1. Unit 3 Accounts & Finance
Ratio Analysis

2. Learning Objectives To be able to calculate ratios
To be able to use ratios to interpret and analyse financial statements from the perspective of various stakeholders
HL – To evaluate the possible financial and other strategies to improve the values of ratios

3. Five main groups of ratios
Profitability ratios
Gross Profit Margin
Net Profit Margin
ROCE
Mark-up
Liquidity ratios
Current Ratio
Acid Test Ratio
Financial efficiency ratios
Stock (inventory) Turnover Ratio
Debtor Days Ratio
Creditor Days Ratio
Shareholder or investment ratios
Dividend Yield Ratio
Earnings per share ratio
Gearing ratios
Gearing Ratio
Accounting Ratios
Key word – Efficiency
How well a firm is using its resources

4. Profitability Ratios
Profitability – How profitable a firm is in relation to sales and assets
1. Profit Margin Ratios
Gross profit margin and net profit margin ratios are used to see how successful a business has been at converting sales revenue into both gross and net profit
They measure the performance of a company and its management team

5. Profit Margin Ratios Gross profit margin (%) = gross profit
sales revenue
Net profit margin (%) = net profit
You can work out gross profit like this…
Total Revenue – Cost of sales
X 100
X 100

6. How to use Gross profit and Net profit margin ratios
Gross profit margin is a good indicator of how effectively managers have ‘added value’ to the cost of sales
It is misleading to compare the ratios of firms in different industries because the level of risk and gross profit margin will differ greatly
When 2 firms are being compared and their gross profit margins are very different but net profit are more alike it suggests one company may have relatively high overheads
Can also compare with previous years

7. Evaluting ways to increase profit margins
Method to increase profit margins
Examples
Evaluation
Increase gross and operating profit margin by reducing direct costs
Use cheaper materials
Cut labour costs by re-locating production to low labour cost countries
Cut labour costs through automation
Cut wages
Quality issues
Quality issues – communication problems with distant factories
Purchasing machinery will increase overhead costs
Motivation levels may fall
Increase gross and operating profit margin by increasing price
Raise the price of the product with no significant increase in variable costs. EG. Raising prices
1. Total profit could fall if too many consumers switch to competitors
Increase net profit margin by reducing overhead costs
Cut overhead costs, such as ret, promotion or management costs but maintain sales levels
1. Moving to a cheaper area could damage reputation, fewer managers could reduce efficient operation of business HL

8. 2. Return on capital employed (ROCE)
Profitability Ratios
2. Return on capital employed (ROCE)
Most commonly used means of assessing the profitability of a business – sometimes referred to as the PRIMARY EFFICIENCY RATIO
ROCE (%) = net profit
capital employed
X 100
Capital Employed = (non-current assets + current assets) – current liabilities

9. 2. Return on capital employed (ROCE)
Higher the value of this ratio, greater the return on the capital invested in the business
The return can be compared with other companies and with the ROCE of previous year’s performance
Result can also be compared with the return from interest accounts (Could the capital be invested in a bank at a higher rate of interest and no risk?
ROCE should be compared with the interest cost of borrowing finance – If it is less than this interest rate, then any increase in borrowings will reduce returns to shareholders
ROCE can only be raised by increasing the profitable, efficient use of the assets owned by the business, which were purchased by the capital employed

10. Profitability Ratios X 100 3. Mark-Up Ratio
Mark up is the amount of profit added to the cost of sales.
A low mark up might indicate an attempt to increase profit by gaining a larger market share
Mark-Up (profit margin) = Gross profit
Cost of goods sold
X 100