1. 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

2. 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

4. 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

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

6. 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

7. 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

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

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

10. 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

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

12. 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

13. 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

14. 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?)

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

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