1. Ratio Analysis GCSE Business Studies tutor2u™
Revision Presentations 2004

2. Introduction
Analysing financial performance is about judging the successes and failures of a business by considering a number of financial measures. Most of these measures are known as ratios.
A ratio is a measure of one piece of information in terms of another
A non-financial ratio might be the numbers of boys to girls in a class, or the number of GCSE passes in business studies as a percentage of all the GCSE passes in the school.
Ratios are normally compared with the previous years’ figures or with figures from competitors to see whether the business has improved or not and whether it is better or worse than a rival.
The main areas that ratios look at are:
Profitability
Financial efficiency
Liquidity

3. Who Might Use Ratio Analysis
Anyone with an interest in the financial performance of the business will find ratio analysis useful
Owners/shareholders (e.g. return on investment; profitability ratios)
Employees (e.g. profitability ratios)
Managers (the full range)
Creditors and banks (e.g. liquidity ratios)
Competitors (profitability and liquidity ratios)
Government (e.g. the Inland Revenue – who calculate how much tax is due by a business)

4. Profit and Profitability
Profit is an absolute measure – it equals sales revenue less costs
Profitability is a relative measure – it shows amount of profit “relative” to what created profit
e.g. ROCE investment ratio measures relative profitability of a business compared with amount of capital invested in business.

5. Profitability Ratios What are they? Why use them? Gross profit margin
Operating profit margin
Why use them?
Insights into how well the business is trading in its markets
Is sales revenue being maximised?
Are costs being kept under control?
Analyse and spot favourable and unfavourable trends
Compare performance with competitors

6. Gross Profit Margin Calculation Why it might increase
Gross profit divided by sales (expressed as a percentage)
Why it might increase
Increase in selling price of existing products
Introduction of new products which achieve a higher gross profit margin
Reduction in cost of sales e.g. a fall in raw material prices

7. Gross Profit Margin - Example

8. Return on Capital Employed (“ROCE”)
How calculated:
Net profit as a percentage of capital employed
Also known as primary efficiency ratio - a better indicator than profit alone of how well a business is using money invested
Shows how much profit is being generated from investment compared with alternative investments in similar businesses or with interest from bank deposits

9. ROCE Example

10. What does ROCE Tell Us? Three main things to look for
The change in ROCE from one year to the next
The ROCE earned by other companies (if this information is available)
A comparison of the ROCE with the cost of borrowing money (i.e. is the business making a ROCE that makes borrowing worthwhile?)
Ways to increase ROCE
Increase net profits without increasing or introducing new investment
Reduce amount invested in business by selling assets that do not contribute to profit earned

11. Net Profit Margin How calculated
Amount of net profit generated per pound of sales
Calculated as net profit divided by total sales (or revenues)
Expressed as a percentage

12. Net Profit Margin - Example

13. Liquidity Ratios Concerned with ability of business to pay its debts
Ratio of short-term liabilities to liquid assets
Indicate ability of business to cover its short term liabilities
Liquid assets are those assets that held in cash form (e.g. cash at bank) or can be turned into cash very quickly
Main ratios:
Current ratio
Acid test ratio

14. Current Ratio
Calculation: Current assets divided by current liabilities
Interpretation
How to improve the current ratio
Increase value of profitable sales
Turn its overdraft into a long term loan (reduces short-term liabilities and increases capital)

15. Acid Test Ratio Liquidity ratio – similar to current ratio
It is a tougher test of liquidity
Stock takes longer to turn into cash – so are excluded from current assets in calculation

16. Stock Turnover Number of times stock is turned into sales
Higher figure, more quickly stock has been sold or turned over
A fruit stall will have a higher figure of stock turnover than a car dealership

17. Reasons for an Increase in Stock Turnover
Lower stock levels
Disposal of slow moving or obsolete stock
Reduction in range of products stocked

18. Debtor Days Working capital ratio
Number of days it takes for a business to collect money from customers who have bought products on credit

19. Encouraging Debtors to Pay Quicker
Offer discounts for early payment
Threaten to take customer to court
Refuse to supply more products or hold back part of an order until payment has been made

20. Creditor Days
Number of days it takes for business to pay creditors.