

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Gross Profit Margin - Example

Jan Feb Mar Apr


£'000 £'000 £'000 £'000

Sales Revenue 1000 1250 1400 900

Cost of Sales
Raw Materials 250 300 325 225
Labour Costs 300 315 325 295
Packaging 25 30 35 20
Total costs 575 645 685 540

Gross Profit 425 605 715 360

Gross Profit Margin 42.5% 48.4% 51.1% 40.0%

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Return on Capital Employed (“ROCE”)

How calculated:
 Net profit as a percentage of capital employed
Also known as primary efficiency ratio - a better indicator than
profit alone of how well a business is using money invested
Shows how much profit is being generated from investment
compared with alternative investments in similar businesses
or with interest from bank deposits

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ROCE Example

1999 2000 2001 2002


£'000 £'000 £'000 £'000

Fixed Assets 5000 5000 5250 5400

Current Assets
Stocks 1100 1015 1200 1250
Debtors 1500 1600 1750 2000
Cash 350 300 400 375
Creditors -750 -800 -825 -860

Net Assets 7200 7115 7775 8165

Profit Before Tax 800 750 850 925

ROCE 11.1% 10.5% 10.9% 11.3%

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What does ROCE Tell Us?

Three main things to look for


 The change in ROCE from one year to the next
 The ROCE earned by other companies (if this information is
available)
 A comparison of the ROCE with the cost of borrowing money
(i.e. is the business making a ROCE that makes borrowing
worthwhile?)
Ways to increase ROCE
 Increase net profits without increasing or introducing new
investment
 Reduce amount invested in business by selling assets that do
not contribute to profit earned

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Net Profit Margin

How calculated
 Amount of net profit generated per pound of sales
 Calculated as net profit divided by total sales (or revenues)
 Expressed as a percentage

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Net Profit Margin - Example

2000 2001 2002


£'000 £'000 £'000

Revenue 10,150 12,535 15,100


Less cost of sales 4,250 4,700 5,950
Gross profit 5,900 7,835 9,150
Less expenses 4,235 5,675 6,480

Net profit 1,665 2,160 2,670

Gross Profit Margin 58.1% 62.5% 60.6%


Net Profit Margin 16.4% 17.2% 17.7%

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Liquidity Ratios

Concerned with ability of business to pay its debts


Ratio of short-term liabilities to liquid assets
Indicate ability of business to cover its short term liabilities
Liquid assets are those assets that held in cash form (e.g.
cash at bank) or can be turned into cash very quickly
Main ratios:
 Current ratio
 Acid test ratio

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Current Ratio

Calculation: Current assets divided by current liabilities


Interpretation
How to improve the current ratio
 Increase value of profitable sales
 Turn its overdraft into a long term loan (reduces short-term
liabilities and increases capital)

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Acid Test Ratio

Liquidity ratio – similar to current ratio


It is a tougher test of liquidity
Stock takes longer to turn into cash – so are excluded from
current assets in calculation

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Stock Turnover

Number of times stock is turned into sales


Higher figure, more quickly stock has been sold or turned
over
A fruit stall will have a higher figure of stock turnover than a
car dealership

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Reasons for an Increase in Stock
Turnover
Lower stock levels
Disposal of slow moving or obsolete stock
Reduction in range of products stocked

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Debtor Days

Working capital ratio


Number of days it takes for a business to collect money from
customers who have bought products on credit

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Encouraging Debtors to Pay Quicker

Offer discounts for early payment


Threaten to take customer to court
Refuse to supply more products or hold back part of an order
until payment has been made

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Creditor Days

Number of days it takes for business to pay creditors.

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