1 Introduction to Ratio Analysis Higher Grade Business Management 2009

2 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.

3 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.

4 Types of Ratio  Ratios can inform us about three main areas of final accounts:  Profitability  Liquidity  Efficiency

5 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?

6 Types of Ratio: Profitability  Gross Profit Margin  Profit Mark-up  Net Profit Margin

7 Types of Ratio: Liquidity  Current Ratio  Acid Test Ratio

8 Types of Ratio: Efficiency  Return on Capital Employed  Rate of Stock Turnover

9 Gross Profit Margin  This ratio relates gross profit to sales revenue: GP %=Gross Profit Sales Revenue x 100 1

10 Gross Profit Margin  Using the example of Gill’s Gym Equipment Ltd for 2003: GP %=90,000 (Gross Profit) 850,000 (Sales Revenue) =10.6 % x 100 1

11 Profit Mark-up  This 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

12 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

13 Net Profit Margin  This ratio relates net profit to sales revenue: NP %=Net Profit Sales Revenue x 100 1

14 Net Profit Margin  Using the example of Gill’s Gym Equipment Ltd for 2003: NP %=25,000 (Net Profit) 850,000 (Sales Revenue) =2.9 % x 100 1

15 Current Ratio  The 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.

16 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

17 Acid Test (Quick) Ratio  The 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

18 Acid Test (Quick) Ratio  Using the example of Gill’s Gym Equipment Ltd for 2003: Acid Test =( ) : 250 =1 : 1

19 Return on Capital Employed  Return on capital employed relates profitability to the capital invested in a business: ROCE % = Net Profit Capital Employed x 100 1

20 Return on Capital Employed  Using the example of Gill’s Gym Equipment Ltd for 2003: ROCE % = 25,000 (Net Profit) 900,000 (Capital Employed) =2.8 % x 100 1

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

22 Stock Turnover Ratio  Using the example of Gill’s Gym Equipment Ltd for 2003: Stock Turnover=760, ,000 =2.76 Times Note: Average Stock = ( ) / 2 = 275

23 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.

24 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.

25 Task  Calculate the ratios that we have covered today for Gill’s Gym Equipment Ltd in 2004.