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Introduction to Ratio Analysis

Higher Grade Business Management

2009

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Why Do We Need Ratios? Taken on their own, figures from final

accounts can be confusing.

However, when financial ratios are used to analyse the information more closely, the figures become clearer.

Accounting ratios are used as a tool in the decision-making process and as an aid to financial interpretation and planning.

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Analysis is the Key!Ratios are no use on their own. They

must be compared to:

Previous ratios, in order to see trends.

Competitors, to check competitiveness.

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Types of RatioRatios can inform us about three main

areas of final accounts:

Profitability

Liquidity

Efficiency

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Types of Ratio Profitability

Is the organisation earning more than it is paying in costs?

Liquidity Does the organisation have enough money to pay

its bills?

Efficiency Is the organisation making best use of its

resources?

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Types of Ratio: ProfitabilityGross Profit Margin

Profit Mark-up

Net Profit Margin

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Types of Ratio: LiquidityCurrent Ratio

Acid Test Ratio

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Types of Ratio: EfficiencyReturn on Capital Employed

Rate of Stock Turnover

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Gross Profit MarginThis ratio relates gross profit to sales

revenue:

GP % = Gross ProfitSales Revenue

x 100 1

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Gross Profit MarginUsing the example of Gill’s Gym

Equipment Ltd for 2003:

GP % = 90,000 (Gross Profit)

850,000 (Sales Revenue)

= 10.6 %

x 100 1

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Profit Mark-upThis ratio is used to calculate the gross

profit as a percentage of cost of goods sold:

Profit Mark-up % = Gross Profit

Cost of Goods Sold

x 100 1

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Profit Mark-up Using the example of Gill’s Gym Equipment

Ltd for 2003:

Profit Mark-up % = 90,000 (Gross Profit)760,000 (Cost of Goods

Sold)

= 11.8 %

x 100 1

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Net Profit MarginThis ratio relates net profit to sales

revenue:

NP % = Net ProfitSales Revenue

x 100 1

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Net Profit MarginUsing the example of Gill’s Gym

Equipment Ltd for 2003:

NP % = 25,000 (Net Profit)

850,000 (Sales Revenue)

= 2.9 %

x 100 1

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Current RatioThe Current Ratio is also known as

the Working Capital Ratio.

The Current Ratio is used to indicate a business’s ability to meet its short term debts without having to borrow money.

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Current Ratio The formula for the Current Ratio is:

Current Assets : Current Liabilities

For Gill’s Gym Equipment in 2003:

550 : 250

This can be simplified: 2.2 : 1

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Acid Test (Quick) RatioThe Acid Test Ratio is similar to the

Current Ratio although it takes into account the fact that stock may take some time to be turned into cash.

(Current Assets - Stock) : Current Liabilities

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Acid Test (Quick) RatioUsing the example of Gill’s Gym

Equipment Ltd for 2003:

Acid Test = (550 - 300) : 250

= 1 : 1

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Return on Capital EmployedReturn on capital employed relates

profitability to the capital invested in a business:

ROCE % = Net Profit Capital Employed

x 100 1

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Return on Capital EmployedUsing the example of Gill’s Gym

Equipment Ltd for 2003:

ROCE % = 25,000 (Net Profit) 900,000 (Capital Employed)

= 2.8 %

x 100 1

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Stock Turnover Ratio The purpose of this ratio is to give the number

of times per period that the average stock is sold.

Stock Turnover = Cost of SalesAverage Stock

Average Stock is calculated by adding the opening and closing stocks together and dividing by 2

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Stock Turnover Ratio Using the example of Gill’s Gym Equipment

Ltd for 2003:

Stock Turnover = 760,000275,000

= 2.76 Times

Note: Average Stock = (250 + 300) / 2 = 275

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Uses of Ratio Analysis Ratio analysis can provide the following

information:

Current performance relative to previous performances (intra-firm).

Current performance relative to that of competitors (inter-firm).

Why performance changes occur and how to improve.

Information for budgeting.

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Limitations of Ratio Analysis Accounting information used is historical and so can be

irrelevant to the future.

Any comparisons must be made with firms of similar size in the same industry.

Findings may not take into account external factors.

Different stock valuation methods can result in different figures.

Ratios do not show other elements such as staff morale or staff turnover.

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TaskCalculate the ratios that we have

covered today for Gill’s Gym Equipment Ltd in 2004.