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# Ratio Analysis

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

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)

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

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

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

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 Margin 42.5% 48.4% 51.1% 40.0%

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

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

## ROCE 11.1% 10.5% 10.9% 11.3%

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

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

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

## Gross Profit Margin 58.1% 62.5% 60.6%

Net Profit Margin 16.4% 17.2% 17.7%

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

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)

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

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

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

Debtor Days

## Working capital ratio

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

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