1. Unit 2 Financial & Management Accounting
RATIO ANALYSIS
Mr. Barry
A-level Accounting Year 12

2. What this presentation covers
Why a business needs to be analysed
How a business is analysed using ratios and percentages
Areas of financial statements that need to be analysed
Stakeholders – people who need to know about the financial ratios
Mr. Barry
A-level Accounting Year 12

3. The financial health of a business
Ratios assess the financial health of business in three main areas:
Profitability – this indicates the level of return and earning power of the business
Liquidity – this measures the resources the business has in the short-term to meet its immediate debts
Capital structure – this shows the reliance of the business on long-term external finance compared with its own capital
Mr. Barry
A-level Accounting Year 12

4. Stakeholders – who needs to know?
Business managers and owners – looking at performance and making decisions
Shareholders – investors in large companies to ensure they will get a good and safe return on their money
Lenders – banks, to make sure they will get their money back
Employees – to make sure their job is safe in the future
Mr. Barry
A-level Accounting Year 12

5. A-level Accounting Year 12
Assessing the financial statements
Sales and profitability how do they compare? What are the trends?
Income Statement
Examine the current assets and current liabilities to assess short-term resources
Balance Sheet
Examine long-term borrowing and capital to assess financial strength
This assessment is carried out by examining key figures in the financial statements and using financial ratios.
Mr. Barry
A-level Accounting Year 12

6. A-level Accounting Year 12
What is a ratio?
A ratio compares the size of two numbers, example 2 : 1
Current Assets £200,000 :
Current Liabilities £100,000
The ratio is 2 : 1
Financial indicators can be written as ratios, but they are often also written as percentages:
A ratio of 2 : 1 converted into a percentage becomes:
(2 x 100) ÷ 1 = 200%
Current Assets to current liabilities of 1.5 : 1 becomes:
(1.5 x 100) ÷ 1 = 150%
We will now explain the ratios which assess business profitability, liquidity and capital strength.
Mr. Barry
A-level Accounting Year 12

7. A-level Accounting Year 12
Profitability Ratios
Mr. Barry
A-level Accounting Year 12

8. 1. Gross profit percentage/ margin
gross profit % = gross profit x sales
Income Statement
Sales ,000
Cost of Sales 250,000
Gross Profit ,000
Expenses ,000
Net Profit ,000
250,000
x 100
500,000
= 50%
This percentage - also known as ‘gross margin’ - measures the gross profit in relation to sales, before all expenses have been deducted.
Mr. Barry
A-level Accounting Year 12

9. A-level Accounting Year 12
2. Gross profit mark up
gross profit mark up = gross profit x cost of sales
Examiner tip: Please be able to distinguish between mark up and margin formula’s
Mr. Barry
A-level Accounting Year 12

10. 3. Net profit percentage/ margin
Also known as profit in relation to revenue
net profit % = net profit x sales
Income Statement
Sales ,000
Cost of Sales 250,000
Gross Profit ,000
Expenses ,000
Net Profit ,000
125,000
x 100
500,000
= 25%
This percentage measures the ‘bottom line’ level of profit (after all expenses have been deducted) in relation to sales.
Mr. Barry
A-level Accounting Year 12

11. A-level Accounting Year 12 A-level Accounting Year 12
4. Return on capital employed
Return on capital employed (ROCE) = operating profit* x capital employed**
Operating Profit ,000
*Profit before interest and tax
** Equity + Non-current Liabilities
Balance Sheet
Non-current Assets ,450,000
Current Assets ,000
Less Current Liabilities 100, ,000
2,500,000
Less Long-term loan ,000
2,000,000
Financed by:
Capital and Reserves ,000,000
125,000
x 100
2,000,000 +
500,000
= 5%
This percentage shows the return the business is making on its long-term capital.
Mr. Barry
Mr. Barry
A-level Accounting Year 12
A-level Accounting Year 12

12. A-level Accounting Year 12
gross profit x sales
1. Gross profit percentage =
Profit related to selling the product
net profit x sales
2. Net profit percentage =
Profit made after all expenses have been deducted
3. Return on capital employed (ROCE) =
operating profit x capital employed
Return on long-term capital
Mr. Barry
A-level Accounting Year 12

13. A-level Accounting Year 12
Liquidity Ratios
Mr. Barry
A-level Accounting Year 12

14. A-level Accounting Year 12
What is liquidity?
The liquidity of a business is based on the short-term resources it has: cash in the bank, money due from debtors, stock it can sell - these are current assets
Liquidity is needed to pay off short-term debts: short-term loans, tax bills, money due to creditors - these are current liabilities
The liquidity of a business = current assets minus current liabilities: this is known as ‘working capital’ or ‘net current assets’
A business that has little or no liquidity could easily fail, so it is important to be able to measure the liquidity
Mr. Barry
A-level Accounting Year 12

15. A-level Accounting Year 12
1. Current ratio
Liquidity ratios are based on the current assets and current liabilities of a business
current assets current liabilities
150,000
100,000
Current Assets
Inventory 40,000
Debtors ,000
Bank , ,000
Less Current Liabilities
Creditors ,000
Net Current Assets ,000
= 1.5 : 1
(or 150%)
The current ratio is an indicator of the ability of a business to meet its short-term liabilities.
Mr. Barry
A-level Accounting Year 12

16. A-level Accounting Year 12
2. Liquid capital ratio/ Acid test ratio
The liquid capital ratio is the current ratio with stock deducted from the current assets
current assets - stock current liabilities
150,000
- 40,000
100,000
Current Assets
Inventory 40,000
Debtors ,000
Bank , ,000
Less Current Liabilities
Creditors ,000
Net Current Assets ,000
= 1.1 : 1
(or 110%)
The liquid capital ratio is more demanding: stock is deducted because it may not be sold so easily or quickly.
Mr. Barry
A-level Accounting Year 12

17. A-level Accounting Year 12
3. Inventory turnover
There are further indicators which relate to liquidity; some are quoted in days/ times rather than percentages
This can be calculated in two ways:
average inventory x 365 days cost of sales
cost of sales average inventory OR
Trading Account
Sales ,000
Opening inv ,000
Add Purchases ,000
290,000
Less Closing inv ,000
Cost of Sales ,000
Gross Profit ,000
Average stock =
(60,000 +
40,000)
÷ 2
= 50,000
50,000
250,000
= 73 days
Mr. Barry
A-level Accounting Year 12

18. 4. Receivable/ debtor days
The debtor collection period is the average number of days debtors take to pay their invoices
The debtor collection period can affect the liquidity of a business: slow payers can cause a shortage of cash
The formula is:
debtors x 365 days credit sales
Current Assets
Inventory 40,000
Debtors ,000
Bank , ,000
72,000
x 365 days
436,000
= 60 days
30 to 60 days is often an acceptable figure. Too many overdue debts may cause liquidity problems.
Trading Account
Sales: on credit ,000
cash sales ,000
Mr. Barry
A-level Accounting Year 12

19. A-level Accounting Year 12
5. Payables/ creditor days
The creditor payment period is the average number of days taken to pay supplier invoices
The creditor payment period can affect the liquidity of a business: paying too quickly can cause a shortage of cash
The formula is:
creditors x 365 days credit purchases
100,000
x 365 days
Current Liabilities
Creditors ,000
220,000
= 166 days
Trading Account
Purchases: on credit ,000
cash purchases 10,000
30 to 60 days is often an acceptable figure; 166 days shows slow payment to creditors.
Mr. Barry
A-level Accounting Year 12

20. A-level Accounting Year 12
Summary of liquidity ratios
Current ratio compares current assets and current liabilities to provide a basic indicator of liquidity
Liquid capital ratio takes the current ratio and deducts stock from current assets to provide an indicator of short-term liquidity
Stock turnover calculates the average number of days for which stock is held; an unusually high figure may indicate a business unable to sell its stock
Debtor collection period indicates the average number of days debtors take to pay their invoices; an unusually high figure indicates a business that is poor at credit control
Creditor payment period indicates the average number of days taken to pay supplier invoices; an unusually high figure indicates a business that has liquidity problems
Mr. Barry
A-level Accounting Year 12

21. A-level Accounting Year 12
Gearing Ratio
Mr. Barry
A-level Accounting Year 12

22. A-level Accounting Year 12
Measuring the financial strength
A business that is too reliant on long-term external finance, e.g. bank loans, can become vulnerable
A business that is financially strong will have substantial capital and reserves from accumulated profit
Non- current Liabilities x Equity Capital
The formula is:
Balance Sheet
Fixed Assets ,450,000
Current Assets ,000
Less Current Liabilities 100, ,000
2,500,000
Less Long-term loan ,000
2,000,000
Financed by:
Capital and Reserves ,000,000
500,000
2,000,000
= 0.25 : 1
or 25%
Gearing over 1 : 1 or 100% is not a good sign because the business is too reliant on external finance.
Mr. Barry
A-level Accounting Year 12

23. A-level Accounting Year 12
Measuring the financial strength
A business that is too reliant on long-term external finance, e.g. bank loans, can become vulnerable
You can also use capital employed to calculating gearing:
Non- current Liabilities x Capital Employed
The formula is:
Please be able to explain the results of the gearing ratio as it could be a possible exam question this year
Mr. Barry
A-level Accounting Year 12

24. An introduction for May 2017
Analysing Ratios
An introduction for May 2017
Mr. Barry
A-level Accounting Year 12

25. Gross Profit margin and Mark up
What does the result of these ratios tell you about business performance?
GPM
* How much GP as a proportion of sales
* How much GP in pence to every £1 of sales
Mark Up
* GP in relation to cost of sales
* for every £1 of cost of sales how much GP
(in pence) is being made
Mr. Barry
A-level Accounting Year 12

26. Gross Profit margin and Mark up
(Both ratios) What if the % is increasing?
Either that the business has changed its pricing policy and has put up selling price
Or the business is paying less for it’s cost of sales
(Both ratios)
Changed pricing policy and put down it’s selling price
Or the business is paying more for it’s goods it buys in and sells on.
Mr. Barry
A-level Accounting Year 12

27. Net Profit margin/ profit in relation to revenue
What does NPM and Overheads/ turnover %’s tell us about business performance?
NPM % tells us:
How much net profit is being made in relation to sales
How much net profit is being made for every £1 of sales
If the % increases:
Either the business is making more Gross Profit
Or that costs have been held at a previous level or reduced
Or some combination of these factors
If the % is decreasing:
Either the business is making LESS gross profit
Or that costs have risen above previous levels
Mr. Barry
A-level Accounting Year 12

28. Overheads in relation to revenue
The overhead / turnover % tells you:
How much is being spent on an overhead in relation to turnover
For each £1 of sales how much in pence is being paid for an overhead
Mr. Barry
A-level Accounting Year 12

29. Net Profit margin and Overheads / turnover ratios
If % is increasing:
The business is less efficient than it was previously in regard to controlling costs
If the % is decreasing:
The business is more efficient than it was previously in regard to controlling costs
Mr. Barry
A-level Accounting Year 12

30. Return on Capital Employed
The ROCE ratio % measures:
Net profit in relation to capital employed
How much profit (in pence) is made for every £1 of capital employed
If the ROCE ratio is increasing:
Either the business is making more net profit
Or the business has employed less capital
Or some combination of both these factors
That every business is using its resources (in the form of assets) more effectively
Mr. Barry
A-level Accounting Year 12

31. Return on Capital Employed
If the ROCE ratio is decreasing:
Either the business is making less profit
Or the business has employed more capital
Or a combination of the above
That the resources it uses are done so less effectively
You can compare this figure with other businesses for investment, return and efficiency purposes, as well as investigating the level of risk involved in investing (instead of saving)
Mr. Barry
A-level Accounting Year 12

32. A-level Accounting Year 12
Examiner’s Tip
Approach data in a simple way to start with, for example:
What’s happened to turnover?
What has happened to the ratios?
Is there a pattern of change in the ratios a good or bad thing for the business.
Then try to see if you can deduce any important information from the data that can help make a judgement about a business’s success.
Try to explain what may have caused the changes in the
ratio
Have a clear view point as to whether the business
performance is improving or not
Mr. Barry
A-level Accounting Year 12