LO. Define & provide examples of the 5 main financial ratios. Ratio Analysis LO. Define & provide examples of the 5 main financial ratios.

Ratios Ratios are used to measure and compare performance and liquidity of a business. Ratio analysis

Performance ratios Return on capital employed Operating profit ROCE (%) = Operating profit Capital employed X 100 Shows how successful the managers are at earning a profit from capital used in the business.

Calculations Return on Capital Employed =55% Analysis Operating profit Fixed assets ฿ Land 10,000 Vehicle 5,000 Machines 1,000 Current Assets Debtors 1,000 Cash 500 Stock 2,000 Current Liabilities Creditors 600 Bank loan 800 Net-Current Assets (Working capital) Net assets --------------------------------------------------- Financed by: Profit / Loss 10,000 Share capital 8,100 Capital employed Return on Capital Employed ROCE (%) = Operating profit Capital employed X 100 ROCE (%) = 10,000 18,100 X 100 2,100 =55% Analysis For every baht (฿) invested, the business makes 55% extra. 18,100 18,100

Performance ratios Gross profit margin Gross profit Sales turnover X 100 Shows how much gross profit is made for every $ earned

Calculations =84% Analysis Sales turnover X 100 42,000 50,000 X 100 ฿ Sales turnover 50,000 Cost of Sales 8,000 Gross profit Expenses Rent 15,000 Utility bills 4,000 Wages 10,000 Net profit Gross profit margin (%) = Sales turnover X 100 42,000 Gross profit margin (%) = 42,000 50,000 X 100 13,000 =84% Analysis For every baht (฿) make from sales, 84% is kept as gross profit

Performance ratios Net profit margin Net profit Sales turnover X 100 Shows how much Net profit is made for every $ earned

Calculations =6% Analysis Sales turnover X 100 5,000 80,000 X 100 ฿ Sales turnover 80,000 Cost of Sales 20,000 Gross profit Expenses Rent 35,000 Utility bills 10,000 Wages 10,000 Net profit Net profit margin (%) = Sales turnover X 100 60,000 Net profit margin (%) = 5,000 80,000 X 100 5,000 =6% Analysis For every baht (฿) make from sales, 6% is kept as Net profit profit

Which ratio to use? =84% Analysis =6% Analysis Sales turnover X 100 Gross profit margin (%) = Sales turnover X 100 Gross profit margin (%) = Net profit Sales turnover X 100 Gross profit margin (%) = 42,000 50,000 X 100 Net profit margin (%) = 5,000 80,000 X 100 =84% Analysis For every baht (฿) make from sales, 84% is kept as gross profit =6% Analysis For every baht (฿) make from sales, 6% is kept as Net profit profit

Liquidity ratios Current Ratio Current assets Current liabilities Shows haw many times a business can pay its short term debts with current assets. A good current ratio would be between 1.5 : 1 – 2 : 1 A ratio less than 1 would mean that a business could not pay its short term debts, and could be forced to cease trading. (It has no working capital)

Calculations Liquidity ratio =2.5:1 Analysis Current assets Fixed assets ฿ Land 10,000 Vehicle 5,000 Machines 1,000 Current Assets Debtors 1,000 Cash 500 Stock 2,000 Current Liabilities Creditors 600 Bank loan 800 Net-Current Assets (Working capital) Net assets --------------------------------------------------- Financed by: Profit / Loss 10,000 Share capital 8,100 Capital employed Liquidity ratio Current ratio = Current assets Current liabilities Current ratio = 3,500 1,400 2,100 =2.5:1 Analysis 2.5:1 means the business can pay it’s short term debts two and a half times. It has high liquidity! 18,100 18,100

Liquidity ratios Acid test ratio OR Liquidity ratio Current assets - stock Current liabilities Similar to current ratio, however without stock because the nature of some companies may mean it is difficult to sell stock quickly (their stock is not liquid) for example a estate agent / car sales. A good acid test ratio is between 0.5 : 1 – 1 : 1

Calculations Liquidity ratio =1:1 Analysis Current assets - stock Fixed assets ฿ Land 10,000 Vehicle 5,000 Machines 1,000 Current Assets Debtors 1,000 Cash 500 Stock 50,000 Current Liabilities Creditors 600 Bank loan 800 Net-Current Assets (Working capital) Net assets --------------------------------------------------- Financed by: Profit / Loss 10,000 Share capital 8,100 Capital employed Liquidity ratio Current ratio = Current assets - stock Current liabilities Current ratio = 3,500 1,400 50,100 =1:1 Analysis 1:1 means the business can JUST pay it’s short term debts. It has virtually no Liquidity! 79,600 18,100

Revision Questions

What is meant by a financial budget? [2] Think, Pair, Share... Write your answer on your white board A financial budget is a numerical/quantitative plan showing future financial targets (goals or limits) for a specific time period. [2]

Calculate the net profit margin for BTX in 2009. [2] Think, Pair, Share... Write your answer on your white board Profit margin is profit/sales %. [1] 250/1100 × 100 = 22.72% Answer = 22.72% [2] 22% – 23 % acceptable for [2] Method alone or arithmetic error [1], correct number without % [1] If figures for 2008 are used (correctly) then 1 method mark could be available.

Explain what the current ratio tells Manfred about BTX’s financial position. [4] Think, Pair, Share... Write your answer on your white board

Knowledge of current ratio can be shown by indicating what it is or how it is calculated [2] An answer that simply says ‘shows current assets and current liabilities of a business’ [1] Analysis of usefulness: analysis implies saying something about what the change means to BTX using the data [2] So an answer that says ‘the figure has changed from 1.2 to 0.7’ is merely a description not an analysis and therefore would not be given a mark.

Current ratio is a measure of the relationship between current assets and short-term debts. It is a liquidity test designed to show the ease by which a company can pay debts on demand. (How easily assets can be turned in to cash). A fall in the ratio shows a decline in liquidity and therefore is not seen as a good thing because it implies that not all short-term debts can be met quickly. Knowledge of current ratio [2] Analysis of usefulness [2]

Do you think that the management of BTX should be worried about the performance of the company in 2009? Justify your answer. [6] Think, Pair, Share... Write your answer on your white board

• net profit rise (25%) good sales fall (8.3%) bad • net profit rise (25%) good • profit margin rise (16.6 % to 22.72%) good • return on capital (ROCE) down (20% to 16.6%) bad • current ratio down (below safe levels) bad Identification of directional changes in relevant indicators of BTX’s success [2] (The sales have fallen by 8.3%, this suggests the management should be worried about the performance because… Analysis of data [2] Interpretation of the information could be quantitative or qualitative (However, net profits have risen…) Evaluative comment [2] This will involve a positive assertion supported by a justification comment based on the analysis. Therefore I think they should be worried because… ROCE OR I think they should not be worried because… PROFIT MARGIN