earning capacity ratios

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Ratios

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The analytical technique of ratio analysis permits businesses to study end of period reports in order to base decision making for the future.

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RATIOS

Presented as % or as ratios Assist in:

Decision making Interpreting financial figures Assessment of enterprise’s:

Profitability Stability Effectiveness

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ProfitabilityProfitability is the ability to earn income within the present financial structure of the enterprise

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Profitability Ratios

• Gross Profit Ratio• Net Profit Ratio• Return on Equity Ratio

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Gross Profit Ratio

Indicates the ability of a business to retain profit from sales

Compare result to industry benchmarks to determine suitability of business performance

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Result indicates:

for every $ of sales – indicates the number of cents retained as gross profit

how effective business is in passing on increases in COGS to customers

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High result may indicate:

ability of business to cover all expenses capacity to earn acceptable net profit and

return to ownerLow result may indicate inability to: meet further expenses Return acceptable net profit return satisfactory rate to owner

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RecommendationsImprove sales Ascertain:

Stock levels - should be high enough to meet demand

appropriateness of stock to appeal to market demand for stock held Appropriateness of selling price

Conduct market research/analysis to assist with the above.

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Institute policy to lower COGS

Investigate alternative suppliers selling similar quality products for less

Take advantage of discounts offered to lower costs

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Net Profit Ratio

Indicates the effectiveness of managers to minimise expenses per dollar of sales

Compare result to industry benchmarks to determine suitability of business performance

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Result indicates:

for every $ of sales – number of cents retained as net profit

how effective business is in minimising expenses

poor GP ratio will impact on NP ratio

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High result may indicate:

High operating revenue Low operating expenses

Low result may indicate inability to: Inappropriate pricing policy Inadequate sales Inappropriate stock expenses too high

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RecommendationsImprove Gross Profit• as per Gross Profit recommendations

Minimise expenses• Set budgets for departments Investigate alternative suppliers to lower costs As per Gross Profit recommendations

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Rate of Return on Equity RatioIndicates the rate of return generated by an entity on investment of the owner

Aim for a return of, around, 14% which allows funding for future growth and a return on investment.

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High result may indicate:

Efficient operations business may be under capitalised(owner has not

contributed equity to the optimum level) Under-capitalisation can be identified when NP

ratio is close to or under industry benchmark yet ROE is well above industry benchmark

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Low result may indicate:

owner’s money may perform better invested elsewhere

business may be over capitalised (if owner has invested over the optimum sum into the business) Can be identified when NP ratio is close to industry

benchmark yet the ROE result is well below industry benchmark

management may take little risk therefore business is cautiously managed

inefficient management making poor decisions, lack of vision.

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RecommendationsImprove net profit result using previous recommendations.

Check level of capital invested to ensure appropriateness for industry.

If under-capitalised owner should consider investing more funds into the business.

If over-capitalised owner should consider investing excess funds into alternative investments.