Ratio Analysis Lesson Outcomes: Interpret the performance of a business by using simple accounting ratios (return on capital, gross and profit margin, current ratio) Using accounting ratios make evaluative comments on the success and performance of a business

Example Business Ltd   Income Statement 20X1 20X0 Year Ended 31 December £'000 Revenue 21,450 19,780 Cost of sales 13,465 12,680 Gross profit 7,985 7,100 Distribution costs 3,210 2,985 Administration expenses 2,180 1,905 Operating profit 2,595 2,210 Finance costs 156 120 Profit before tax 2,439 2,090 Tax expense 746 580 Retained profit 1,693 1,510

ANALYSIS OF PUBLISHED ACCOUNTS LIQUIDITY is the ability of a business to pay back it’s short term debts It is important to choose more than one figure from the accounts when trying to find how a business is performing Comparing two figures from one Business account is called RATIO ANALYSIS

RATIO ANALYSIS OF ACCOUNTS There are two main types of ratios : PERFORMANCE RATIOS and, LIQUIDITY RATIOS

PERFORMANCE RATIOS These are used to see how the business is performing The three most common performance ratios are: RETURN ON CAPITAL EMPLOYED GROSS PROFIT MARGIN PROFIT MARGIN

RETURN ON CAPITAL EMPLOYED This is calculated by the formula: Return on capital employed (%) = Net profit/Capital employed x 100 This is how much the business was able to get back from the capital it had employed

GROSS PROFIT MARGIN This is calculated by the formula: = Gross profit / Sales turnover x 100

PROFIT MARGIN This is calculated by the formula: Profit margin (%) = Profit before tax / Sales turnover x 100

LIQUIDITY RATIOS These measure the ability of a business to pay back it’s short-term debts Two common liquidity ratios are: CURRENT RATIO and ACID TEST or LIQUID RATIO

CURRENT RATIO This is calculated by the formula: Current ratio = Current assets / Current liabilities Ideal result will be between 1.5 and 2

ACID TEST or LIQUID RATIO This is calculated by the formula: Acid test or Liquid ratio = (Current assets – inventories) / Current liabilities Ideal result will be between 1 and 1.5

DISADVANTAGES OF RATIO ANALYSIS Ratios are based results collected in the past and therefore will not be able to show how a business might perform in the future Accounting results over time will be affected by inflation Different companies might use slightly different accounting methods

Written Question An oil company make 69%, a supermarket make 20% and a local butchers make 32% on their Gross Profit Ratios. Explain why these values are not very useful in helping us to understand how well each business is actually doing. [4] (Hints. Are they all in the same type of industry? Do we have any figures for previous years?)

Complete either Exam question 1 (a-e), pg 312

H/W- Complete the worksheet- What is Ratio analysis all about