RATIO ANALYSIS JW S4 Int2 BM

Ratio Analysis The Trading Profit and Loss and the Balance Sheet can be analysed to highlight an organisation’s: Profitability – to show whether the organisation is earning more that it is paying out Efficiency – is the organisation making the best use of its resources? Liquidity – does the organisation have enough money to pay its bills? JW S4 Int2 BM

Ratio Analysis – Why use Ratios? Ratio analysis is used to: Compare current performance with that of previous years Compare performance with that of similar organisations Identify differences in performance to help decide on future action Highlight trends over a period of time To assist with decision making JW S4 Int2 BM

Ratio Analysis Gross Profit Percentage Net Profit Percentage Profitability Ratios Gross Profit Percentage Net Profit Percentage JW S4 Int2 BM

Gross Profit Percentage Profitability Ratio Gross Profit Percentage Gross Profit x 100 Net Sales Measures the profit made from buying and selling stock. If the GPP needs to be improved, a business may: Increase its selling price Find cheaper suppliers Try to negotiate discounts from suppliers Increase supervision to reduce theft or breakages of stock JW S4 Int2 BM

GROSS PROFIT PERCENTAGE Profitability Ratios GROSS PROFIT PERCENTAGE A decrease in GP% ratio might indicate: the price of goods bought has gone up goods have been stolen There is wastage in the production process An increase in GP% ratio might indicate: The selling price has gone up the cost of materials has decrease a cheaper supplier has been found There is improved efficiency in the production process Improvements: either cut the costs of production, or increase the selling price to customers JW S4 Int2 BM

Net Profit Percentage Net Profit x 100 Sales Profitability Ratio Net Profit Percentage Net Profit x 100 Sales Measures the profit made after the business has paid all business expenses. Ways to improved the NPP: Identify any expenses that can be reduced Try to improve their gross profit percentage JW S4 Int2 BM

Ratio Analysis Liquidity Ratios Current Ratio/Working Capital Ratio Acid Test Ratio JW S4 Int2 BM

Current Ratio/ Working Capital Ratio Liquidity Ratio Current Ratio/ Working Capital Ratio Current Assets Current Liabilities Shows the ability of a business to pay its short-term debts. An answer of 2:1 is regarded as generally acceptable. To improve the WCR: try to increase current assets, particularly cash seek ways to decrease current liabilities. However, The WCR can be too high. A high bank figure may mean that funds could be better employed in the business to generate income rather than sitting in the bank. JW S4 Int2 BM

Acid Test Ratio Liquidity Ratio Current Assets –Stock Current Liabilities Shows the ability of a business to pay its short-term debts in a crisis situation. An answer of 1:1 is regarded as generally acceptable Stocks are removed from current assets as it cannot be guaranteed that they can be quickly sold to generate cash to pay off debts. too high = too much money tied up in liquid assets (cash in the bank could be put to better use) Too low = cash flow problem exists – will not be able to pay short term bills JW S4 Int2 BM

Ratio Analysis Efficiency Ratios Return on Capital Employed Stock Turnover JW S4 Int2 BM

Return on Capital Employed Efficiency Ratio Return on Capital Employed Net Profit x 100 Capital Employed Measures the return on the capital invested in the business by the owner or shareholder. The owner or shareholder should compare the Return on Capital Employed with the return offered by other investment opportunities JW S4 Int2 BM

RATE OF STOCK TURNOVER The RoST measures efficiency RATE OF STOCK TURNOVER = Cost of Goods Sold Average Stock this measures the number of times during the year a business sells its stock. There is no ideal figure: A greengrocer will buy and sell daily or weekly whilst a furniture shop will buy and sell 3-4 times per year However, a a general rule businesses want to turnover stock quickly! JW S4 Int2 BM

If stock turnover is reducing this may indicate: Efficiency Ratios Rate of Stock Turnover If stock turnover is reducing this may indicate: Higher stock levels, eg slow moving stock obsolete stock.(out of date – no longer able to sell) May need to tighten up control over purchasing JW S4 Int2 BM

Ratio Analysis – Why use Ratios? Ratio analysis is used to: Compare current performance with that of previous years Compare performance with that of similar organisations Identify differences in performance to help decide on future action Highlight trends over a period of time To assist with decision making JW S4 Int2 BM

Limitations of Ratio Analysis Information contained in annual accounts is historical as it relates to last year’s trading. Inter-firm comparisons must be made with firms of similar size and in the same type of industry. JW S4 Int2 BM

Limitations of Ratio Analysis Findings may not take into account external (PESTEC) factors such as recession, inflation or exchange rates Findings do not show the implications of product developments or declining products Findings do not reveal internal problems such as staff morale or staff turnover JW S4 Int2 BM